Stephen King: Runaway growth was a sign of excess credit and risk-taking
The Bank of England never properly dealt with inflation shocks from abroad
Monday 18 May 2009
With a few green shoots here and there, we're in serious danger of failing to learn the lessons of the financial crisis. Yet we need to do so because, whether or not the UK economy is bottoming out, the pain isn't yet over. In the months to come, wages will be cut, unemployment will soar and repossessions will rise. Contrary to popular belief, the Bank of England will be struggling not with the forces of inflation (despite its decision to turn on the printing press) but with the perils of deflation. In the years to come, the population at large will still be struggling to cope with the longer-term costs of the financial crisis: taxes will be rising while the shackles will have to be placed very tightly on public spending.
One easy way to gauge where we're heading relative to where we thought we would be is to look at the latest economic forecasts and compare them with the forecasts made only a year or so ago. In this year's Budget, the Treasury forecast that the economy would shrink 3.5 per cent this year after a 0.75 per cent gain in 2008. For next year, the Treasury projected a gain of 1.25 per cent followed by a gain of 3.5 per cent in 2011. In last year's Budget, the Treasury was a lot more optimistic: in 2008, the UK was supposed to enjoy growth of 2 per cent with an acceleration this year to 2.5 per cent. This was the classic rosy scenario, an attempt to make the fiscal numbers add up by keeping the forecaster's head in the sand.
These revisions add up to a very big difference in the level of economic activity. The new Treasury forecasts imply that the UK's GDP will be 7 per cent lower in 2009 than forecast a year ago, and more than 8 per cent smaller in 2010. Unless there is a recovery on a scale never seen before, this implies there will have been a permanent loss of economic well-being compared with last year's expectations. Green shoots or not, this is a hugely damaging outcome.
There are important lessons to be learnt from the crisis itself and from the events which, over a number of years, led to the crisis.
The first lesson, I think, is to accept that inflation targeting is flawed. There's nothing wrong with wanting to have price stability over the medium term, but the right definitions have to be used and must be used over the appropriate time frame.
The Bank of England, alongside other central banks, never properly dealt with inflation shocks from abroad which, in themselves, said nothing about whether domestic monetary conditions were either too tight or too loose. Earlier in the decade, when outsourcing and off-shoring were all the rage, prices of a huge number of manufactured goods tumbled, lowering inflation in the process. This counted as a gain in the terms of trade for the UK economy. Import prices fell, as more and more goods were sourced from China and other low-cost producers, thereby making consumers and companies better off than before. Prices fell relative to wages and profits, thereby boosting spending power.
Lower prices, though, meant inflation was in danger of dropping below target. To prevent this from happening, policymakers had to boost domestic spending even further through a combination of lower-than-necessary interest rates and overly-accommodating fiscal policy. Put another way, they had to encourage additional borrowing to make sure inflation didn't end up too low.
This surely wasn't the right approach. For a very open economy like the UK's, all sorts of external shocks are going to come along which, temporarily, are likely to push the inflation rate away from target. Later in the decade, the authorities discovered that the earlier benefits stemming from cheap manufactured imports were being swamped by the impact on the prices of oil and other commodities of strong growth in emerging economies. Having earlier encouraged people to go on a borrowing binge, they suddenly had to whack on the brakes because inflation was beginning to get out of control.
In effect, the inflation targeting framework has introduced a "stop-go" element into British policymaking: inflation itself may have been better behaved but only at the cost of an amplified and increasingly unstable credit cycle.
The second lesson, then, is to recognise that economic instability can occur even with inflation under control (arguably, the control of inflation month-by-month may contribute to economic instability). Indeed, it would be sensible for policymakers to recognise that economic instability, associated with soaring and then collapsing confidence, is a fact of life. Too often, policymakers believe they have cured the source of economic instability only to find instability cropping up somewhere else. In the 1950s and 1960s, the balance of payments was the prime source of instability. In the 1970s, inflation became public enemy number one.
By the late 1980s, the housing market was bubbling away while a rapidly widening balance of payments deficit was conveniently ignored. More recently, the housing market has again been a problem but, in addition, policymakers have not properly understood the impact on the UK of both foreign price shocks and international capital flows.
One obvious way, in hindsight, that economic instability manifests itself is our elected officials' fixation with the idea that, through a sprinkling of productivity fairy dust, they can unleash much faster growth. How often do policymakers claim that, through a series of dubious supply-side reforms, the "flexibility" of the British economy has increased sufficiently to allow the economy to expand at a faster rate than before? The Tories did so in the early 1970s and the late 1980s and for the last few years Labour have done much the same. Rapid growth has too often been a sign not of a productivity miracle but of excess credit and ludicrous risk-taking. Eventually, the economy is forced into a period of austerity, as occurred in the late 1970s, the early 1980s and the mid-1990s.
The third lesson is not to be wedded to one particular economic outlook. It's easy enough for policymakers to hide behind the fiction of future economic certainty but that is no more than an illusion. To be fair, the Bank of England publishes "fan charts" designed to pick out the outcomes which are likely to occur on "90 out of 100 occasions", raising the possibility of some more violent surprises on either the upside or the downside. A year ago, though, the Bank's fan chart only skirted recession: given that the credit crunch was in full swing, I can't understand why a full-blown recession wasn't considered a higher-likelihood outcome.
Uncertainty doesn't just apply to monetary policy. Fiscal plans are too often destroyed by unexpected economic events. Our political leaders, though, are human (all-too-human when it comes to expense claims). They always like to assume that the good times will last. This Government has been particularly guilty. Earlier in the decade, when the economy was doing a little better than it is today, the Government allowed a budget surplus swiftly to turn into a budget deficit. The justification came from the assumption that the UK economy was now on a new, higher trajectory for output and, hence, for tax revenues. It was a remarkably convenient assumption which was, as it turns out, totally wrong. The inconvenient truth is that governments should learn to be more cautious with our money. As events in Westminster have proved in recent days, that lesson has yet to be learnt.
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