The Chancellor rejects the proposition. His abiding contention is that the macro-economic policy under his control cannot deliver better employment opportunities or higher levels of national output, not in the long run at any rate. Such things, Mr Lamont says, are determined by basic economic performance - productivity, entrepreneurship and the flexibility of real wages. Micro-economic policy has a role to play in this regard, improving the functioning of markets for labour and goods and services. By contrast, the role of macro-economic policy is to deliver stable financial conditions and - ultimately - price stability.
The financial strategy does nevertheless observe some political speed limits. The key supposition is that a counter-inflation programme will lead to a temporary rise in unemployment (though naturally not a permanent one), the scale of that dislocation depending on the facility with which employers and employees adapt to the lower-inflation environment. A shock therapeutic approach - aiming immediately for zero inflation - would concentrate this dislocation but thereby possibly sow the seeds of a policy reversal. The Government's ill-starred marriage with the European exchange rate mechanism can be interpreted in this light. The intention, if not the practice, of the strategy is rather to spread the temporary unemployment cost of counter-inflation policy over several years, increasing its chances of longevity.
None of these ideas are terribly new, of course. Their intellectual provenance goes back to the monetarist revolution led by Professor Milton Friedman in the late 1960s. Their political provenance is the famous U-turn of the Labour government in the late 1970s. Bowled over by circumstances that appeared to vindicate all Friedman's central propositions, James Callaghan, the prime minister - reading out a speech allegedly written by his son-in-law - in effect renounced the government's full-employment objective and blew away the post-war Keynesian consensus.
Thirteen years after the original medium-term financial strategy and a quarter of a century after Friedman's intellectual revolution, it would not be inappropriate for the Government to reappraise fundamentally the philosophical basis of its economic programme, preferably in a properly structured public debate. The practical experience of running over-ambitious full-employment targets was ultimately the undoing of the old post-war orthodoxy, but on several counts history has hardly been much kinder to the over-ambitious pursuit of inflation targets enshrined in the new orthodoxy.
For a start, it is pretty clear that the successful containment of inflation has gone hand-in-hand with a permanent - not temporary - rise in unemployment, despite vigorous labour market reforms. Although there are many ifs and buts, the evidence suggests that macro policy can have significant long-term effects on the structure of the economy and, therefore, on employment opportunities.
The second observation is that the financial strategy has been associated with some of the wildest business cycles of the post-war era - a deeply ironic outcome for a policy designed to promote stability. Global shocks and poor technique are partly to blame. But the late 1980s boom was initiated by a government concerned to reduce intolerably high unemployment before the 1987 general election. So the failure of unemployment policy contributed directly to the failure of stabilisation policy.
The scope for upset is presumably that much greater under a government that enjoys nothing like the parliamentary advantages of Margaret Thatcher's administration.
A natural synthesis of the old and new orthodoxies may well involve quantifying medium-term targets for both unemployment and inflation. There would be several advantages. It would force explicit consideration of the impact of counter-inflation policy on the structure of the economy. It would also help guard against destabilising lurches of macro policy triggered by belated political reaction to unemployment levels. Macro lovers would have to be set to deliver a politically sustainable mix over the period of the plan.
The practical implication for current policy is that the Chancellor's inflation objective is probably too ambitious and wrongly constructed. The reasoning concerns Britain's strategic trade problem. Lasting recovery in output and employment opportunities depends on the delivery of economic growth led by exports and by import saving. A conventional consumption-led recovery, by contrast, would eventually founder on the rocks of an explosive trade deficit and an associated erosion of Britain's overseas assets.
To curb consumer demand and support net exports, the Chancellor needs to combine further currency depreciation - at least 10 per cent - with sizeable increases in taxation. As the charts indicate, Britain is still over-consuming, despite high savings, thanks to aberrantly high levels of real disposable income - a legacy of Mr Lawson's tax-cutting budgets. The appropriate tax increase could easily be four times the amount programmed into the Chancellor's latest budget.
The difficulty is that this ideal strategy is liable to involve big, albeit once-and-for-all, upward shocks to the price level - both through higher import prices and, in view of the Government's income tax objectives, higher indirect taxes. Alas, there is very little room for manoeuvre within the Chancellor's chosen regime. On the Treasury's arithmetic, the underlying inflation rate hovers just below the prescribed ceiling for the next two years, granted an unchanged level of sterling. As a result, the strategy of the budget was predicated on the need to bolster sterling and defer tax increases.
By obstructing the implementation of an appropriate macro strategy, the Chancellor's inflation target has paradoxically increased the chances of another destabilising boom and bust over the medium term. Once households and businesses have repaired their debt-laden balance sheets, the scene is set for another period of heady growth led by domestic spending. Although the trade deficit would widen alarmingly, the Chancellor may well decide to lie back and enjoy the ride. Markets may oblige too, at least for a while. Rising activity - containing the budget deficit - may attract international funds into sterling, particularly if the Government talks again of re-entering the ERM. In the end, however, the boom is liable to get out of hand, initiating an all-too-familiar sequence of inflation followed by contraction. It goes without saying that such destabilisation is damaging to the economy's efficiency and employment opportunities.
A part-solution to Mr Lamont's dilemma would involve a redefinition of the inflation target to provide more flexibility. The impact of indirect tax increases and the rise in import prices relative to export prices should be excluded from the targeted measure of retail prices. A more complete solution, however, will have to involve a radical rethink of the medium-term financial strategy and root-and-branch reform at the heart of the policy-making machine.
Mr Martin is the chief UK economist for UBS. Christopher Huhne is on holiday.Reuse content