ANALYSIS:Demand stimulus is all important as inflation is no longer a threat, writes Samuel Brittan
THOSE WHOSE economic experience has been confined to the decade or so of steady growth and low inflation in the UK and the euro zone might be surprised to find me saying that the "bold" cut of 1½ percentage points in official interest rates announced yesterday by the Bank of England is barely adequate and will probably need to be followed by further cuts soon.
Official interest rates have in this period normally moved by a quarter percentage point at a time, with even half a point regarded as exceptional. But these are not normal times.
The big difference in diagnosis is between those who still think in terms of a conventional business cycle with output fluctuating in familiar snakelike fashion around a stable trend given by "supply side" factors, and those who believe that something more apocalyptic has happened.
For this first group it is important to worry about the size of the current budget deficit, re-establishing fiscal guidelines in the medium-term and the maintenance of an arm's length relationship between governments and central banks.
The obvious exponent of this view has been the European Central Bank, with its insistence that its economic task is to maintain the stability of a consumer price index. Its limited half-percentage-point cut in its base rate to 3.25 per cent shows how reluctant it is to abandon this point of view.
At the other extreme are those who believe we are now in a new game where the cliche about the old rules no longer applying is for once correct and that a successful demand stimulus can influence the future output trend and not merely fluctuations around it.
Central banks and governments need to co-operate to provide this stimulus. Inflation is a rapidly receding danger, and central bankers who worry about inflationary expectations setting off a wage-price spiral are like generals fighting the last war. More significant are the sporadic stories beginning to appear worldwide of workers accepting wage cuts to protect jobs.
The obvious champion of the second, revisionist, view is the US Fed. Its chairman Ben Bernanke, who is a distinguished authority on the Great Depression, will need no prodding from the president-elect to use unorthodox means to maintain nominal spending. Critics say that Alan Greenspan's reduction of the Fed funds rate to 1 per cent in 2003 sparked off the recent credit bubble and its subsequent collapse. They do not say what else should have been done to prevent Asian savings surpluses from generating a world depression. But even if it is conceded that Mr Greenspan went down too far for too long, Mr Bernanke now faces a radically different situation in which the very existence of the US and world monetary systems has been threatened.
Not long ago the Bank of England might have been said to be somewhere in between the two camps. But recent utterances, even before yesterday's cut, have placed it nearer the revisionist one. For instance, Mervyn King, the governor, has said that "not since the first World War has the banking system been so close to collapse" and that the "economic news over the past month has probably been the worst in such a period for a very considerable time". Why then has the monetary policy committee not immediately slashed the bank rate to somewhere near the US Fed funds rate, now again at 1 per cent? The normal argument for gradual changes is uncertainty about the course of the economy. The only uncertainty now, however, is about how far the UK recession will go. On present evidence, it looks deeper than either the US or the euro zone one. The only plausible argument against moving down by several percentage points at a time is the sense of panic it might generate.
One response might be to move down in a series of frequent steps, which would mean abandoning the bank's self-imposed timetable of monthly intervals.
Interest rates matter mainly for their effect on money flows. The combination of banking turmoil and changes in rules and definitions makes it almost impossible to say what has been happening to the money supply. What is clear is that MV - the product of money times velocity, also measured by our old friend nominal gross domestic product - has had a severe check. According to Goldman Sachs's estimates, UK nominal GDP growth, after hovering in the past few years in a range of 4-7 per cent a year, has now ground to a standstill.
Many analysts fear that central banks will soon have "run out of ammunition" because official interest rates cannot fall below zero. This is the famous "zero interest rate bound" known as Zirb to its friends. Bernanke, then a Fed governor, showed that this is not the case in speeches during the 2002-03 deflation scare.
To begin with, central banks can expand the range of securities in which they deal, as they are to some extent now doing. But the ultimate weapon would be a fiscal stimulus financed by money creation - the equivalent of the famous helicopter drop. You could call this monetary policy made effective, or fiscal policy supported on the monetary side, according to taste. If you are too hidebound to countenance this move you deserve to run the risk of a severe slump.
