Economics: In the end, not a bad performance

Click to follow
The Independent Online
There have been few dull times since I began writing a regular column about economic events over a decade ago. There has certainly never been a shortage of subjects, not least because the economic columnist can properly graze over almost any matter to which economic analysis can be applied.

There are economic aspects to the debates about education, crime, health, defence, aid, broadcasting and so on. Indeed, one of the trends of the Eighties was the march of homo economicus over areas that had previously subsisted without him.

But the macro-economy of growth, jobs, taxes and interest rates has inevitably been the mainstay. When I began, the debate between the monetarists and the Keynesians was in full swing. The Government was committed to raising interest rates to whatever level necessary to meet its monetary targets.

But the policy was soon discredited. The 1979-81 recession was far more severe than the Government had expected, belying the contention that adjustment to low inflation would be painless and rapid. Then inflation fell even though the broad money supply accelerated, which was not what the theory predicted. By 1985, the money supply had become only one of many indicators.

Some former monetarists, like Lord Lawson, gravitated to the notion that a fixed exchange rate link with the German mark would provide a better rule for demand management, thereby joining a band of people (including myself) who had favoured our ERM membership for the entirely different reason that the interdependence of Europe's economies made exchange rate stability desirable.

In the end, the centrality of the German mark in the system, combined with the impact of the reunification of Germany, proved to be the ERM's undoing. The post-war Bretton Woods system crumbled for similar reasons: the deficit financing of the Vietnam war undermined the dollar, which was the central currency. One day, governments will take Keynes's advice and base an exchange rate system on a non-inflationary currency representative of all its members.

Whether in favour of fixed or floating rates, most economists agreed during the Eighties that the management of demand had to be more sophisticated than the first Thatcher administration had supposed. But crude Keynesianism was certainly not reinstated.

The dominant ideas of the late Eighties relied on the classical claim that the economy is essentially self-stabilising, with Keynesian unemployment implicitly described as a special case of the Thirties, or as a merely temporary phenomenon. The implication was that macro-economic policy should be directed at controlling inflation, because any effects on growth and jobs could only be short-term.

This remains the conventional wisdom, and it will probably continue to do so, at least among policy-makers, because it is politically convenient. Society cannot survive without necessary social fictions: we have to hold the perpetrators of crimes responsible for their actions, even though elementary research shows that unemployment and growing inequality foment criminality. This tension between the analysis of social causes and the need for individual responsibility appears in economics too.

Central bankers need to proclaim that unemployment depends solely on the behaviour of the labour market, and is attributable to such causes as high benefits or lack of training, even though there is accumulating evidence for the more Keynesian view that macro- economic policy matters even in the long term.

If policy-makers admitted that interest rates or fiscal policy could ameliorate unemployment, they would come under pressure to abuse those levers. Indeed, the levers might therefore become less powerful. After all, the post-war golden age ended in part because of the acceleration of wage demands from 1968. If governments could guarantee employment, why not ask for pay rises too?

Behind the necessary rhetoric, though, cack-handed macro-economic policy can have long-lasting effects for good or ill, pushing output and employment from one equilibrium to a lower one. This is, I think, what happened in 1979-81. The exceptional severity of the manufacturing recession caused by the overvaluation of the pound weakened Britain's trading accounts, and reduced its capacity to grow without sucking in excessive imports.

The balance of payments matters. Economies are ultimately bound to consume no more than they can produce, whatever the delay in the day of reckoning brought about by ease of access to overseas finance. Economies are not so flexible that people can be effortlessly moved from an activity entirely directed at the domestic market - such as hairdressing or schoolteaching - to a more tradeable activity like manufacturing or investment banking. So we should take more care of our tradeable sectors than we have in the past.

This argument about the failings of 1979-81 must be used cautiously, since Joseph Schumpeter said that economies need the 'creative destruction' of recessions to retain their vitality, and Mancur Olsen thought that the Germans and the Japanese derived economic advantage from wartime defeat for similar reasons.

But there are limits. The undoubted improvements in the performance of the economy through the Eighties - as shown by productivity growth, profit and investment shares, the end to the decline in our share of world export markets, jobs growth and the early fall in unemployment last year - were surely due to privatisation, competition and greater incentives. They would have been even greater without the mistakes of 1979-81.

The errors of 1987-89 are another example of ill-judged macro- economic policy casting a long shadow. When Nigel Lawson persisted in cutting taxes on an heroic scale in his March 1988 budget, he compounded the impact of financial market liberalisation on mortgage lending to create a grandmother of a boom.

Hindsight is one of the greatest weapons of the columnist, but I plead not guilty on this occasion. It was clear when the balance of payments figures for January 1988 came out that the economy could not afford tax cuts, and there were also warnings from more elevated sources at the National Institute and London Business School.

But Lawson stubbornly persisted in policy error as only the very clever, with their exceptional talent for rationalisation, can do. By the summer of 1988, the balance of payments was reaching crisis point even as he proclaimed at the Berlin IMF-World Bank meetings that it did not matter. The long attempt to correct the deficit and the accompanying overheating in the economy began. The fat years of living beyond our means were so predictably followed by the lean years.

They are not over, I fear. We have paid bitterly for Lord Lawson's mistakes. Even though this recession has been the first since the Thirties to touch the southern heartlands of the overborrowed middle classes, it has still failed to curb our appetite for imports enough to bring the current account of the balance of payments back into surplus.

This is one of the most worrying aspects of Britain's outlook. The figures are poor because of the change in the statistical system with the advent of the European single market, so we cannot be sure where we are. Things may turn up, and we must hope that they do. But my guess is that the balance of payments remains one of the most worrying weaknesses of the UK economy.

The excess of imports over exports, combined with the need to correct the Government's own budget deficit, means that this upturn will be quite different to the last one. We will grow. Output will rise. But consumer spending must rise by less than output, because much of the increase has to go abroad just to pay for our existing level of imports.

This hairshirt recovery will be a remarkable contrast with the free- spending and high-living Eighties. The Government, whether led by John Major or, as I suspect, by Michael Heseltine, will find it more difficult to spend its way back to pre-election popularity.

The Chancellor will have to be wary of the financial markets' reaction. There was just a taste last week of a nasty run on sterling, with the market in sterling futures suggesting that investors are becoming nervous about holding sterling assets. UK gilts have also suffered most in the world-wide bond sell-off since February.

The other great cause for concern is that we are opting, without realising the consequences, for a much less cohesive, unequal and more criminal society. Inequality has soared since the end of the Seventies, largely because of the scarcity of skilled and educated people. But the Government has compounded the trend by raising taxes on everyone, when previously the better-off benefited most from tax cuts.

Nevertheless, I remain essentially optimistic about the British economy. In a recent paper, the eminent economic historian Professor Nick Crafts assembled the considerable evidence that we have improved our performance since the dark days of the Seventies. Although we have not grown as rapidly as we did during the golden age of the post-war reconstruction until 1973, we have closed the gap with our Continental rivals and I believe we will continue to do so. By European standards, we are now a successful economy. The problem is that Europe's standards are no longer very high.

As I leave to pursue my old interest in international economics in the City, I am sure that my successors will bring fresh insights into the perils of the economy, and to the successes and failures of policy-makers. The Independent and the Independent on Sunday have long enjoyed a fine reputation for economic reporting and commentary - the names include Sarah Hogg, Alan Budd, Bill Robinson and Gavyn Davies. I predict it will go from strength to strength.