Hamish McRae: A message to borrowers - if you don't want expensive credit, cut back while it's cheap

Maybe, just maybe, this upward cycle of interest rates is going to surprise us by not rising as much as some people seem to expect - and by turning down sooner.

Maybe, just maybe, this upward cycle of interest rates is going to surprise us by not rising as much as some people seem to expect - and by turning down sooner.

That would be the good news, or good news at least for British home- buyers. The bad news would be the reason for all this - that worldwide growth next year will be lower than people currently expect.

The argument goes like this. World growth has been puffed up by cheap money and easy fiscal policies. This has been especially evident in the US but also, to a lesser extent, in other countries. A huge boost to demand has been delivered by the swing from surplus to deficit - all those public sector jobs - as well as rising consumer borrowing. Most of continental Europe has public sectors in substantial deficit, as does Japan. But the most notable global splurge is taking place in China, where both consumption and particularly investment have been whistling up at hair-raising rates. Chinese demand is one of the main reasons the oil price has been so strong. This rise has helped increase inflationary fears more generally, which is why everyone expects more expensive money in the months ahead.

The most recent signs have been that the US economy is growing faster than Federal Reserve chief Alan Greenspan expected - or at least that is what he is telling people - and this has led to predictions of a rise in rates. Here, Mervyn King, the Governor of the Bank of England, has been warning about unsustainable house price rises, which is being taken to mean that further rate increases will come swiftly. In continental Europe, it is now generally accepted that the next move will be up, not down.

However, there are a number of reasons to suspect that this upswing may not be very steep or prolonged. One is that the US recovery may falter next year. At some stage, even Americans will not want to take on yet more debt, particularly if their house prices start to fall. As in Britain, the general perception is that homes are overpriced.

Another reason is that growth in China seems likely to slow, maybe very suddenly, in the next year. The authorities are trying to rein back an investment boom. Even if they succeed in doing so gently, Chinese demand for raw materials and for oil will ease, reducing the pressure on world energy prices and hence world inflation.

Here, the authorities are determined to avoid what seems to have happened in Australia, where house prices are estimated to be nearly 40 per cent overvalued. Australia led the upward movement in interest rates (left-hand chart) and the central bank warned repeatedly of its concerns about the housing market. Now, two years after it started the credit-tightening cycle, prices are starting to fall. But if that decline becomes too dramatic, expect Australian rates to starting coming down again - and they are only just over 5 per cent.

In so far as Britain has a similar housing finance structure to Australia, it is perfectly plausible that base rates of, say, 5.5 per cent would be enough to check property inflation here. Actually, there have been signs recently that prices, in some areas at least, have stopped rising.

The view of HSBC is that central banks in general have left interest rates too low for too long, so encouraging people to take on too much debt. Since even small increases could be very unsettling, the result will be that rising rates this year are followed by falling ones in 2005.

That might sound like good news but it isn't really. The possibility is that what we may see, once this present little upward spurt in inflation is over, is a return to widespread deflation. Central banks all over the world are trying to convey a message that borrowers should be careful. Mr King is making that message explicit. It is: we may have to increase rates further and that may have more of an impact on house prices than you expect. The message is more opaque in the case of Mr Greenspan but he, too, is trying to signal concern that people have assumed rates will stay very low for ever, which they won't. Both are trying to use words to influence behaviour so that future action does not need to be so tough.

And there's the rub. Provided people cut back their borrowing now - or at least slow the rate of increase - interest won't need to go up much. So how high do rates have to rise and when will they start to come down?

How high? Focus on the UK. The right-hand chart looks at real interest rates over the past 10 years - actual rates adjusted for the rise in the consumer price index (CPI). CSFB, which did the chart, calculates that the average real interest rate is just under 4 per cent. Inflation is currently 1.5 per cent on the CPI measure, so our rates have to go up to 5.5 per cent to match that average. Anything higher and they will be above it. That is not a ceiling, of course, but it is at least a target to aim at. We have borrowed so much, even that ought to start worrying people, so don't expect rates to go much higher than this.

And when will they start falling? That depends partly on us: the sooner we cut back borrowing, the sooner rates will come back. But it also depends on the US: will rising rates next year, after the election, frighten US borrowers, too? And it depends on China: if there is a sharp fall in investment there, and a fall in commodity prices and the oil price, global inflationary pressures will wane. That would support conditions for lower rates. The HSBC view is that the cost of borrowing could be falling by the second half of next year in both the US and UK. That seems pretty plausible to me.

Everyone agrees Europe needs pension reform. So why is it so hard to accomplish?

Reports urging the case for Europe to make economic reforms keep coming. The Economist Intelligence Unit produced a report last week arguing that the pension position of most EU members was unsustainable. "Demographic decline will be the biggest social and economic challenge that Europe will face over the next 50 years," says Daniel Franklin, the editorial director of the EIU.

It splits the EU countries into three groups: those with a fair outlook (the UK, Ireland, Netherlands and the Nordics); those with an unsettled one (Belgium, France, Germany, Hungary, Poland, Portugal, Slovakia); and those with a stormy one (Austria, the Czech Republic, Greece, Italy and Spain). If our relatively benign demographic outlook means we will all have to carry on working until we are 70, as the stories last week suggested, think what it will be like in Italy and Spain.

But we know all that. In a way, what is more interesting than the need for reform is the inability to carry it through. Why is change so difficult?

That question was posed last week by Val Koromzay, the director of country studies in the OECD's economics department in Paris. His paper starts with the observation that most economic reform either copes belatedly with problems, or takes one step forward and one step back.

His argument is that to have real reform, two factors must come together: a popular awareness that "things have to change" and a leadership that can translate broad dissatisfaction into policies. How do you spot a real reform rather than an arbitrary change in policy? He argues that real reforms are those that take away the inefficiencies in the system - including the benefits that those inefficiencies bring to the few.

The economist calls these distorting benefits "rents", which has nothing to do with rent on a flat, but rather the extra payments some groups receive from others because of distortions in the economy. For example, unions in monopoly services can extract more for their workers than they would get in the open market. The buyers of the service have no option but to pay, but there is no net gain: money is simply taken from one group and given to another. Or there are tax loopholes and subsidies which enable some people to gain at the expense of the broad mass of taxpayers.

In the first instance, the way forward is to remove the monopoly; in the second, close the loophole and cut overall tax rates. But both cases have losers who can block reform.

So, you need a crisis and a government with clear ideas of what to do about it. Dr Korom- zay cites the UK in 1979, the Netherlands and New Zealand in the 1980s, and much of Scandinavia in the early 1990s as examples where this worked. But Japan in the 1990s and the six founding EU countries since then were not prepared to make changes. Do things have to get worse before they get better? Sadly, it seems so.