QUERETARO, Mexico, Nov. 8 (UPI) -- Beware Greenspanism; it is contagious. Both the Bank of England and the European Central Bank cut interest rates Thursday by 50-basis-points (half of one percent), thereby emulating the latest cut Tuesday by the U.S. Federal Reserve Bank.
The ECB's was the most unexpected cut of all. Et tu, Wim? But were the BoE and the ECB right to cut?
Both were influenced by the terrible events of Sept. 11. The latest Confederation of British Industry survey, carried out in October, found that the Sept. 11 terrorist attacks in the United States had had a major impact in Britain.
According to the CBI: "A third of companies expect a serious impact on demand. Twenty nine per cent said they had already seen a significant number of orders cancelled and almost four out of ten expect this to continue over the next 12 months."
Business confidence in continental Europe, too, has slumped. The decline in German business confidence in September, according to Germany's Ifo index, was the sharpest month-on-month change since November 1973 when action by Organization of Petroleum Exporting Countries was causing oil prices to quadruple.
Factory orders in Germany fell in September by 4.1 percent from August, the steepest month-on-month drop in six years. Businesses in Germany fear outright recession in 2002.
So there is evidence of weakness in both the UK and European economies, weakness that has been exacerbated by the shock of the Sept. 11 terrorist attack. But does a one-off event such as an attack merit further loosening of monetary policy? Is there danger in cutting too much?
John Butler, UK economist of HSBC Bank in London thinks that for the UK economy, there is and that the half point rate cut may not he justified. He points out that the inflation measure that the Bank of England targets, RPIX, is, at 2.3 percent, only just below the 2.5 percent rate that the Bank is charged to target.
"Moreover, core inflation has doubled over the past 9 months and is now 2.8 percent," Butler explained.
Butler was already concerned about the level of corporate debt in the UK economy. Cutting rates will help the corporate sector deal with its debt burden but households have shown "a huge appetite to use low rates to accumulate debt," Butler says. "That is good for now, but will create a more vulnerable economy further out. As and when the world economy does recover, the UK economy will be extremely sensitive to movements in interest rates."
The risks the UK runs by cutting interest rates fast may be similar to those in its trans-Atlantic cousin. In the United States the housing boom was still roaring as recently as August: fostered by the series of rate cuts this year. In the United States, too, corporate and consumer exposure to debt is very high. U.S. consumers, like their British counterparts, need little incentive to borrow.
The danger of rising debt and, indeed, rising property prices -- for both in the United States and Britain, house prices were rising as recently as August -- is that debt will cast a cloud over the economy for some time to come. This happened in Britain in the late 1980s and early 1990s after house prices had spiraled in 1986 and 1987.
How should policy-makers respond to a burst asset price bubble? That is the question to which we return. In the UK and the United States monetary policy is being directed towards keeping the consumer borrowing and spending. A more neutral monetary policy, which left rates higher than they are now, would cause a more abrupt slowdown. Companies and consumers would be forced to change their behavior. Borrowing and spending would fall. Saving would rise. The stock market would fall further.
But all this short-term pain might provide a gain. In both the United States and in Britain the trade deficit is close to an all-time high and debt levels are unusually high. A sharper slowdown would have checked these imbalances and helped to correct them swiftly. And in 2002 there would remain plenty of scope to cut rates to help recovery along. Instead, Alan Greenspan, in particular, has spent most of his ammunition. U.S. rates cannot go much lower.
It is Europe that has shown most caution over rate cutting. But Thursday Wim Duisenberg followed up on the signal he gave Monday, when he pointed to declining inflationary expectations in the euro-zone, and cut rates by more than most economists expected. Despite this the euro has weakened further Thursday. It closed in U.S. trading today at 89.2 U.S. cents, against 89.8 U.S. cents at the close of trading Wednesday. But there can be little doubt that the fall would have been much more pronounced had Duisenberg delivered only a quarter point cut.
The euro's vulnerability against the U.S. dollar, despite the enormous U.S. trade deficit and the fact that the U.S. economy is now in recession, stems from the view that in the end the U.S. economy will come out on top. It is the team that has won the World Series one year after another. Its weakness is thought temporary and passing, while the market has little hope for Europe, a permanent loser.
Against this and against the structural flaws of the European economy Duisenberg can do little. Yet his cut now looks better justified than that in the US or the UK. And the greater caution he has shown hitherto may have benefits medium-term.
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