I have spent the last week on a farm south of
Matera in the Basilicata
region of .
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
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
- 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
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
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
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
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.