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It was never in question that the Bank of England would cut interest rates today to their lowest level since the institution was founded in Threadneedle Street 315 years ago. Concern that the financial crisis, a housing market crash and a global downturn will result in a deflationary spiral meant that the short-term cost of borrowing was always going to head into uncharted waters. All that was at issue was the size of the cut.
Why are rates so low?
This is a different sort of crisis from those that have troubled policymakers since the second world war. Over the past 60 years, problems in Britain and elsewhere have tended to be caused by rapidly rising inflation, which central banks and finance ministries have tackled by raising interest rates aggressively. That cured inflation by pushing up unemployment and, once the cost of living was back under control, interest rates were cut and borrowing resumed. This crisis is different: despite the bubble in various housing markets around the world there was not the same sort of generalised inflationary pressure seen in the 1970s and 1980s. The collapse of property bubbles has severely weakened an over-extended financial system, which has curtailed lending as a result. Activity is weakening, making lenders even warier about granting loans and borrowers reluctant to take on debt.
So is the current policy pointless?
Not entirely, but cuts in the bank rate in this sort of environment are much less effective than during a period of high inflation. Although not all the benefits of lower rates are being passed on by banks to their customers, there has been some improvement in the financial position of borrowers. The problem is that the rate cuts have come late in the day and have arrived with unemployment going up rapidly and firms going bust almost every day. Demand for borrowing would be weak even without the drying up in lending from the banks.
What happens next?
Further cuts in the bank rate look inevitable. The City is expecting another half point to be shaved off the cost of borrowing in both February and March, which would leave rates at 0.5%. The risk is that they might go lower, to zero or slightly higher.
Is that all the government can do?
No, the next step is to look at fresh ways of boosting lending. These include a new recapitalisation package for the commercial banks, so that they have the ability to lend more money, and the implementation of the Crosby review, which would provide £100bn of state guarantees for mortgage lending. This would fill the gap left by the collapse of the securitisation market, which until the freezing of the financial markets in August 2007 allowed home loan lenders to fund mortgages from the wholesale money markets rather than from savers.
What is quantative easing?
The government is actively considering the policy known as quantative easing as a fallback position. Under this policy, the authorities buy up bonds either from banks or from the commercial sector. There are two potential benefits. The first is that the banks get cash in exchange for the gilts they sell back to the government and the increase in the money supply leads to an increased volume of lending. The second is that decreasing the supply of gilts pushes up their price. When gilt prices go up, gilt yields go down and it is gilt yields that determine long-term interest rates for overdrafts, some fixed-rate mortgage products and most business lending. This policy was first tried in the 1930s and has been dusted off by the Federal Reserve, America's central bank, in an attempt to get the US economy moving again.
This sounds pretty desperate stuff?
It is fraught with risk, but these are desperate times. The big risk is that governments create a bubble in the bond markets in their attempt to clear up after the collapse of the bubble in the housing market. For the scheme to work, the financial markets have to be totally confident that interest rates will be kept low for a protracted period, but some analysts are warning that expanding the money supply so aggressively may lead to a surge in inflation, not now, but once the global economy starts to pick up. If that happened the bubble in the bond market would collapse. Alternatively, there are fears that the authorities have left it too late for quantative easing and that it will prove another damp squib.
What if it doesn't work?
The next step would be full public control of the banking system, on the grounds that if the bankers cannot be persuaded to increase the flow of credit the state will have to take on the responsibility itself. This is not nearly as big a jump as it would have been 18 months ago, since the taxpayer already runs Northern Rock and the Bradford & Bingley, has a controlling stake in RBS and owns a big chunk of Lloyds TSB-HBOS. It would certainly resolve the confusion at present, with ministers on the one hand criticising the banks for not lending enough and on the other encouraging them to boost their profitability so that they can pay back the money owed to the taxpayer. Intellectually, though, it would be a seismic shift in policy for Labour which, over the past 15 years, has learned to love the market and embrace the City.
Surely that would do the trick?
Not necessarily. The danger is that deflation takes hold before cuts in interest rates, quantative easing and nationalisation have any real impact. In those circumstances, monetary policy becomes ineffective because the value of debt increases year by year. When debtors are in trouble, governments usually respond by cutting the cost of borrowing until it is lower than the inflation rate. In a period of deflation, this is not possible and individuals hoard money in the knowledge that goods will be cheaper in the future. Governments then have to step in and replace private spending with public spending. Provided the fiscal boost is big enough, it will - in conjuction with the monetary policy measures listed above - get the economy moving again. This is not theoretical stuff: Barack Obama is planning a fiscal boost worth between 4% and 5% of US GDP to supplement the Fed's quantative easing. For the UK that would mean a £60bn-£75bn package and a public deficit of about £250bn.
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