Recession? It’s time the Bank let go of interest rates

The ONS figures released yesterday show that the UK entered a small (or paper) recession in the last quarter of last year. For the average person on the street, this means very little. Ever since the 2008 banking crisis, most developed countries have been locked in a cycle of recession and stagflation. Living standards have declined or stagnated, and economic discourse has become depressing.

The UK has been hit hard by this stagflation cycle. This is partly because we were more dependent on the banking sector to drive our headline GDP. We were also hit harder than many economies by the impact of the pandemic because our economy is disproportionately dependent on the service sector. Another factor is that the promised Brexit “sunlit uplands” seem tragically hard to find.

Most Western economists predict that interest rates will fall this year. It’s not a matter of if the Bank of England will cut its base rate, but when.

But what would happen if we don’t cut? What if low interest rates are the reason why the West is in a stagflation doom loop?

Between 1945 and the 2008 financial crisis, the average UK interest rate was around 7%. During this time, UK GDP growth averaged around 3%. A similar scenario was found in most Western countries. Admittedly there were some major bumps in the road, but looking back, this period appears to have been a golden age of capitalism.

In 2008, Western governments took joint concerted action to counter the ravages of the financial crisis by employing two policies to prop up the economy. Interest rates were cut to near zero, and money was pumped into the economy through financial institutions via Quantitative Easing (QE). This was broadly done for four reasons.

First, the banking collapse of 2008 severely damaged the balance sheets of many banks and financial institutions, leading to a credit crunch and a reduction in lending. By lowering interest rates and implementing QE, central banks aimed to support the banking sector, improve liquidity in financial markets, and restore confidence in the financial system.

Second, by lowering interest rates to almost zero, central banks aimed to encourage borrowing and spending by both consumers and businesses, preventing what became known as the Great Recession from becoming the Second Depression.

Third, the fiscal stimulus had the effect of increasing the prices of assets such as stocks and housing. This helped stabilise financial markets and prevent a further decline in asset values, which were severely impacted during the financial crisis.

Lastly, after the financial crisis, many economies faced the risk of deflation. With QE, central banks aimed to increase the supply of money and credit in the economy, thereby boosting demand and preventing deflation.

However, this temporary financial package rolled on and on, with Western financial systems addicted to what appeared to be free money. The Bank of England kicked off its QE program in March 2009, snapping up approximately £165 billion in assets by September of that year. By the end of October 2009, that figure had ballooned to around £175 billion. Over the following years, in five additional rounds of bond purchases spanning from 2009 to November 2020, the QE juggernaut surged, ultimately reaching a peak total of £895 billion. During the same period, the Bank of England slashed interest rates from 5.75% to a historic low of 0.5% following the 2008 crash. Interest rates never rose above 0.75% until last year, with a low of 0.25% in August 2016 to mitigate the post-Brexit referendum wobbles.

The impact of these near-zero interest rates and QE is that financial institutions and the assets they gear loans upon have decoupled from the wider economy. Take the simplest expression of asset value: house prices. According to data from the UK House Price Index, the average house price in the UK stood at £160,304 in January 2008. By December 2023, this had risen to £284,691. This represents an increase of approximately £124,387, or around 78% growth. For the same period the UK’s Gross Domestic Product (GDP) was £1.4 trillion in 2008 and had risen to around £2.1 trillion by 2022. This represents an increase of approximately £700 billion or around 50% growth. House prices have inflated far more than the general economy.

Perceived wisdom is that an undersupply of housing is the major contributing factor in this price inflation. However, in 2008, the total housing stock in the UK was approximately 25.6 million homes, according to data from the Office for National Statistics. As of 2023, the housing stock of the UK stood at approximately 28.6 million homes. In other words there has been a 12% increase in housing stock since 2008.

The population of the UK has increased over the same period, according to estimates from the Office for National Statistics, from 61.4 million in 2008 to 68.1 million in 2023. This represents an increase of around 6.7 million people, which translates to around 11%.

