Stephen King: Time for a spoonful of Reaganomics to help the inflation medicine go down
Monday 28 July 2008
Last week, we learned that retail sales in the UK fell 3.9 per cent in June and that Tim Besley, a member of the Bank of England's Monetary Policy Committee, voted at the last committee meeting for an interest rate increase. This combination is rather intriguing.
Perhaps Mr Besley will change his mind at the next committee meeting now that May's apparent boom in retail sales turns out to have been, for inflation hawks, no more than a phantom menace. I'm not so sure. While the focus on monthly economic minutiae is understandable, the big problem confronting the Monetary Policy Committee is not so much that the UK economy is slowing down – that's been obvious to everyone other than the compilers of the retail sales data for some months now – but, rather, that the economy may not be slowing down enough to deal with persistently higher-than-expected inflation.
The trade-off between growth and inflation has been deteriorating for quite some time. Five or six years ago, reasonable economic growth in the UK was accompanied by remarkably low inflation. Now, much slower growth is accompanied by unpleasantly high inflation. As reversals of fortune go, this is most unwelcome. Suddenly, life for Monetary Policy Committee members has become difficult.
To what degree should policymakers slam on the brakes to bring inflation to heel? Mervyn King, the Bank's governor, is seen by many to be a prototypical hawk but, in the past, he's revealed a softer, cuddlier, side.
He was, after all, one of the 364 economists who signed the now-notorious statement on economic policy, published in The Times back in March 1981, which heavily criticised the Thatcher government's attempts to squeeze inflation out of the system.
The statement was a response to the aggressive tightening of fiscal policy announced by Geoffrey Howe, the then Chancellor of the Exchequer, in his Budget earlier that month. The increase in taxes – equivalent to a removal of 2 per cent of aggregate demand in the deepest recession since the 1930s – was certainly enough to raise a few eyebrows. The 364 argued that "there is no basis in economic theory or supporting evidence for the Government's belief that by deflating demand they will bring inflation permanently under control and thereby induce an automatic recovery in output and employment."
They added that "the time has come to reject monetarist policies and consider urgently which alternative offers the best hope of sustained recovery".
Famously, according to Mrs T, there was no alternative. Her views, though, were very much in the minority. Having been asked by a journalist to name two economists who agreed with her views (she offered Alan Walters and Patrick Minford), one of her advisers expressed his relief that she had not been asked to name three.
In hindsight, the debate seems rather anachronistic. Deflating demand, on its own, is unlikely to get rid of inflation. This, though, was an unfair characterisation of the monetarists' core beliefs. In modern-day parlance, they took the view that a pre-commitment to control of the money supply would stabilise inflation expectations and that, the greater the credibility of the commitment, the lower the cost in terms of lost output. And, to the extent that big budget deficits in a world where central banks lacked independence undermined the credibility of monetary policy, it was relatively easy to argue in favour of tax increases rather than tax cuts.
Nowadays, central banks concentrate on inflation targets rather than money supply targets, but the pre-commitment is still there. Mr Besley's vote in favour of a rate increase could easily be seen in these terms: add to anti-inflation credibility now in order to avoid bigger output losses in the future.
The story, though, doesn't end there. We now have a government intent on rewriting its fiscal rules having discovered that the years of prudence were, perhaps, not so prudent after all.
In truth, the existing rules are really rather silly. Most nations have, from time to time, had to increase government borrowing dramatically, whether through wars, recessions or financial meltdowns. During these troubling times, budget deficits have typically risen well beyond the targets now embraced by the Treasury. Fiscal rules need to be able to cope with these contingencies.
Perhaps, then, the Government should, in time-honoured fashion, allow the budget deficit to rise. After all, borrowing rose to over 7 per cent of national income in the mid-1970s, stayed fairly high until Howe's 1981 Budget, went into surplus at the tail-end of the Lawson boom (when tax receipts were remarkably buoyant) and then back into heavy deficit during the recession at the beginning of the 1990s before the more recent string of "prudent" outcomes. Other countries' rules – including the eurozone's stability pact and the Gramm-Rudman-Hollings deficit reduction act in the United States in the 1980s – have typically provided get-out-of-jail free cards in the event of a major recession. While it's desirable to have low budget deficits through the cycle as a whole, there are times when deficits should be big. There are also times – although politicians have tremendous difficulty admitting to this – when surpluses should be big. They almost never are.
At the current juncture, there is, in my view, a case for looser fiscal policy. To my mind, the UK is facing two separate problems. Inflation is too high but growth is too weak. It's easy enough to pretend, in these circumstances, that lower growth will, in time, deliver lower inflation. But there's no guarantee. Imagine, for example, that the UK economy next year is facing a combination of recession and still high inflation. What, then, needs to happen?
We either need a mild dose of Geoffrey Howe-style savaging – taking the view that the defeat of inflation will allow the broader economy to recover, as was the case in the early 1980s – or, alternatively, we need a dose of Reaganomics.
For those who've forgotten, Reaganomics, amongst other things, was a mixture of tight monetary policy through the actions of Paul Volcker's Federal Reserve and loose fiscal policy, associated with Reagan's tax cuts and congressional spending largesse. The combination led to high real interest rates and, as a result, a rapid appreciation of the dollar which, in turn, provided the US economy with some insulation from inflationary difficulties building elsewhere in the world.
Ultimately, the policy led to all sorts of global imbalances, some of which are still with us now. For the UK today, though, there is a certain attraction: strong sterling to ward off the inflationary evils coming from the rest of the world set against an expansionary domestic fiscal policy which might help to rebuild confidence in the housing market and the financial system.
There are, though, two problems with this approach. First, as a nation, we have spent well beyond our means for many years. Recessions are never desirable, but their avoidance sometimes merely postpones and makes worse the inevitable economic hangover, as we discovered during the 1970s and early 1980s.
Second, combining monetary and fiscal policy in this way requires a high level of co-operation between government and central bank. No matter how soft and cuddly he used to be, Mervyn King is unlikely to be in the mood to go down that route today.
Stephen King is managing director of economics at HSBC firstname.lastname@example.org
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