The Government and Bank of England are dramatically increasing their borrowing to fund

1. Their investments in the partly nationalised banks
2. The temporary VAT reduction
3. The reduced tax take due to the economic slowdown
4. Almost unlimited lending to banks who are unable to access the money markets effectively for funding

It makes sense for them to reduce interest rates to artificially low levels in order to make their cost of borrowing lower.  It could really have nothing to do with fears of deflation.

Ironically if interest rates were increases tax revenues would increase from a variety of sources reducing the need to increase government borrowing in the first place.

1. Taxes on Retail Deposits

A recent Bank of England report gives the level of retail deposits from individuals in the UK as approximately £893bn.  A simple analysis shows how increasing base rates to 6% would generate tax revenues £6.70bn more than base rates of 1% (which may be coming soon).

2. Tax on Profits of Financial Institutions

Higher interest rates allow financial instututions to increase their margins - generating more corporation tax

3. Higher Taxes on Repatriated Earnings

If higher interest rates lead to a more stable currency then taxes on foreigh earnings repatriated to the UK would increase

Britain's lending boom was financed in large part by foreign investors buying up vast swathes of securitised debt obligations.

The banks/building societies issued mortagages or credit card debts that far exceeded the deposits they took in.  They were able to do this by issuing bonds, directly or via specially created companies that in turn issued bonds, backed by the underlying debt and security.  They also took in shorter term money market deposits from foreign banks and institutions. These deposits and bonds offered foreign investors an attractive rate of return which ensured there was a constant supply of funds to drive up the lending bubble.

When the bubble burst, the government and Bank of England abopted a strategy of dramatically reducing short term interest rates in the vain hope of increasing lending.  However, the real problem was not the price of lending but the availability of lending.

The effect of reducing interest rates so precipitously was, not only to punish domestic savers, but to make any securitised debt or Sterling money market deposits completely unattractive to foreign investors.  This has lead to a dramatic decline in the value of the pound which makes these Sterling investments even less attractive.

A more rational course of action would have been to increase interest rates to make the pound more attractive, and sterling moeny market deposits more appealing to the crucial foreign investors.