By Tony Dolphin | 1 October 2012
Macroeconomic policy makers failed to predict the biggest recession in 70 years. It’s time to rip up the rule book, chuck out the useless models – and look for a new angle on how to promote growth
History shows us that economists’ views on how macroeconomic policy should be framed and conducted evolve over time. In the postwar period, the consensus has variously been that policy makers should target full employment, low inflation or economic stability; that the focus should be on the target variable directly or on some intermediate variable, such as monetary growth or the exchange rate; and that the target should be achieved through an active fiscal policy, an active monetary policy, or some combination of the two.
However, despite the financial crisis and consequent recession, there has been no significant challenge to the broad framework in which macroeconomic policy is currently made – or even any serious questioning in policy-making circles of this framework. This is despite recent evidence suggesting policy is not working and growing criticisms of various aspects of policy.
Most obviously, the current set of policies is failing to achieve economic recovery. Official statistics show the economy was back in recession in the first half of 2012 and output is still around 4% below its peak level before the 2008 recession. Yet inflation, measured by the Consumer Prices Index, has been above its 2% target level for 33 consecutive months, and was 2.5% in August.
According to the models on which current policies are based, this should not have happened. They suggest weak growth should lead to spare capacity in the economy, which in turn should lead to lower inflation. Evidence for spare capacity is abundant, but inflation has proved surprisingly resilient.
When the authorities have tried something different, they have come under fire. The Bank of England defends its programme of quantitative easing, arguing that economic growth would have been even weaker if it had not acted as it did. But QE has been criticised for its distributional effects (it works by boosting asset prices, and so benefits disproportionately the wealthy who, by definition, have the most assets); and because it has led to low bond yields, which have meant smaller pensions for those who have bought annuities in recent years.
But, for the most part, policy makers have adapted rather than changed their approach. Thus, fiscal policy is now focused on eliminating the cyclically adjusted deficit and stabilising the ratio of government debt to gross domestic product. This is to be achieved through a multi-year programme of tax rises and public spending cuts that will be implemented irrespective of developments in the economy. It is not clear at this stage what will happen when the deficit has been eliminated but it is a fair bet that policy will continue to be determined primarily by reference to largely arbitrary fiscal targets involving the level of debt and the size of the cyclically adjusted budget balance.
This is not necessarily the wrong approach. Studies have shown that a very high level of government debt relative to GDP is associated with lower growth. The debt ratio in the UK is already substantially higher now than it was five years ago and is set to increase further in the next few years. What constitutes a ‘very high’ level of debt, however, is likely to vary from country to country, and probably over time too, so it is impossible to say what the danger level might be in the UK. Certainly, the UK has historically had much higher levels of public debt than now. Perhaps the best argument for the consensus view is that the current level of debt leaves future governments with less room to manoeuvre should the economy fall into recession again.
Putting the cyclically adjusted current balance at the heart of fiscal policy is more problematic because there is no wholly satisfactory method for making the cyclical adjustment. Most economists agree that it is desirable to allow the deficit to narrow and widen as a result of fluctuations in tax revenues and welfare benefit spending caused by the economic cycle. Otherwise fiscal policy would tend to be pro-cyclical: if a recession caused tax revenues to fall and the deficit to widen, tax increases or spending cuts would be needed to rebalance the budget, which would further weaken the economy. In practice, though, calculating the cyclically adjusted balance is very difficult. The Office for Budget Responsibility, which is currently tasked with producing the official numbers, changed its estimate for 2011/12 between March and November 2011 from 3.2% of GDP to 4.6%, almost wholly as a result of new information on the economy, rather than changes in government policy.
The fact that changes of this magnitude can occur within the space of less than a year is problematic for policy makers. They face a choice between two flawed alternatives: setting policy relative to a measure that is insensitive to the cycle, so risking exacerbating booms and busts; or setting it relative to a definition of the deficit that it is impossible in practice to measure. One conclusion that might be drawn from this unenviable choice is that fiscal policy should be used only in certain limited circumstances – when monetary policy appears to be proving ineffectual.
