Inside Politics – The Policy Exchange newsletter (London), 7 November 2007
It has been quite a remarkable week in terms of economics. For the first time since August 2005 the Bank of England has lowered its base rate, and for the first time since 1995 the Halifax recorded three consecutive months of falling house prices. Both things are, of course, closely connected, but reacting to falling house prices with an interest rate cut was by no means the only option, let alone the best one.
The conventional wisdom behind the rate cut is well known. Falling house prices are regarded as a harbinger of economic trouble, and given recent experiences this is understandable. As house prices have risen strongly in the past decade, they have helped to bolster consumer spending. It was far more attractive to borrow against the value of your home in the expectation of further price increases than to save money for a rainy day. In this way, the economy had become dependent on the property market.
Now that house prices are taking a dip in the wake of the subprime crisis, Northern Rock and the credit crunch, this business model of UK plc is no longer viable. If house prices are stagnant or even falling slightly, this could well translate into weaker private consumption. No wonder that retail executives, worried about their Christmas business, were publicly urging the Bank to consider a rate cut.
However, bank rates should not be set according to Tesco’s Christmas wish list, but after weighing the long-term pros and cons for the economy. True, keeping interest rates up would have hurt some retailers and got those borrowers who will be coming off fixed rates in the next year into trouble. But cutting interest rates, by comparison, only seems like the easier solution.
The Bank has only postponed the unavoidable. Sooner or later, this country will have to get rid of both its sweet tooth for debt and its addiction to constant house price inflation. Having put this off for the time being, the Bank of England will find the necessary readjustment even harder when it does eventually happen.
All this raises questions about Gordon Brown’s alleged record of sound economic management if the economy is thrown into a state of panic just because house prices remain by-and-large stable for the first time in a decade. The emperor of prudence has finally lost his clothes.