Hamish McRae: Our economy is like that of 100 years ago

We have an economy that can't stand 4.75 per cent interest rates without grinding to a halt
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The Independent Online

People trying to sell their homes will doubtless breathe a sigh of relief, for one of the reasons why the economy has slowed has been the stagnation in the housing market. But if you stand back from the immediate decision, the idea that interest rates need to come down is pretty odd. This is the first time since the 1950s that the peak of the interest rate cycle has been so low. In the late 1950s the peak for Bank rate - the so-called crisis rate that stopped the economy growing - was 7 per cent. Now we are not in any crisis but we do seem to have an economy that can't stand 4.75 per cent without threatening to grind to a halt.

We seem to have got an economy that simply cannot tolerate high interest rates - something that has not happened in most of our lifetimes. You would have to go back to the 1930s for a peacetime example of an economy that needs such cheap money to keep itself going. What might this mean?

I suppose the first thing to say is that the Bank of England has been pretty successful if it has managed to stabilise a housing boom without - yet - creating a housing crash or plunging the economy into recession. Remember the disaster of the early 1990s, when Britain was in the European exchange rate mechanism and it did both. But there is something much bigger happening than that.

Look at the eurozone. There is a lot of pressure for a cut in rates there, though it is unlikely that the European Central Bank will bow to those. But rates are only 2 per cent and there is economic stagnation in much of the region. So on the Continent they have economies that can't stand even 2 per cent rates. Even in the United States, where the boom continues, people reckon that rates will not go much higher than 4 per cent, at least for the time being.

What is common to the entire developed world is very low inflation. In fact UK inflation on the Treasury's preferred measure was only 1.3 per cent a year for 2000-2004, the same as it was for 1900-1904. It has come up a bit but is still only 2 per cent. In Japan they have had stable or falling prices for a decade. Low inflation makes low interest rates possible, so in one sense the world is getting the payback from its success in controlling inflation. But there is a downside that I think we are only gradually becoming aware of.

This is that while we are in a world of low inflation and look like remaining in one for a generation or more, we are only slowly adapting to it. Our habits have been tuned to expect prices to go up because that is our lifetime experience. It is reinforced by what has happened in the housing market, at least until recently, and to some extent by government behaviour.

For example, the Government seems to regard it as normal that it should make sharp increases to the charges it makes for some services: passports and foreign visa fees. Local government still is increasing the charges it makes for local services by much more than inflation. Ken Livingstone has increased the congestion charge by 60 per cent.

Thanks to this embedded assumption that prices will eventually go up, we accept paying double-digit interest rates on credit cards and we don't save nearly enough for our pensions. Reason says that this is nuts. But our practical experience says it isn't. Provided you don't let credit card debt build up, the convenience more than offsets the charges, and many people who saved for a pension have found their pension pot eroded by poor investment returns. Better to have not saved for a pension and borrowed to buy a holiday home instead.

The result of this is an economy that is carrying a huge burden of debt. Because we have so much debt we don't need interest rates to go up by much to feel the pressure. Servicing debts can quickly become a burden. Add to that the probability, if inflation stays virtually non-existent, that debt will have to be repaid in real money, not devalued stuff. That is the key change. No one alive now has had the experience of paying back debt with money that is worth as much as the money that they borrowed in the first place. Provided you could service the debt, inflation would always come to the rescue in the end.

The fact that 4.75 per cent interest rates have been enough to choke off borrowing suggests that a lot of us now intuitively know that something may change. This shift of expectation is not explicit. I don't think that most people really believe the price of a house may in another 30 years be lower in money terms than it is now. Cars, suits, computers, whatever, maybe, but not houses. But if you are running a business you are very aware of the lack of pricing power: the fact that if you want to move stock you have to cut the price. If you are in that position you have to be very careful about the amount you borrow and the price you pay for the loan. For the rest of us there may be a general unease but nothing more.

However, collectively we may be wiser than we are individually. Individually many of us have taken on far too much debt and are going on doing so. Collectively, however, we seem to have responded to what has been, by all recent standards, a very mild credit squeeze by starting to pull back.

This has the most profound implications. If this pattern continues we will go though the rest of our lives with very low interest rates.

But that means much lower investment returns. It means lower increases in pay, at least in money terms, though maybe not in real terms. It may even mean a world where people increase their standard of living by lower prices rather than higher incomes. It is a world where rewards go to savers rather than spenders. It is a world much more like that of 100 years ago than anything we have experienced in our lifetimes.

And if all that sounds fanciful, consider this. If 10 years ago someone had said that 4.75 per cent interest rates would lead to falling house prices you would have thought they were mad. But 100 years ago it would have seemed quite normal.