Will reducing interest rates help?

• by Robert Peston

There is a good deal in Evan Davis's remarks this morning on Today that all the fuss about whether the Bank of England should cut interest rates may be the equivalent of bald men arguing over who should have the comb - and his apology to my old friend Roger Bootle, a follicularly challenged economist, was priceless.

To return to my boring refrain of the past 18 months, the biggest problem for our economy is not the price of money but the availability of it. Banks are contracting the amount they lend. So the question is whether a cut in the Bank of England's policy rate to a historic low would increase the supply of credit.

In normal times, a cut in the Bank Rate would help to boost the flow of new lending. But right now it's not clear that a reduction would have much positive impact

The reason is that the main headache for the banks is that both regulators and markets are forcing them to hold more capital relative to their loans, their assets.

The risks of lending are perceived to have increased. So lenders to banks and also the FSA officials paid to stop banks falling over want them to hold more capital as a cushion against future credit losses.

Capital is scarce. The main source of it right now is us, taxpayers. Banks aren't keen to be nationalised to any greater extent than happened last year. So the route the banks are taking to boost the ratio of their capital to assets is to lend less, to deleverage (to use that ghastly euphemism).

Here's the good news. When interest rates are cut, that provides an opportunity for banks to generate capital. How so?

Well if banks fail to pass on the reduced cost of funds to borrowers, such as companies and those with mortgages, banks' profits increase, which in turn boosts capital (so long as banks don't pay out the profits as dividends). To put it another way, if banks make greater profits from lending that's one of the best incentives for them to lend more.

Here's the less good news. With interest rates so low, banks are under intense and understandable political and populist pressure to maintain interest rates for savers while still passing on the rate cut to borrowers.

In other words, they are under massive pressure to generate reduced profits from lending - which of course serves as a disincentive to lend.

And as the Bank of England's Bank Rate moves closer to zero, the louder is the clamour for the banks to keep rewarding savers while charging next-to-nothing for loans.

Which would squeeze profit margins till the pips squeak.

And there's a further drain on their profit margin as interest rates fall, which is that there's an unstoppable shrinkage in the margin between their average lending rate and the 0% rate banks always pay to the millions of us who keep some of our money in current accounts that never pay interest.

All of which is to say that cutting the Bank Rate now that rates are so low won't cure the disease that's afflicting the economy - the shortage of credit. And there's a risk that cutting rates to almost zero could make the illness worse.

Which is why it won't be too many weeks before we see policies that would be the equivalent of giving a comb to a hairy economist.

These, as I've been saying for some time, would involve taxpayers lending more to businesses and households, the further nationalisation of the credit-creation system.

What's still unclear is what form this nationalisation will take.

It could involve taxpayer guarantees for some bank loans. It could involve extracting loss-making assets or toxic loans from banks, to give the banks greater confidence that their capital won't be eroded. It could involve the state taking direct control of the provision of some credit to the real economy.

There's a massive amount of work on all this going on in the Treasury. And ministers are doing a great deal of agonizing about it all. The results of that agonising matter a great deal more than whatever decision is taken today by the Bank of England on interest rates.