By Michael Baxter 27 May 2010 [0 Comments | 933 views]
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Yesterday, the latest OECD Economic Outlook report was released. If you dig deep into the report, you finally come across a recommendation for the UK that, if applied, would wreak economic havoc across the land. Earlier this week the OECD issued another report predicting economic crisis as a result of measures taken by governments to deal with the current crisis. One well known economist described the OECD recommendation as ‘mad’. In the US, truly terrifying data was revealed yesterday which brings back memories of the 1930s.
The OECD’s latest report is not an easy read. And the real headline grabbing stuff is buried within reams of quite innocuous prose. And the recommendation that has elicited cries ranging from “What? – they are mad” to “Yes, I thought so, too” did seem to be at odds with some of the other statements in the report.
This is what Angel Gurría, OECD Secretary-General said in his speech which accompanies the unravelling of the report: “Because of modest activity and demand in most OECD countries, inflation is set to remain tame. By contrast, outside the OECD area, vigorous growth is creating inflationary pressures and monetary policy has already begun to normalise, not least in China, India and Brazil.”
Those comments seem about right. And to an extent the inflationary pressures in the big developing countries could be tamed by allowing their domestic currencies to appreciate. So if China, for example, was to bow to US pressure and let the yuan go up, it would be taking a key step towards fighting off the building inflationary pressures.
But then dive into the report and you find this statement: “The normalisation of policy interest rates should commence in most OECD economies in the course of this year, Japan being an exception, where continued deflation warrants keeping rates close to zero until 2012 or later.” See OECD Outlook
Umm, so “the normalisation” process should begin, eh? So what does that mean? This is what it said about the UK: “In the United Kingdom, the authorities face the challenge of preserving credibility, with headline inflation and some measures of inflation expectations exceeding the targeted rate in the context of extremely expansionary monetary and fiscal policies. The reversal of the December 2008 VAT cut and higher fuel prices have contributed to the recent jump in inflation. Notwithstanding the temporary nature of these price developments, the gradual drift up of some measures of inflation expectations implies a need to increase interest rates earlier than previously thought and no later than the last quarter of 2010. The projected increase of core inflation to the Bank of England target warrants an increase of the policy rate to 3½ per cent by end-2011.”
And that was the bolt of lighting. The thunderclap was supplied by the media, who are full of the OECD’s big idea that the UK should up interest rates to 3.5 per cent by the end of next year.
Maybe such a move would not be that sensational. After all, under normal circumstances a 3.5 per cent interest rate would be considered quite low. But this is what Jonathan Loynes of Capital Economics said: “It’s completely mad. The recovery is still fragile, there is an enormous fiscal squeeze coming and there is no sign the markets are panicking about inflation.” Capital Economics, by the way, sees rates staying at half a per cent throughout all of next year.
Despite low interest rates the demand for credit in the UK is low. Consumers are saving more, business is saving a lot more. Some people criticise low interest rates, saying you can’t fight a debt crisis by encouraging more debt. But the real point about low rates is that they make the cost of existing debt much cheaper. So mortgage holders find they have more disposable income, governments, which are in it up to their eyes, find the cost of trying to fund their nasty fiscal black holes is lower.
Should rates rise from ½ to 3.5 per cent over the next 18 months it is very hard to see how the UK, at a time of deep cuts in government spending and rising taxes, could avoid another recession. And it is very difficult to see how house prices could avoid another crash.
Mind you, just because the policy would be disastrous, it does not mean the policy is wrong. Sometimes we are left with choosing between the lesser of evils.
And on that note, the OECD also revealed another tricky one. William White, who is the chair of the OECD’s Economic Development and Review Committee, has got a paradox for us. This is how the OECD puts it: “Are the policies that governments have put in place to stabilise the global economy and restore growth sowing the seeds for a new economic crisis? While more welfare spending and easier credit can temporarily help to shore up economic activity, they could in the medium term make the problems that caused the current crisis worse.”
To be honest, there is no rocket science behind the sentiments of the report, although no doubt lots of maths and heavy formulas have gone into the OECD document. Most of us were aware of the dangers the report alluded to anyway. Of course, the problem is the one of dealing with a debt crisis via more debt. The flaws in such a response are obvious. It is just that the alternatives are not very palatable either.
Mr White’s recommendations are quite controversial, however. He argues: “While distasteful to many, (enhanced recourse to bankruptcy and debt workouts) can be to the mutual advantage of creditors and debtors, and done in such a way as to minimise moral hazard and the risks of encouraging further crises. Debt alleviation frees up productive resources for other uses, and it reduces the debt–and also the uncertainty about debt servicing–that inhibits spending. Evidently, if carried far enough, confronting frankly the debt problem of borrowers requires the restructuring and possible bankruptcy (or nationalisation) of lenders as well. While challenging, such a process would seem better than the alternative of refusing to face up to reality: if the money is already gone, the only relevant question is how the losses are to be distributed.” See the OECD report by clicking here
In other words, rather than lending to banks and countries that are in debt, let them go bust. It is controversial, although not a new idea.
It was a theme touched on here recently. There are those who argue that the inevitable consequence of the debt crisis will be inflation. But we would suggest debt default is more likely, which may lead to deflation. A part of the problem today is not high debt per se, but the way wealth is distributed. Those with savings are hoarding cash, pumping their money into government debt. Savers are adopting risk averse strategies and in the process are creating massive risks for all. See Punish savings .
Meanwhile, the news out of the US is enough to make you want to rush for the economic equivalent of the air raid shelter.
According to a piece in today’s Telegraph, the US money supply is now declining at a pace that matched the average rate of contraction seen between 1929 and 1933. According to the Telegraph’s Ambrose Evans-Pritchard, the US M3 money supply contracted by 9.6 per cent in the three months to April. He quoted the economist Tim Congdon, a man who one might describe as a monetarist, as saying “It’s frightening…The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly.” See US money supply plunges at 1930s pace as Obama eyes fresh stimulus
The snag is, the Fed does not publish data on M3 any longer. We have to rely on estimates produced by economists such as those from Capital Economics, that have been referred to here many times. See US money supply contracts like a boa constrictor
Of course, regular readers here should not be surprised to read about the contracting money supply. It has been a problem in the US for over half a year now. In the UK, sterling M4 is still growing, but at a very slow pace.
And this brings us back to the OECD’s idea for increasing interest rates. For controlling inflation the rate of interest isn’t that effective. For that matter, quantitative easing has not really done what it was meant to. But right now, we have a problem of banks being forced to up capital ratios, while businesses, and to a lesser extent consumers, are saving. These are the real problems today. Saving is a logical response to economic uncertainly. When everyone starts to save more, the economic outlook becomes a lot more uncertain. Saving may make sense for individuals, but for the economy as a whole it is of dubious value.
And that’s why the OECD’s recommendation of sharp rises in interest rates carries very grave risks.
