Time for a spoonful of Reaganomics
Marketing department of HSBC Bank Malta plc
The trade-off between growth and inflation has been deteriorating for quite some time in the UK.
Five or six years ago, reasonable economic growth was accompanied by remarkably low inflation. Now, much slower growth is accompanied by unpleasantly high inflation. As reversals of fortune go, this is most unwelcome. Suddenly, life for the Bank of England has become difficult. To what degree should policymakers slam on the brakes to bring inflation to heel?
It is nearly the universal practice that central banks concentrate on inflation targets rather than money supply targets, but the overall objective to control inflation is still there. Interest rate increases could easily be seen in these terms: add to anti-inflation credibility now in order to avoid bigger output losses in the future.
Also the British government is intent on rewriting its fiscal rules having discovered that the years of prudence were, perhaps, not so prudent after all. In truth, the existing rules are very inflexible. Most countries have, from time to time, had to increase government borrowing dramatically, whether through wars, recessions or financial meltdowns. During these troubling times, budget deficits have typically risen well beyond the targets now embraced by the Treasury. Fiscal rules need to be able to cope with these contingencies.
Perhaps, then, the government should, in time-honoured fashion, allow the budget deficit to rise. After all, borrowing rose to over 7 per cent of national income in the mid-1970s and stayed fairly high until the 1981 budget.
Then went into surplus and then back into heavy deficit during the recession at the beginning of the 1990s before the more recent string of "prudent" outcomes. Other countries' rules - including the eurozone's
growth stability pact and the Gramm-Rudman-Hollings deficit reduction act in the US in the 1980s - have typically provided an emergency exit route in the event of a major recession. While it is desirable to have low budget deficits through the cycle as a whole, there are times when deficits should be big.
There are also times - although politicians have tremendous difficulty admitting to this - when surpluses should be big. They almost never are.
At the current juncture, there is a case for looser fiscal policy. The UK is facing two separate problems. Inflation is too high but growth is too weak. It is easy enough to pretend, in these circumstances, that lower growth will, in time, deliver lower inflation. But there is no guarantee. Imagine, for example, that the UK economy next year is facing a combination of recession and still high inflation. What, then, needs to happen?
It will be either a significant tightening of fiscal policy taking the view that the defeat of inflation will allow the broader economy to recover, as was the case in the early 1980s - or, alternatively, a dose of Reaganomics.
Reaganomics, among other things, was a mixture of tight monetary policy through the actions of Paul Volcker, the Federal Reserve Bank chairman at the time and loose fiscal policy, associated with Reagan's tax cuts and large congressional spending. This combination led to high real interest rates and, as a result, a rapid appreciation of the dollar which, in turn, provided the US economy with some insulation from inflationary difficulties building elsewhere in the world.
Ultimately, the policy led to all sorts of global imbalances, some of which are still with us now. For the UK today, though, there is a certain attraction: strong sterling to ward off the inflationary evils coming from the rest of the world set against an expansionary domestic fiscal policy which might help to rebuild confidence in the housing market and the financial system.
There are, though, two problems with this approach. First, as a nation, the UK has been spending well beyond its means for many years. Recessions are never desirable, but their avoidance sometimes merely postpones and makes worse the inevitable economic hangover, as we discovered during the
1970s and early 1980s. Second, combining monetary and fiscal policy in this way requires a high level of co-operation between government and central bank.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Five or six years ago, reasonable economic growth was accompanied by remarkably low inflation. Now, much slower growth is accompanied by unpleasantly high inflation. As reversals of fortune go, this is most unwelcome. Suddenly, life for the Bank of England has become difficult. To what degree should policymakers slam on the brakes to bring inflation to heel?
It is nearly the universal practice that central banks concentrate on inflation targets rather than money supply targets, but the overall objective to control inflation is still there. Interest rate increases could easily be seen in these terms: add to anti-inflation credibility now in order to avoid bigger output losses in the future.
Also the British government is intent on rewriting its fiscal rules having discovered that the years of prudence were, perhaps, not so prudent after all. In truth, the existing rules are very inflexible. Most countries have, from time to time, had to increase government borrowing dramatically, whether through wars, recessions or financial meltdowns. During these troubling times, budget deficits have typically risen well beyond the targets now embraced by the Treasury. Fiscal rules need to be able to cope with these contingencies.
Perhaps, then, the government should, in time-honoured fashion, allow the budget deficit to rise. After all, borrowing rose to over 7 per cent of national income in the mid-1970s and stayed fairly high until the 1981 budget.
Then went into surplus and then back into heavy deficit during the recession at the beginning of the 1990s before the more recent string of "prudent" outcomes. Other countries' rules - including the eurozone's
growth stability pact and the Gramm-Rudman-Hollings deficit reduction act in the US in the 1980s - have typically provided an emergency exit route in the event of a major recession. While it is desirable to have low budget deficits through the cycle as a whole, there are times when deficits should be big.
There are also times - although politicians have tremendous difficulty admitting to this - when surpluses should be big. They almost never are.
At the current juncture, there is a case for looser fiscal policy. The UK is facing two separate problems. Inflation is too high but growth is too weak. It is easy enough to pretend, in these circumstances, that lower growth will, in time, deliver lower inflation. But there is no guarantee. Imagine, for example, that the UK economy next year is facing a combination of recession and still high inflation. What, then, needs to happen?
It will be either a significant tightening of fiscal policy taking the view that the defeat of inflation will allow the broader economy to recover, as was the case in the early 1980s - or, alternatively, a dose of Reaganomics.
Reaganomics, among other things, was a mixture of tight monetary policy through the actions of Paul Volcker, the Federal Reserve Bank chairman at the time and loose fiscal policy, associated with Reagan's tax cuts and large congressional spending. This combination led to high real interest rates and, as a result, a rapid appreciation of the dollar which, in turn, provided the US economy with some insulation from inflationary difficulties building elsewhere in the world.
Ultimately, the policy led to all sorts of global imbalances, some of which are still with us now. For the UK today, though, there is a certain attraction: strong sterling to ward off the inflationary evils coming from the rest of the world set against an expansionary domestic fiscal policy which might help to rebuild confidence in the housing market and the financial system.
There are, though, two problems with this approach. First, as a nation, the UK has been spending well beyond its means for many years. Recessions are never desirable, but their avoidance sometimes merely postpones and makes worse the inevitable economic hangover, as we discovered during the
1970s and early 1980s. Second, combining monetary and fiscal policy in this way requires a high level of co-operation between government and central bank.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.