Debts & Loans

When the last raven leaves the Tower of London and it is time to engrave an epitaph on the nation's headstone, there is no doubt what it will say: "Britain: the country that liked to spend now and pay later."

Today's pre-budget report is all about the government's attempt to exploit this deep-rooted character trait. Assuming the nudges and winks from Whitehall are correct, VAT will be cut to entice consumers back into the shops for a pre-Christmas spending splurge. The theory is that behaviour will be driven more by lower prices today than by the threat of higher taxes at some point in the future. On past form, that looks a reasonable bet.

This is not the pre-budget report that was envisaged three months ago, but since the summer the skies have darkened. The financial crisis has led to the first synchronised global recession since the early 1980s and to the threat of the triple-zero economy.



Growth rates are turning negative and that will drag down the inflation rate. It is likely that the cost of living in Britain, as measured by the retail prices index, will fall next year as a result of lower interest rates and tumbling commodity prices. It will take longer for the consumer prices index yardstick of inflation to decline because it doesn't include housing costs, but there is a chance that it too will drop below zero in 2010.

As far as the modern age is concerned, this is uncharted waters for Britain. Periods of deflation were common up until the second world war, but for the past 70 years policymakers have not had to contemplate what the impact of falling inflation would be on a nation mortgaged up to the eyeballs. It is not an alluring prospect, because deflation increases the real value of a debt.

Should sub-zero growth lead to sub-zero inflation, the pressure will be on the Bank of England to cut interest rates as close to zero as possible. Lower VAT will add to that pressure since it will cut prices in the shops. Clearly, it is impossible for bank rates to fall below zero, but there is no reason why they should not be reduced to 0.5% next year, should the deflationary threat materialise. Japan already has rates below 0.5% and the US is heading in that direction.



Policymakers in Tokyo have had experience of dealing with the triple-zero economy (zero growth, interest rates and inflation) but their counterparts in the west have not. The go-for-broke nature of the pre-budget report is indicative of the mood of desperation: all the conventional policy responses have been tried and, so far, failed. Episodes of severe dislocation go through five distinct phases: bubble years, when everybody assumes the good times go on for ever; the denial stage, when it is assumed any problem from the bursting bubble will be localised; the acceptance phase, when policymakers finally realise they have a real problem on their hands; the panic stage, where nothing seems to work; and the recovery phase, when the cycle eventually starts to turn. We entered the panic phase in mid-September and, to be frank, the recovery phase still looks a long way off.