Base rates are a broken lever

The Bank of England's reduction of its base lending rate to 1% is proof of the utter irrelevance of the economic theories under which it and the prevailing academic consensus is working. By reducing the base rate to 1%, it is announcing that a rate of 1.5% will not work.

1.5% was itself a record low. If reducing the base rate was going to work at all, then 1.5% should have been quite low enough. It was less than half the current level of inflation and meant that anyone with a tracker mortgage set at 1% above base would have been paid to borrow, in real terms.

The drop to 1% is akin to the tragi-comic situation whereby a character discovers that a particular control for a runaway machine no longer works but, instead of reassessing the situation in order to establish control by some other means, continues to pull on the broken lever in the vain hope that somehow it might spontaneously repair itself.

Thus it is that the Governor of the Bank of England, the members of the Monetary Policy Committee, the Prime Minister, the Government's Treasury team, most economic commentators and everyone else who takes base rate reductions as a serious solution to the present economic crisis can number themselves amongst a cast of notables that includes Dick Dastardly, Wile E. Coyote and the Keystone Cops.

To understand why this is, let us consider the theory behind the raising and lowering of interest rates.

Very simply, the theory is that when base rates are low, people borrow more and because people borrow to spend, so more spending takes place and the money moves around the economy faster. When saving rates are low, there is less incentive to save, because savings rates are low.
The implication of this is that there is only so much money within the economy, and people are either spending it or saving it. They cannot do both. What is not addressed is the question, if people are saving less and borrowing more, from whom are the borrowers borrowing?

The unspoken truth, of course, is that borrowers do not borrow from savers. Their borrowings are entirely new money created as debt by the clearing banks.

Even so, the lowering of interest rates at the retail level should stimulate economic activity, because through increased borrowing, more new money is created, enabling businesses to sell more, employees to earn more, people to spend more, and so on. It has always worked like this before.
The trouble is that we have never before had the levels of debt within the economy that we have now. People with tracker mortgages, who are finding themselves with hundreds of pounds extra money to spend each month are not spending it. They are using it to pay off even more of their mortgages, worried that in a few month's time, they might be unemployed.

Everyone with even the slightest amount of fiscal awareness, obviously excluding Dick Dastardly et al, listed above, is doing the supremely sensible thing for themselves and their families of paying off their mortgages and other debts, and building up their savings, no matter how low the interest rate they might earn, against the possibility of their own domestic financial difficulties.

This sensible course of action is disastrous for the economy. What is good for individuals is bad for the economy. What is good for the economy, indeed, what is essential for the economy is for individuals to borrow massively, even against their own long term best interests. This is a perversity within our current monetary system that rarely gets mentioned.

This peculiar and perturbing fact is due to our high dependence upon debt to provide the money supply. Without large numbers of solvent borrowers taking out mortgages for homes, loans to start businesses or credit cards to consume, our money supply would almost totally disappear.

This explains the Government's obsession with getting banks lending, 'to get credit flowing once again'. The trouble is that for the banks to lend, someone else has to borrow. The Government itself is doing its bit, but Government borrowing has fallen over recent decades as a proportion of overall national borrowing, and there is a political limit on future increases, especially if the Conservatives win the next election. They have so vilified Government borrowing, that whilst they might find it expedient to increase it slightly themselves should they come to power, they cannot do so by much without becoming a laughing stock.

So the burden of borrowing the increasing amounts necessary, a need that rises exponentially year-on-year, to fund both day-to-day economic activities and the high level of residual interest on past borrowing, will fall on the private sector, both households and businesses.

The question is how much increased borrowing are we, as a nation, collectively able and willing to undertake?

Even with base rates at 1%, with mortgages fallen to an all time low, the desire to borrow (and ability to repay) is modest. Even if people were not worried about possible unemployment or other insecurities, their borrowing might be expected to decline, for the very simple fact is that there is a limit to the amount that anyone can borrow.

Micro-economic factors feature rarely, if at all, in the macro theorising of most monetary economists, but real people, unlike lines on graphs have their limits.

With average unsecured debt for households that have such debt standing at £21,000 and average outstanding mortgages for the 11.7 million households who have mortgages standing at £104,000, there is a very real possibility that we have maxed out on debt. We have gorged ourselves and can borrow no more. There must be a limit somewhere.

If the limit has been reached, then cheap loans will not aid us. In that case, if we adhere to the economic orthodoxy that us got us into this mess, the only solution is to take the pain of our indigestion for the next decade or so as our level of indebtedness declines through house-repossessions, bankruptcies and high levels of unemployment.

With the current Bank of England base rate at the lowest point it has ever been in the Bank's 315 year history, firstly as a private company, then since 1946 as an agency of the state, we are clearly living in historic times. Few man-made processes last forever. We might well have reached the end of the Era of Debt.

There is, of course, an alternative to a money supply consisting of debt. We could quite easily switch to a debt-free money supply of the sort that currently exists in the minds of most ordinary people, who are baffled by the concept of money as debt. It does not make sense. Indeed, it does not, and we can expect to see the end of it during the next decade.