For three centuries financial and political observers have waited with bated breath for the regular Bank Rate announcement from the Bank of England. They also watch the policy rates influenced by the US Fed, the European Central Bank and the Bank of Japan. Is it possible they are looking the wrong way?
I am not concerned here with the relative role of government and central banks in these decisions. This will depend on the balance of institutions and personalities. But the crucial question is how far public authorities can determine interest rates. The whole issue is an example of the popular tendency to exaggerate the role of governmental authorities for good or ill. The result of this exaggeration is to limit the beneficial role they can potentially play.
The late Professor Joad, one of the founders of the BBC’s The Brains Trust, would have answered, “It all depends on what you mean by interest rates and what you mean by determine.” And he would have been right. Policy-determined short-term interest rates range between zero and 0.5 per cent for the main central banks of the world. There is a widespread and reasonable assumption that these rates are liable to rise — an assumption reinforced by the unexpectedly vigorous recent UK recovery and the unexpected recent slight upturn in UK earnings. Allowing for inflation, all these interest rates are negative in real terms. But there is a widespread fear that they are bound to rise before long, despite the current hesitations in the world economy.
Suppose, however, that the Bank of England delays too long in raising the Bank Rate for good or bad reasons. It may overestimate the amount of usable spare capacity. It may underrate the strength of economic recovery now taking place in the UK. It may be overinfluenced by current fluctuations. This is quite apart from the election next spring, which will be hardly an influence for higher rates for house buyers or durable goods purchasers. Central banks are not often accused of excessive animal spirits but stranger things have occurred.
By definition, the unusual does occasionally happen. The immediate effect of any such misjudgment of the state of the economy might be to stimulate a short-term boom in the UK but ultimately to increase the inflation rate. Thus the real interest rate may fall for a while. But the eventual effect would be higher not lower interest rates, at least as expressed in cash terms.
Economists used to teach that interest rates brought into balance savings and investment. So long as intended savings remain high relative to investment opportunities real interest rates will stay low or even negative. But negative real rates have an air of impermanence. Small savers will not rush abroad at the first whiff of inflation threat, but they will gradually and in increasing numbers tumble to what is going on and will look for overseas opportunities.
In the end governments and central banks determine mainly inflation rates and not interest rates despite appearances to the contrary. There is a difference, however, between the bottom and the top of the range. There is a limit to how far nominal interest rates can fall in a slump but no limit to how much they can rise in a boom. It is possible to imagine various devices by which companies could borrow at negative rates. They could issue securitires at above par. Such investors would make a loss on redemption but might still find it better than keeping their savings under the mattress. The fact is that even large companies do not think in these terms.
That is why some of us vainly urged a fiscal stimulus on George Osborne in his first three years. These same economists may soon start thinking in terms of a fiscal check. They will have an uphill struggle. The Bank will probably at first act too little and too late, before perhaps panicking after the election.
There is a difference between interest rates in a boom and a slump. In a slump there is a quasi-technical limit to how far they can fall. In a boom the limit is more political. Remember how often Margaret Thatcher said that she hated high interest rates.
I am not concerned to give not very valuable predictions here, but mainly to use interest rates as an example of how governments have much less influence for good or ill than people think.
Does all this mean that governments are helpless in the face of a slump or an inflationary boom? Decidedly not. But it does mean that they need great care in the choice of weapons. It is precisely because interest rates cannot readily fall below zero that the followers of Keynes urged an activist fiscal policy, using variations in the Budget balance to keep the economy on an even keel.
I say “followers” because Keynes himself was reluctant to embrace deficit finance. He preferred to limit budget stimuli to what is now known as the capital account. But the current capital distinction does not always make sense in the public sector. Expenditure on school buildings is capital, while payments to science or maths teachers are current.
A bigger problem is to decide at what level of government stimulatory or restrictive policies are to be applied. It would hardly do for you or me, dear reader, to slash a restaurant bill in the hope that the owner will do the same with his suppliers. On the other hand, the world as a whole would hardly be the right scale to apply demand management, even if it were feasible. At the time of writing it looks as if the US is likely to need an application of the brakes while many European countries still need a stimulus. Faute de mieux action will still have to be at the national level.