Just suppose, for the sake of argument, that base rates do have to go up to protect sterling at some stage in the autumn. One might argue that the chances are better than even that they will not, and point to things like the latest opinion poll in France which suggests that the French will vote 'yes' to Maastricht as a confirmation that tensions in the exchange rate mechanism will tend to decline.
One could point to the natural tendency for currencies at the bottom of their ERM bands to strengthen because, providing the bands retain their credibility, the risk/reward ratio for being in a currency at the bottom is extremely favourable: the currency can only go up.
Then there are the reserves. Providing there was no general crisis of confidence, the Bank of England in theory could go on supporting sterling at its ERM floor for some time without having to run down the reserves to a dangerous level.
But even if the chances are a little better than even that rates will not go up, there is a significant possibility that base rates will have to rise. It would be absurd to deny that. The Treasury therefore ought to have a plan for damage limitation. What might this be? The central plank of any such contingency plan must be to bolster consumption.
There is a reasonable intellectual case to be made that a rise in interest rates would not have as much of an impact on either the personal or the company sector as many people think. It is worth remembering that individuals have, in total, more savings than debt. A rise in interest rates tends to increase the return on those savings, so that in total, there should be more money to spend. That helps explain why very low interest rates in the US and Japan have failed to stimulate consumers - the number of savers who lose income is larger than the number of borrowers who gain.
In practice, however, at least in Britain, a rise in rates would almost certainly hit consumption, largely because of the link between interest rates, confidence and the housing market. Anything which hits confidence and/or house prices is liable to make people save yet more. This might seem a recipe for supporting house prices, perhaps along the lines suggested by Abbey National yesterday. But while there are legitimate reasons for wanting to shave off the bottom of the house price cycle, helping housing is a slow and indirect way of helping consumption.
If one believes that a fall in consumption, particularly in demand for big-ticket consumer durables, would be very dangerous at this fragile stage of the recovery, then one should target consumption itself. But how?
Enter the Germans. One of the tactics used in German fiscal policy is to adjust tax levels for a specific period. In Britain this measure has been tried for the housing market, by giving relief on stamp duty for a limited period, now ending. It has not been a wild success. Why not, instead, attack consumer spending directly by cutting VAT for a specific period?
The Chancellor, faced with flat or declining consumption at the time of the autumn statement in November, would announce that VAT would be cut to 15 per cent until, say, the end of the financial year, when it would go back to 17.5 per cent. This would cost money but not an impossible sum: the net cost would be of the order of pounds 2 billion.
The aim would not be to boost the general level of consumption permanently: rather it would be to encourage people planning to buy big-ticket consumer durables to bring forward their purchases. Because the cut would be temporary, it would not deflect the Government from its long-term strategy of shifting the burden of taxation away from direct and towards indirect taxation. Unlike income tax cuts, the money 'given back' could not be saved. And unlike additional public spending, which takes months to plan if the cash is to be used sensibly, the money would go straight into the economy from day one.
There are, of course, objections. One might be that such a move would simply encourage more imports. The argument here is that import penetration of consumer durables is so high that the benefit would not go to British manufacturers.
To some extent that is true: there is bound to be some leakage into imports. But even imports create employment and activity, for they help the transport and distribution sectors. Furthermore, come the winter there are some structural reasons for being less concerned about the trade deficit, for oil output will be building up sharply as new fields come on stream, and Japanese car production will be rising thanks to the investment of recent months.
Another objection would be that when the cuts were over, the economy would flop back. Maybe, but the aim of the plan is not to try to give a permanent boost to consumption, but to help bring forward the recovery by a few months.
Another objection would be that the public sector borrowing requirement is already close to the credible financing limit. It would, it could be argued, be seen as unwise to increase it further. The answer to that would be to point out that this, unlike virtually all other tax measures, is a once-and-for-all venture. While it costs money in the short run, it does not damage the medium-term profile of the Government's finances.
Finally, the measure has a short-term advantage in cutting prices: it brings down the headline rate of inflation for a few months. While that does not help the underlying inflationary picture, core inflation is falling so rapidly that by the time VAT was to go up again, the retail prices index would be less of a problem indicator. In other words, a temporary cut in VAT would not only bring forward some of the expected rise in consumption: it would also bring forward some of the expected fall in the RPI.
The more one looks at this wheeze, the more attractive it becomes. It is quite possible that it will not be needed, that the pound will hold up, that the Germans will start to trim their interest rates in the late autumn, and that the recovery will become more secure without artificial stimulants. But as stimulants go, it appears remarkably free from unwanted side effects.Reuse content