Friday, 17 October 2008

Gordon Brown and the financial crisis: a 1 minute comparison

Three ways to worsen a credit crunch:

1. Lower interest rates: this discourages saving because one gets little reward for delaying one’s gratification (in economic parlance, time-preferences are undervalued), while at the same time encouraging borrowing, thus further reducing the supply of credit relative to demand;
2. Allow inflation to escalate: this also discourages saving because the nominal reward for saving (the amount one’s money goes up) is eroded by the fall in the value of money (what your savings are actually worth), and for the same reason encourages borrowing: at present, the Bank of England base rate is lower than inflation which means that savings are worth less with time (in economic parlance, interest rates are negative);
3. Increase public borrowing: This takes money out of the credit markets: money that is being saved and would be invested in profitable businesses is now diverted into Government bonds and then invested in businesses that are not creditworthy (if they were, they would not need a Government bail-out).

Government policy:

1. Lower interest rates
2. Allow inflation to escalate
3. Increase public borrowing

Remember than the next time somebody tells you that Brown is having a good crisis.

3 comments:

oranjepan said...

Now this is controversial, seeing as Nick Clegg has stated his preference for a 2% cut in interest rates to counter his concerns about the potentially damaging effects of a deflationary spiral.

If deflation is the real threat then borrowing may actually be necessary and a good thing, however I still think it is too early to say for certain which course of action will work because I don't think we know yet which way the economy is turning.

He hasn't though clarified whether he would prefer that such deep cuts should be gradual or immediate, but I think it is interesting that harmonising rates with the Eurozone countries may actually be the most benefitial result of this action.

Tom Papworth said...

Yeah. I'm not much taken with this cozy "Economic concensus" that has seen all the parties declare in one voice that inflation is the key.

Inflation is what got us here in the first place!!

It is worth noting that agreeing with the concesus is not helping us in the polls despite Vince Cable being in a position to 1) say "I told you so" and 2) sound like a wise old economist.

oranjepan said...

Are you referring to ICM's latest which puts us on 21%?

I'd also like to ask you whether you think Clegg is being slightly too bold in calling for a 2% rate cut and that a better balance may be found by making a graduated reduction? ie does our economy need to detox or does it need radical surgery?