Sean O'Grady: The good news and the bad news after Britain's very old-fashioned slump

It doesn't take much imagination to see how higher rates would now be crucifying mortgage holders if we were suffering from a Greek-style crisis
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The Independent Online

There's nothing like a little economic history to make you feel better of a Monday morning, and we should be grateful for a superlative effort from the Bank of England in their latest Quarterly Bulletin. Celebrating its 50th birthday, the Bulletin invites us to take the long view: it puts the recession in the context of three centuries of ups and downs.

There's good and bad news. The bad news is the confirmation that this is a new kind of recession, or rather an older kind of recession reborn – and that's about as welcome a return as rickets.

Most of the downturns we have experienced since the Second World War were short and shallow by the standards of the 2008-09 slump. In 1974, 1979 and 1990 the country set about squeezing inflation out of the system, whether it had been domestically generated, blown in from abroad eg via an explosion in oil prices, or a bit of both. Painful as the adjustments were, output fairly quickly got back to its trends, though employment usually lagged quite a way behind.

In each case there was a fiscal squeeze, interest rates went sky-high (though usually they were much less frightening once inflation was factored in), but the banks would still lend in the normal way. Dramatic as the three-day week of 1974 was, or the riots of 1981, they were soon over. These episodes were, in essence, interruptions to long periods of unbroken growth and prosperity – 1945 to 1973 and 1993 to 2008 were the longest such periods in our entire island story.

Now this relatively happy pattern is in sharp contrast to the slump we've hardly dragged ourselves out of now, which was induced by a banking crisis of a very old-fashioned kind, rather than one of those modern attempts to get rid of inflation. It would come as no shock to our great-grandparents, and their antecedents. Apart from the weather, famine and war, the economy in the 18th and 19th centuries was driven by periodic financial crises, banking failures and the subsequent implosion of credit supply, closely followed by a collapse in the demand for loans from households and companies, and a crash in stock and property markets. The 19th-century Bank of England's job was to try to deal with such traumas in its role as "lender of last resort" to banks temporarily embarrassed by a lack of funds and panicky depositors.

Yes, that does sound familiar, doesn't it? Except that nowadays entire countries suffer "runs" too. We know by now that ours is much more a "classical" sort of slump, one induced by the private sector – the banks – rather than by conscious public policy. The banks are still, basically, bust. Because the banks can't lend, and in turn because they have to rebuild their balance sheets, they cannot turbo-charge the recovery by pumping spending power into the economy as soon as consumers and firms start to regain their confidence.

We have taken a step-change down to a lower growth path – again a very traditional way of making economic progress. We won't see 2008 levels of output until 2012 at the earliest, whereas by post-1945 standards we should be back to normal by now.

So that's the downside, as economists say. The upside is the plentiful long-term evidence that devaluing the pound or allowing it to depreciate, as now, does usually aid recovery.

Given the 25 per cent or so drop in the overseas value of sterling since its 2005 peaks, we might have expected to see rather more of a benefit than we have. But some of the most recent surveys suggest that manufacturing and service exports are picking up in the face of still-difficult world conditions (as in the eurozone, where 55 per cent of our exports go).

Some exporters have opted to take the benefit of a lower pound in the form of fatter profit margins, which is also helpful in its own way, funding investment and protecting jobs; but more traders are now starting to price competitively in foreign-currency terms and are therefore picking up more orders.

The best export-led recovery was the last one. After the pound fell out of the European Exchange Rate Mechanism on Black Wednesday in 1992 (special adviser to the Chancellor was David Cameron), a newly competitive currency coupled with endemically low inflation and genuinely reformed labour, product and capital markets opened up a decade of sustainable growth, before things started to go awry and the seeds of subsequent destruction were sown. The lesson there is hardly an economic one, more a political or even moral verdict: the danger of complacency. Had we borrowed less – public and private sectors – going into the crash it would have been both less dramatic in the first place and easier to crawl out of. As it is, we were lucky not to go the way of the Irish.

Previous export-led booms have been shorter-lived; the 1967 devaluation of sterling, the one where the Prime Minister, Harold Wilson told us it wouldn't affect the "pound in your purse or pocket", worked for about five years before all the original advantage was lost through higher domestic inflation, by way of wage rises and an accommodative monetary policy.

The same could be said, in varying degrees, about the 1949, 1976 and 1986 episodes.

Taking Britain off the gold standard in 1931 did the country little good even in the short term when the world economy slumped and everyone went for protectionism. Prior to that, the magical automatic mechanisms of the gold standard delivered "internal depreciation" – cutting wages and prices at home to alter the exchange rate in real terms – and could usually be relied upon to get the British economy moving. In short: the UK has long made its way by selling and investing abroad, and now is no different; "export or Die" is an old but durable slogan. Meanwhile the other piece of good news is the usefulness of cheap money to help us out of a slump. We certainly have that now, though more at the official than the retail end of things. Even so, it doesn't take much imagination to see how higher rates would now be crucifying mortgage holders – and the wider economy – if we were suffering from a Greek-style crisis.

At the start of the Great Depression of the Thirties, as Milton Friedman always pointed out, interest rates on both sides of the Atlantic were too high, and monetary policy was not inflationary enough as deflation loomed.

Real rates were often above 5 per cent in Britain, a painfully severe regime, as against negative rates for the past couple of years. We have successfully avoided a repeat of that, so far.

The final lesson is that war has often provided a powerful stimulus to the British economy – perhaps the most reliable of all, in Napoleonic times and later. It was in fact only the Second World War that ended mass unemployment, pushing the jobless rate below 10 per cent for the first time in two decades. I told you there was mixed news.

Such is their Palladian achievement that I have to name-check the authors – Sally Hills and Ryland Thomas of the Bank, and Nicholas Dimsdale of The Queens College, Oxford (to whom I owe an additional debt as he taught me some of what little I can recall of my economics).

By the way: last week I wrote that Mervyn King would be up for reappointment for another term as Governor of the Bank of England in 2013. Not so. Legislation limits him to two terms. I am happy to correct my error.

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