Economic Commentary: Lamont's guiding star is off-beam
Thursday 31 December 1992
Of course, guarantees should not be accepted at face value, especially if offered by economic forecasters. But the guarantee of recovery is fortunately not dependent on the niceties of economic modelling. The assurance arises rather from the complete reversal of Britain's economic circumstances following the events of Wonderful Wednesday when sterling took its unplanned leave of the European exchange rate mechanism.
Within the ERM, the economy was in effect sentenced to a lifetime's depression, a result of debt deflation, capacity contraction and a monetary policy regime that was overtight and unbending - suited to German but not UK needs. Caught in the ERM's icy embrace, the economy was forced to adjust to policy. But now the boot is on the other foot; policy is adjusting to the real needs of the economy.
The relaxation of monetary policy since exit day has been substantial - but that in itself does not guarantee recovery. Far more important is the fact that policy is now fully adjustable, and can respond to any unforeseen blow to activity. In short, the economy has back a monetary stabiliser. So while forecasters will continue to argue over the scale and timing of recovery, its arrival is no longer in question.
It is perhaps because of these new certainties that the official policy debate is already shifting into quite different territory. The best minds in Whitehall are again searching for that holy grail, an anchor for Britain's price level. The question is whether there is a guiding star by which the Government can now steer its counter-inflation strategy.
Recovery, rather than ever lower inflation, is rightly the Government's immediate goal. Yet it would be pointless and harmful to generate a recovery that led merely to an accelerating inflation and so to another debilitating period of retrenchment. The Chancellor really needs to have a better clue about the safe limits within which the economy can grow.
A few months ago, Mr Lamont and his speech writers thought they knew what anchored the price level. The answer was the exchange rate, fixed to the mark and Germany's low-inflation standards. At that time Mr Lamont left his audiences in no doubt about the consequences of breaking the sterling/mark link. The option of quitting the ERM and cutting interest rates would leave the credibility of the Government's counterinflation strategy 'in tatters'. Furthermore, 'We know from bitter experience that devaluation just does not work for Britain'.
Mr Lamont and his Treasury team are now singing a rather different tune. Indeed, their new framework for counter- inflation policy comprises a disharmonious medley of songs, old and new. Pretty well everything has been thrown into the pot, including broad and narrow measures of money supply, sterling and house prices. In addition, the Government has implemented a formal pay policy in the public sector and hinted strongly that pay restraint would be jolly helpful in the private sector as well.
On the Treasury's latest projections, this framework produces the neat combination in 1993 of 1 per cent growth and an underlying inflation next Christmas just below the ceiling of Mr Lamont's new 1-4 per cent target range. Thereafter, the promised land of growth at over 3 per cent and inflation under 3 per cent dutifully hoves into view. On the revisionist Treasury arithmetic, it seems - goodness gracious - that devaluation works in Britain after all.
Alas, there is no reason why anyone should trust such projections while the Chancellor's monetary framework remains so muddled. Its architects appear to have borrowed everything, but learnt nothing, from history. Take, for example, the new emphasis on pay restraint - a wonderful flashback to the 1950s and 1960s. In those innocent days, it was conventional wisdom to suppose that wages set by collective bargaining were the ultimate anchor of the price level.
Governments, it was claimed, could secure lower unemployment at some given cost in terms of higher inflation and hope to improve that mix by judicious use of pay policy. As we now know, this intellectual framework fell apart during the 1970s, when unemployment and inflation rose at the same time and pay policies collapsed ignominiously.
Even more depressing is the continued strong emphasis put on the value of sterling. It is, of course, the Government's intention to return to whatever remains of the ERM when conditions permit. And the most influential Treasury officials made their name in greener days by propounding an anglicised variation of what was known in the late 1970s as 'international monetarism'. Perhaps its key conclusion was that sterling devaluation would ultimately be reflected fully in an offsetting rise in wages and prices.
So the continued emphasis on sterling is predictable. Yet it is also wholly misplaced. Indeed, one wonders how severe a disaster has to befall the economy before the Government's fixation with exchange rate targetry is finally expunged. History reveals the following. First, it is not possible to target monetary growth and the exchange rate at the same time. Second, inflation really is a monetary phenomenon and not, over the long term, the result of cost-push considerations, such as import prices or wages.
Thus in the late 1980s, the Government's ill-starred flirtation with the ERM enabled a runaway expansion of credit and a destabilising acceleration of inflation. Just as damaging, levels of expenditure in the economy were driven well beyond the capacity of its internationally trading sector, leaving Britain with a profound structural balance of payments problem. Similarly, the collapse of credit and monetary growth in the early 1990s and the ensuing depression were the unintentional consequences of the Government's overvalued sterling target.
Reasonable folk would surely conclude that it is the money supply - and not wages or the exchange rate - that should provide the anchor for Britain's price level. Admittedly, monetary targets cannot be treated as automatic pilots. Money numbers, which can be distorted and misleading, need careful interpretation.
Judgement is needed, then. The real question for Britain is whether we should trust to the judgement of those whose credibility has been eviscerated by events, or establish new institutions - an independent central bank and an independent think-tank of economic advisers with executive power - to perform the vital task. Somehow one doubts whether the British economics establishment will make the correct choice.
The author is chief economist at UBS Phillips & Drew.
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