Why a drastic interest rate cut will prolong the misery

Philip Booth examines the prospects for the economy in the Yorkshire Post

Whether there will be a recession is a moot point, but there is certainly more turbulence to come. Sometimes an economic downturn happens as a result of a series of factors beyond anybody’s control. But even where an individual, organisation or institution is at fault it is normally impossible to avoid the consequences of past mistakes. Attempts to soften the consequences of financial market turbulence merely prolong the agony. The efforts of George Bush and the Democratic Presidential candidates in the US to aid the economy by increasing the budget deficit and by subsidising people who have lost money will lead to difficulties in the future. We should not make that mistake here. Neither should we cut interest rates dramatically as the Fed has done.

Where did the current problems originate? If we only had to deal with the fallout of the US sub-prime crisis, we probably need not worry too much. But there have been policy mistakes here too. The Bank of England may have made some minor mistakes – though the judgements it has had to make have been difficult ones. The Government, though, has made some big errors that have contributed to the current problems and which will make recovery much more difficult.

The Government made a bizarre decision in 2003 to change the inflation index that the Bank of England targets to one which excludes altogether the cost of housing. This meant that, when the cost of other goods was falling relative to housing, the Bank of England kept monetary policy looser for longer. We all experienced rapidly rising prices but the government told the Bank it had to ignore them because a large part of the rise in prices was in the housing market. Arguably, slack monetary policy and low interest rates led to over-inflated asset prices, higher house prices, the mis-pricing of credit and the credit binge. There is no way of avoiding the consequences of those past decisions now. If we reduce interest rates whilst there are inflationary pressures in the pipeline we will prolong the misery. Indeed, there is a possibility of higher inflation and recession happening together – the Bank needs to keep its eye on the former.

It is possible that we may have problems in financial markets without a recession. There is no necessary connection. But, if there is recession, we need dynamic, flexible labour markets to ensure that those who are thrown out of work are able to find work quickly. We are not well prepared in this respect. Since 1997, the government has taken a series of steps that have made labour markets more rigid. The tax credit system leads to a very high marginal rate of tax for most families; the minimum wage will price more people out of a job in a downturn; and employers are increasingly bound up in red tape imposed from Brussels and from Whitehall.

On the positive side, migration has been a blessing to many firms and individuals in times of economic growth as migrants have filled job vacancies. Migration also provides a safety valve in tough economic times. As the demand for labour falls migrants will return home to relatively better economic prospects or potential migrants will decide not to come to this country. This is all well and good and partly compensates for the rigidity that governments have imposed on labour markets in other respects. However, migration and emigration are not a substitute for sound domestic policy. If our economy has high taxation and over-bearing regulation, we all suffer in the long run.

Fiscal policy should also be in harmony with monetary policy. It is vital that weak fiscal policy does not close off any scope there may be for cutting interest rates. After several years of economic growth, the government should be in surplus. In fact it is likely to borrow over £40bn this year. There is no scope to raise taxes given our rapidly rising tax burden and it does not seem likely that the government will cut its burgeoning spending which is ra