Thursday, 9 October 2008

Government spends a lot of money and reduces interest rates

Well golly gosh! Yesterday morning Alistair Darling and Gordon Brown cooked up a plan to spend half a trillion of your pounds on bailing out the banks and ending once and for all the credit crunch. This is how the money breaks down...

£250bn........... Government guarantees for bank bonds.

£200bn........... "Special Liquidity Scheme", ie short-term loans for banks temporarily strapped for cash.

£25bn............ Capital injection into banks by buying preference shares (and the equivalent for building societies which don't have shares, called PIBS if you're really interested.)

£25bn............ Same as above if the first £25bn didn't work.

Voila, £500bn! However the cannier readers will have noticed that most of the cash is actually "guarantees" and "loans", ie not money that really has to found from somewhere, not if the bail-out plan works anyway. So you may be wondering just how much the taxpayer is really in the hole for here. Well, about £80bn is going to have to raised in extra borrowing to cover recent events, including of course compensating ICEsavers, and rescuing Bradford & Bingley.

It's even possible that over the longer term the taxpayer could even make a profit on the deal. Apparently Sweden did when they bailed out their banks in the 1990s. I mean, prices are bargain-basement at the moment. The government is doing what's known technically as "bottom feeding".

So although at first blush it looks like the British plan at £500bn (or US$875bn approx) is actually bigger than the American TARP which is $700bn, in fact the money spent is likely to be far less; TARP remember involves actually buying these "troubled assets" rather than just taking a stake in the banks involved.

At the same time as this jazzy bail out plan was announced the BoE and a load of other banks around the world dropped interest rates by 0.5%. So we now have base rates looking like this:

UK.......... 4.5%
USA......... 2.0%
Euro........ 4.25%
Australia... 6.0%
Canada...... 3.0%
Japan....... 0.5%

So what about inflation? At the last count CPI was at 4.7%, considerably more than its 2.0% target, in fact more than double. The BoE has persistently refused to raise rates enough to tackle inflation.

But their failure has led us to an economic recession; there may even be a depression in the offing. We've had stagflation for a while now, but the future is deflation. Already things are getting cheaper: oil, food, housing; not gold of course, this isn't fairyland!

So you may think I applaud that. I mean, I'm always banging on about the dangers of inflation. Well, no! You see, the whole aim when running an economy, the Holy Grail if you like, is "non-inflationary growth". This means everyone earns more but prices don't go up, so everyone is richer. It's no good earning more if prices go up by as much or more; and it's no good prices coming down if your earnings come down by even more; either way, you're poorer. You may be thinking, "but my earnings aren't reducing." Well, wait until you've lost your job, or been put on short hours. And even if you aren't personally affected other people will be. National earnings will be falling soon.

And what is the point of reducing interest rates anyway. Is it so we can all borrow more, and even the government can borrow more? Surely borrowing is what got us into this mess in the first place? No, the answer to too much borrowing is: repayment. What we need now as a nation (even as a hemisphere, America you too!) is a prolonged period of austerity and debt reduction. The spending frenzy of the last decade must be paid for, and the sooner the better.

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