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Hamish McRae: We've no choice but to keep inflating

A bubble or not a bubble? Right now I think the best answer is not yet

Wednesday 11 November 2009 01:00 GMT

Have they merely created another bubble? The huge effort by this and other governments to pump up the economy seems to have checked the economic decline. It has certainly helped global share prices recover and seems, here in the UK at least, to have helped house prices bottom out.

But everything comes at a price. The public debt of the main developed economies seems set to reach around 100 per cent of GDP, while the near-zero interest rates and unorthodox ways being used to boost money supply may have set the scene for a revival of inflation. These policies cannot continue for that much longer, here or anywhere else, and there is a danger that when they are withdrawn, demand will flop back and unemployment will continue to climb. There is a real danger of a W-shaped recession, with another downward dip in activity next year.

As a result, far from helping the world economy through recession, the charge runs, government policies may have at best been ineffective, and at worst, may actually have impeded the recovery. The danger is that, a year from now, we might be back in recession and there would be nothing government could do about it.

It is a charge that all governments face in some measure, but it is one that applies more seriously to the UK than elsewhere, as our fiscal position is worse than that of any other major developed nation. Accordingly, as the Fitch ratings agency has warned, Britain is at the greatest danger of losing its prime credit rating. As a result not only has the country's debt shot up; it may cost more to service it in the future.

It is a serious charge and deserves a serious answer. Simply asserting that government is doing all it can to help people and companies through the recession, as has our own and others, won't do. Saying that because the policy isn't working very well we have to do more of it, is not a very credible response either. There are things that can sensibly be said but in the maw of politics the sensible thoughts tend to be drowned out by the stupid ones. So let's step back and look at where we are.

The first thing to say is that stopping things going down is not to be dismissed as an inadequate outcome. Of course it is not the sort of success that politicians like to boast about and it is certainly very different from the stuff we used to get from Gordon Brown in his successive budgets. But it is a start. The world's banking system is functioning again. That has been achieved at great cost, to be sure, and maybe the system is not functioning as well as it should but we are no longer looking over the precipice. In any case the world economy, viewed as a whole, is growing reasonably strongly. True, most of the developed world is not doing well but China and India are; so is most of Latin America and Africa.

The next thing to say is that recessions typically take a while to turn round. In previous cycles economies have bounced along the bottom for 18 months or so before staging a proper recovery. It is not pleasant and it would be great if we were clever enough to crank up growth faster. But we are not.

The third thing is that the initial effect of monetary expansion, be it through low interest rates or unorthodox measures, will be to boost asset prices. Thus the Bank of England had a check list of things it expected to happen when it announced its "quantitative easing" programme this spring. The list started with a rise in money supply and a fall in long-term interest rates; ran through a rise in corporate credit and share and bond prices; and finished up with a rise in real spending and output – and finally, a rise in inflation.

We will get more of a view about where we are, or at least where the Bank thinks we are, with the forthcoming Inflation Report but meanwhile I think it is right that a recovery in asset prices is a crucial element in restoring confidence. Think what things would be like if stock markets round the world were still flat on their back and house prices here and elsewhere were still falling.

That is the case for the defence of monetary policy and I for one think it stacks up pretty well. Yes, monetary policy has puffed up asset prices but it was the right thing to do. Our fiscal policy, running up debts on an incredible scale, has been a catastrophe. But monetary policy has been relatively successful so far. The problem is what happens next.

Next year fiscal policy goes into reverse. It has to, whoever forms the next government. So some combination of higher taxes and lower public spending will be a drag on the economy, maybe enough to push it down into a second dip. That will put great pressure on monetary policy to remain easy. The unorthodox measures to boost money supply will be scaled back but interest rates will remain very low. There will then be a very real danger of an unsustainable bubble.

Think about the UK housing market. If house prices continue to climb and would-be owners start to feel they are missing out, there could be a scramble to buy, fuelled by very low interest rates. Or think about US share prices. If the Federal Reserve keeps interest rates at near-zero levels and the US keeps flooding the world with dollars that may in the short-term help prices but in the long-term we have another dollar crisis. That could be profoundly unsettling for the world economy, in fact just the sort of thing that might plunge it into another and maybe more serious dip.

So, a bubble or not a bubble? Right now I think the best answer is: not yet. We are still just about OK. Share prices and house prices have recovered but are not yet at unsustainable levels. But we are in more peril than most people realise. The peril is not so much that asset prices will plunge back next year, though they may fall somewhat. The peril is that if the recovery were to falter next year there would be tremendous pressure on monetary authorities around the world to keep printing the money to try to keep the economies puffed up. That would lead to another crash when people realised what they were doing was unsustainable.

Meanwhile we have to have a credible medium-term plan to repair the fiscal disaster and to get back to normal monetary policy. We don't have either and that is scary indeed.

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