Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 4 May 2012

On Major Macroeconomic Policy Mistakes

            I have spent the last week on a farm south of Matera in the Basilicata region of Italy. Wonderful scenery, sun, hospitality and food, but no internet access. Returned to find a very wet UK, and that the economy has officially entered a second recession.

When UK GDP fell in the last quarter of 2011, I wrote that the 2010 Budget should rank as one of the major UK macroeconomic policy errors since the war. A number of comments on that post and since have asked why I single out fiscal policy rather than monetary policy for such criticism? This is a good question, which has much more general applicability than to just the UK.
There are three charges that could be made against recent monetary policy.

1)                          That it could have done something to prevent the financial crisis itself, by raising interest rates by more in the middle of the last decade.
2)                          Following the crisis, central banks could have cut rates more quickly, or done more in terms of ‘unconventional’ monetary policy.
3)                          Policy should have moved to some form of price level or nominal GDP target. 

Let me take each in turn.
            Policy was clearly at fault in allowing the financial excesses that preceded the crisis. There is also a strong case that monetary policy should have reacted to excess leverage, as my recent post summarising Woodford’s new NBER paper suggests. There is plenty to debate about who should have seen the danger signals and ‘shouted from the rooftops’ about them. However I see the financial crisis as primarily a failure of financial regulation, and not conventional monetary policy. A laissez-faire attitude to the financial sector, rather than the setting of interest rates, was the major policy failure here.
            The second criticism is also probably valid. If the Bank of England had cut interest rates as rapidly as the US Fed, or if it had tried to orientate its Quantitative Easing policy to where the credit constraints were most acute, then this might have improved things somewhat. However I’m reluctant to label this a major policy error. Monetary policy, in contrast to fiscal policy, did move in the right direction. My view would be different if the UK had followed the ECB in raising interest rates in 2011, as they nearly did
The most serious charge against current monetary policy is that it is being too conservative in sticking to low inflation targets rather than moving to some form of price level targeting with, for a time, an implicitly higher inflation target. In 2009 or even 2010 such a change would have been seen as radical, but there now seems to be a growing weight of academic opinion (for example here) behind such a move. However, in the UK there is very little pressure to make any change. In part this is because – unlike the US - any move to price level or nominal GDP targeting would have to come from the government rather than the Bank of England. The government sets the Bank’s mandate, which has the 2% inflation target at its centre. Most academic expertise on UK monetary policy works through the Bank. One possibility would be to ask the Treasury Select Committee to take up this issue. If any UK academics reading this blog feel this would be a worthwhile thing to try and do, please contact me.
            So in retrospect the failure to move to some form of price level targeting may come to be seen as a major policy error. However, at least in the UK, in the absence of any great pressure from either academic economists or the opposition to make such a change, this error may reflect ignorance as much as anything. This was not the case with fiscal austerity in 2010.
            As I have noted before, the Conservative Party opposed the government’s countercyclical fiscal policy following the recession. They bought the idea of expansionary austerity, which many have pointed out contradicts basic macroeconomic theory in a liquidity trap. There can be no excuse that the right policy was new, untried and radical – the appropriate policy was simple and well understood. When a government chooses to ignore mainstream academic theory, and the economy suffers as a result, it has made a major error and it should be held to account for that.
            Does this make me a closet old fashioned Keynesian? Well for the record I think there have been only two errors of similar magnitude in the UK over the last 30 years, and both have involved monetary policy. The more recent was the decision in 1990 to enter to Exchange Rate Mechanism (ERM) at an overvalued exchange rate of 2.95 DM/£. Although an economic downturn in the early 1990s was probably inevitable given the overheating in the late 1980s, joining the ERM at an overvalued exchange rate made the recession unnecessarily sharp. On that particular occasion I really can say that ‘I told you so’. The other was the brief adoption of money targeting in the early 1980s. Once again, tightening of policy was required to reduce inflation, but the adoption of money targets led to deflation that was both too sharp and uncontrolled, and the hysteresis effects of the resulting large rise in unemployment blighted the rest of the decade. (The fiscal contraction in the 1981 budget that I have written about here was a mistake given the very tight monetary policy at the time, but a more optimal policy would probably have involved fiscal tightening and a looser monetary policy.)
            A common feature of all three episodes is that they caused increases in unemployment that were unnecessary, at a time when unemployment was already high. For reasons I have noted here, this implies a major decline in social welfare. Why have I not included any examples of errors that led to higher inflation? Well if I had gone back further then clearly the rise in inflation in the 1970s was a major policy error. The rise in UK inflation in the late 1980s was the result of policy errors, but I am being generous here because to some extent the consumer boom at the time was unexpected. (I discussed this briefly here.)
            Is it a coincidence that all three major errors were made by Conservative Chancellors? Perhaps. The catastrophic rise in inflation in the 1970s largely took place under Labour. The increase in government spending by Labour around 2005 was underfunded, but I would not call this a major policy error because I do not think it led to a large decline in social welfare.
            These three errors all had a uniquely national element. The US flirtation with money targets was briefer and much less damaging. Although German unification was the prime cause of the temporary collapse of the ERM, joining at an overvalued rate was the UK’s choice. Whereas many Eurozone countries have been forced into austerity by the markets and a lack of coordination by the ECB, the UK was never under similar pressure because it is not part of the Eurozone.    
            At least one characteristic connects all three episodes. They all get some of their appeal from simplistic macroeconomics. In 1980, it was the idea that there is a simple and reliable link between some measure of money and inflation. In 1990, it was that the medium term equilibrium real exchange rate is always equal to the PPP rate. And most recently, that private sector demand will automatically replace public sector demand (Says Law), or perhaps that monetary policy in the form of inflation targeting is always capable of stabilising demand. Most of the time I do not think sound macroeconomic policy is very complicated, but it is not that simple either. 


  1. "The increase in government spending by Labour around 2005 was underfunded, but I would not call this a major policy error because I do not think it led to a large decline in social welfare."

    The loss in social welfare is never felt at the time of the increase in government spending (the reverse is true) but after the party is over (i.e. today). Deficit spending in a boom is just as bad a policy mistake as (as I am sure you'd agree) attempting to balance the books in a recession.

    That symmetry argues for me that 2005-7 labour policy was a very large, very predictable policy error. Arguably worse than anything the current government is guilty of. You can argue the Conservatives could do more (run larger deficits for longer) but they are at least the right way round (running a large deficit in a bust).

    Labour were running a large deficit in a boom. Exactly the wrong thing to do.

    1. You are exaggerating the case. The budget deficts from 2003-2008 were between 2-3.5%. These deficits did not cause the crisis, they may have exacerbated it, but didn't create it.
      Osborne's policy has created a recession from a newly born recovery.

  2. I also believe the issue was regulation more then monetary policy that was the most (although not sole) factor in this whole mess. The big banks were extremely reckless, and many of them simply became giant hedge funds. Why this was not understood or stopped by regulators I still don't understand, but the "light touch" regulation was the biggest factor.

  3. I'd like to take up the point that the Labour government could have done more to regulate the financial sector in the early years after the millennium. I think you are entirely right. However this doesn't take into account the wider social and media environment. Only now are we beginning to see how successive governments have had to be in the pockets of the press to survive. This reveals how much of a hostage to fortune governments are to conventional wisdom and in this particular case the markets.

    Ever since the big bang conventional wisdom has said that deregulation is the only way. This is basically the markets, through the media, holding a gun to the heads of whoever is in power. The markets thought the party would go on for ever and would shoot any who tried to regulate them otherwise.


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