Stephen King: Three pillars of economic consensus starting to give way

The world is changing in ways the current policy framework may be ill-equipped to deal with

I've been in the US over the past few days – east coast, west coast and a few little bits in between. On a few occasions – typically waiting around in airports – I was congratulated for my English accent and, by implication, my part in Saddam's downfall. I pointed out that my role in the demise of the Baath party had been minimal – limited to helping out the British armed forces via the Inland Revenue – but that didn't stop the plaudits: it was enough to have come from the same land as the great Tony Blair.

The combination of victory and palpable relief also appears to have led to some shifts of opinion within the investment community. In New York, the general mood is one of hope. No one's sure that the bear market is definitely at an end but there are a lot of people who buy the argument – first put about by the Federal Reserve – that economic weakness since the final quarter of last year can all be put down to geopolitical risk. With Iraq sorted out, the deep despair that infected financial markets could now be coming to an end.

Not everyone, however, shares these sentiments. Others remember the false dawn in the first half of 2002 when economies appeared to be recovering and equity markets were bouncing strongly – all, ultimately, to no avail. And there are those who recognise that beating Saddam does not guarantee lasting stability: America has yet to win the peace in Iraq and the challenges to its supremacy are still hotting up elsewhere in the world, notably in North Korea. Meanwhile, from an economic perspective, severe acute respiratory syndrome (Sars) couldn't have come at a worse time. With the global economy already very fragile, the threat to trade and travel stemming from the mystery virus is very real.

These arguments all, of course, assume that there is an underlying, predictable, steady state in the global economy. If it weren't for Sars, or for Iraq, or for North Korea, the global economy and financial markets would be in a reasonably healthy state. No room, then, for policy errors. And no room for markets to get it wrong. Our policy makers know how to create the conditions for economic stability. And the markets will always ensure the most efficient allocation of resources. We live, therefore, in the best of all possible worlds. Dr Pangloss would be proud of us.

This may be an unfair caricature of people's perceptions about the world but I'm not sure that it is so far from the truth. My worry is that the world economy is now at one of those major inflexion points, one of those moments of major change when the hitherto accepted consensus about economic policy and economic development begins to break down.

Historically, these occasions are few and far between and, when they do occur, they can be immensely disruptive. The model of unfettered capitalism that had characterised the first three decades of the 20thcentury began to break down in the 1930s when activity collapsed and unemployment rose rapidly. The post-war model of full employment based on demand management policies began to break down in the late-1960s with the emergence of inflation and, subsequently, the collapse of the full employment consensus. Could it be that the latest "consensus" – referred to by the Nobel Prize-winning economist Joseph Stiglitz as the Washington Consensus in his best-selling Globalization and Its Discontents – is also beginning to show signs of vulnerability?

Mr Stiglitz argues the Washington Consensus is a view based on three pillars – namely fiscal austerity, privatisation and market liberalisation – and is rooted in the free market philosophies that developed in the early years of Margaret Thatcher and Ronald Reagan. I don't want to go through the details of all three pillars but it seems to me that the world's latest economic problems challenge at least some parts of this Consensus.

Take, for example, the idea of fiscal austerity. Although the Washington Consensus – reflecting the views of the IMF and the US Treasury – has been used primarily to force changes on the policies of developing economies, it is quite clear that the Consensus has also had a dramatic impact on the way in which fiscal policy has been put together in the US, the UK and the eurozone.

Gordon Brown's fiscal rules are a fairly flexible interpretation of the demands for fiscal austerity: after all, he is free to borrow for capital spending purposes and is only obliged to have a balanced budget on current spending over the course of an economic cycle as a whole.

But take a look elsewhere. In the US, individual states signed up to balanced budget amendments in the 1980s and 1990s, promising never to borrow again. Now, with revenues falling away as a result of a stagnant economy, they're being forced to cut public spending aggressively, contributing to further economic weakness. In the eurozone, the Stability Pact has done very much the same thing: France and Germany may be daringly naughty this year by allowing their budget deficits to rise a little above the 3 per cent of GDP upper limit mandated within the Stability Pact but these increases in no way represent a significant shift towards fiscal support.

The case for fiscal surpluses rested on two key observations. First, there was the general case for small government based on the idea that, in general, the private sector was a better allocator of resources. Second, there was the fear that, left to their own devices, governments would increase borrowing dramatically and subsequently choose to inflate their way out of the problem.

In other words, fiscal surpluses were a means to two different ends. So long as the private sector was able to spend and to use resources efficiently, there was a case for limiting government borrowing. And so long as inflation was a major threat, fiscal surpluses would credibly lock in low expectations of future inflation.

In my view, however, both of these arguments have shifted. The private sector in many economies around the world is now awash with debt and has neither the appetite nor the ability to spend in a sizeable fashion. Other things being equal, the result should be a persistent undershoot of demand and an inflation rate that is too low, not too high, a view reflected in HSBC's latest economic forecasts (see table). Under these circumstances, the game changes: suddenly, there is room for much bigger budget deficits. And that's exactly what we're likely to see in the years ahead. The institutionalised arrangements that guarantee limited government borrowing may eventually come crashing down.

The second area I want to mention is the issue of market liberalisation. One aspect of this has been the general belief in free trade and the benefits associated with the exploitation of comparative advantage. This, of course, is all standard textbook stuff but I wonder if politicians will be tempted – as they often are – conveniently to put the textbooks to one side. Over the next few years, the world will continue to be characterised by weak growth, low profits and excess capacity. Given these factors, the incentive to find scapegoats becomes very intense. After all, if I'm right, manufacturing industry in Europe and the US will remain in long-term decline as jobs head off to other, cheaper, parts of the world. Under these circumstances, trade disputes and, perhaps, trade barriers could increasingly become part of the international economic scene.

So, although we all – rightly – worry about Sars, about Iraq and North Korea, these challenges do not quite capture the true nature of the economic problems that we're now facing. If I'm right, the world is changing, and it's changing in ways that the current policy framework may be ill-equipped to cope with. I'm not sure what the end game will be but I suspect that economics is about to become really interesting again

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com