In his speech yesterday, George Osborne said this:
“Of course, there are those who argue we should not be reducing the deficit – we should be spending and borrowing even more. But that argument ignores a crucial fact: inflation in the UK has been significantly above the Bank of England’s 2% target since the end of 2009. That is due to a combination of commodity price shocks, the lagged effects of a lower exchange rate and a worsening underlying productivity performance, and it has very important implications for fiscal policy. Looking backwards it means that over this period looser fiscal policy would almost certainly have been offset by tighter, or less loose, monetary policy.”
This is an argument I have already discussed, but it is the first time I have seen the government use it. It is an improvement on those based on bond markets, confidence fairies, or expansionary fiscal contraction. Yet even if you buy it (which I do not think you should), the key phrase here is ‘looking backwards’.
In judging policy, we should not look backwards. Lots of things are true in hindsight, whereas policy has to be made under uncertainty. Good policy should be as robust as possible to this uncertainty. In 2010, when additional austerity was announced, the government did not know that inflation was going to be unexpectedly high in 2011. So it cannot have known that the MPC would have been debating whether to increase interest rates in the spring of that year. A more likely outcome was that inflation would be falling and interest rates would be firmly anchored at their lower bound. As a result, high inflation in 2011 is a poor excuse for a bad decision.
It was a bad decision because the government should, at the very least, have considered the possibility that demand was going to be weaker than they expected, and that monetary policy would be unable to do much about it because interest rates were at the zero lower bound. If they did not think about this possibility, it was irresponsible. If they did and took a risk, we are now experiencing the consequences.
The Chancellor in his speech also quoted Mervyn King as saying that current UK policy was a “textbook response” to the current situation. I do not know where that quote comes from (it is not in the text of the Governor’s speech at the same occasion), so I will focus on what the Chancellor thinks. He goes on to explain: “Theory and evidence suggest that tight fiscal policy and loose monetary policy is the right macroeconomic mix to help rebalance an economy in the state [of high indebtedness].” To which I can only say – no, not when interest rates are stuck at zero.
Central banks get a lot of criticism: some justified, some not. When it comes to what monetary policy can do in a liquidity trap, they do not want to appear too pessimistic. But there is a danger of giving the opposite impression, which is that nothing much has changed except the way policy is implemented. I would much prefer them to be quite explicit about how much more uncertain Quantitative Easing is as an instrument, and that fiscal policy will have a much greater impact on demand as a result.
Regular readers may think I’m beginning to sound like a record on this. Indeed, Jonathan Portes argues that the proposed new programme discussed yesterday by the Chancellor of government guarantees to support new house-building and infrastructure investment concedes the intellectual and economic argument. To quote: “The economic difference between the government borrowing from the private sector to finance investment spending, and the government guaranteeing the borrowing of another entity - with the government guarantee meaning that the lender has no more or less risk of non-repayment than if the money was lent direct to government - is marginal.” If the new investment happens, I would agree.
I also suspect that Mervyn King would not describe such schemes as pure monetary policy. He says: “But the long term nature of the lending and its pricing mean that the Bank could conduct such an operation only with the approval of the Government, as offered by the Chancellor earlier. So such a scheme would be a joint effort between Bank and Treasury. It would complement the government’s existing schemes, and tackle the high level of funding costs directly.” That sounds like code for this is also fiscal policy.
But why quibble. If measures of this kind allow the government to carry on the fiction that they are sticking to Plan A, and if it produces a recovery which it is then claimed has nothing to do with fiscal policy, should we mind? I think we should, because today’s myths have a danger of becoming tomorrow’s received wisdom.