Letter: A united effort to put the British economy right

Sir: Much has been said about the inflationary effects of a further fall in interest rate. We are told that this is a 'soft option' which may yield short-term gains but, by reducing capital inflows, would cause exchange rates to fall and thus import prices to rise. These price rises would feed through into our domestic prices and we would once more enter an inflationary spiral.

This is undoubtedly true - so far as it goes. But it has yet to be quantified and, anyway, it is only a part of the story.

First, the effect of imports on domestic prices is likely to be very small. Our imports amount to about one-third of our GDP and at most half of this would be affected by our realignment within the exchange rate mechanism. Therefore, a devaluation of 10 per cent would increase our costs by 1.5 per cent (10 per cent x 15 per cent). Spread over three years this would add only 0.5 per cent to our inflation per annum for these three years only.

On the other hand, the cut in interest rate would reduce domestic production costs, reduce the mortgage pressure on wages and salaries and relieve public expenditure by reducing the interest paid on the national debt. Furthermore, a cut in interest rate would stimulate home demand (particularly for non-importable construction) and, by spreading fixed costs, would reduce average cost of home-produced goods.

This reduction in domestic costs would improve our current account and thus, to some extent, offset the capital outflow. The net effect on exchange rates may therefore be quite small.

Having left the ERM, we are free to choose our interest rate/exchange rate combination. Let us make the most of this freedom to release the productive potential of the real side of our economy and reduce interest rate substantially and soon.

Yours faithfully,

DAVID F. HEATHFIELD

Department of Economics

University of Southampton

26 September