Stephen King: Prudence is fine, but history tells us that austerity can be a costly business
Monday 18 February 2008
King's austerity. With echoes of Sir Stafford Cripps, he of the regular cold baths, Marxist beliefs and puritanical tendencies, the Governor of the Bank of England has announced to the nation that tough times lie ahead. He's right. As the credit crunch takes hold, and as inflation continues to edge higher, it's time to face the funereal music. No longer can we continue enjoying ourselves. Having built up a mountain of debt over recent years, we've now got to pay some of it off. That means hard work, more saving, less fun. And should the Chancellor of the Exchequer think about providing some fiscal solace in this newly austere world, Mervyn King will simply have to say, "not now, Darling".
Of course, Sir Stafford faced a very different world when he became Chancellor of the Exchequer in 1947. The Second World War had ended only two years before and much of British industry was still bombed out. Inflationary pressures may have existed but they were kept in check through rationing. Monetary policy was aimed not so much at stabilising inflation but, instead, at controlling the exchange rate.
Like now, though, the UK had an enormous current account deficit. In 1947, this amounted to £311m which, at over 2.5 per cent of GDP, was uncomfortably large (in those days, when international capital markets were poorly developed and generally rather illiquid, it was a struggle to fund current account deficits of any size). Today, we have a current account deficit not far short of 6 per cent of GDP. Mr King, like Sir Stafford before him, thinks this is too much to stomach.
Those celebrating the end of the war presumably were hoping, by the late-1940s, to be enjoying themselves. Cripps, though, was having none of it. He recognised, rightly, that Britain couldn't live beyond its rather limited means (which, of course, had become a lot more limited through the costs of the war).
However, his attempts to impose a strict diet on the UK's population ultimately came unstuck. The current account position did improve substantially, but not enough to prevent the Labour government of the day from devaluing sterling in 1949. A year later, Cripps was gone, forced through ill health to resign. Labour went the same way the following year, losing the second election in just a handful of months to the Conservatives. In 1952, Cripps died.
Like so many other guardians of our economy – Jim Callaghan in 1967 and Norman Lamont in 1992 spring to mind – Cripps found it more or less impossible to resolve seemingly conflicting objectives. To preserve the value of sterling, he wanted to reduce Britain's borrowing from abroad. To do this, he needed to lower the current account deficit and, in the absence of any neat tricks to boost exports, he had to deflate the domestic economy. The policy was deeply unpopular, leading to speculation that, eventually, the exchange rate would have to go. In due course, it did.
For the current Government and for the Bank of England, these tugs-of-war between domestic economic stability and the exchange rate are no longer relevant. Our exchange rate now floats and, because it does so, we no longer need to face the "stop-go" policies that became such a depressing feature of the economic landscape throughout much of our post-war history.
Or at least that used to be the conventional wisdom. According to Mervyn King, "stop-go" is about to make a return, not because the exchange rate is a problem but, rather, because inflation is too high. What matters for today's policymakers is not so much the external value of sterling – how it trades on the foreign exchange markets – but its internal value. And, like Cripps, Callaghan and Lamont, today's crop of policymakers are suddenly faced with an uncomfortable conflict. How do you ensure a reasonable growth rate while, at the same time, delivering price stability, whether of the internal or external kind? As the Bank of England admitted in its latest Inflation Report, released last week, "the combination of slow growth and above-target inflation poses substantial challenges for policy".
In my view, the challenge is a little bigger than the Bank of England is letting on. The Bank has one policy instrument – the interest rate – which it uses to control the overall economy. Its mandate is to deliver price stability, defined as a rate of consumer price inflation of 2 per cent.
Changes in the policy rate affect the inflation rate through three main channels: the aggregate demand channel (which influences the growth rate and the amount of spare capacity); the exchange rate channel (which has an impact on import and export prices); and the price expectations channel (which has an impact on wage settlements and so on). If inflation gets out of hand, the economy will have to be held back to bring inflation back down again, which is presumably why Mervyn King has signalled the need for a period of ongoing austerity. If inflation is the primary objective, that's the only reasonable conclusion to reach.
However, the Bank's major problem, in my view, is not so much the increasingly elevated inflation rate but, rather, the degree to which the financial system has seized up. The connection between policy rates and the ultimate performance of the economy is, at best, indirect and, too often, rather unpredictable.
The Bank's intentions have to feed through the black box otherwise known as the financial system. And, as the Inflation Report acknowledges, the financial system is currently in a bit of a mess. Unless and until the financial system is fixed, the Bank's influence on either growth or inflation may prove to be insubstantial.
Put another way, planned austerity could give way to either unplanned recession or unplanned inflation. The Bank's powers have been emasculated in recent months and, as a result, the economic risks are significantly larger than usual. This is not just an issue about difficult trade-offs between growth and inflation but about whether our policymakers maintain any significant direct influence over our collective economic destinies.
Meanwhile, across town, the political stakes are getting bigger. Mr King may be right to warn of austerity, but that will hardly be music to the Government's ears. Cripps, Callaghan and Lamont may have had their moments but, as chancellors, they were all ultimately associated not just with economic failure but also with political defeat. In each case, the attempt to impose harsh economic realities on the general public forced the incumbent out of Number 11, leaving the government of the day nursing a badly damaged reputation for economic competence. Prudence is one thing, but austerity brings with it a sense of economic decline. No wonder Gordon Brown bites his nails.
Stephen King is managing director of economics at HSBC
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