Hamish McRae: The world is now heading towardsan era of much cheaper money

Economic View
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The Independent Online

They have hit the panic button. The Bank of England has gone on to red alert. But there is, I am afraid, no quick fix.

It has become increasingly evident that something big and bad has been happening to the UK economy over the past three or four weeks: that there has been a vicious fall in both confidence and demand. It always takes a bit of time before what is happening in the shops and factories to show through in the figures, but this time things are coming through fast.

This is happening here, but it is also happening throughout the world. The US economy, which had been holding up pretty well, has come off suddenly too. German demand, heavily dependent on exports, has slid down. Even China is coping with a post-Olympic flop. It is small comfort that we are paid-up members of the global downturn club.

There is, however, no easy way to easier money. Lower interest rates are part of the policies that will be needed to shepherd this country and others through the downturn, but the fuss over the size of the interest rate cut yesterday misses the big point. That is that if people cannot borrow the money, or don't want to, the level of interest rates is a bit of an irrelevance. Add in the effect of the wonky transmission mechanism between official rates and market rates and any cut in the former is merely a small element of the much bigger process of rebuilding the world's banking system. Of course it matters, and of course it is welcome, but we should not kid ourselves that it is more than one helpful policy move out of many. Slashing rates to 3 per cent is dramatic, but there will be more drama to come.

The really big question is whether the world is heading into deflation. At the moment, we have asset deflation, pretty savage in the equity markets worldwide and in house prices in many economies including the UK. But we don't have current deflation, for the retail price index is 5 per cent up year-on-year.

This is the reverse of the situation of a couple of years ago when asset prices were surging and current prices were restrained. The central banks then made an error in that they were lulled into complacency by the low official inflation numbers and failed to lean hard enough against the asset boom. Now they have been in danger of making the same mistake in reverse – fearful of the soaring inflation numbers and not leaning hard enough to try to reflate the economy. The US Federal Reserve has got the message and driven rates down to 1 per cent, but as recently as this summer the European Central Bank was increasing rates and you could until yesterday have argued that the Bank of England was in danger of making a similar mistake.

That is history now. Around the world, central banks are or will be driving rates downwards, haltingly still in India and China but with increasing determination everywhere including Europe, which of course made a start yesterday. We are moving into a period of low rates everywhere and it is quite plausible that the UK, like the US, will have rates at or close to 1 per cent before next summer is out.

In the UK both broad money supply and money supply as it relates to households have both fallen through the floor; indeed the squeeze on households now seems to be greater than it was at the bottom of the 1990s recession. There was, however, a slightly different situation then. Money was sort of available, but it was very expensive; now it is quite cheap and becoming cheaper, but you can't get it, or at least that is what a lot of businesses are now reporting.

This is changing behaviour. Companies are postponing investment and sometimes being forced to sell assets to reduce their borrowings. Even firms that you would expect to be well-positioned are suffering. One chilling bit of news is that BMW's Mini plant in Oxford is shutting for a whole month over Christmas. This is a factory that has been perhaps the hardest-worked assembly plant in the world, until recently running 23 hours a day and 364 days a year. It produces very efficient vehicles, just the sort that should benefit during a squeeze, but evidently this is not enough to maintain production.

The obvious cloud hanging over the world is Japan. That country has some of the greatest companies in the world, and is still the second largest economy. But it had a gigantic property bubble in the late 1980s and last week shares were the lowest they had been for 26 years. Japan has, despite its commercial and industrial excellence, experienced nearly two decades of stagnation. This does not hit the visitor. I happened to be in Tokyo last week and can report that the city seems as shining and stylish as ever. But my friends told me that below the surface there was real hardship, particularly among the elderly and among young people who did not have good educational qualifications. For people in secure jobs stagnation may not be too bad, but it does hit those least able to bear a squeeze on their living standards.

So will the world go Japanese? Might Britain experience not just a recession but a long period of stagnation?

I think there are a number of reasons why this is unlikely, one of which is that the authorities have moved swiftly to make sure the banks declare their losses and recapitalise themselves. In Japan the banks were permitted to hide their bad debts for years, with the result that they had so many duff loans on their books that they could not make credit available to new and more creditworthy customers. But we do have to be realistic and accept the US experience in recent months has shown cheap money of itself does not reflate an economy.

This is probably because of time lags – or at least that is what we have to hope. Just as there has been a considerable lag between the start of the credit crunch in the summer of 2007 and it really damaging the economy, so there will be a lag between the easing of credit and the rebuilding of the banking system and an economic recovery. Realistically we should not expect much recovery, at least in the UK, until 2010. But then we always knew that next year would be the crunch year. My own concern is that 2010 will be difficult too, for it takes something like 18 months before any act in monetary policy feeds fully through into the real economy. Housing experts talk of there being no recovery in house prices until the second half of 2010 and that does seem a long way away.

Meanwhile there will be some testy, ill-tempered months ahead. The data will get worse. Government revenues will plunge and I am afraid some people will lose their jobs. The bad news that compelled the Bank to act will continue to pile up. And because nearly half the UK workforce has never experienced recession, it will be all the more frightening. But at least we have the policy levers to pull. Unlike in the early 1990s, we have the freedom to cut interest rates and permit sterling to drop on the exchanges and become more competitive. The interest rate lever was yanked hard yesterday; expect it to be pulled again soon.