Why the Government’s plans to rescue the economy don’t seem to be working

The Times captures the mood perfectly: “The economy is plunging deeper into recession despite emergency tax cuts and the multibillion-pound bank bailout, the Bank of England said yesterday.”

What it fails to mention is that this is all utterly predictable and indeed inevitable. The reason that “Cutting the base rate to its lowest level in more than 50 years, the Bank said the outlook now was worse than a month ago, with manufacturing and consumer spending in sharp decline” is that cutting the base rate is not going to have much impact.

The base rate is just one driver of credit, and it is not by far the most important. What is more, it does not address the real problems in the economy, which is that the credit expansion of the last decade has fooled entrepreneurs into thinking that investments were viable when in fact they were not. In some cases, whole businesses will now need to be liquidated as reality crashes in on those who had been fooled by artificially-low interest rates.

Reducing interest rates again cannot solve the problem. Just as the first rule when one finds oneself in a hole is to stop digging, so the first rule when one finds oneself facing the inevitable crash following an inflationary spike is to stop inflating. Further interest cuts (as preached by all political parties) are simply attempts to stimulate more credit expansion, which means further inflation. This will lead to more poor decisions by entrepreneurs and more unviable businesses being created, expanded or propped up. That can only lead to an even bigger crisis in the long run.

“The Bank of England pinned much of the blame for the economy’s slide on the borrowing drought that high street banks have inflicted on consumers and businesses alike” according to The Times, but in doing so the Bank misses the point. The borrowing drought is the result of banks making sensible economic decisions in avoiding making the same kind of loans that got us into this mess in the first place.

For let’s be clear about this: the loans that the banks are currently proving reluctant to make are those that they fear may not be repaid; those that, in American parlance, are “sub-prime”. In a market where asset prices are falling, many homeowners are in negative equity and many businesses are destined for bankruptcy, further lending would not only be stupid, it would be irresponsible.

Far from cutting interest rates, the Bank of England should be raising them so as to reduce the demand for credit and increase the desire of savers to provide it. In doing so, it will not only redress the massive imbalance between saving and borrowing that has led the West to borrow trillions of dollars of the (thrifty) Asians as well as creating money through government-backed central banks, but it will also accelerate the reallocation of “factors of production” between unviable and viable industries. As a result, it might just make this a sharp but short recession, instead of another painfully-drawn-out one.