The economic benefits of self-indulgence

A CHILLING phrase was heard on Wall Street at the end of last week: 'Monetary policy has lost its traction.' In other words, US central bankers may be revving the engine, but the wheels are spinning.

Chilling, because last week both the Bank of England and the European Central Bank joined America's Federal Reserve and gambled that hefty cuts in interest rates will pull our economies through war and recession.

The cuts represent an embossed invitation card from usually stonefaced reserve-bank chiefs to consumers and companies to get out there and start borrowing and spending.

Self-indulgence has become a patriotic duty, much as in the late Fifties, when President Eisenhower urged Americans to combat an economic slowdown by buying something. 'Buy what?' he was asked. Einsenhower replied: 'Anything.'

But suppose this handsome invitation receives the RSVP: 'Thanks, but no thanks'? It could happen. Across the Atlantic, there are warning signs as America's admittedly dismal savings rate picks up. Consumers are using tax cuts and cheap money to rebuild their balance sheets - the one thing the Fed does not want them to do. Hence fears of 'lack of traction'.

In theory - the theory that has dominated Western policymaking for the past quarter century - traction ought to be pulling at 100 horsepower. As the cost of anything falls, people will consume more of it. Money is no exception, and interest is the price of money.

That price is controlled by the monopoly suppliers of notes and coins, the central banks. Should they wish to pep up a flagging economy, they make their product cheaper, stimulating borrowing, spending and investment.

The same principle works in reverse - a rise in the cost of money will depress borrowing and stimulate saving. As with all other products, it is the 'real' - inflation-adjusted - price that matters. British base rate, at 4%, translates into a real rate of 1.7%.

What can possibly go wrong? For a start, the fruits of this policy are hit and miss, to say the least. Take the high inflation Seventies, when real interest rates were frequently negative. Those who borrowed were paid to do so and saving was madness.

In 1975, the average base rate was 11% and the average inflation rate 24.2% - a real interest rate of minus 13.2%. In 1975, the savings ratio (the net amount of income tucked away) stood at 8.5%. In 1990, by contrast-base rate averaged 14.3% and inflation 9.5%, giving a real interest rate of 4.8%. The savings ratio? Just 7.4%.

Nor is monetary policy much more reliable at regulating consumption. In the January 1985 sterling crisis, rates were rammed up from 9.5% to 14%, putting an immediate strain on mortgage-holders. Retail sales duly dived in the first quarter of 1985, down 19% on the previous quarter. But they had dived 19% in the first quarter of 1984. It was the routine post-Christmas hangover, not the crisis, that did the trick.

With the specific circumstances of November 2001, these traction problems could prove especially acute. British consumers were heavily in debt even before the Bank's post-September 11 promptings to live a little. Outstanding credit card, overdraft and personal loan debts stand at about £75 billion, against about £52 billion at the end of 1998. The savings ratio has slumped from 9.3% in 1997 to just over three% now.

This is hardly the ideal starting point for a credit binge. Pavlov's dogs may have salivated when the dinner bell rang, but not, surely, when they had already downed a tin of Pedigree Chum? Furthermore, as the recent dismal history of Japan has shown, even zero interest rates can do nothing to jolly along a resolutely downbeat economy. The Bank of Japan is in the same undignified position as the doorstep salesman unable to give away his dusters and dishcloths.

Looming above all this is the spectre of the 'liquidity trap', the nightmare scenario sketched out by John Maynard Keynes in which, because interest rates cannot fall below zero, a deflating economy (like Japan's) is stuck with increasing real rates even when the rate is precisely nought. All other prices go negative, but interest is the one price that cannot follow.

The best hope of counteracting any loss of monetary traction in Britain may be Chancellor Gordon Brown's public spending boost, which is putting billions into both public-sector wage packets and the profits of firms building schools, clinics and the rest.

This is ironic, given that the official line of the past 25 years has been that monetary policy ought to be the sole instrument for running the economy.

But then, if we can learn the lesson that monetary policy is just one useful tool, not a branch of occult magic, and that central bankers are tradesmen, not white wizards, then something worthwhile will have come out of our present difficulties.