Economics: Be tough on taxes and cut rates again

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THE CHANCELLOR last week sent a frisson of excitement through the Bank of England, which is henceforth to be given control over the timing of interest rate changes. Since neither the Bank nor the Treasury will specify the extent of the Bank's flexibility, it would be wise to assume that this modest step towards independence for the Old Lady confers no more than the freedom to cut interest rates before or after lunch.

But the first part of the Chancellor's Budget certainly took the markets by surprise. Kenneth Clarke announced a half-point cut in interest rates to 5.5 per cent, and said that the reduction took 'full account' of the other measures in Tuesday's Budget. In other words, there will be no further interest rate cut until after the Budget, and only if inflation or growth are more feeble than expected.

The implication is surely that the Chancellor is unlikely to alter radically the overall balance of taxes and spending. There may be much shuffling of the fiscal furniture, with taxes going up and down, but the net change may be small. If interest rates are only to come down a little, that means fiscal policy is unlikely to be tightened a lot.

I hope I am wrong. Even with the recent excellent - and incredible - trade figures, we face two monster deficits. There is the budget deficit worth 8 per cent of national income this year, and there is a balance of payments deficit probably worth some 2 per cent of national income.

The budget deficit will tend to shrink as the recovery pours tax revenue into the Treasury's coffers, but there are few economists who believe that a prolonged burst of growth will cause the deficit to vanish. The Chancellor may need to increase taxes overall by some 1 per cent of national income. The trade deficit, by contrast, will tend to rise as consumption and imports pick up more rapidly than exports. We normally run a payments surplus at this point in the business cycle.

The Chancellor could whistle a happy tune and hope that the Central Statistical Office delivers nicer numbers; that the Japanese car plants prove more successful in continental markets than the recent job cuts at Nissan in Sunderland suggest; and that the undoubted improvement in our trading performance is enough to avert hard decisions. Super-strong export-led growth would banish the ghosts of the twin deficits.

Inaction buttressed by fantasy has many precedents in British public life, but is risky. If something does not turn up, Mr Clarke will have to make more politically painful adjustments close to the next general election. And there is less margin for error if the unexpected turns out to be unpleasant news instead.

The sensible alternative is tax increases. Those who argue that another dose of fiscal tightening might stall the recovery have not been studying the recent numbers. Consumers' spending has been far stronger than expected, rising by 2.4 per cent over the year to the third quarter. Indeed, an analysis by the economists at Warburg shows that almost all of the increase in gross domestic product since the trough in the first quarter of 1992 has been due to consumers' spending, with net exports accounting for a mere 0.3 percentage points of the 2.4 per cent growth.

One of the more effective measures to stimulate both exports and business investment would be a further cut in interest rates. This might indeed lead to some easing in sterling, which has been so stable when measured by its effective exchange rate index as to raise suspicions about whether the Government has really kicked the targeting habit. But any modest fall in the pound should unwind as German interest rates come down.

However, a stimulus to business from a further cut in interest rates would also be a stimulus to the consumer, which would raise imports and worsen the trade deficit. Hence the case for offsetting tax increases, best targeted on those who gain from interest rate cuts through an abolition of mortgage interest relief. We need a tough Budget to help rebalance the recovery towards net exports and away from consumption.

Another reason for interest rate cuts is simply that rates are too high. The proper measure of the impact of interest rates on the economy must allow for the rate of inflation as well, because part of the actual interest rate merely compensates lenders for the erosion of their capital by inflation. The real interest rate - the actual rate minus expected inflation - is the rate against which businesses should assess investment projects, and consumers think about borrowing plans.

It is difficult to estimate the expected rate of inflation, but we can take the actual interest rate minus the actual inflation rate as a proxy for real interest rates. In the main, most people expect future inflation to be like past inflation.

The results for UK mortgage rates are shown in the second chart as far back as the Datastream machine would allow. These real interest rates are a couple of percentage points higher than the real rates available to banks and large corporate borrowers on the money markets, but they are a realistic representation of the rates affecting most borrowers.

Real interest rates were modestly positive through most of the post-war period. Then the oil price shock hit in 1973/4, pushing inflation up and real interest rates down. Through most of the Seventies, real interest rates were actually negative, so that lenders and savers were effectively paying borrowers to borrow money. This was why heavily indebted house buyers did so well, and why elderly people with savings did so badly.

It was perhaps partly as a result of the experience of being fleeced by borrowers during the Seventies that real interest rates were so high during the Eighties: savers and lenders were determined to extract a risk premium in case British governments should be minded to run an incontinent monetary policy again.

Another factor was international: the enormous borrowing of the US government pushed credit demand up. In the Anglo-Saxon economies and Japan, the liberalisation of financial markets also made it easier for people to borrow. In Britain, the queuing and rationing system for mortgages ended. That in turn meant that real interest rates - the price of borrowing - had to be higher to control the pent-up demand.

It still was not high enough. The high debts acquired during the Eighties are one reason why real interest rates need to fall sharply now. The lower are real rates, the quicker people and companies will be able to bring their borrowings into a more satisfactory relationship with their incomes and assets. With the risk premium for inflation also subsiding, real rates are likely to be lower around the world during the Nineties.

Britain, though, is still lagging. With the recent fall in inflation to 1.4 per cent, Britain's real short-term interest rates are still 4.1 per cent. Even measured by our underlying inflation rate of 2.8 per cent - more comparable with other countries' ways of measuring inflation - our real interest rates are a minimum of 2.7 per cent (and 4.7 per cent even for mortgage borrowers whose lenders cut rates last week).

This compares with 0.5 per cent in the US and 1.2 per cent in Japan, both economies with similar burdens of debt. Only in Europe are real interest rates still relatively high. Germany's real interest rate is 2.7 per cent, the same as ours even though the German economy is still suffering the inflationary hangovers of reunification. Thanks to the determination of the French and other governments not to let their currencies slide against the German mark, France has real rates of 4.7 per cent and Italy 4.3 per cent.

Clearly, Britain has to be more cautious than either the US or Japan because we are a much smaller economy and are hence more open to foreign trade. A sharp fall in sterling raises the price of imports and can cause inflation. But the half-point cut in rates last week went down well with the foreign exchanges, where sterling was trading higher at the end of the week than at the beginning. Providing that the Chancellor has not funked all tough decisions in the Budget, he should cut again as soon as he decently can.

(Graphs omitted)

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