Stephen King: The perils of learning from the past

High hopes dashed. No, not Andy Murray's unsuccessful quest to win Wimbledon this year. I'm thinking of last Thursday's US employment report for June. It was hardly the best news ahead of the July 4th Independence Day celebrations.

Payroll employment fell by 467,000 in June – much worse than market expectations. Earlier in the year, job loss in the US had been slowly attenuating, consistent with the emergence of green shoots.

With the June release, some of those green shoots have fallen victim to the recessionary scythe. No longer are investors quite so convinced that recovery is on the way.

I should add the usual caveats.

The payrolls data are notoriously prone to revision. It's not so much that government statisticians re-write history in an Orwellian sense. Rather, their initial view of the recent past is extremely foggy, based on a few limited bits and pieces of data. Government statisticians, the archaeologists of the economics world, only slowly piece together a data set which is then over-analysed, poked and prodded by others. The June figures were still the second best employment outcome since the fall of Lehman Brothers.

However it wasn't just the decline in employment which offered renewed confirmation that the US labour market is in a parlous position. The unemployment rate ticked up yet again. Only once before in the post-war period has unemployment scaled 9.5 per cent. That was in the early 1980s, when US policymakers had to cope with the Scylla and Charybdis of rampant inflation and rising unemployment; it eventually rose beyond 10 per cent.

That rise was sanctioned by policymakers – notably Paul Volcker at the Fed and Ronald Reagan in the White House – who believed, rightly, that the US would be unable to make any serious economic progress unless there was a return to price stability. For them, temporarily higher unemployment was a price worth paying.

Today, inflation isn't a worry, at least not in the near term. Workers have no pricing power. Demand for their services is falling rapidly, reflected in the lowest average workweek – just 33 hours – since records began in 1964. Average hourly earnings aren't disastrously weak, but pay-packets are under tremendous strain. Deflation is a bigger worry than inflation.

Economists and policymakers have to do some serious thinking.

For decades, policymakers thought the defeat of inflation was a necessary and sufficient condition to deliver lasting economic prosperity. How wrong they were.

As John Maynard Keynes said: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."

Defunct economists, in turn, are typically slaves to the periods in which they were brought up.

The economics establishment's focus on inflation today is inextricably linked to the inflationary disasters of the 1970s and early 1980s which, appropriately, led to a renewed focus on the role of money within the economy. The establishment seems unable to offer any coherent solutions to the latest crisis. The reason is simple: with inflation tamed, this crisis was not supposed to happen.

The odd thing about the establishment's view is its remarkably short-sighted approach.

The Depression of the 1930s followed a decade in which prices in the US were falling rather than rising. Keynes' General Theory scarcely mentions inflation, for the obvious reason that inflation had nothing to do with the 1930s Depression. The Austrian economists, Ludwig Von Mises, Friedrich Hayek and others for the most part thought markets to be wonderful and didn't quite see eye-to-eye with Keynes. But they still couldn't find much room for inflation in their theories of booms and busts. We are, then, slaves to a particular period of economic history. We appear to have forgotten, or conveniently ignored, what happened in earlier times.

Moreover, we've failed to learn one of the key lessons from the 1960s and early 1970s. Back then, when Keynes was, if anything, more fashionable than he is today, the conventional wisdom suggested that governments and policymakers could, and should, aim for full employment.

With the tools of Keynesian demand management, it was apparently easy to avoid the economic disasters of the inter-war period. As Richard Nixon declared in 1971, "We're all Keynesians now".

If, though, full employment was guaranteed, the onus was no longer on businesses and workers to negotiate competitive wage packages.

The level of employment was now determined by the government through a series of demand-management policies. It no longer mattered whether wages went up 3 per cent, 5 per cent or 10 per cent because full employment was supposedly guaranteed by the state. It didn't take long before both inflation and unemployment were on the rise.

Price stability, like the full employment of the 1960s, has also tempted people to behave in ways which are not consistent with lasting economic stability. If people are told that low and stable inflation is both a necessary and sufficient condition of economic stability, it no longer matters whether they choose to mortgage themselves up to the hilt, or decide to binge on credit cards, or are tempted to buy assets using all of the investment nous displayed during the South Sea Bubble.

It's not so much that the pursuit of price stability is wrong, or that the aim of full employment is anything other than admirable. Rather, the problem lies with the implicit claim that, if these objectives are reached, economic stability is assured.

The lessons from history consistently suggest otherwise. Maybe it's time for economists and policymakers to put their complex mathematical models to one side and reflect on what takes place in the real world.

They would then surely realise that, unlike their models, the world is a highly uncertain place with a disarming propensity to veer off in unexpected, and sometimes highly undesirable, directions. Policy- makers should spend a lot more time thinking about what might go wrong, rather than simply assuming that everything will be alright.

stephen.king@hsbcib.com

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