Attacks on fiscal stance are just plain wrong
Monday 16 March 1998
The absence of timely measures to control the boom some time ago now leaves the economy in a more perilous state than was desirable or necessary. Although a soft landing may remain just about the most likely single outcome over the next three years, two other much worse developments - an early downturn in activity this year, or an intensification of the consumer boom, followed by rising inflation and then a slump - are together almost as likely as a soft landing.
The fact that the United Kingdom has once again manoeuvred itself into this perilous cyclical position, in an economy whose long-term health is essentially quite robust, is testimony to a series of well-worn truths - that the British consumer is more prone to credit booms than consumers elsewhere; that sterling is potentially more volatile than other European currencies; that the manufacturing sector wields a more powerful punch in the UK economic debate than is justified by its economic weight; that the labour market is not as docile as some would like to believe; and that politicians still believe in generating "electoral" economic cycles, even though voters now see right through them.
All of these truths have been self-evident for a long while, yet their potential for causing trouble remains undimmed.
The problem is not that a consumer boom is certain in the next 12 months, nor that a sharp economic slowdown is unavoidable this year, but that either of these extremes is perfectly plausible. This makes the setting of economic policy a game of Russian roulette, with luck now being the main ingredient needed to achieve a soft landing.
Some people will see this as an absurdly over-pessimistic assessment of the state of the economy today. After all, unemployment continues to fall, inflation remains tolerably subdued, and on the latest data economic growth has dropped to almost exactly its trend rate. The economy ain't broke, so why try to fix it? The trouble is that the economy did not appear "broke" in 1972-73, 1977-79 or 1988-89 either, only for it to appear very broke for the next several years. This is the knife-edge on which we are poised.
Those who do not recognise this dilemma should read the minutes of the Bank of England's Monetary Policy Committee (MPC) February meeting published last week.
Until now MPC minutes have been masterworks of bureaucratic non-speak, successfully hiding any substantive disagreements that may have emerged on the committee. This time, they have been unable to conceal the chasm that divides the two schools of thought on the state of the economy. Four professors (King, Budd, Buiter and Goodhart) paint an alarming picture of an economy which is near to overheating, which is not slowing down, and which is already generating domestically-produced inflation at a rate of 3.5-4 per cent a year.
If their reading is right, then monetary policy should not only be tightened immediately, but this should have happened far earlier and far more decisively - not only before the election, but also in its immediate aftermath.
Yet there is an equally strong, and entirely opposite, view expressed by the four doves (George, Clementi, Plenderlieth and Julius). They see the economy as already slowing down, with generally subdued inflation pressures, and with important downside risks stemming from Asia and an overvalued equity market.
If their main thrust is right, then not only should interest rates not now be raised, but they should have been reduced some time ago to head off the risk of recession. The debate on the MPC may be dressed up as a nuance about a quarter point rise in base rates. In fact, it is a serious divide about the main direction of the economy over the next few years, and about its underlying structure.
My main point here is not to seek to adjudicate between the four professors and the four doves (who actually count for five, since Eddie George effectively votes twice in a tie-break situation). In passing, I may note that I have much more sympathy for the professors. The real purpose of my argument is to establish that the risks of policy error must be extraordinarily high when two such diametrically opposed groupings can appear on a committee of independent people.
How does all this relate to the Budget? If things do go badly wrong in the next two years, it is already clear who conventional-thinking commentators will blame - the present Chancellor, Gordon Brown.
Pick up the business section of a newspaper, open it at random, and there is a good chance that the following paragraph will appear: "The test for the Budget is whether Mr Brown will be prepared to take the necessary measures to get sterling down. In particular, will he tighten fiscal policy so as to allow for a quicker loosening of monetary policy? His failure to do this last summer drove sterling up. There is little evidence of a change of heart."
This view - from the Lex column in the Financial Times on Saturday - holds that the main culprit for the current dilemma is that fiscal policy has hardly been tightened at all, while monetary policy has been tightened too much.
The difficulty with this conventional line of attack is that it is almost entirely unsupported by the facts. The first graph shows that the restraining impact of fiscal policy on GDP - working mainly through extremely tight control over public spending - has been much greater than the impact of domestic monetary policy (ie higher base rates).
This is in stark contrast to the same period of the last cycle - 1988-89 - when fiscal policy was actually eased, and domestic monetary policy tightened much more than it has been this time.
Meanwhile, the second graph shows that while overall monetary conditions have tightened substantially, this is mainly because sterling has risen, not because of any marked tightening in domestic policy by the Bank of England.
Fiscal policy is extremely tight, and has already been tightened very significantly further by Mr Brown, via the public spending austerity of his first two years. He should explain this much more clearly in his second Budget than he did in his first, otherwise the entire public debate might continue to proceed on the entirely invalid opposite assumption.
By contrast, domestic monetary policy has tightened hardly at all in the past two years - a somewhat risky strategy for a newly independent Bank in the face of a surging consumer boom.
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