Stephen King: Global changes cause policymakers to wobble on their tightrope

The world is changing in so many ways that the old 'rules' may no longer apply
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The Independent Online

Cyclical versus structural. Short-term versus long-term. Policymakers always have to make difficult choices. Should they respond to unexpected deviations in economic activity by adjusting interest rates, taxes, government spending or the exchange rate? Or should they leave well alone, choosing instead to believe that these unexpected deviations may reflect structural change that cannot really be affected by macroeconomic policy at all?

Policymakers are always engaged in a high-wire act. They may know roughly where they want to get to, but they constantly have to make adjustments to ensure that they don't fall off the rope, throwing them far away from the chosen path. Moreover, when they get to the end of the rope, they may discover that their chosen goal was no longer quite so useful after all, at which point they are forced to perform yet another high-wire stunt.

There have been plenty of high wire acts over the past 40 years. In the late 1960s, governments thought they had discovered the secrets of economic success, only to find out that attempts to maintain full employment led to a rather nasty dose of inflation. In the 1980s, the UK government attempted to defeat inflation. For the most part, it did a rather good job: however, the belief that lower inflation would generate higher sustainable growth was grossly exaggerated and the late-1980s boom led eventually to recessionary tears and the end of a political era. In the 1990s, the US increasingly embraced a belief in the "new economy" miracle, creating one of the biggest stock-market bubbles - and subsequent crashes - of all time.

Policymakers are facing equally testing times today. The world is changing in so many ways that the old "rules" may no longer apply. We saw some of this last year, when initial signs of economic recovery led some central banks - praised at the time for their "pre-emptiveness" against inflation - to raise interest rates, only for them to cut interest rates later on when it turned out that the signs of recovery were not sustainable. Judged by old yardsticks - raise interest rates to deal with the evils of inflation - these central banks did the right thing. But do those old yardsticks still apply?

There are four areas where, in my view, the old yardsticks may no longer be relevant. If I'm right, policymakers may be in danger of falling off the tightrope once again.

First, there is the issue of inflation itself. Our belief that inflation wrecks economies may be right, but it has transposed itself over the years to a modified belief, namely that it is only inflation that wrecks economies. Not only is this not true, it is also potentially a very dangerous conclusion. Yet it is a conclusion that, in some ways, has become enshrined in central-bank thinking. The arrival of inflation targets over the last few years wouldn't really have happened without some form of this belief.

The trouble, though, is that inflation itself may simply be the wrong indicator to look at from the perspective of macroeconomic policy success. After all, inflation remained very well-behaved in the second half of the 1990s, but that didn't stop recessions from unexpectedly turning up all over the place. Why might inflation have become less useful as an indicator of economic health? One possible answer is that, although inflation is, in its broadest sense, a monetary phenomenon, institutional changes may have altered the relationship between inflation and the broader economy. Two of these changes are the arrival of new technologies and the integration of Chinese and Indian labour markets into the global economy. By opening up both labour and product markets to greater competition, these new themes have made it much more difficult for companies to get price increases to stick. Excess demand pressures may no longer reveal themselves in the form of higher inflation: instead, the new symptoms may be excessive debt and ever-increasing current account imbalances.

Second, as my charts show this week, the price of capital goods is collapsing relative to the price of labour. The collapse in capital goods prices is, in itself, a reflection of the arrival of new technologies, but it presents new challenges to companies and to labour markets. In simple terms, if the price of one factor of production - capital - is falling rapidly compared with another factor of production - labour - it makes sense for companies increasingly to substitute out of labour into capital. As companies do this, parts of the labour market will become weaker and weaker. The problem for macroeconomic policy is that a recovery in capital spending is typically regarded as a lead indicator of future economic success yet, in these circumstances, it points more to a persistent displacement of labour. US companies may now have started to create some jobs in the service sector but the manufacturing jobs market remains very poor.

Third, the combination of rapid price changes in product and labour markets - in different directions - means that traditional lead indicators of inflation are no longer terribly helpful. Commodity prices may be going up, but labour costs are coming down. Shipping activity may be surging upwards but a lot of this activity is happening because Asian economies are using their cost advantage to increasingly take market share away from more expensive western operations. Which of these changes should a central bank focus on in setting interest rates? Persistent ambiguity in price movements makes life a lot more difficult for those that want to keep our economies on the straight and narrow.

Fourth, there is the whole issue of debt. Because inflation has been low, some central banks have been relaxed about the build-up of debt. That's fine as long as people can afford to repay not just the interest payments but also the capital. However, if people haven't fully worked out the implications of a low-inflation world - not just low interest rates but also low wage growth, something that is too often forgotten about - they may eventually regret the amount that they have borrowed. We may already be seeing some signs of this: in the US, mortgage refinancing has collapsed over the past three months, which probably also implies that mortgage equity withdrawal has also fallen back. That means one of the key drivers of consumer spending over the past two or three years may no longer be so supportive.

Policymakers always walk a tightrope. They have to work out both the key challenges facing them and also how to confront those challenges. Pinpointing some of the key structural changes affecting the global economy suggests that staying on the tightrope is easier said than done. If I am right, the big structural changes now confronting the global economy are making policy decisions more, rather than less, difficult. Inflation itself may no longer be a serious problem but that doesn't mean to say that policymakers now have an easy life. Other difficulties are springing up, suggesting that our old yardsticks of economic success and failure, just like western manufacturing industry, are becoming increasingly redundant.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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