Beware of false hopes in low rates

Low interest rates failed to stimulate the Japanese economy. Could it happen here?

SUPPOSE EVERYONE does cut interest rates, as the massed ranks of politicians and business people are urging, and the economies of the developed world still head into recession, what then?

The Japanese experience is the dispiriting prospect, where neither very low interest rates, nor a budget deficit approaching 6 per cent of GDP have managed to stimulate the economy. Could this happen elsewhere?

Most people would say no. They would point to aspects of the Japanese economy which make it different from those of Europe or North America: the weakness of the Japanese banking system, the over-close links between the banks and their commercial customers, or maybe the reluctance of Japanese companies to slim down their workforces and focus on profitability. It could not, they would say, happen here.

There are certainly considerable differences between the Japanese economy and those of other developed countries, and the banking system does remain a problem despite the efforts to inject taxpayers' money into the system. But you might expect the combination of very low interest rates and a large budget deficit to create some increase in demand.

It is not happening. People (and companies) are not eager to borrow, even at low interest rates. And whenever the government cuts taxes to put more money into people's pockets, they save the cash. While exports - at least to Europe and North America - remain strong, any increase there is offset by weak exports to East Asia. In any case, the size of exports relative to the whole economy is too small to make a material impact on domestic demand. Somehow, the Japanese have to persuade their consumers to spend more. They won't, partly because they are frightened about their future (see graph), but also because the longer they delay their spending the lower the prices they are likely to pay. This is what deflation means.

I don't quite see North America or Europe - and certainly not the UK - catching as virulent a version of this deflationary disease as Japan. But you can catch a sense of danger in the air, particularly in Continental Europe. That danger may have increased in the past three or four days.

What have we learnt about European economic policy following the weekend summit? Three things. First, there will be considerable pressure on the European Central Bank to run a loose monetary policy. Second, the bank will resist this. And third, the European countries which continue to have high unemployment rates will adopt a looser fiscal policy to try to kick-start their economies.

You can see this in confrontational terms. But while there will be new rows, to focus on these will be to miss the substance of what is happening, which will be a struggle between different ideas. There will be pressure on the central bank to cut rates because politicians believe that this will boost the European economies.

Latest expectations are that the central bank's discount rate will be about 2.6 per cent next January, rather than the 3.3 per cent that had been forecast a month ago. But wait a minute - if interest rates at little over 3 per cent do not boost any economy, what makes anyone think that rates of 2.6 per cent will do the trick? Or 2 per cent? You have to ask: why are people not borrowing? Part of the answer lies in the fact that ordinary mortals cannot borrow at these rates. Banks add on their interest charges, commission and so on. So not a lot of the cuts in money market rates actually filter through to the people who might want to borrow.

On the other hand, cuts in interest rates do cut the return to savers. Insofar as retired people rely on income from a building society to top up their pensions, a fall in interest rates is a disaster. Thus while on balance lower interest rates boost demand, the lower you get the less dramatic the impact. The UK still has quite high interest rates, although not nearly as high as in the 1980s, so cuts in rates could be effective. But Continental rates are becoming so low that the interest rate weapon has become blunted.

There is a further danger. Were the European Central Bank to build up a reputation for being pushed around by politicians, anything it might do by cutting short-term rates might be offset by a rise in long-term rates. That would offset part of any stimulus that lower short rates might create.

The same danger applies to fiscal policy. There is nothing magic about the 3 per cent Maastricht rule, so there is no particular reason why it should not be exceeded for a while. But given Europe's adverse demography and the impact this will have both on welfare and pension costs and on the size of the workforce, it is unwise for governments to be running a deficit at all. Money borrowed now will have to be paid back by a smaller cohort of working people in 25 or so years' time.

If the Maastricht rule is broken for a long period, the bond markets are likely to want a larger risk premium: in other words they will push up long-term interest rates. If increasing the fiscal deficit merely puts up bond yields, it might have the opposite effect from the one intended - it might cut demand, not increase it.

So what can be done? European countries are going to start a great experiment, trying to boost job creation by manipulating their tax and benefit systems and by helping employers take on more people. If they can fine-tune their tax systems to reduce disincentives, then that is great, for there is plenty to play for. If they try and create jobs by Japanese-style grand investment projects, financed by borrowed money, they are liable to have precisely the same effect as the Japanese: not much will happen - except that they will have piled up yet more debt, which future taxpayers will then have to pay back.