October 9, 2008 | posted by Michael Baxter in inflation, rate of interest |

It happened in 1987; it happened again after 9/11; the final outcome was tears. On BBC2 Newsnight yesterday evening, Nigel Lawson reminded us how in 1987 he cut interest rates, along with many other governments and central banks, because they feared the stock market crash of that year could lead to global recession. History tells us that, actually, the recession of the early 1990s was caused because the worldwide rate cuts created an unsustainable boom.

Earlier this decade, deflation was supposed to be the big danger, and central banks slashed rates. Well, we now know that the boom this created led to commodity and house price inflation, a debt bubble and then to that thing called a credit crunch, followed by banking collapse.

And now they are at it again.

Yesterday, seven central banks across the world cut rates. Not only were rates down in the UK, US and Eurozone – by ½ per cent in each case – but rates were also reduced in Sweden, Switzerland, Canada and China.

It seems this is the first step. Capital Economics now predicts UK rates will fall to 2 1/2 per cent next year. In the US, rates are now 1 1/2 per cent, and many expect them to fall to just half a per cent in 2009.

But not all agree. There are plenty of inflation hawks out there, warning inflation will be back. Debt will be washed away by inflation – and we will be left with paying the bill for years to come. Are these fears right?

It does seem that, actually, when you dig beneath the surface, inflation fears are simply wrong. They are being expressed by economists who put too much emphasis on interest rates, and miss the underlying forces at work.

What has really caused this crisis; that is, really caused it? We can talk about a debt/property bubble, but that is just a symptom of a wider problem.

The truth is that, on a worldwide scale, savings were too high. China, and oil exporters, saw a massive surge in savings. If the US and UK consumers had not gone out and spent, the global economy would have hit a nasty recession from the moment that dotcoms crashed – and we might still be in it now.

If you really want to look for a fundamental parallel with the 1930s, it is this: thanks to impressive advances in technology, the world in 1930, just like the world in 2000, had a massive surplus of capacity.

This has not gone away.

Oil is now below $90. According to data from the British Retail Consortium, out yesterday, month-on-month High Street inflation was zero in September. In fact, food prices fell by 0.2 per cent; non-food prices were flat. Okay, the annual figures are high, but that’s down to the legacy of rising prices earlier in the year.

Have you noticed, it costs less to fill the car up with petrol now, than a few months ago?

But, above all, the credit crunch will surely have a had a crippling effect on consumer and business finances.

For the time being at least, central banks can get away with slashing rates, and they should.

Some argue that it will do no good. But that surely is the point. If small cuts in rates do no good, then how can these cuts be inflationary?

The problem of the 1930s, and the problem of Japan in its lost decade, was deflation. Deflation will continue to be the main threat for as long as the benefits of globalization and technical innovation outstrip demand.