For about six years there has been a consensus that manipulation of short-term interest rates is the only valid instrument of macroeconomic policy, and that rates should be set with the control of inflation as the main, if not sole, objective.
By implication, fiscal policy should play no role in economic management. Budgets are to be balanced or restricted to low proportions of gross domestic product (GDP).
The lacunae in this programme should have been obvious from the start. What should be done if demand is chronically inadequate? Or if endemic and growing imbalances in foreign trade develop? What should be done to hold credit cycles in check?
It took me some time to realise that the new policy regime was a full-dress resurrection of “market” macroeconomics which I had supposed went out forever when monetarism was tried and failed during the 1980s.
But, like monetarism, the new macroeconomic theories could only work if it were true that economies are self-righting organisms that will spontaneously deliver full employment and balanced growth so long as governments are prudent and keep out of the way. In fact the new regime is not working. After years of euphoric growth, the world has become locked into a stagnation that gets worse by the day.
Large imbalances, particularly in trade and in personal debt, have been allowed to develop in the United States and Britain, which mean that growth is unsustainable. Given the existing policy regime, medium-term prospects begin to look frightening.
The US is already in a growth recession because private investment has fallen while a record balance of payments deficit has been bleeding the circular flow of income on an increasing scale.
These negative forces have been partly offset by an unsustainable splurge in household borrowing, a consequence of the fall in interest rates and the boom in house prices, in the absence of any control over credit expansion.
The US output gap would be larger had the government not administered a large fiscal stimulus — the equivalent of about 4% of GDP. This stimulus was applied contrary to the principles of the new consensus, which may be the reason why people don’t talk about it much, preferring to suppose that the shallowness of the recession in 2001 was the result of the US economy’s underlying strength.
The future cannot be like the past. The US consumer boom, because it was based on credit expansion and rising debt, cannot be an abiding source of growth. Unless net export demand turns round in a spectacular way, further growth can only take place when the budget deficit reaches stratospheric proportions.
Yet the obstacles in the way of net export growth are formidable. The stagnant world provides an unpromising market for US tradables, the surplus countries are impeding the needed depreciation of the dollar, and the transfer problem is such that to eliminate the deficit, domestic absorption of goods and services has to fall by about 5% relative to what the US produces.
Britain’s position has similarities. Total demand is stagnating. Such growth as there is is unsustainable because it is dependent on a rising flow of net lending to households, while investment has been weak and net export demand falling. The recent decline in the exchange rate is to be welcomed because it brings some relief to the manufacturing industry, on which any substantial recovery in exports depends.
The fall has not been large enough to produce a repeat performance of 1992 to 1997 — a rare interlude when growth was export-led. It would have been helpful if the monetary policy committee had cut interest rates again, but this would have run contrary to its narrow terms of reference.
There is a desperate need now for self-generated expansion outside the US. Europe is hamstrung by the extraordinarily perverse rules that govern budgetary policy. Japan, still hobbled by a defective financial system, is itself hoping for an impetus from exports.
Things are going wrong in such a complex way that any simple set of remedies cannot be laid down in advance.
The credit booms, in the UK and in the US, will unravel fairly soon; and if they unravel rapidly there could be technical recessions in both countries, about which not much could be done.
More generally it will have to be rediscovered that economic policy must encompass many different objectives, not just the control of inflation, and that there will sometimes be conflicts so that difficult choices have to be made.
Also, that every policy instrument — all the dimensions of fiscal and monetary policy including some form of quantitative control over credit — will have to be reinstated and used flexibly. The needed changes probably won’t happen until they are forced on us. — Â