The Agenda

Fiscal Conservatism and Monetary Activism: the British Synthesis

The broadest gap between U.S. conservatives and British conservatives on economic policy at the moment is perhaps best captured by a line from Chancellor of the Exchequer George Osborne’s recent speech at the Conservative Party Conference: 

 

Keeping interest rates as low as possible for as long as possible is crucial for dealing with a debt crisis. It’s the first part of our plan. But because banks are damaged they won’t lend at the current low rates. It’s like putting your foot on the accelerator but because the transmission mechanism isn’t working properly, the car wheels don’t respond.

So this is the second part of our plan.We’ve got to get credit flowing in our economy. Credit means investment. Investment means jobs. We’re making sure that British banks are strong enough, holding enough capital to cover loans in an emergency. We’ve expanded loan guarantees. We’ve struck a deal with the big high street lenders to increase lending to small businesses by 15 per cent this year. But all this may not be enough. 

Of course the Bank of England have their own independent judgement to make on quantitative easing. I’ve said many times before I will follow the procedures of my predecessor and give Treasury approval if they ask. But there is more the Government itself can do to get credit flowing and encourage investment. David Cameron and I have always said we would be fiscal conservatives and monetary activists. 

Everyone knows Britain’s small firms are struggling to get credit and banks are weak. So as part of my determination to get the economy moving I have set the Treasury to work on ways to inject money directly into parts of the economy that need it such as small businesses. It’s known as credit easing. It’s another form of monetary activism. It’s similar to the National Loan Guarantee Scheme we talked about in opposition. It could help prevent another credit crunch; provide a real boost to British business; and over time help solve that age old problem in Britain: not enough long term investment in small business and enterprise. And if this party is anything, it is the party of small business and enterprise. [Emphasis added]

While Texas Gov. Rick Perry accuses Ben Bernanke of treason for his embrace of quantitative easing, Cameron and Osborne are fully committed to monetary activism. 

But how has the British approach fared? Within Britain, many on the left argue that fiscal austerity policies — really, the coalition government has been various cautious about fiscal consolidation, but that doesn’t change the kind of attacks they’ve had to deal with — have been a disaster, pointing to a still sluggish economy. 

It’s worth wondering about the counterfactual, however. Arpit Gupta, my friend and colleague, said the following about the British case a few weeks back:

Britain had one of the worst profiles heading into this crisis — a decade of creeping government to absurd levels, Southern Europe-like debt problems, combined with America-like financial problems, and an open economy linked to declining markets. Ex ante, one would expect Britain would have a very hard time dealing with this set of issues.

Yet the Treasury-Bank of England coordination has worked quite successfully. The BoE has a formal inflation targeting plan; and recently they have been interpreting their mandate in a manner consistent with NGDP targeting. So they’ve been very comfortable loosening in the crisis — and, more importantly, conveying those expectations to the market. This works symbiotically with austerity measures. While the planned level of austerity is low, the overall signal for future debt burdens allows Britain to enjoy low interest rates, and reassures monetary authorities that they won’t have to work to monetize debt in the future. Meanwhile, monetary easing counterweights any demand shortfalls resulting from that austerity.

If you look at the trio of (unemployment, GDP growth, inflation), Britain will probably end up this year with the best of those trios among any developed country. Again, thinking about this counterfactually, this is not what one would expect in 2008 having a rough sketch of the crisis to follow. Mervyn King deserves a good share of the success here; both in pioneering easing as well as in convincing Lib Dems to go along with austerity.

One point to make I suppose is that their inflation is running a little higher than other countries. According to the market monetarists; the central bank can set the aggregate level of nominal spending in an economy, but is not able to decide what share of that manifests as nominal or real growth. It seems likely that Britain does have some sort of structural problems that results in higher inflation. However, they are fortunate enough have a central bank willing to live with slightly higher inflation today in the pursuit of the more important long-run goal of price and macroeconomic stability. Unfortunately, we are generally pursuing things in the wrongheaded reverse manner: large doses of fiscal stimulus, combined with (relatively) weak monetary policy that hasn’t changed expectations (even if some asset purchases have been large). [Emphasis added]

Arpit is friendly towards market monetarism, so he is not an unbiased source. But he’s given us a useful lens through which to view the British experience. I’m inclined to think that Britain has done things better than we have, while facing a situation that is in many respects a more challenging one. 

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