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Are low interest rates the answer – or the problem?
There is a near universal belief among economists, politicians and the public at large that low interest rates encourage economic growth. In the UK, we have had 0.5% bank rate since March 2009 and City economists keep putting back their estimates of when it might rise. The current consensus is that it will not happen until November 2015!
Having painted itself into a corner with interest rates, the Bank of England conjured up Quantitative Easing to further stimulate the economy. QE has not been without its detractors, both for its inflationary impact and because some think it benefits the banks rather than the real economy. The Bank of England admitted that the first bout of QE increased CPI inflation by 0.75% to 1.5%, but claimed that it boosted the economy by between 1.5% and 2%, reducing yields on medium-dated gilts by 1%.
The Bank of England gets its sums wrong
But was the Bank of England right? The Bank of International Settlements – the central bankers’ bank – thinks not. Instead of 5-25 year gilt yields falling by 100 basis points (1%), the BIS believes QE pushed them down by just 27 basis points (0.27%). And while the Bank reckons that the second bout of QE will be as effective as the first, the BIS disagrees: “It may be harder to achieve the same degree of effectiveness as with the initial programmes once the surprise or novelty element wanes”.
We have been arguing that the Bank is not only wrong about QE, but also about the effect of long-term negligible interest rates. On The World at One before Christmas, Bank of England Deputy Governor Charlie Bean was challenged on this. Less fluent than elsewhere, he stammered that, “Had we tried to rein inflation back sharply this year that would have led to too sharp a contraction in activity and what we would also find is inflation dipping well below the target next year.”
Despite saying, just over a year earlier, that savers should stop complaining and start spending to help the economy, Mr Bean now claims to “have every sympathy with savers. They weren’t the people who caused the financial crisis but they are carrying a considerable burden of the adjustment to it.”
Is it time to raise interest rates?
Given the state of the economy after almost three years of 0.5% base rate, it is remarkable how few people – other than us – have queried whether low interest rates are having the desired effect. Anthony Hilton, Financial Editor of the London Evening Standard, is almost alone in daring to challenge the consensus. Recently he wrote an editorial headlined: “Time to look at raising interest rates?”
“There is,” he wrote, “an argument that the policy of minimal interest rates is approaching its sell-by date. The problem is it perpetuates the sense of abnormality in the economy, and as such it could hinder rather than help the return to normality which everyone craves.” Low interest rates are not stimulating corporate investment, he points out, but serving to remind companies of the abnormality of the economic environment.
He acknowledges that rate rises might cause problems to over-extended borrowers but reckons that many problem loans have already been dealt with and that higher rates would inject some urgency into sorting out the rest. Some urgency is clearly needed, for the persistence of the low interest rate environment is not curbing the appetite or demand for debt. According to the Bank of England, there is “little sign that households in aggregate are making an active effort to pay down debt more quickly than in the past”, a survey by Shelter finds that almost a million people have taken out payday loans to help pay rent or their mortgage in the past year while offers of 0% interest on credit card debt have again become common.
Hilton believes there would be several benefits from raising interest rates. It would put money back in the pockets of those who have saved to supplement their pensions. As we have consistently argued, much of this extra income would be spent, boosting consumption.
Banks, building societies and insurance companies, struggling on minimal profit margins with rates near zero, would be healthier and thus more likely to lend.
Higher rates would also slash the deficits of pension funds and lift a major funding burden from companies.
People are emotional, not rational
Hilton concludes that, “We are running with an economic theory that assumes people are rational rather than emotional. Conventional economic wisdom says low interest rates deliver economic activity because they make it easier for entrepreneurs to turn a profit on an investment. But since Keynes in the Thirties we have also understood that low interest rates might not drive such behaviour when people are simply too depressed or too scared to think their projects will work. That is where we are now. When rock-bottom interest rates present a daily reminder that things are far from normal, it is surely possible they are adding to the uncertainty rather than bolstering our fragile confidence. Perhaps it is time to see them as part of the problem, rather than part of the solution.”
Even Mr. Bean acknowledges that low interest rates can cause problems. “If you have a very long period of low interest rates it leads to a build up of distortions, takes away the incentive for people to save and that’s something we want to encourage in the long run.”
If interest rates do not rise until late 2015, will there be anybody left willing to save? Will there be a new generation of savers or will young people, having seen how savers sacrificed to bail out the imprudent, consider it a foolhardy thing to do?
According to This Is Money on 29th December: “The Governor is under intense pressure from the likes of campaign group Save Our Savers who predict that Britons will lose £42billion over the next 12 months thanks to the toxic combination of low rates and high inflation eating away at the spending power of cash.”
We intend to keep that pressure up in 2012 and hope that more commentators will break with the consensus, follow Anthony Hilton’s lead and question the policy of long-term low interest rates. Otherwise, if those City analysts are right, we could be in for four more years of this lunacy.