Since the British economy hit trouble last summer, Gordon Brown and Alistair Darling have been pumping out the message that this is a global problem and that they are not to blame. In his Mansion House speech in June, Darling blamed the “twin global shocks of rising commodity prices and the credit crunch” and claimed “No country can escape these”
The rise in oil prices and the collapse of the US housing market were, indeed, beyond Brown’s control. But this government has been in power for 11 years and the current situation owes much to its actions. Not only has the government tied its own hands in the face of an economic downturn, but it did much to bring it about in the first place.
To trace the problem back from its effects to its causes the property market is a good place to start. Between 2001 and 2006 UK house prices rose by a staggering 90%. To meet the rising prices people borrowed and mortgages account for 80% of a UK consumer debt of £1.4 trillion.
It was cheap for people to borrow. Between 1993 and 2001, interest rates, averaged 6%, from 2002 to 2008 they averaged 4.5%. Since 1997 rates have been set by the Monetary Policy Committee (MPC) of the Bank of England which was given this task in almost the first act of the Labour government.
Why has the MPC been setting such low rates? Its orders from the government are to keep inflation at 2% per year with a 1% either margin, failure to achieve this requires the Governor of the Bank of England to write an explanatory letter to the Chancellor.
Given its importance its worth asking what exactly inflation is. What it is not is a rise in oil or wheat or house prices when all other prices remain the same. These are just price rises reflecting relative demand and supply. Rather, inflation is “the increase in the general level of prices over a specified period”.
Its important to understand how inflation is measured. Back in 2003 Brown ditched the traditional measure of inflation, the Retail Price Index (RPI), for the Consumer Price Index (CPI). Like the RPI, the CPI works by picking out a basket of goods and services (including everything from tinned tuna to adult magazines) and seeing how the prices rise or fall over a given period.
There are crucial differences between the two measures. Unlike the RPI, the CPI doesn’t include Council Tax and a range of housing costs, such mortgage interest payments, which have been some of the fastest rising components of household spending in recent years. As well as the incredible rise in house prices, Council Tax increased by 67% between 2001 and 2007. Any inflation measure, like the CPI, which excludes them, is fundamentally flawed.
Since 2003 the CPI has averaged 1.9%, meeting the governments target. In contrast the RPI, a more honest measure of inflation, has averaged 3.3%. If the MPC had had to base its interest rate decisions on the RPI instead of the CPI, rates would have been higher earlier and much of the disastrous borrowing would not have happened.
This is how the government has been responsible for much of the pain being felt now. By adopting an artificially low inflation measure, Brown prompted the Bank of England to maintain artificially low interest rates. These have encouraged people to borrow more than was sensible. In the short term this made people feel richer, no bad thing for a politician seeking election. However, it has left borrowers exposed to just the sort of economic storms we now face and the direct effect of these actions are a rise in repossession orders of 24% compared with a year ago.
But not only has Brown prompted the public to play with fire, he’s thrown away the extinguisher by fuelling inflation.
The price of money acts like any other price. When money is scarce its price, the interest rate, will be higher. So, to bring the price down the central bank must make more money available. It does this through ‘open market operations’. These involve the central bank buying bonds from other banks. The money paid by the central bank for these bonds then, through these other banks, goes out into the wider economy in the form of loans and lowers interest rates.
But the central bank pays for these bonds by writing cheques which are not backed by anything. The money used to buy the bonds is simply created out of thin air. But if the amount of goods and services available in an economy is not increasing at the same rate as the supply of money, if there is too much money chasing too few goods, we see an “increase in the general level of prices over a specified period” – inflation.
Indeed, fact bears out the theory and the money supply has been growing. According to the Bank of England, “Provisional figures for June indicate that M4 (a measure of the amount of money in circulation) rose by £34.1 billion, seasonally adjusted; above the average flow for the previous six months of £13.6 billion.” This avalanche of cash brought about by a loose monetary policy is where the current bout of inflation has come from. Even the CPI is now outside Brown’s range at 4.4% although the more reliable RPI has it at 5%.
This is the second charge against Gordon Brown stemming from his adoption of the CPI. By giving the MPC an artificially low inflation target interest rates have been lower than they would have been with the more realistic RPI measure and the resulting flood of money has caused inflation.
And this is where Gordon Brown has tied his own hands. To fulfil its mandate of bringing inflation back below 3% into the governments target range, the MPC will have to raise interest rates but this will slow investment, weaken an already wobbly economy and inflict more pain on a public already struggling under its burden of debt. On the other hand an economic boost of interest rate cuts is out of the question without causing further inflation. Thus Gordon Brown and the MPC find themselves in a Catch 22 situation; raise interest rates and see the economy struggle still further or cut them and see higher inflation.
(Printed in London Student, vol 29 issue 1, 15/09/08)