Sometimes, economic policy decisions are relatively easy. In the mid-1990s, inflationary pressures were generally low, growth was middling and there were few signs of imbalances. Back then, monetary and fiscal decisions could be made with some degree of confidence. The chances of getting it right were relatively high and, even if a mistake were made, it could be reversed without doing too much damage.
The same cannot be said of other periods of economic history. The UK's membership of the ERM seemed to promise a great deal – inflationary stability, greater certainty for our exporters, a more predictable growth rate over the medium term – yet the reality was, of course, very different. Ultimately, Britain's membership of the ERM turned into high farce, as the government of the day tried to persuade increasingly incredulous investors of the benefits of membership. As the charts show, this persuasion took the form of higher and higher interest rates, designed to convince a sceptical domestic and international audience that here was a government that meant business.
The Government was faced with an awkward dilemma. Either it could stick to the exchange rate target come what may or, alternatively, it could devalue. Neither option was particularly attractive and, at the end of the day, it was the markets that made the choice on behalf of the government. From a policy perspective, there was no easy way of knowing beforehand what the eventual outcome was going to be: after all, the French faced a similar problem in 1993 and ended up with a different solution that ultimately enabled them to maintain their status within the ERM.
The moral of this tale is that, sometimes, the world is a much more uncertain place. The range of possible outcomes from a certain point in time widens out considerably, leaving policy makers with a lack of easy choices. This has been particularly true over the past three or four years. Think about the Fed's dilemma. Here was a central bank that had presided over high growth, low inflation, an apparent productivity miracle but, at the same time, a collapse in private savings and a huge widening of the current account deficit. And it was thrown a couple of awkward "left-fielders" in the form of the Asian crisis and the liquidity threat associated with Y2K. What should it do? Cut interest rates to maintain liquidity and confidence in the short term? Or raise interest rates to deal with signs of excess domestic demand, as revealed in the widening current account deficit?
The choice was not easy. A failure to cut interest rates would have left the Fed having to explain – with some degree of difficulty – why it was failing to offer support to a global economy in crisis. On the other hand, a failure to raise interest rates raised a more medium-term threat of excessive demand, a bubble in asset prices and, eventually, a collapse, either in terms of asset prices or in terms of the economy more broadly.
We all know, of course, that the Federal Reserve went down the first of these routes. Whatever it did, there would be problems but, in the event, short-term expediency won out. We are seeing the consequences of that choice today: excessively loose monetary policy in the late 1990s doubtless had a significant influence on the growing instability of financial markets ever since.
There are few signs that these policy "dilemmas" are in any way abating. The apparent inconsistencies between different areas of economic performance suggest that policy makers are still in a position where the best that they may be able to do is to minimise error rather than maximise success. Apparently, for example, the US economy is now recovering and, judged by the tone of recent consumer spending numbers and manufacturing surveys, it is only a matter of time before we are back to the heady growth rates of the late 1990s.
Yet, against this, we have ongoing weakness of equity prices – suggesting heightened uncertainty both about corporate profits in the future and – given Enron – corporate profits in the past. Equally, despite strong consumer spending, we have growing signs that the demand for consumer credit – one of the mainstays of US economic strength in the late-1990s – may be showing signs of peaking out. And there are worrying signs of a shift in asset class preferences – bonds outperforming equities, for example – that have previously pointed to a structural shift downward in underlying economic growth.
These uncertainties are, of course, not just restricted to the US. Over the past few days, we have seen further amazing increases in UK house prices set against an ongoing disaster scenario for UK manufacturing. Once again, this seeming inconsistency increases the chances of things going wrong. What we do know is that the situation cannot persist. If consumers carry on spending like there is no tomorrow while manufacturers continue to go to the dogs, we are going to end up with the mother of all current account deficits. That, in turn, implies all sorts of problems for the exchange rate, for interest rates, for inflation performance and, ultimately, for the ease with which the UK government will be able to swing opinion in favour of Britain's joining the euro.
So how is this situation going to be resolved? The dilemma facing the Bank of England is not dissimilar to the Fed's problems after the Asian crisis, even though, this time, it's a matter of saving just the UK economy, not the world. Rate cuts will help support manufacturing, but at the cost of an ongoing consumer boom. Rate increases may restrain the consumer boom but could ultimately send manufacturing even deeper into the mire.
Perhaps the most useful approach is to think either about the kinds of indicators that could usefully point to a final resolution of this dilemma or, alternatively, think about policies that could help bring a resolution about. So far, the debate has not been particularly inspiring with people quite happy to stick to their underlying prejudices. For some, the economy is booming whereas, for others, the economy is stuck in a deep recession. Neither position is correct: the UK did grow in the final quarter of last year but only just. In other words, no boom but no recession either.
In terms of indicators, there are two main areas to focus on. The collapse in manufacturing is, in part, a function of the global economy. So if there are clear signs of a strong, sustained recovery in global economic activity, there could be a case for raising interest rates. At this stage, however, there are only the first green shoots and they, on their own, should not be sufficient to justify a tightening of monetary policy. On the domestic front, the key issue is the labour market: would consumers carry on spending in such a way if job insecurity were rising at a rapid rate or if wage growth were pushed down to much lower levels? After all, both things will ultimately happen if the corporate sector stays in its current parlous state.
Of course, it may be a long time before we get answers to these questions and, in the meantime, there could be a further deterioration in both the household balance sheet and in the productive potential of manufacturing industry. Perhaps, therefore, now is the time to accelerate the process of resolution. A well-targeted series of tax increases at the next Budget, focused on the housing market, could be sufficient to take the wind out of the consumer's sails, allowing the Bank of England to get on with its job without having too many sleepless nights.
Stephen King is managing director of economics at HSBC.Reuse content