Jeremy Warner: When interest rates reach zero, what does the Bank do then?

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The Independent Online

Outlook: Things must be bad, mustn't they, if interest rates have been cut all the way down to 2 per cent, the lowest since 1951 and indeed equal lowest in the Bank of England's entire 314-year-history, with markets predicting still more reductions to come? Well, plainly they are, but it is an interesting thought that though rates as low as these can hardly be described as "a return to normality", in the broad sweep of history, they are not as unusual as you might think.

Excepting the odd blip, rates were at 2 per cent throughout the period from 1933 to 1951, and a relatively low interest rate environment persisted right up until the late 1960s. Rates were also exceptionally low for much of the late nineteenth century. It was only really during the great inflation of the 1970s and '80s that relatively high interest rates became the norm.

If rates continue falling to perhaps as low as zero, as some economists now anticipate, then these would plainly be uncharted waters, at least for Britain, and be indicative of a degree of economic calamity quite without precedent in the modern age. Yet it is to avoid such a calamity, rather than in anticipation of its reality, that rates are being cut with such abandon.

You have to believe, given the sheer weight of money being thrown at the problem, that eventually all this policy action will have some effect, and that, like a coiled spring, the economy will jump back to life, accompanied, in all probability, by a prolonged bout of inflation. Yet that's obviously not the sentiment of the moment, with the mood one of the blackest I have ever observed in all my 30 years as a financial journalist.

A year ago, the mainstream view was still that Britain and the US would likely avoid a recession. Today, many are saying we'll be lucky to escape a depression. So will all this monetary easing work? Rather ominously, even the Bank of England's Monetary Policy Committee notes that "normal volume lending" is unlikely to be restored without further measures still.

And there's the rub, for it is not so much the cost of money as its availability which is the root of the problem. If interest rates are cut to zero, nobody is going to lend at that rate if they can't borrow at lower still. Even in a world where banking returns to its origins as a safe deposit box business in which the depositor pays the bank to hold his money, that's never going to happen.

Less than two years ago, money was still growing on trees. Any Tom, Dick or Harry could borrow almost as much of it as they wanted. Today, the credit-creation machine lies broken. The banks cannot borrow in the way they used to be able to, and therefore cannot lend in such quantity either. That's not to say that cutting interest rates is pointless. For those with tracker or variable-rate mortgages, it puts money back in their pockets and therefore enables them to spend more.

Yet it doesn't help the underlying problem of lack of credit availability, and even on the cost of credit the authorities are fast running out of road. The soon-to-be Government- controlled Halifax last night announced it was passing on only a quarter of the latest 100 basis-point cut in bank rate to those with standard variable-rate mortgages, citing the need to preserve profitability.

Despite the lower bank rate, wholesale money, on which banks rely for a large proportion of their funding, is getting relatively more expensive. Halifax complains that it is being charged more for the money it borrows from the markets than it is able to charge many of its customers. Some kind of an overall margin has to be maintained, or it will be out of business.

The same is true of retail and corporate deposits, which still account for the bulk of bank funding. The average deposit rate has been rising even as bank base rate falls, and these deposits are becoming scarcer too. In any case, there is plainly a limit to how far lending rates in the real economy can fall, and we may already be quite close to it. Even in Japan in the period of zero interest rates, banks still charged 2.5 per cent to 3 per cent for mortgages.

But as I say, it's not really the cost of money which is the restraint on economic activity, but rather its scarcity. Banks cannot return to former levels of lending until they can find alternative sources of funding, and, for the time being, the only such source is governments.

So what more can the authorities do? Once no more can be done on conventional fiscal and monetary easing, the next stage is "unorthodox" policy action, or "quantitative easing". This is a fancy name for a simple concept – turning on the printing presses and creating money.

One method of achieving this is for the central bank to be allowed to expand its balance sheet by buying commercial and mortgage debt. This is already happening on a substantial scale in the US, but has yet to be applied in its purest form in either Britain or Europe. In any case, the effect is to allow the banks to replace bad debt with cash and therefore enable them to start lending again.

Another way of achieving the same thing is simply to underfund the budget deficit, or put another way, for the Government to spend more than it is raising from taxes and borrowing. If an individual attempted such a wheeze it would be called fraud, but then debasing the coinage has been a characteristic of desperate governments down the ages.

The lesson from Japan, where all these options have been tried, is that policy applied too late in a debt deflation is unlikely to have much traction. Western policymakers are therefore rushing to apply the medicine early. It's a funny old world that treats a crisis caused by an excess of credit by attempting to create even more of the stuff, or rather, by giving the money away for free, but there you go.

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