The road to recovery

Few economists believe the Chancellor has yet done enough to save Britain from a serious recession, but what other policy options does the UK have left? Sean O'Grady reports
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The Independent Online

More cuts in interest rates

Everyone agrees that these would be a "good thing"; but not all believe they will work. The Bank of England has reduced rates from 5 per cent as recently as October to 2 per cent now, the lowest since 1951. The Fed has gone even further, with the benchmark federal funds rate at 1 per cent. European rates stand at 3 per cent.

All will be lower soon: perhaps falling towards zero in a desperate effort to bolster consumer confidence and fix the money markets.

However, not everyone agrees this will work. First, cuts in official interest rates are only partly feeding through to households and businesses as the banks cannot or will not pass the cuts on to customers. Second, as John Maynard Keynes observed, where confidence has been drained from an economy and a deflationary mindset has set in, no rate of interest will outweigh the benefits of waiting to see prices fall. Relying on low interest rates in such circumstances was famously likened by Keynes to "pushing on a string".

Interest rate policy also has an obvious limit in that you cannot easily reduce rates below nil; so other measures may be needed.

More tax cuts, higher public spending

France is the latest major economy to announce a fiscal boost. President Sarkozy's €26bn (£22.6bn) package amounts to about 1.5 per cent of French GDP, slightly higher than the value of the VAT cut and other measures announced by Alistair Darling in the pre- Budget report. It's also the generally agreed policy of the G20 to "use fiscal measures to stimulate domestic demand to rapid effect, as appropriate, while maintaining a policy framework conducive to fiscal sustainability".

However, Germany is sceptical, though the country has plenty of scope. The German fiscal deficit will be about 0.8 per cent of GDP next year – against 8 per cent in the UK and 4 per cent in France.

Yet Chancellor Merkel has only approved a boost of about 1 per cent of GDP, and is unwilling to go further. In the US, next year's US fiscal deficit will probably hit $1 trillion (£670bn), and President-elect Barack Obama's plans to save jobs and spend will add still more debt – but the proposals seem to have gone down well in the markets.

Quantitative easing

Or "printing money". This is what Fed chair, Ben Bernanke, has called "helicopter money" – dropping cash into the economy. The central bankers do this via "open market operations", where the government offers cash for assets, usually Treasury securities.

However, they could also buy "toxic waste" mortgage-backed securities, as originally envisaged in the Paulson plan and still on the table for the US, or corporate debt, or government securities, or second-hand cars if they really wanted to – just so long as the money hits the economy.

An alternative would be to leave the government's deficit unfunded; for example, by crediting the bank accounts of every pensioner in the country with £100. Longer term, this could create inflation. It was Bernanke himself who said a few years ago: "People know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation."

Unconventional measures

Can be closely related to printing money; for example, where the government is buying equities (as Japan did in the 1990s), or corporate debt. Perhaps the most interesting idea is to create a "Bad Bank". This has been the favourite idea of the Liberal Democrat Treasury spokesperson, Vince Cable, and the difficulties the banks are having in reducing their balance sheets in an orderly fashion has brought it back into contention.

A bonus would be that some of the so-called toxic debts are valued at nil because there is no market for them; but if held to maturity they might yield a respectable return. Crucially, buying corporate bonds would drive the current crippling cost of capital much lower.

Further bank recapitalisations

Openly discussed by the Bank of England and others. However the costly (to the taxpayer) recapitalisations so far have failed to transform the situation. Even though the banks have plenty of regulatory capital now, the markets are still unconvinced, as periodic pressure on their share prices shows.

Direct measures

The Government, as a majority or controlling shareholder in some of the major groups, could simply order them to lend, though they might be left with the problem of bad debts and lower profitability as a result. A statutory code of practice for the remaining, privately owned, bank groups would also, it would be argued by them, reduce their profitability and ability to build up capital from their own resources.

Nationalise the banks

Many arguments against this, not least competition and how a democratic government can decide which firms will live and which will die in a recession. The net effect may simply be to nationalise the bad debts the banks have run up. Nor does it repair the international credit markets.

Join the euro

Not impossible, if it is the price we have to pay for Europe saving our financial system. The problem is the size of the UK's banks in relation to her GDP. Not as bad as Iceland, on something like 700 per cent, but with total liabilities at 200 to 300 per cent of the national income – on top of our already colossal public and private debt mountains – the task may be beyond the nation's means.

Still, even Iceland didn't have to join the euro to survive, with the IMF providing life support instead.

Let a big bank fail, but save the depositors

The systemic damage would be huge, but it might be a rational way of facing up to the inevitable, and less costly than continually borrowing to prop up unsustainable institutions. It worked with Bradford & Bingley; why not others?

Government guarantees for lending

Already being implemented on a small scale and proposed by the Crosby report for a new generation of mortgage-backed securities. This is the nationalisation of the credit system, but easier to manage than nationalising the banks themselves.

Germany stands alone

The fact that Angela Merkel, leader of Europe's largest economy, was not invited to yesterday's European summit in Downing Street speaks volumes about the federal republic's hostility to the current vogue for Keynesian solutions, and the friction within the EU.

Last Friday Mrs Merkel said Germany would not "join in a multibillion race simply to create the impression we have done something".

Looking at the Japanese example – where years of spending and tax cuts left nothing except a huge legacy of public debt, the German government fears that large tax cuts may not have the expected impact because households would save them, that the semi-independent German Lander is borrowing too much anyway, and the Social Democrats oppose them.

German figures also worry about the longer-term effect that huge fiscal deficits will have on the credibility of the euro; the Stability and Growth Pact's rules on government debt are being increasingly ignored, a source of potentially even greater conflict within the EU.