Any interest in another rate cut?

So the Bank of England has decided to reduce the bank rate to !%, its lowest ever rate. The main motivation behind this is presumably to get people to increase their personal and corporate spending based on a lower cost of borrowing. And with a recession already under way there may be some who would argue that the Bank of England has to be seen to be doing something. Well, perhaps, but there are strong arguments to suggest that this rate cut will not achieve what the previous four have failed to do.

Almost all analysts are agreed that the root cause of the current almost-global recession is the "credit crunch", a liquidity crisis. What the Bank of England's decision seems to neglect is on which side of the market for loanable funds the problem actually lies. The credit crunch is a phenomenon whereby lenders are reluctant to lend due to increased risk aversion, a lack of confidence in the ability of the borrower to repay, which may be more apparent than real. On the demand side there is no lack of desire to borrow: indeed "retail therapy" has become almost a national sport. The lowering of the Bank's base rate will do little to stimulate consumer spending, in part because banks and other lenders remain overly cautious, and also because so many retail lenders continue to raise their interest rates. While the Bank of England makes history reducing tis own rate of interest, one of the key providers of credit cards, Capital One, has raised their rates of interest. I guess we all know what's in their wallet! Capital One has argued that it has become more difficult for them to acquire the funds which they effectively lend out to their credit card holders. It is in remedying this aspect of the credit crunch which the Bank of England should concentrate its efforts, rather than using the blunt instrument of interest rate reductions ad absurdum.

Basic macroeconomic theory tell us that in a recession, when the LM curve is virtually horizontal, monetary policy will be largely ineffective. Under such a scenario expansionary fiscal policy is much more effective. Unfortunately, instead of perhaps increasing government spending on long-term infrastructure projects this government has chosen to bail out the very people who have put us where we are: the heads of the banking system. While there is little doubt that a bail out of the banks was warranted--and certainly preferable to allowing wholesale failures--surely the price should have been the replacement of those who had done the damage? The bailout will do little in the short term to get aggregate demand rising. Given that it may be difficult for the UK government to spend more at this point, then we should look to permanent tax cuts to stimulate demand. A marginal cut in VAT will make no difference. What is needed is a significant cut in income taxes, preferably in reduced tax rates (not the future increases which Mr Darling has opted for). Cuts in corporate tax would help some struggling businesses, but without demand for their products it would do little to run round the economy and move it out of recession. The only remaining solution is to cut personal income taxes by a significant percentage. People are much more likely to spend if they feel they have more income than if they see some prices coming down marginally. If they chose to save any additional income it would have the added bonus of increasing the supply of savings available for borrowing, thereby reducing the rate of interest at a broader level than can be achieved by the Bank of England.

We have been here before, on several occasions in the past. We seem to condemned to repeat the same fallible mantra, which is why I have no interest in another rate cut by the Bank of England. Time for an election, perhaps?