If you ever studied economics at A-level you would have been told that the answer to a deficit in the balance of trade, was increasing the rate of interest. Such a move, goes the theory, will lead to less demand, and therefore less imports. Strange then, because in the real world, the relationship seems to work the other way round. A cut in interest rates leads to less money flowing into the economy, so the currency falls, and exports improve, and imports reduce.
So how can theory and practice be so different?
The answer really lies in the difference between short and long run. In the short run a cut in interest can lead to a cheaper currency, helping the balance of trade; in the long run, well there the picture gets murky.
Yesterday, in what, by the way, was one of the best speeches we are aware of from a central banker on the issues plaguing the global economy, Mervyn King put his finger on key issues. He talked about two gales, both blowing in different directions. The gale from the US – the credit crunch, and the gale from the east – higher commodity prices.
“A lower average level of the exchange rate can, by supporting overall economic activity, help protect us from the worst effects of the wind blowing across the Atlantic” said Mr King, “but, by pushing up import prices, it will exacerbate the impact of the other wind now buffeting the UK economy, which comes from the east – the inflationary effect of higher energy and food prices.”
And that says it all. Lower interest rates are good because they help push the pound down, thus lifting exports and help grapple with the underlying lack of balance in the economy. But lower interest rates encourage more borrowing, thus exacerbating the underlying problem of too much spending and not enough saving.
A lower pound helps exporters, but it leads to inflationary pressure too.
Yesterday, Mr King made the headlines when he joked, “It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the Chancellor.”
He added, “Although there is little we can do now to avoid some rise in inflation this year, the task of the Monetary Policy Committee is to ensure that it is short-lived. If inflation expectations were to pick up in the wake of a rise in inflation this year, then only a more-prolonged slowdown would allow inflation to return to target. But if the rise in inflation does not affect longer-term expectations, then inflation could start to fall back towards the end of the year.”
The fundamental problem, though, as Mr King rightly pointed out, “The low level of national saving is apparent from the current account deficit – our new net borrowing from overseas – which in the third quarter of last year was, relative to GDP, the biggest in the past fifty years and the largest in the G7. It is possible to run a current account deficit for a considerable period. Australia, for example, has done so in every year since 1974. But our own position is becoming more difficult. For some years we have been able to finance current account deficits by borrowing, often through banks, at unusually-low interest rates on world capital markets. Such borrowing is now becoming more expensive. Unless we spend less and save more, our current account position will deteriorate.”
To read the full speech click here
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