It feels like one more throw of the dice for central bankers stuck in the Last Chance Saloon. Last week’s rate cuts from the European Central Bank and gilt purchases by the Bank of England were certainly better than nothing. We shouldn’t kid ourselves, however, that they’ll provide the answer to life, the universe and everything. Our economic and financial problems are too big to be fixed with a simple flick of the interest rate switch or an extra £50bn of quantitative easing.
Yet, until now, the puppet masters who pull our economies’ strings have persuaded themselves they know how to deliver us to the Promised Land. Central bankers have persistently provided forecasts for economic growth which, in hindsight, have proved to be far too optimistic.
In the summer of 2010, for example, the sages of the Federal Reserve thought US economic growth would be between 2.9 per cent and 3.8 per cent in 2010 and between 2.9 per cent and 4.5 per cent in 2011. The actual outcomes were 3.0 per cent and 1.7 per cent respectively. The BoE was similarly optimistic, believing that the most likely outcome for UK growth in 2011 was around 3 per cent, a view conditioned on £200bn of asset purchases. The actual outcome was a rather more modest 0.7 per cent.
Does this mean monetary policy has lost its capacity to have any influence on economic outcomes? That, I think, is too pessimistic a conclusion. As the Bank for International Settlements notes in its 2012 Annual Report, the policy stimulus on offer post-Lehman was far greater than anything provided during the Great Depression. As a result, the economic outcome has been far superior: the overall peak-to trough decline in US GDP this time around was 5.1 per cent compared with a whopping 30 per cent or so in the early-1930s.
The problem, then, is not so much that policy hasn’t worked but, instead, that we expect too much from it. Stagnation is a lot better than Depression but there are still plenty of people out there who believe that, with a bit more effort and a few more macroeconomic policy wheezes, the good times will return – despite the evidence of persistent “optimism bias” in official forecasts based on no more than blind faith in the potency of policy.
For those who seem addicted to stimulus, the answer to monetary impotence is more fiscal stimulus. This, apparently, costs nothing (unless you happen to be unfortunate enough to be living in the eurozone). As part of the correspondence generated by their original provocative article (“A manifesto for economic sense“, 27 June 2012), Paul Krugman and Richard Layard argued that “If public sector deficits were increased, interest rates would rise little, especially if, as is desirable, the extra government debt was largely purchased by the central bank” (Letters, 1 July 2012).
It would be a cheap shot to mention the Weimar Republic or Zimbabwe in this context. Nevertheless, Messrs Krugman and Layard are making a highly-suspect assumption about the response of nominal activity to this kind of unconventional stimulus. Quantitative easing was supposed to boost UK growth but, instead, the UK ended up with higher inflation, squeezing real take-home pay and making debt repayment a lot more difficult. This was totally unexpected and thus provides a significant challenge to those who continuously demand even more stimulus. Can we be sure that the stimulus will affect real economic activity and not, even if indirectly, the price level?
Krugman and Layard’s manifesto stated that “today’s government deficits are a consequence of the crisis, not a cause.” Tautologically true (how could today’s deficits have caused the failure of Lehman?), the authors conveniently ignore the fact that fiscal positions had already deteriorated a great deal pre-financial crisis. During the good times, fiscal policymakers simply hadn’t been sufficiently frugal. Their subsequent firepower was, as a result, necessarily diminished.
The OECD estimates that, at the end of the 1990s, both the US and the UK were running cyclically-adjusted budget surpluses of around 3 per cent of GDP, excluding interest payments on existing debt. Long before the financial crisis, however, these 3 per cent surpluses had turned into 3 per cent deficits, thanks to big tax cuts and spending increases (the US) and spending increases alone (the UK). The subsequent collapse in economic activity obviously made fiscal positions far worse. Today’s fiscal predicament, however, stems in part from a lack of budgetary control during the good times. The convenient assumption was always that the good times would roll, a reflection yet again of a built-in “optimism bias”.
Promising a pot of gold at the end of the policy rainbow is all very well, but the public is surely now cottoning on to the fact that a succession of post-Lehman policy wheezes hasn’t delivered a sparkling recovery. Maybe they have recognised that, in a heavily-indebted world, there are limits to what policy can actually achieve. Yes, it can prevent the worst outcome but, no, it cannot take us back to “business as usual”. There is, of course, an obvious reason for that: business as usual would require a continuously-inflating housing boom, a persistent increase in household indebtedness and, as it turns out, ongoing fiscal stimulus. We won’t be returning to those conditions any time soon. Those who think we can must, then, be suffering from optimism bias.