Economics: Unlock the manacle of debt deflation

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The Independent Online
THE Government's economic policy is changing before our eyes, and it is a messy business. The ejection of sterling from the exchange rate mechanism destroyed the foundations of the old policy, but did not fatally wound many of its assumptions. Not surprisingly, policy- makers are taking time to reorient themselves to the freedoms and the dangers that this new world brings.

This exercise is particularly difficult when political and economic pressures are so acute. The economic figures have taken a dramatic turn for the worse. The British Chambers of Commerce last week reported an 'alarming' contraction of orders and the Confederation of British Industry survey this week will be another spine-chiller. The only good news last week was the apparent rise in retail sales volume, which was hailed by the Chancellor as a sign of an upward trend. However, the relatively high August and September levels may have been due to once-off purchases of household goods. There was a spurt of house-buying to beat the reimposition of stamp duty in August.

National output is probably falling again, in large part because so many businesses anticipated a post- election recovery that failed to materialise. As their production outstripped their sales, their stocks of unsold goods rose, an ominous sign that emerged from the summer CBI surveys. Now they have little option but to cut production, as the manufacturing output figures show.

The burst of redundancies - now running at their highest level since the recession began - probably reflects the final blow to hopes of a post-election recovery. Finance directors have called time on the rosy revenue forecasts from sales departments. Another factor behind the sudden rush of job losses is that it is easier to be hard when others are also: there is less opprobrium and less effect on morale.

The impact on confidence, though, is likely to be dire. The new wave of uncertainty about job security is bound to hit spending and the housing market. First-time buyers are unlikely to want to take on mortgage commitments if there is a real possibility of losing their jobs. The continuing fall in house prices also feeds on itself. Any first-time buyer who bought at the beginning of this year in the South-east has already lost his or her 5 per cent deposit.

All in all, there is now a tangible risk of the economy moving into slump. Ever since the economy failed to respond in the normal cyclical fashion with a recovery last autumn, it has become steadily more clear that this is not a conventional cycle. Its distinguishing factor is the burden of debt on both companies and people, but particularly people. With the debt-to-income ratio twice as high as at the beginning of the Eighties, there is a compulsive desire to reduce the perceived threat to family well-being. People want to repay debt rather than spend.

This is already the longest recession since the Second World War, and it is almost certainly set to become the deepest. Solid businesses that would normally have good prospects are being pushed into receivership, their proprietors often facing personal bankruptcy as guarantees are called in and homes are sold. The banks are having to set aside ever larger provisions against bad debts, and then to sell assets that merely depress prices and the value of their remaining security even more. This is debt deflation.

In these circumstances, there is an overwhelming case for the Government to support activity. First of all, the Chancellor should cut interest rates sharply - by at least 2 per centage points to 6 per cent - in a clear signal to businesses and consumers that he is going for growth.

There is a danger, of course, that a sharp interest rate cut would provoke such a run on the pound that the Government would be panicked into a reversal. The financial markets owe no government a living, and they will not necessarily deliver a mixture of interest rates and exchange rates helpful both to ending the recession and to the control of inflation. The second graph shows what happened in January 1985, when the then Chancellor, Nigel Lawson, raised bank base rates sharply despite rising unemployment.

But the danger of a spiralling downturn now outweighs the inflationary risk that the pound will go into free fall. For what it is worth, the markets are already anticipating a sharp further cut in interest rates, which suggests that they might react calmly to a cut. The futures market expects 6.5 per cent by Christmas, while the interest rates at which banks lend to each other for three months are 75 8 per cent. Even more important, the markets are also expecting sharp cuts in German rates.

Lower interest rates will help people to repay debt more quickly, and will therefore bring forward the point at which normal spending growth resumes. But the length of time during which people repay debt rather than spend could be considerable. In the United States, where debt is at similar levels, the recovery has been anaemic despite interest rates at only 3 per cent. There is a long debt work-out to come.

The case for other measures is thus a strong one. This must in part mean special measures to stabilise the housing market, which has been a key component in our economic crisis. The manifesto in the Independent on Thursday rightly called for tax incentives to encourage first-time buyers to enter the market, triggering the buying chains that mean other people can move house.

But the third strand of a package for recovery should be increased public spending. As we report elsewhere, the Government may well encourage the private sector to fund spending off-budget. The most honest course would be to build public works and borrow openly to do so. Even if the borrowing requirement soars to 6 per cent of national income this year, it will not be wildly out of the line with the expected European average of 4.9 per cent, especially as our recession is deeper and more advanced.

It is not even inevitable that the gilts market - where the Government issues bonds to borrow long-term - would fall, pushing up the cost of financing the deficit. After all, a cut in short-term interest rates will push some investors out of cash and into longer-term lending as a way of keeping up their incomes.

But the best way to reassure the financial markets that a growth strategy does not mean financial irresponsibility is to give the Bank of England day-to-day responsibility for interest rates, independently of political influence. (The Bank should also lose its responsibility for banking supervision, which can only ever damage its reputation). The Government should also promise to raise taxes when growth exceeds 2.5 per cent a year, and private spending is therefore resilient enough to withstand it.

An immediate boost to growth combined with a long-term commitment to low inflation looks like a policy designed by St Augustine: 'Give me chastity and continence but not yet'. But there is no intellectual contradiction between the two. The more credible the Government's commitment to low inflation and a balanced budget over the cycle, the more the markets will be prepared to finance a reflation without a run on the pound or a sharp fall in bond prices. The medium term matters.