Jeremy Warner's Outlook: Debt, not inflation, is Bank's policy challenge

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The Independent Online

Just when we all thought the housing boom was dying of exhaustion, along comes new data to show there's life in the domestic property market yet. Both the British Bankers' Association and the Council for Mortgage Lenders published figures yesterday showing a strong rebound in mortgage lending in June to a new monthly record.

Just when we all thought the housing boom was dying of exhaustion, along comes new data to show there's life in the domestic property market yet. Both the British Bankers' Association and the Council for Mortgage Lenders published figures yesterday showing a strong rebound in mortgage lending in June to a new monthly record.

That doesn't necessarily mean the boom is picking up pace again. It may only be a last gasp from a market already past its best as deals agreed in the early spring finally reach completion. Anecdotal evidence is that what remains of the great house price inflation is now largely confined to the North and the lower end of the market as prices homogenise in the search for affordability. In the main, prices in London and the South-east have flattened out. Estate agents suggest that some are falling.

None the less, the new figures may be enough to provoke the Bank of England into fresh action when the Monetary Policy Committee (MPC) meets to decide on rates early next month. The MPC is not meant to target house price inflation directly in its deliberations, but only the effect it might have on general price inflation. Yet as I've stressed in this column on numerous occasions before, after an extraordinarily long period of excessively loose monetary and fiscal conditions, we are in uncharted waters, and the MPC is as much in the fog about where things are heading as the rest of us.

Normally, a loosening of such magnitude and duration would have been enough to trigger a sizeable rise in inflation. Why it hasn't, either in Britain or the United States, is still not entirely clear, but top of most people's list of explanations is China, whose industrial expansion has had a deflationary effect on the price of goods, and the American productivity miracle, which means that many goods and services can be offered for less.

Yet although these factors have kept general price inflation in check, the low interest rates they've allowed has also encouraged a massive build up in debt, which in turn has fed the consumer and housing booms. Across the developed world, there has also been an explosion in government spending and borrowing. Both public and private borrowing have reached record levels. This is thought acceptable because of the illusion of affordability engendered by low interest rates.

The dangers are all too apparent. A monetary policy determined solely by meeting a particular inflation target may be creating an unsustainable debt overhang as an unwanted side effect. I make the point in relation to Britain, but it could just as easily be applied to America, where the problem is perhaps even more acute, or Japan, where the debt overhang is being shifted from the private to the public sector.

Policy therefore has to become more flexible. The salutary lesson is Japan, where with inflation in abeyance, a relatively easy monetary policy was pursued throughout most of the 1980s in apparent disregard of the debt-fuelled bubbles it stoked in property and equity markets. The result was disaster ­ a massive demand shock when eventually the music stopped, causing a deflationary spiral, which exaggerated the size of the bad debts as they crystallised. Fifteen years later, Japan has yet to recover from the consequent implosion.

I'm not saying that the same thing is about to happen in Britain. At this stage, any such outcome continues to look rather unlikely. Yet the signals are flashing amber all over the place. The low interest rate environment has created an unprecedented search for yield in global capital markets, which in turn means that a much higher degree of credit risk will have been taken on within the world's financial system than is usually the case. As interest rates return to more normalised levels, causing some borrowers to default, the chances of catastrophe rise accordingly.

The trouble with the present regime for governing interest rates is that it was established to deal with the world as it existed in the mid-1990s, when it was widely assumed that the old economic cycle of inflationary booms and busts would continue to rule unless brought to heel. Few people were far sighted enough to see the profound effect globalisation and information technology would have on general price inflation.

Whether the present policy framework is capable of meeting these challenges by delivering the hoped for soft landing is anyone's guess. The suspicion is that the Bank is being drawn towards a more touchy feely approach to policy regardless of the rigidity of the regime under which it operates. Interest rates are rising strongly at the moment despite the fact that inflation remains well below target. The Bank justifies the tightening on the basis that inflation is expected to overshoot target in two years, but this is only an extrapolation of past trends, which in today's environment may count for little. The assumption in some quarters of the City is in any case that the forecasts are being made to suit the script.

Even so, policy may up until now have been unduly targeting the wrong thing ­ inflation. In fact the larger threat to the economy both in Britain and America is now debt, a monster which paradoxically the very act of inflation targeting has helped create.


As our news analysis highlights, the number of prescriptions written in the US for branded medicines has been falling for nearly two years now. That's mainly explained by the rise in generic versions of established medicines as they fall off patent. Yet the increase in the rate of decline that was recorded in the last quarter may reflect a more worrying trend, as there was no apparent compensating growth in sales of generics. Could it be that doctors and patients are simply giving up on the pharmaceuticals industry?

Over the past year, there has been a sudden and pronounced loss of public trust in Big Pharma. For an industry whose whole raison d'etre is to improve the quality and duration of human life, there could hardly be a greater calamity. The phenomenon is more apparent in the US than elsewhere, but since America accounts for nearly a half of all pharmaceutical sales, it is as concerning for the likes of GlaxoSmithKline (GSK) and AstraZeneca as it is for the giants of the US pharmaceuticals sector.

Big Pharma is now routinely accused of profiteering at the expense of patients. Over enthusiastic marketing departments are also accused of misleading physicians, or as in the case of GSK with the anti-depressant, Paxil, actively suppressing adverse research data. Perhaps worse, there is a growing perception that many drugs simply don't do what they are supposed to, don't work at all, or are positively harmful.

Meanwhile, the US Food and Drug Administration is setting the bar ever higher for both safety and efficacy, which means that fewer drugs are being approved to replace the ones that are coming off patent. The industry is caught in a downward spiral of growing public mistrust and ever more costly research and development. It is also sinking under a mountain of litigation, which progressively seeks to challenge the legality of its methods and sales.

As Sir Christopher Gent begins his induction at GSK before stepping up to the chairmanship at the end of the year, he faces a myriad of different challenges, but perhaps the biggest is this issue of public trust. Once it has gone, it is extraordinarily hard to win back, yet there is no particular mystery as to how it might be done. The trusted corporation has to be open, honest, transparent and accountable.

I'm not saying that GSK and the others aren't all these things, but they have to be perceived as such. Big Pharma is all too often seen as arrogant, aloof, patronising, inward looking and secretive. These are the characteristics of monopolists, not the customer facing organisations that pharmaceutical companies need to be. It is a mighty task of cultural and structural change that lies ahead.