Economic Commentary: Releasing homeowners from the trap

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The Independent Online
The natives are becoming increasingly restless. Until last week, senior industrialists had been remarkably supportive of the Government's economic strategy, considering the depth of the recession, but now several are openly calling for a sterling devaluation, or at least for a general realignment of currencies in the exchange rate mechanism. Furthermore, Howard Davies, the new director general of the Confederation of British Industry, has argued explicitly for an easier budgetary policy, involving 'a prudent increase in borrowing to finance investment'.

It has always seemed to me that the Government has had much more room for manoeuvre than it thinks on the fiscal side and that, in continually rejecting this, it has allowed itself to become foolishly trapped in the rhetoric of the early 1980s. I am, therefore, a natural ally of the CBI's thinking in this area.

However, the problem is that the recession has been allowed to deepen to such an extent that the outlook for government borrowing has begun to look rather worrying, even in the context of abundant private savings and shrinking private investment. The graph shows that, during the 1980s, the Thatcher government managed to reduce very substantially the ratio of public debt to GDP. Initially, this was done by allowing inflation to explode, but as the decade wore on, the debt/GDP ratio was reduced by a succession of Budget surpluses. Unfortunately, like much else in the economy, the debt burden was not so much being improved as being privatised. Individuals and companies were encouraged by financial liberalisation to borrow. That borrowing boosted economic activity. Buoyant activity meant the Exchequer's coffers were bulging with revenue. And that was how the public sector debt was paid down. The reverse is now happening: the private sector has been busy off-loading its debt burden on to anyone who would have it, and so far the Government has been willing to oblige.

This process cannot continue indefinitely (even if the private sector would like it to), since the rise in the public debt ratio will eventually start to erode financial market confidence, and the Government's deficit will become impossible to finance. That is precisely what has happened in Italy in the past few weeks.

As the lira has come under speculative attack, the Bank of Italy has responded by pushing up short-term interest rates from about 12 to 18 per cent. But this has not had the desired effect on market confidence, partly because investors know higher rates will add to the government's massive interest burden, making the public sector deficit still worse. This further undermines confidence, and encourages investors to conclude that the authorities cannot afford to keep rates high indefinitely. The currency therefore remains under pressure.

I do not wish to suggest that the UK is approaching this form of debt trap - our debt/GDP ratio, for example, is only about a third of the Italian level. But it does seem that Britain should put itself on some form of voluntary 'credit watch' long before the rating agencies contemplate doing the same thing. If there is to be any easing in fiscal policy (which on balance might still seem to be just about affordable), it needs to be clearly seen as temporary and self-cancelling as soon as a sustainable recovery in activity is under way.

Furthermore, it would seem sensible to aim budgetary assistance directly at the heart of the problem besetting the economy - high real interest rates, which are still undermining the housing market. One idea would be to introduce variable tax relief on mortgages so the effects of raising and lowering interest rates, no longer possible within the ERM, could be partly replaced by the fiscal system. The scheme could work as follows.

Homeowners receive tax relief on mortgages up to pounds 30,000 calculated at a tax rate of 25 per cent. With mortgage rates at 11 per cent, interest payments on a loan of pounds 30,000 amount to pounds 3,300, and the tax relief on that sum is worth pounds 825 a year.

If, instead, the Government decided to calculate the tax relief at a different rate, say 35 per cent, the relief would be worth pounds 1,155 a year. Later, once interest rates were lower and/or the economy had recovered, the Government would need to commit itself not only to eliminating the additional subsidy element, but to recovering the cost by calculating the tax relief for a period at a much lower rate, say 15 per cent.

It is easy to anticipate the standard Treasury objections to such a proposal. It would be expensive (costing about pounds 2.6bn a year if tax relief were calculated at 35 instead of 25 per cent). It would be hard to reverse. And it would mean temporarily increasing the subsidy element on housing, which the Treasury has been desperately attempting to eliminate for years. Worst of all for the politicians, words would have to be eaten.

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These disadvantages are considerable, but any change on any front will require some words to be eaten, and this proposal at least has the merit of being directed precisely at the heart of the current problem. The same cannot be said for an alternative proposal which periodically crops up in the City, which is to 'under-fund' the PSBR. This is an arcane matter that generates intense heat among monetary economists, but it is hard to believe that its effects would be anything other than cosmetic.

The funding rule basically requires that the Government should sell enough public debt to the private sector (excluding the banks) to entirely offset the monetary effects of the PSBR. It is sometimes sloppily suggested that a shift to under- funding would somehow 'inject' money into the system, thus aiding the process of recovery. But this is based on a misunderstanding both of the monetary process in the UK, and of the system of government finance.

Monetary holdings in Britain are determined by the demand for money, with 'supply' simply reacting passively to that demand. (In fact, the term money supply is so misleading that it really should be banned from the English language.) In order to change the demand for money, one of its fundamental determinants needs to change, most probably interest rates. But interest rates in the UK are now set by the requirements of the ERM and other international forces.

Whatever it does with funding policy, the Government cannot allow short- term rates to change without this undermining sterling in the ERM. Meanwhile, long-term interest rates have been entirely unaffected in the past few years by huge shifts in the quantity of gilts sold into the market. Why should the small changes in the gilt issue that are likely to follow an amendment to the funding rule be any different?

Without changes in interest rates, fiddling with the funding rule is likely to be of minimal importance - and interest rate changes are ruled out by ERM membership and the integration of the world's financial markets. Frankly, I could not care less what the Chancellor, Norman Lamont, does with the funding rule, since it will not alter the direction of the economy one jot, whatever he decides.