Stay up to date with notifications from The Independent

Notifications can be managed in browser preferences.

Hamish McRae: The global cash boosts will work, eventually, but beware flying bricks

Economic View

Sunday 08 March 2009 01:00 GMT

Another week, another cut in interest rates. There won't be many more of those now, with official rates at a mere 0.5 per cent. So the story has shifted to "quantitative easing", such a bizarre expression that it is generally translated as "printing money".

If this has a certain ring of desperation about it – a touch of Zimbabwe – that's because it is, indeed, desperate stuff. What the Bank of England is doing is finding a new way of boosting the money supply. It does not have to print more; what it does is to increase the deposits of the banking system. But the effect is pretty much the same, for the banks, in theory at least, should be able to increase their lending as a result, which in turn creates more money still.

The rationale is simple. The Bank can ease credit in two ways. It can reduce the price or it can increase the amount. Cutting the price has not worked, or to be more precise does not appear to have worked so far. So now it is increasing the supply. During the early 1990s squeeze, the problem was the cost of credit. Money was available but no one could afford it. This time there is no problem with the price but the banks won't lend. Or rather, they are reserving what funds they they have available for prime customers that don't need to borrow, or for the walking wounded that need more credit to get through. In the harsh commercial world of the moment, companies that look as though they might not make it are getting the chop.

This is not made any easier by the structure of lending. Some companies have half-a-dozen banks involved in one loan. Getting them to agree a restructuring is a nightmare. If just one of the banks is in dire trouble, the whole renegotiation becomes impossible. The danger is that sound companies may go under simply because the banks cannot agree. Quantitative easing does not help directly, but should create conditions where banks are not so desperate to cut back their loan books. This does, however, take a long time and that delay has led to a certain scepticism: nothing has worked yet so why should we expect this to work now?

I really have no idea whether this will ease the credit crunch but then I don't think anyone else does either. The most powerful form of monetary easing so far has not been the cuts in interest rates (though they are helping many families' monthly budgets), nor these new unconventional measures (though these are likely to have some effect). No, the most effective policy, if you could call it that, has been the depreciation of the pound. As you can see from the small graph, we are back to the bottom of the range of the past quarter century, a savage decline similar to that after the ERM exit in 1992.

This affects the economy in a number of ways. Most obviously, imports become more expensive and exports cheaper. So exporters benefit, as does any UK company that can substitute for imported goods. This does not give immediate blanket help for the whole economy and some sectors, such as importers, suffer. Besides, being super-competitive is less help when world trade is in a slump than when it is in a boom. But the benefit is already evident in some spots. London retailers with many foreign customers are doing well. Ditto hoteliers. Even car companies are better off than they would otherwise have been. Demand may have fallen by a quarter but since sterling has fallen by much the same amount, the pounds they are receiving for their exported output remains the same. (It is not quite as good as that, as they required many component manufacturers, even UK ones, to price in euros – but that means the suppliers are benefiting too.)

So why is it taking so long for "green shoots" to sprout? The answer is, it always does. Ben Bernanke, the chairman of the Federal Reserve Board, recently noted that economic policy is like pulling a brick with a piece of elastic. The analogy is not original – it has been used many times before – but it is useful. Usually it is explained that the brick fails to move at all for a long time, until the elastic is fully stretched and the brick leaps towards you and traps your finger.

I was pondering that last week, so I tested the analogy with a brick in the garden. No, the elastic did not break and yes, eventually, with the band at full stretch, the brick did come toward me. But while it started to move suddenly it did not snap at my finger. Actually, it moved reluctantly: a lot of friction was holding it back.

That may indeed be what happens to the world economy over the next couple of years. The effort being made around the world to get things moving is huge. Every country of any size is pumping more demand into the economy. Fiscal deficits are soaring, interest rates are being slashed, banks are being recapitalised, companies are being rescued – the full Monty. That is bound to have some effect. True, there has been criticism that the policy is unco-ordinated. Do not expect the G20 economic summit in London next month to provide a panacea, though a show of co-operation will be put on. But it does not matter too much if the policies are unco-ordinated as long as they are acted on. Different countries are experiencing different conditions and have different exchange rates. As long as no country tries to support demand by damaging others, loose co-operation is enough.

Besides, even if the effect of efforts to crank up growth is more limited than the architects of the policies would like, the economy has natural powers to heal itself. First, the markets have to establish a price for all the devalued assets at which there are willing buyers. Then the markets will clear: the toxic debts will be held by people who are prepared to take a risk, with the hope of a profit at the end. Think of it in housing terms. At some stage, prices will be so low that the market will bottom out and people will start to move home again. Once that happens they will put in the fitted kitchens and all the kit to go into them. Result: demand for consumer durables cranks up again.

Timing? I like the comment of Sir Martin Sorrell, the chief executive of WPP, that there will be a recovery "of sorts" next year. That would fit in with the pattern of post-war cycles – as far as the UK is concerned probably worse than the early 1990s downturn but better than the one in the early 1980s. WPP is the second largest group of advertising agencies in the world and advertising is a good early indicator of the state of global demand. Besides, he (like some of the rest of us) always warned that 2009 would be the really bad year.

So a recovery in 2010, but a recovery "of sorts"? Yes, I think the brick will move reluctantly. And all these policies to boost demand will eventually have to be unwound.

Recessions are all in the mind. We need a little more confidence

The best way to beat the recession is to be optimistic. True. If you don't believe it, try that most erudite of publications, The Economic Journal. An article in its most recent issue suggests that economic recessions may be largely caused by widespread pessimism among businesses and individuals, rather than being the result of any inherent systemic problems. So what you need to do to tackle re-cession is create optimistic beliefs.

At least these are the conclusions of new research by Professors Ananish Chaudhuri, Andrew Schotter and Barry Sopher. They used economic decision-making experiments to simulate an extreme example of a real-life problem of co-ordinating actions. They concluded that: "Getting a message to co-ordinate is not enough. Each person must be convinced that others have received the same message and interpreted it in similar ways ... Thus in combating crises, we really need to think of innovative actions or social processes that generate optimistic beliefs."

This must make sense. I suppose you might say in the context of the current crisis that we need internationally co-ordinated action (in contrast to what I have written above!). But individual countries can be effective, too. One example of an action that generates greater confidence was the UK Government's plan early on for major equity injections into UK banks, backed up by guarantees on bank debt to get lending going again. That did stabilise the UK banking system and seems to be becoming a model for other countries.

The problem, of course, is not how to create an optimistic outlook but how to sustain it in the face of adversity. Barack Obama came into office on a huge wave of optimism, but in the two months since his inauguration the Dow Jones index has fallen by 20 per cent, the worst such performance for a century. Of course he cannot be held responsible at all for the plight of the US economy, but investors should note they should not be too audacious or too hopeful too early.

Join our commenting forum

Join thought-provoking conversations, follow other Independent readers and see their replies


Thank you for registering

Please refresh the page or navigate to another page on the site to be automatically logged inPlease refresh your browser to be logged in