Meanwhile, monetary policy makers have abandoned their models in the short term to justify the maximum degree of policy easing. Despite inflation being more than one percentage point above its target level for two years, the Bank of England’s Monetary Policy Committee has held its bank rate at the record low level of 0.5% since March 2009 and has embarked on a programme of quantitative easing that now stands at £375bn. Avoiding a depression and trying to get the economy growing again has taken priority. Many economists blame the depth of the 1930s Great Depression on the failure of central banks to relax monetary policy aggressively as economies slid into recession.
Yet the framework in which the MPC operates has not changed. The governor still has to write a letter to the chancellor every three months whenever inflation is more than one percentage point away from its target rate. The presumption is that once the economy has recovered, quantitative easing will be reversed and the MPC will go back to nudging interest rates up and down in response to its best guess about growth and the output gap. The fact that this framework did nothing to prevent the deepest recession for almost 70 years and was thrown out in the crisis appears to count for nothing.
In 2006 and 2007, the MPC’s models told it that consumer price inflation was likely to stay close to its target rate if interest rates were nudged slightly higher, so they increased them from 4.5% to a peak of 5.75%. Meanwhile, policy makers were turning a blind eye to a financial bubble that had been developing for several years – the unintended consequence of a period of low interest rates that was justified by an extended period of low consumer price inflation.
At the very least, this suggests monetary policy needs to be set by reference to a broader consideration than consumer price inflation. Policy makers should consider a range of explanations for developments in the economy and a range of possible outcomes following any policy action. Computers are now powerful enough to allow them to carry out highly sophisticated simulations of policy actions (the use of quantitative easing by the Bank of England is one example of a policy that would be informed by such an approach). And policy makers should also develop a better knowledge of history and take it into account when making decisions.
In the UK context, this suggests a more relaxed approach to domestic inflation pressures since they seem to be largely absent, even when the economy is doing well. Instead, greater attention should be focused on asset prices, particularly house prices, and on the oil price.
The UK has experienced four major recessions in the past 40 years. Each one was preceded by a large increase in the oil price and a period of rapid gains in house prices. While there is not much that policy makers in the UK can do about oil prices, they should at least be fully aware of when they pose a serious risk to the economy and give them a more prominent role in their deliberations.
Similarly, controlling house price inflation might not always be possible. But if policy makers could find a way to prevent future surges in house prices, for example through the imposition of maximum loan-to-value ratios, it would do far more to reduce the risk of a future recession in the UK than minor adjustments to interest rates designed to keep consumer price inflation close to 2%. At the very least, house prices should be given the same weight in policy deliberations as consumer prices. They should also be a focus of the Bank of England’s Financial Policy Committee.
A world in which house price inflation continues to be a major source of instability in the UK economy is only one possible outcome for the next decade. It appears just as likely that the need to reduce high household debt levels will condemn the UK to a long period of sluggish economic growth. Policy makers need to break out of their traditional thinking and develop new ideas for such an environment. They also need to be aware of their limitations. Traditional economic thinking gives them a misleading sense of their ability to use macroeconomic policies to guide the economy. New ways of thinking, such as the complexity approach, argue that economies are dynamic, subject to endogenous change and contain relationships that shift over time.
As a result the nature of the economic cycle will evolve in unpredictable ways. Policy makers cannot accurately forecast economic developments; nor can they be sure of the response of the economy to macroeconomic policy changes. As a general rule, therefore, they should do less. This does not mean they should never intervene in the economy, but when they do their actions should be based less on formal models and more on their intuition and common sense. Policy-making is a complex business and policy makers need to adapt and learn as they go along. History suggests narrow, rules-based approaches to macroeconomic policy do not work for long.
It is time for policy makers to acknowledge their own limitations, abandon their models and better understand the effects of their policies by using simulations and impact assessments.
Tony Dolphin is senior economist and associate director for economic policy at the Institute for Public Policy Research. This feature first appeared in the October issue of Public Finance and is an edited extract from Complex new world: translating new economic thinking into public policy, published by the IPPR
