Rate cuts can help cure economic ills, but are not a magic bullet

With deflation looming, central banks will make money cheaper over the coming months

It is rate-cutting time again, with an almost certain cut from the European Central Bank later today. Rates in the US, too, are set to fall. So both the US and Europe are now in the middle of a huge economic experiment in discovering whether cheap money can really give a sustained boost to demand.

The story is slightly different on the two sides of the Atlantic. Rates have fallen so far already in the US that the question is whether they can continue to encourage Americans to borrow to maintain consumer spending. In Europe the cuts have come through more slowly and the position is complicated by the fact that countries with very different inflation rates all have the same interest rate. As a result, the most immediate question is whether rates have come down far enough to stop the region's largest economy, Germany, following Japan into a period of deflation.

The US story will be familiar to people in Britain, for it is one of a boom supported by consumption. Americans, like Britons, have borrowed to maintain their living standards, with consumption taking an increasing proportion of national income.

You can see the extent to which spending has run ahead of income in the first graph. In every downturn people try to maintain their living standards but the gap that has opened up in this economic cycle looks larger than that of the early 1980s or early 1990s.

Much of the additional borrowing has been against the security of people's homes. In the next graph you can see the surge in equity take-out, which is almost as high proportionately in the US as in the UK, and the relationship with house prices. Alan Greenspan, the chairman of the Federal Reserve, does not think there is a house price "bubble" and he may or may not be right. But that level of equity withdrawal is not sustainable and the most recent signs are that American consumers have started to pull back their spending.

It is very tempting to borrow more when you are accustomed to expensive terms and suddenly find borrowing is virtually free. But high interest rates were associated with high inflation, whereas the price of goods in the US (and the UK) is falling. The only thing that is keeping the consumer price and retail price indices in the positive zone is a surge in service industry charges. Once people realise that they are repaying debts in money that is worth more, not less, they will be less willing to borrow. And were house prices to start to fall, banks would be less willing to lend against them.

Some fall-off in consumption would also square with the fall-off in confidence, as reported in surveys of consumer opinion. HSBC, which produced the graphs above, thinks that consumption will rise by only 1.5 per cent this year and that there is a risk of an outright decline in consumption in the three months starting end-March.

If that is right, what can the Fed do? Rates are already so low that further cuts have only a symbolic impact. If you are not borrowing because you are worried you are about to lose your job, another quarter per cent off money market rates is neither here nor there. The only thing that would change matters would be for companies to get hiring again. And there is not much sign of that. Eventually the US economy will recover of course and cheap money will contribute to that. But by postponing the pain, the Fed may well have also postponed the recovery.

In Europe the problem is different – in Germany, very different for the Germans don't spend. You can see the way in which consumption has run ahead in both the US and UK but has plunged in Germany.

So why have Germans not taken advantage of low interest rates to borrow more? The answer is doubtless partly cultural and institutional. There is less of a tradition of borrowing to support a higher standard of living and a less developed consumer loans industry, pressing money on people. It is also partly because house prices are falling in Germany, not rising, so the main collateral that people have to offer would not support equity take-out.

But it is also because real interest rates are higher in Germany than the rest of the eurozone.

Huh? Surely the whole point of the eurozone is that they all have the same currency and hence interest rates?

That is right, but they all have the same money interest rate, not the same real interest rate because different countries have different inflation rates. You can see the difference in the final graph, which shows that whereas the eurozone ex-Germany has near-zero real interest rates, in Germany they are still about 2 per cent.

As a result, several of the fringe countries with high inflation, such as Ireland, have real rates that are actually negative while the country with the lowest inflation, Germany, has rates that are too high.

Does this mean that Germany will follow Japan and slip into deflation? That is a question asked this week by two banking houses, HSBC and Goldman Sachs. HSBC thinks that it is in "clear and present danger" of so doing. It shows three out of the four characteristics of Japan a few years ago. These are a prolonged period of economic weakness, weak banking lending and a collapse of asset prices. It does not yet show the other sign, falling nominal wages, but reckons that core inflation in Germany will go negative next year.

Goldman Sachs is slightly more positive. It acknowledges that the euro has created serious difficulties for Germany and that it will continue to underperform economically. But it thinks that growth elsewhere in Europe will gradually pull the country up.

We will see. My own view for what it is worth is that Germany will indeed experience deflation. The modest structural reforms will be insufficient to compensate for having both the wrong interest rate and the wrong exchange rate – the latter more wrong, by the way, now that the euro is at a four-year high against the dollar.

So the experiments continue. The wonderful and terrifying thing about economics is that you only know whether a policy will work long after the event. When the US cut rates savagely in response to the slowdown, Americans congratulated themselves that they had managed to avoid the mistakes of the Japanese. When the euro was launched it was heralded as a move that would strengthen the European economy by making it more cohesive, giving it advantages of scale similar to the US. Those of us with slightly longer memories can also recall how Japanese policy in 1990/91 was praised because it seemed to be keeping Japan out of recession.

At a time like this, when the threat of deflation looms, cheap money is certainly more appropriate than expensive money. So welcome the cuts in rates that will keep coming through in the months ahead. But there is no magic bullet. Fortunately the world economy is self-healing and low interest rates create conditions where it is more likely to be able to heal itself. But it won't keep US consumers spending if they are frightened to do so. And I fear that in Europe the ECB will be unable to stop Germany slithering into deflation.