George Osborne makes a curious remark here:
1. What’s the mechanism through which deficit reductions would allow mortgage rates to stay low? One possibility is the Keynesian one - they would depress demand, and the Bank would keep rates low in response. Another possibility is some form of the fiscal theory of the price level, which says that expectations of future government deficits affect inflation now.
If Osborne believes the former, he should concede that his Labour critics have a point - spending cuts would tend to hurt the economy. If he believes the latter, he should distance himself from those who have claimed that quantitative easing is inflationary - because you can’t (pdf) believe in both (pdf) monetarism and the FTPL.
2. Would low mortgage rates really “do more to sustain a recovery than anything else”? Yes, personal debt exceeds households’ bank deposits by £454.9bn, which suggests that households would get an extra disposable income of £4.5bn a year for each percentage point fall in interest rates, relative to what they would otherwise be. But this is only 0.3 per cent of GDP. And there’s a danger that this would be saved rather than spent if highly indebted households use their windfall to pay off debt; I suspect this is a big reason why the savings ratio rose last year.
Of course, it’s possible that low mortgage rates would eventually lead to increased borrowing. But how is this consistent with the claim that “Britain’s new economic model must be built on saving”?
If Osborne means that a low Bank rate would stimulate corporate borrowing, then he might have a point - though I fear the interest elasticity of capital spending is low - but then, why talk about mortgage rates?
3. Doesn’t Osborne’s claim put a limit onto the size of the fiscal squeeze? Bank rate is already as low as it can go - which means mortgage rates are near their lowest feasible level. This means that if the economy turns out weaker than expected this year - sufficiently so that the Bank keeps Bank rate at 0.5% - there’s simply no room for lower government borrowing.
Granted, Osborne might mean that deficit cuts will reduce shorter-term gilt yields and hence fixed rate mortgages. But the effect here is small; short-dated yields depend far more upon interest rate expectations and overseas yields than they do upon government borrowing.
4. Is it wise to pre-announce this intention? Imagine it’s the day after a Tory election victory. FX markets figure: “the Chancellor wants interest rates to be as low as possible, so let’s dump sterling.” The pound then falls - possibly a long way, if rising interest rates in the US and euro zone cause carry traders to short sterling. This in turn would limit the Bank of England’s ability to hold rates low.
In this sense, Osborne’s policy would be self-defeating.
The overriding objective of fiscal policy must be to provide the credible deficit reduction plan that allows the Bank of England to keep mortgage rates as low as possible for as long as possible. That will do more to sustain a recovery than anything else.This raises 4 questions:
1. What’s the mechanism through which deficit reductions would allow mortgage rates to stay low? One possibility is the Keynesian one - they would depress demand, and the Bank would keep rates low in response. Another possibility is some form of the fiscal theory of the price level, which says that expectations of future government deficits affect inflation now.
If Osborne believes the former, he should concede that his Labour critics have a point - spending cuts would tend to hurt the economy. If he believes the latter, he should distance himself from those who have claimed that quantitative easing is inflationary - because you can’t (pdf) believe in both (pdf) monetarism and the FTPL.
2. Would low mortgage rates really “do more to sustain a recovery than anything else”? Yes, personal debt exceeds households’ bank deposits by £454.9bn, which suggests that households would get an extra disposable income of £4.5bn a year for each percentage point fall in interest rates, relative to what they would otherwise be. But this is only 0.3 per cent of GDP. And there’s a danger that this would be saved rather than spent if highly indebted households use their windfall to pay off debt; I suspect this is a big reason why the savings ratio rose last year.
Of course, it’s possible that low mortgage rates would eventually lead to increased borrowing. But how is this consistent with the claim that “Britain’s new economic model must be built on saving”?
If Osborne means that a low Bank rate would stimulate corporate borrowing, then he might have a point - though I fear the interest elasticity of capital spending is low - but then, why talk about mortgage rates?
3. Doesn’t Osborne’s claim put a limit onto the size of the fiscal squeeze? Bank rate is already as low as it can go - which means mortgage rates are near their lowest feasible level. This means that if the economy turns out weaker than expected this year - sufficiently so that the Bank keeps Bank rate at 0.5% - there’s simply no room for lower government borrowing.
Granted, Osborne might mean that deficit cuts will reduce shorter-term gilt yields and hence fixed rate mortgages. But the effect here is small; short-dated yields depend far more upon interest rate expectations and overseas yields than they do upon government borrowing.
4. Is it wise to pre-announce this intention? Imagine it’s the day after a Tory election victory. FX markets figure: “the Chancellor wants interest rates to be as low as possible, so let’s dump sterling.” The pound then falls - possibly a long way, if rising interest rates in the US and euro zone cause carry traders to short sterling. This in turn would limit the Bank of England’s ability to hold rates low.
In this sense, Osborne’s policy would be self-defeating.
Do you honestly think that the FX markets would go shorter sterling on a Tory (let's do something to control the deficit) vicory than a Labour (spend, spend, spend on our lovely client state) victory?
If so, you're deluded.
The pound isn't crashing BECAUSE the markets are pricing in a return to sanity under the Conservatives.
Posted by: Jackart | January 25, 2010 at 03:28 PM
Isn't it the case that the cause/s of currency movements are largely unknown or speculative themselves?
If causes were known, then so would future exchange rates - and clearly they are not...
see for example:
http://fabooks.wordpress.com/2009/08/28/shouldn%e2%80%99t-it-be-illegal-to-make-such-statements-when-they-are-unsupported-by-evidence/
This also applies to interest rates.
Make a list of economists and financial who predicted the lowest central bank rate in the UK in 300 years...oh, and is George Osborne or Alistair Darling on the list?
Posted by: Trevor Brown | January 25, 2010 at 06:24 PM
Of course, we know that the whole point of the paragraph is the phrase "keep mortgage rates as low as possible". The rest is mumbo-jumbo, whose only purpose is to march the vote-catching key phrase into the public eye.
Posted by: william | January 25, 2010 at 06:48 PM
There is only one option now that we have a budget deficit of 13% of GDP and zero nominal interest rates. A massive fall in the pound. At least it shows Mr Osborne hasn't forgotten the lessons of 1992.
Posted by: Econoclast | January 27, 2010 at 08:42 AM
William is right. The Tories were once the political arm of the rural landed interest, now they are the provisional wing of the urban landed interest - property development. Let's not forget that back in the late summer and autumn of 2008, a full year into the financial crisis, when it was actually becoming difficult to get trade credit for shipping, the Tories' headline economic policy was a tax giveaway off stamp duty.
Meanwhle, I see "Jackart" is arguing that the lack of a sterling crisis is evidence of one, presumably between spraying shark repellent around his house - it must be working, because he's not had a shark in the house for years - and looking for weapons of mass destruction in Iraq.
Posted by: Alex | January 27, 2010 at 07:19 PM