Hamish McRae: If the traditional policies don't work, unconventional ones carry risks too

Economic Life
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The Independent Online

Welcome to the world of zero interest rates. They are now pretty much there in the United States we will probably get close in the UK some time in the new year; and I would expect a further cut in eurozone rates during the spring.

We are also in a world of huge budget deficits. We don't know the plans of the President-elect but it seems safe from what he is reported to be planning to assume that the fiscal deficit will reach at least 8 per cent of GDP. Here in the UK that is bound to happen and to judge by the very latest borrowing figures, which are awful, the peak in borrowing may be higher still. On the Continent the levels of the deficits are to some extent constrained by the Maastricht process but, with the exception of Germany's, they are shooting up too. And Japan? Let's not go there.

So it will by the summer be a world where all the conventional monetary and fiscal shots have been fired. What then? I don't want to argue that these conventional policies will be completely ineffective – that would be to take the case too far. But I think from the evidence so far that they will not be as effective as the politicians hope. Looking at Britain, it is anecdotal of course but the cut in VAT to 15 per cent seems to have had negligible impact, and if so the money borrowed to pay for it will have been wasted. And since interest rates of 2 per cent here seem to have had zero impact on housing confidence, it is hard to see rates at 1 per cent or less having much effect either.

So there is a real possibility that come the summer there will be nothing left to do on either the fiscal or the monetary side. The reason for their apparent ineffectiveness may just be time lags: all policies take upwards of 18 months to have much effect. Or it may be that the compass of the problem is so global that whatever individual countries do they are not likely to affect the whole. But if for whatever reason the conventional policies are perceived to be ineffective that will be the moment that "unconventional" policies will be wheeled out.

They are mostly on the monetary side rather than the fiscal and they fall into two groups: those that put money directly into the financial system; and those that use the creditworthiness of the Government to support other borrowers. On the first, the ideas include not funding government borrowing fully and allowing an even wider range of bank instruments to be exchanged at the central bank for liquid treasury bills. Not funding the Government's borrowing is dangerous because it is seen as a slippery slope to Zimbabwe-style inflation. Instead of the Government borrowing on the market to cover its deficit it would simply create the money, printing it if necessary. But giving government guarantees is dangerous too. If a government guarantees someone's mortgage that makes the loan very attractive, but it also means that the taxpayer is taking on another liability and will have to pay up if the borrower defaults.

My point is simply that unconventional policies carry similar risks to conventional ones but that will not stop them being tried, for the great fear of policymakers is that we are facing a downturn from which escape will be very difficult, as happened in the 1930s.

So maybe that is a good place to go back to. I have been looking at some work by David Owen at Dresdner Kleinwort that seeks to set the present outlook in its historical perspective. For the three large countries, the US, UK and Germany, it was a relatively benign period for the UK, a grim one for Germany and a dreadful one for the US. Most people don't realise it because Franklin Delano Roosevelt's rhetoric was so powerful but the huge boost he gave to the US economy from the New Deal didn't really work. It was only rearmament at the end of the 1930s that got things going. Britain managed to engineer a housing boom that pulled the South and Midlands out swiftly with only the heavy industry areas being left behind. As for Germany, well it was early rearmament with all its consequences.

It is too big a subject to go into detail as to why the UK policy worked and the US one didn't. It was partly because the UK cut the link with gold early and got both interest rates and the exchange rate down, whereas the US delayed and also allowed many of the banks to fail. As a result we managed to rebuild confidence much more swiftly. This time we are not doing very well on the confidence front. That is partly because people are right to be concerned but it is also the result of government rhetoric, which unlike FDR, seems to want to play up the fears. When you have government ministers saying that this is the worst crisis since the 1930s, people can be forgiven for believing them. You can see their difficulty: the only way of justifying their fiscal policy is to say that things are terrible. But that does not excuse it.

Actually the more I think about this the more I am convinced that housing is the key. Once prices stabilise confidence will return and growth can resume. Calculations about prices relative to disposable income, show that the recent peak was no higher than those of 1973 and 1988 and lower than that of 1949. Since prices have fallen by 15 per cent already we are at least half way back to a base. Dresdner Kleinwort says that if prices were to fall by 30 per cent, allowing for the rise in income, by 2011 they would be close to their post-war floor. That feels right. There are a lot of people waiting around for the opportunity to buy in the next couple of years. That said, there is still a long way to go before the economy will be stable. Savings have to be rebuilt and that will constrain demand. People can no longer withdraw equity from their homes for obvious reasons but our savings ratio is the lowest it has ever been in peacetime. It went negative earlier this year and it will take a decade to rebuild.

So whatever happens it will be a long slog. But are the policy-makers actually harming things? Stephen King of HSBC, who of course writes in these pages on Mondays, has just done a paper about the long-term costs of these efforts to boost the economy. He quotes Jürgen Stark, a board member of the European Central Bank, who warned of the dangers of public losing confidence in financial policy: "We cannot and should not risk adding a fiscal crisis to the financial turmoil and economic downturn."

In King's view, though the present batch of policies will have some effect we should not assume that the world economy will quickly bounce back to normal growth. While there are many differences between now and the 1930s, we have to deal with a mountain of debt, the collapse of trust and the international nature of the crisis. The politicians have to be seen to be doing something to alleviate the worst, even if what they do will make the pull out of recession more prolonged and difficult. "Unconventional" measures are dangerous because we don't know their long-term effects.

And that goes to my own main fear: that the policies being followed particularly by the US and UK might make matters worse. Fixing the banking system is vital. No one should argue with that. But the rest?

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