So if anything, the housing stock has increased faster than the population has grown since 2008. I concede there are true pinch points in housing stock around the South East and other desirable locations. Also, there is an increase in single-person households as the population ages, which has the effect of choking supply. But the current housing crisis cannot be purely attributed to an undersupply of housing — far from it.

A major contributing factor, indeed the biggest contributing factor to the house price bubble, is QE, which has decoupled house prices from the real economy. It’s a real and current example of state interference distorting and corrupting a private market to the detriment of those trying to buy into it (the young) and for the benefit of those who hold the asset (the old).

And it’s just plain wrong.

In fact, the whole notion of the state or Bank of England setting a single lending rate for all financial institutions is utterly antiquated. Furthermore the whole idea of the Bank of England printing money and stuffing it into financial institutions for 14 years was morally bankrupt. We will look back on this as the greatest fiscal mistake in post-war history. It was a policy which robbed the young and broke the Burkeian social contract between generations.

If Sunak and Hunt wanted to do something which was truly revolutionary and take advantage of our “Brexit freedoms”, they would pull the state (including the Bank of England) out of any input into setting interest rates and limit the state’s input to oversight of the market to ensure fair play. They would make the UK interest rate system “fiat” in the same way that currencies became fiat in the 1970’s.

The dollar became a fiat currency thanks to the Nixon shock of 1971. President Richard Nixon made the decision to abandon the gold standard, effectively ending the convertibility of the US dollar into gold. This came in response to mounting economic pressures, including high inflation and a deteriorating balance of payments; similar to the UK economy today. By severing the link between the dollar and gold, Nixon sought to address these challenges by making the dollar a fiat currency. It worked.

A fiat currency is a type of currency that has value because a government declares it to be legal tender, meaning it must be accepted as a form of payment within the country’s jurisdiction. Unlike commodity money, such as gold or silver, which has intrinsic value based on the material it’s made of, fiat currency has no intrinsic value and is not backed by a physical commodity. Instead, its value is derived from the trust and confidence of the people who use it and the stability of the issuing government. The Nixon shock was revolutionary, but nearly all modern currencies, including the Euro and the pound Sterling, are now fiat currencies.

In a similar way, the Bank of England should stop setting lending rates by being “the lender of last resort”. The UK economy should let the rates be set between banks themselves. Interest rates should be derived from the trust, stability and confidence of the institutions which lend within the UK system. To aid this, the Bank of England should give risk assessments for all regulated institutions within UK jurisdiction—a job it does already. Additionally, the Bank should concentrate on regulating the system so that there isn’t anticompetitive wrongdoing — as there was with the LIBOR scandal of the late 2000s and early 2010s. All institutions are not the same; risk profiles are completely different, and it is therefore ridiculous they should all have the same borrowing rate of last resort.

In doing this, London would once more become a global Mecca for financial institutions — but this time, only for the low risk and because it was well run. Perhaps London would become that fabled “Singapore Upon Thames”, which has so far eluded post-Brexit Britain.

This new dispensation would not just be confined to large banks, but also embrace insurance markets, pension funds and venture capitalists, small and large. At the same time, dodgy sharks would be jettisoned and forced to make their home where they can share the risk of their shady deals with other financial institutions sharing by a central bank’s base rate.

Vast amounts of capital would come into the country, giving access to the young to gear earnings and buy homes, while the elderly wouldn’t be trapped into using their houses to finance the latter years of life, but secure their financial future through stable pension funds and annuities based on the wider capitalist market.

The financial sector would once more couple itself to the wider economy of the UK and the world. The state would no longer distort the market by printing money through QE, giving it away for nothing through near-zero interest rates.

It’s time for the Government to take a giant step back from the UK economy. Equally importantly, financial institutions should grow up and stop sucking on the teat of the state. It’s time for the British economy to become capitalist once more.

A Message from TheArticle

We are the only publication that’s committed to covering every angle. We have an important contribution to make, one that’s needed now more than ever, and we need your help to continue publishing throughout these hard economic times. So please, make a donation.