Thursday, 17 February 2011

Interest Rates: Why do we ignore the lessons of history

Over the Christmas period I read the excellent book by Liaquat Ahamed on the history of the economic and financial crisis after the first world war as seen through the eyes of the four main central banks (Lords of Finance: 1929, The Great Depression, and the Bankers who Broke the World). Although the technical economic and financial problems of that time are substantially different from those of today (in 1929 it was the problems of over-inflated asset prices on Wall Street while today the problems are those of sovereign debt) there is an eerie sense of there being a parallel with orthodox methods being followed blindly with catastrophic consequences. To quote just one example, in 1925, the then Chancellor of the Exchequer, Winston Churchill (against his own better judgement) was persuaded that the UK should return to the Gold Standard because that was the done thing. The implications of this policy are generally regarded as disastrous for the UK. Other catastrophic policy errors were made by the US Federal Reserve.

To return to the present time, it was announced yesterday that inflation (as measured by the CPI) had increased to 4%. This produced the usual clamour from the City of London for the Bank of England to increase interest rates because this is the usual remedy. But is this the right thing to do in the current circumstances. It is clear that much of this inflation is self-inflicted (e.g. the VAT increase) or a consequence of external trends (e.g. oil price and food price increases). Average earnings growth in recent months has been negative so it doesn’t seem that we are over-paying ourselves.

Let’s avoid beating about the bush. The UK economy is in a very fragile state with very low confidence levels among business and the public. The economy needs all the help it can get. Raising interest rates now in order to follow economic orthodoxy could be catastrophic for the UK economy and the future of public services: The respected economic commentator, Anatole Kaletsky said in March 2010:

Without a commitment from the Bank of England to keep interest rates near zero for the next four or five years, it is almost impossible to imagine how the British economy can return to a growth rate of around 3 per cent in the next Parliament. Without such a return to normal growth rate it will be impossible for the next government to keep a promise to halve public deficits, regardless of whether Labour or the Tories are in charge".

Please, please, please – let us avoid taking advice on interest rate policy from the City. It was they who got us into this mess in the first place. Let’s start using our brains not make knee jerk reactions based on redundant orthodoxy.