Economic Commentary: Bend policy before economy snaps

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The Independent Online
'What do you think of the base rate cut?' I asked a colleague on Friday morning. 'It's the pits,' he replied. I still do not know whether this was a simple statement of causation, or whether it was meant to be taken in a pejorative sense. If the latter, then I would beg to differ.

The activity data that have been published in the past couple of weeks suggest that, just prior to Black Wednesday, the economy was poised to nosedive back into recession. In fact, it no longer seems like an absurd exaggeration to use the word 'slump'. Consumer confidence about the economic situation has dipped to an all-time low, worse than it was when base rates were at 15 per cent in 1990, and worse even than in the darkest days of 1980.

Furthermore, this dramatic setback in confidence has spread to the business sector too, and has led to a startling renewal of labour-shedding. The number of jobs lost in manufacturing in the past two months has been greater than at any previous time in this recession. The disappearance of 30,000 miners' jobs, while still a tragedy, pales into insignificance compared with what is happening each month elsewhere in the economy.

It can no longer be safely assumed that we are merely observing a common-or- garden setback in the course of a prolonged, though painfully slow, recovery. And, as so often happens, the sixth sense of the financial markets - an intuition that considerably exceeds the collective wisdom of the people operating within the markets - got there first. The real message of Black Wednesday was that real interest rates had to fall, and could not do so within the exchange rate mechanism. Attacks on the 'speculators' should not be allowed to obscure this message.

So do we now face a 'slump'? As far as I am aware, this word has no precise economic definition, but it is generally used to denote a state of enduring decline in activity, in which a total collapse in confidence - often associated with an overhang of excessive private sector debt - leads to permanent weakness in asset prices and capital spending.

It is further associated with a decline in the general price level (negative inflation), and describes a situation in which monetary policy alone is powerless to stimulate demand. It is a word most often applied to describe the calamity of the 1930s, from which a combination of Lord Keynes and international rearmament (mainly the latter) eventually rescued the world.


No economic forecaster can put his hand on his heart and say that he is certain that such conditions now apply in the UK. Every single forecaster who actually has to produce a specific numerical view about the economy (as opposed to those who merely pontificate in public, and then apply a selective memory to their outpourings) has now been wrong-footed by this recession. Those who were correct about the initial downturn in 1990 were often too early in predicting recovery last autumn. And those who did not predict recovery last year have all been sucked in this year.

Forecasters can worry about this at their leisure. However, the key point for policy makers is that the Government absolutely cannot rely on any projection about what may happen to the economy next year. What it must do instead is operate intelligently in a world of immense uncertainty - and that demands a sophisticated analysis of risk.

One risk, remote though it now seems, is that policy will be eased too much, in which case the economy will recover surprisingly fast next year, and there will be some boost to inflation over the medium term. This would be a major irritant after all the effort that has now been expended in getting inflation down. But with the economy now working so far below capacity, there is plenty of time - measured in years rather than months - to respond to rising activity by tightening policy before inflation becomes a significant threat.

It no longer makes any sense at all to argue that policy cannot be eased now in case it might have to be tightened again later. Why not just do both?

The alternative risk is that policy is not eased enough now, and that we really are in a slump. The outcome then would be very dire. For every month that unemployment ratchets up and the housing market languishes, the collapse in private sector confidence will become more entrenched, and the policy measures needed to rescue the situation will become greater.

Meanwhile, the public finances will continue to deteriorate, making the necessary rescue operation harder and harder to finance (or so it will look to a cautious Exchequer).

The risks are therefore asymmetrical. Too much easing now will go relatively unpunished; too little could be a real disaster. And there is another point. If the risk/reward trade-off suggests that the accelerator should be pressed by easing monetary policy, the Government should not be debating whether to apply the handbrake (public spending cuts) or the footbrake (tax increases) at the same time. In present circumstances, the vehicle needs some forward momentum, not a combination of changes to the controls that leaves the overall speed the same.

Memories of 1981 - and still more the mythology of 1981 - should be expunged from the mind. Then, a mix of easier monetary policy and tighter fiscal policy eventually hauled the economy out of recession. But the potency of monetary policy was at that time very considerably enhanced by the general absence of debt, and the simultaneous liberalisation of the financial system, which had a massive and unintended stimulatory effect.

This time, monetary easing may be much less effective, as we have already observed in the United States and other highly indebted Anglo-Saxon economies. The correct role for fiscal policy should be supportive of recovery, not the opposite. In the long run, taxes almost certainly should rise to correct the government deficit, but this should happen after, not before, a sustainable recovery sets in. If people must insist on harking back to the 1980s, then taxes should have risen in 1985-88, not 1981. The fact that the opposite was done then is no excuse for making the same mistake now.

In any case, it is becoming increasingly obvious that powerful corrective forces are taking these decisions largely out of the Government's hands. The markets are in the process of forcing a major devaluation of sterling, which probably has much further to go. And the political environment is inexorably exerting pressure for lower interest rates that cannot be resisted. Base rates will be considerably lower than the markets expect by the end of the winter.

And nor will the Chancellor be able to raise taxes in the Budget. If job losses in a nationalised industry might be defeated by a right-wing Tory revolt, what on earth does the Cabinet think would happen to an income tax surcharge? And here lies the greatest of all contrasts with 1981. Then, Margaret Thatcher was able to hold her party together (just) because she seemed to be engaged in a historic mission to undermine the power of organised labour, which had been taken too far in the 1970s. Now there is no historic mission, just one damned decision after another. This Cabinet must bend before the economy breaks.