Surviving the hurricane

Deep gloom has descended over Washington. For years, as the global economy enjoyed the longest boom since the late 1960s and early 1970s, the mood at the annual meeting of the International Monetary Fund was smug.

This year, finance ministers and central bank governors meet amid justifiable concern that a month of mayhem in the markets will lead to a severe, widespread recession.

Somewhat belatedly, the message from the IMF is that it might not have been the smartest idea for policymakers to connive in the build-up of asset-price bubbles. The unspoken sentiment is that central bankers like Alan Greenspan were asleep at the wheel and adopted macroeconomic policies that were far too lax.

To avoid future crises, the IMF says policymakers should give careful consideration to whether they should ”lean against the wind”. This makes sense. In the United States, interest rates were cut from 6% to 1% to revive the economy after the dotcom bubble collapsed, and left there until Greenspan was confident the economy was back on its feet.

By that time, the wave of cheap money had stimulated the biggest housing boom in US history. Having sucked millions of people into the real estate market Greenspan then tightened policy, raising interest rates 17 times. Boom turned to bust, and the Federal Reserve has now brought rates back to 1,5%.

The Bank of England has been guilty of the same mistake. Rates were set too low when the bubble in the housing market was inflating and set too high when the bubble was deflating. Wednesday’s half-point cut was welcome but it came far, far too late.

Policymakers say leaning against the wind sounds splendid but is difficult to achieve. Inflation was low in Britain and the US when house prices were rising strongly; the Bank and the Fed would have been accused of pushing their economies towards deflation had they raised rates at that point. The risk is, however, that recent history will repeat itself unless macroeconomic policy is reformed in a post-crisis world.

This requires changes to the regulatory framework, and to fiscal and monetary policy.

It is now recognised that the pro-cyclical nature of credit creation was an important factor in causing the current crisis. Put simply: when times are good, banks are willing and able to lend more, thereby amplifying the boom. When times are bad, they turn off the tap when businesses and consumers most need it. The answer is to have a system where capital requirements and the amounts banks have to set aside are tightened during an upswing. Spain already has just such a system, and that has helped its banks cope much better than its rivals elsewhere.

The same approach should be applied to fiscal policy.

In the United Kingdom, the government continued to run budget deficits even when the economy was growing at rates of 3%, largely because Gordon Brown overestimated tax revenues. Now the economy is slowing, the scope for increases in spending or cuts in taxes to boost growth is constrained. A change to the fiscal rules is needed to ensure future governments cannot play fast and loose with the public finances.

Finally, there is monetary policy. Here, the screaming need in the UK is for the Bank of England to have a more appropriate inflation target. Recessions tend to follow property booms, but the bank uses the Consumer Prices Index, which excludes house prices and mortgage payments, when setting rates. This makes no sense; once the crisis has abated, the Treasury should abandon the CPI as its inflation benchmark. Unless it does so, any idea of the Bank leaning against the wind will be stillborn.