Why Are We Still Stuck in 1981?
There is a neat symmetry between 1981 and 2012 in the UK macro policy debate.
1) In both cases we have a Tory (ish) government which has been in power for two years, having replaced a Labour government which presided over disastrous macro policy failure. (There’s an interesting argument about whether the 1970s were more or less disastrous than 2008-2010; that’s not the point of this post.)
2) In both cases the new government has spent its first two years – despite protestations to the contrary – more or less in continuation of the failing demand policy it inherited. In 2012, that means 2% inflation targeting plus desperately low, unstable NGDP growth; in 1981 that means uncontrolled inflation and desperately high, unstable NGDP growth. (The Keynesians would argue the Coalition has changed macro policy by tightening the fiscal stance, but that is only a matter of degree: “tightening fiscal stance, 2% inflation target” really was the Coalition’s inherited macro policy.)
3) In both cases we have a monetarist vs Keynesian divide. UK academics famously thought Howe’s 1981 Budget tightened fiscal policy, um, “too far, too fast”; 364 of them writing to The Times. Ramesh Ponnuru and David Beckworth pick up this theme in their recent article for The Atlantic:
The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was “no basis in economic theory or supporting evidence” for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.
This slightly overstates the role of the BoE. HM Treasury was wholly in control of monetary policy in the 1980s, and set the Bank target ranges for broad money growth. If you’re new to this debate it is worth reading the IEA paper from 2006, “Were 364 Economists All Wrong?“, if only for monetarist hero Tim Congdon’s epic contribution which tears chunks of flesh out of the British academic establishment, with regression analysis to boot.
I don’t want to stretch the analogy too far. But when I see comments like this, from Duncan Weldon:
The renewed debate on the UK’s monetary policy regime is a welcome development (and it probably matters a great deal in the long run) but it shouldn’t breed a false complacency – I struggle to think of any monetary regime that could restore decent growth alongside the government’s current fiscal policy.
… it does seem like the UK macro policy debate is still stuck in 1981.
A slightly cheeky question: how many Keynesians believed that the Bank would fail to hit (as in undershoot) its nominal target (the 2% CPI rate) in the presence of the Coalition’s fiscal consolidation? I guess Danny Blanchflower counts as one, he has been consistent in warning about deflation. But whilst I do remember reading lots of dire warnings about low growth from tight fiscal policy, I don’t remember many about sub-target inflation.
Here’s the thing. Anybody who thought we’d undershoot the CPI target was wrong. Not just a little bit wrong. The Bank not only hit but has consistently overshot its nominal target for every single month of the Coalition’s fiscal consolidation. You can make good excuses (as I do) about why the overshoot was so bad, but that’s the evidence.
So why is there even a debate? We’ve had a fiscal consolidation. The Bank has done more than enough (provided sufficient nominal GDP growth) to continue hitting its nominal target in every single month of this fiscal consolidation. Fiscal tightening has therefore been more than offset by monetary policy. End of argument?
Perhaps not; that’s an unsophisticated way to think about either monetary or fiscal policy. But I think the basic point is sound (as does Scott Sumner). The last thing we should worry about is the Bank’s ability to hit their nominal targets. We just need to give them the right nominal target.
In 1981 Geoffrey Howe welcomed the first monetarist counter-revolution to Britain. George Osborne has the opportunity to introduce the second monetarist counter-revolution. Will he take it?