August 11, 2011 9:54 pm

First of all do no harm, then start thinking

The Fed’s undertaking to hold rates until the middle of 2013 seems a pretty cack-handed way of reining them back

The real Lord Keynes was the editor of a series of interwar elementary guides to economic ideas, which had a common introduction edited by the master. For most of these volumes, the introduction merely stated that economics was not a fixed body of ideas but a way of thinking which the reader should try to apply to problems. But in the last few guides the introduction was changed a great deal. He remarked that economics was in a period of turmoil, which until it was resolved, had virtually destroyed its application to policy. He modestly refrained from saying who was responsible for this turmoil.

We are clearly in such a period again. One only has to compare the sharply contrasting views of Otmar Issing, until recently economic director of the European Central Bank, and Kenneth Rogoff, co-author of This Time Is Different: Eight Centuries of Financial Folly, on euro area bail-out policies. Faced with this confusion among more or less established analysts, what is the poor policymaker to do? The academic confusion is most unlikely to be resolved in time to deal with present problems, if at all. It is all very well for financiers and economists to call for “leadership”, but it is all too obvious that they have nothing like a consensus idea of what that leadership should do. Nor do the abrupt changes in the Bank of England’s still complacent forecast inspire much confidence.


On this story

Samuel Brittan

My first piece of advice is along the lines of the medical motto: above all, do no harm. It goes without saying that central banks in western countries should not raise short-term interest rates any further and if possible quietly rein them back towards near-zero. But the US Federal Reserve’s semi-undertaking to hold rates until the middle of 2013 seems a pretty cack-handed way of doing this. Should there be more “quantitative easing” by the Fed or the Bank of England? That is a close call. Is it worth upsetting the financial markets which, however irrationally, distrust such measures in the absence of clear-cut evidence of what earlier rounds have achieved? A lesser, but still important, measure would be for the US Congress to end “the oligopoly of Nationally Recognised Statistical Ratings Organisations before they contribute to or ignite another financial crisis”, as suggested by Bill Miller of Legg Mason Capital Investment. And above all we need more quantification and analysis of the derivatives market.

It would obviously help if China were gradually to take America’s place as consumer of last resort. But the way to achieve this is not to lecture the country on the exchange value of the renminbi, but to point to the opportunities for raising consumption in China. If this is done, the rest will fall into place. Negatively: politicians should not attempt to guarantee any particular level of equity prices or even to comment too much on their movement. The stock exchange always has been and always will be a mixture of investment appraisal and sheer gambling. Most historians seem to agree that the trigger for the Great Depression was not the 1929 Wall Street crash but the subsequent collapse of US banks and the crash of the Austrian Creditanstalt.

Beyond these and other common sense measures, we should consider unorthodox ideas. For example, we should stop ignoring the collapse of money supply growth in both the US and the UK – although I wish monetarists would tell us precisely and concisely how to restore its growth. The economic policy model in most leading countries is based on the idea of an inflation target linked to consumer prices. The contribution to real economic growth is confined to variations in the speed with which departures from target are corrected; and the whole procedure depends on many hours of analysis of whether there is an “output gap” and how large it is.

Some readers will recall that I have always been suspicious of inflation targets, based on the crude empirical fact that the world’s nearest approach to stable prices was achieved under the gold standard when final prices varied a lot from year to year, but there was no distinct long-term trend either way. In Brendan Brown’s new work, The Global Curse of the Federal Reserve (Palgrave Macmillan), there is an explanation of how this was so. Gold was not all that much of “a barbarous relic”, as long-term deviations from price stability were counteracted by variations in the pace of gold exploration and mining.

A less familiar point is that when the year-to-year price level could fall as well as rise, the negative real interest rates which today’s central banks would so much like to achieve occur automatically when prices are seen to be below trend. For instance, a 2 per cent nominal interest rate becomes an effective negative 3 per cent real rate in a year when prices are expected to recover by 5 per cent. This is something to ponder even if one does not share the author’s belief that an ersatz gold standard could be achieved by mandatory monetary base requirements. In the original gold standard the monetary base was regulated by the need to stop gold outflows rather than by legislative requirements. But even a flawed proposal is better than inane cries for leadership.

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