WARTIME RATES: MONETARY v. FISCAL

I recall the satisfaction in Japan when the Yen/dollor exchange rate fell to 130, the rate before WWII. It did not stay there for long or mean anything historically. Today it is 93. The UK bank rate is today back where it was from June 1932 to November 1951 (except a couple of months in Autumn 1939, when it went to 4%). All the way from hungry thirties, global war against fascism, post-war Labour Government, then Churchill only defeating Attlee at the third attempt, rates stayed as low as they are today. If rates fall more - and some call for this and others expect it - UK monetary policy will be as never experienced since 1694. Some opinion-formers argue that a zero bank rate (a negative real rate until deflation catches up) is called for as an alternative to fiscal reflation (big increase in Government budget borrowing & spending). This is also called 'tax & spend' with the tax part merely postponed. A zero central bank rate will not be the case for interbank loans or for their customers. The debate generally assumes that businesses are happy to get cheaper money now and worry less about future tax than households do and that they also worry less about what they earn from cash deposits than personal savers do. Low bank rate is normally a filip to share prices via relatively higher dividends. But returns on equity are now already very high. The main argument is between those who prefer monetary responses (Monetarists) and those who prefer fiscal responses (Keynesians) by Government in a recession.
An ex-member of the Bank of England's MPC and FT columnist, Willem Buiter, urges all the main central banks to take their central lending rates to zero now. "If zero is the floor, there is no reason not to go there immediately... the recession in the US, the UK, the eurozone, Japan and the rest of Europe is, with probability verging on certainty, going to be so deep and so prolonged that the zero lower bound will be reached even by the most anal-retentive gradualist central bank before the middle of 2009. So why not get it over with in December 2008 and possibly do some good in the mean time?"
Bank rates briefly at wartime levels, but heading next to zero? A new financial architecture? Inflation may become deflation, with oil heading back to $25 a barrel from $147 at its peak. Most of us have never experienced this. Onlt those who remember the interwar years will know periods of falling prices.
Bank rate at zero doesn't exhaust the arsenal of monetary interventions by central banks, and will not do so if interbank lending remains at 200-400bp above. Even the experts urging zero now, like Professor Buiter, admit not knowing if it will make a substantive difference. Their hope is that this will "provide a major stimulus to financial intermediation and thus to aggregate demand. But even if it doesn't help, it certainly won't hurt," writes Buiter. It may not feed through to aggregate demand. It may help bring on observable price deflation - not good for pensioners and not good for savers who need income from cash savings. On the face of it, a period of falling prices sounds appealing, but not if you carry a debt burden, in which case income-inflation is better for reducing the relative value of the debt to income. Spare cash buys more now, but not if you save it. A sustained period of deflation leads consumers to put off spending decisions thinking to wait until each purchase gets even cheaper. Consumer Demand falls more than it is falling already, with self-evident drag on output & investment and adding to unemployment. Japan responded to the 1990 property and bank crashes with zero rates (negative in inflation terms)and endured over a decade of falling prices and stagnant domestic consumer demand. Even today the Japanese central rate is just 0.3%. Deflation is a genuine fear in the UK and other countries. Some argue that consumer prices, like house prices and other assets, have to periodically return to their long run trend. But, if our bank rate hits historic lows and approaches zero, how will this transmit through into the supply and pricing of secondary saving and lending and all the financials we experienced in more normal times. Bank customers want to know why banks are not passing on the rate cuts in full in pricing of loans, credit cards and mortgages that might make a difference to personal and small business survival or insolvency? Banking used to take in customers' deposits and lend out prudently to other customers plus obtain secured and unsecured wholesale money markets funding for making up shortfalls and to engage in investment trading. Secured borrowing has dried up except via the central banks, and unsecured borrowing is prohibitively expensive for the banks, demand greatly exceeding supply. As Eric Daniels CEO of Lloyds TSB says, "only around one-quarter of Lloyds TSB's balance sheet moves with the bank rate". And when banks needs to grow their deposits they have to build in sufficient interest amrgin to offer savers tangible rates. The biggest headache for the banks and central banks is how to get greater 2-way liquidity balance into inter-bank funding, Libor lending?
Given that banks are not lending to each other out of solvency fears and supply cannot or will not match demand, then it is hard to see what difference a zero rate will make? Governments will continue to push more capital into the markets by swapping illiquid bank assets for liquid treasury paper. But the interbank market remains unbalanced. Monetary responses therefore appear the lesser of the two choices between monetary and fiscal responses to recession.
Goovernment fiscal reflation by issuing bonds and boosts spending and incomes across the whole economy above what they would otherwise be. With low central interest rates, the price of already issued bonds is high (bearing % coupon from past higher rates), nut new issues will have very low coupons and may appear relatively cheap. Government therefore wants the banks to buy most of next year's several £100bn of bonds and apply them to higher capital reserves (keeping the bonds in effect as non-tradable, non-pledgeable), which may further constrain bank liquidity. The only hope is that reflation measures will put a floor under general confidence and as the prospect of economic recovery becomes imminent (by say end of 2009) then banks will gain more confidence in each other and in the value of each other's net assets? But, given that it may take another year or even two for banks to recover what they can out of loan losses and establish new reliable 'book values', we may have a painful wait before banks' wholesale funding returns to near normal. Hence, this is why Government has no choice but to arm-wrestle the banks into being kindly and soft-hearted about customers' repayment difficulties, and why Gordon Brown suddenly announced a not yet thought through policy of supporting distressed mortgagees for 3 years!