Economics: Britain the misfit of the debtors

A wise Italian observer of Britain's membership of the European Community once said that it was like watching a cricketer in a club of skiers, because the UK's interests were so divergent from those of other member states. At the time, the conflicts were caused by Britain's status as a large food importer with few farmers. In a club of countries with lots of farmers and high support prices, Britain balked both at the high price of its imports, and at the budget cost of farm subsidies.

In the case of food, the genesis of the difference long pre-dated the Community. Britain repealed its protectionist corn laws in 1846, and Britain's urban dwellers were powerful enough to block any subsequent attempt to reimpose protection even when steamships on the North Atlantic halved the landed price of grain from the great plains in the last three decades of the century.

The genesis of the current conflict of interest between Britain and the rest of the Community is more recent, and need never have arisen had we joined the exchange rate mechanism when it began in 1979 rather than in 1990. During the intervening period, Britain adopted the fashionable economic policies of other Anglo-Saxon countries such as the United States, Canada and Australia, liberalising its financial services and thus making it much easier to borrow money.

The liberalisation was an unalloyed plus for corporate lending, particularly for start-ups. It went hand-in-hand with sharp increases in investment which improved the capacity of the economy to produce goods and services. But it went too far with personal lending. The run- up in personal debt fuelled the housing boom, which in turn encouraged more borrowing. The boom of the 1980s was fuelled by easy credit.

All of the Anglo-Saxon countries have had corresponding busts during the 1990s as their governments attempted to put the genie back in the bottle. All have suffered prolonged recessions as consumers have been hit by high interest rates. All have undergone agonisingly slow and faltering recoveries, despite sharp cuts in interest rates. The US Federal Reserve last week announced another half-point cut in the discount rate, which is now at a mere 3 per cent, its lowest level for 29 years.

On a conventional basis, US real interest rates - money market interest rates after deducting the amount due to lenders just to compensate for retail inflation - are a mere 0.4 per cent, against Britain's 5.6 per cent. Given that even those low interest rates have failed to spark a strong US recovery, why should we expect a strong upturn, or indeed any upturn at all, in Britain?

Constrained by our ERM commitments to pay higher interest rates than those in Germany, we are now in a unique position internationally, as Peter Spencer, now of Kleinwort Benson, has argued. Britain labours under an Anglo-Saxon debt burden while paying European real interest rates. This is not necessarily a cause for morbid depression, but it does mean that we are in uncharted waters. Anyone who says they are confident about what is going to happen is a fool, a knave or a City economist.

There are, though, some consoling thoughts. The first is that US interest rates are not quite as low as they look, so that the gap with the UK is not as wide. The international comparisons usually take interbank interest rates, because they are easily accessible. But they are not necessarily a good guide to the rates at which people can borrow. (Corporations are another matter, as they can borrow directly from the markets, and are often more creditworthy than the banks).

Because of the US banks' need for profits to offset their bad-debt problems, the margin - the spread, in bankers' parlance - between the interbank rates at which banks can borrow and the prime rate, which is effectively the lowest at which they lend, has widened sharply.

In 1989, it was about 1.5 to 1.75 percentage points. This year, it has varied between 2.5 and nearly 3.2 percentage points.

A proper calculation of the difference in real interest rates between Britain and the US also ought to take into account the flattering effect of mortgage rates on the UK retail price index. Using the underlying inflation figure, British real interest rates are 4.5 per cent against 2.9 per cent in the US, a difference that is unwelcome but hardly disastrous.

Moreover, UK debt may not be quite as onerous as that in the US. The latest OECD figures for debt payments as a proportion of income, reproduced in the graphs, are not strictly comparable internationally. For example, the higher US figure includes repayments of principal. Even so, they suggest that US consumers are paying out more than British ones. So we may be able to expect a dull and occasionally heart- stopping recovery like that in the US, rather than no recovery at all.

Another consoling thought is that the British savings ratio is a good deal higher than that in the US: last week's figures showed that UK saving as a proportion of income had reached 11.5 per cent. The US savings ratio is a little more than 5 per cent, and therefore has much less room to drop, particularly as much of that is in contractual arrangements (such as contributions to pension funds and life offices).

There is one last consoling thought, which is simply that the pattern of economic growth imposed by debt and high real interest rates is what is needed to work off the problems of the 1980s. Our ERM membership, as I argued on 21 June, is ensuring a rapid decline in inflation. That has two effects: it makes our tradable sector more competitive, which is good news for exports. But it also ensures that real interest rates actually rise, depressing home demand and imports. Both phenomena are likely to keep the trade deficit under control.

For the moment, options are in any case limited. The Chancellor could decide not to sell all the government bonds he needs to fund the public sector borrowing requirement: by mopping up fewer savings flows from the pension funds, he might lower long-term interest rates and redirect flows into the battered stock market. The old argument against such underfunding has lost its force now that money supply is growing so slowly.

More radical options usually have more radical disadvantages. A devaluation within the ERM would raise British interest rates, and provide still more help to an export sector that probably does not need it. A float outside the ERM would provide short-term relief at the probable expense of ditching all hope of a permanently lower inflation rate.

A German revaluation of the mark would cut German import prices and inflation. That would allow the Bundesbank to reduce German and other European interest rates, which would be splendid. But the French will not allow any change in the franc-mark exchange rate, so pleas for such a change fall on deaf ears. Apart from a change in the funding rule or some imaginative ways of persuading people to save less for a while, the Chancellor's best counsel remains patience.