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When it comes to stimulus, can we have too much of a good thing? Given the depressed state of the western world, this might seem an odd question. There is, supposedly, plenty of spare capacity.
This, after all, is the claim of those who demand more in the way of tax cuts, spending increases and quantitative easing. Yet the evidence suggests that perhaps we should not be quite so cavalier.
Following a big drop in sterling in 2008 – in anticipation of quantitative easing – and the QE that subsequently followed, the UK found itself in a rather odd position. Growth surprised on the downside. Inflation, in contrast, surprised on the upside. If the amount of spare capacity – the so-called output gap – was so big, why was it that looser policy led not to higher levels of activity but, instead, to higher inflation?
The UK is not the only one. Since 2003, US economic growth has come in persistently lower than consensus expectations while inflation – at least of the headline variety – has been higher. Those who predict stimulus will bring benefits but no costs may be suffering from an output gap “delusion”.
The performance of western economies since the onset of the financial crisis raises significant questions about the standard cyclical arguments that govern conventional economic discourse. For almost all countries, the initial output decline was off the scale while the subsequent recovery has been painfully weak.
Yet price inflation has, for the most part, remained incredibly sticky. It is not so much that inflation has picked up (although the UK is a clear exception): rather, it has failed to drop despite the supposed vast increase in spare capacity. In many cases, the result has been a major squeeze in real household incomes, either through high unemployment (the US) or low nominal wage growth (the UK).
One reason for this has been the persistent strength of commodity prices, reflecting strong emerging market demand, the impact on commodity demand of QE and, at least with regard to oil prices, continued tensions regarding Iran. It also seems as though the western economic “speed limit” has steadily fallen, a consequence of persistent resource misallocation in the years before the financial bubble burst. Economic stimulus may thus not deliver the results that policy makers hope to see.
Attempts to fix the problem through, for example, a continued commitment to QE are in danger of leading to distortions rather than deliverance. Rather than solving our economic ills, central banks are increasingly in danger of operating as agents of government fiscal policy, foregoing their role as independent guardians of monetary and financial stability.
The more the public begins to believe central bank independence is a convenient chimera, the greater the risk inflation will, eventually, pick up
Recently, for example, George Osborne, the UK chancellor, announced that “holding large amounts of cash in the [Bank of England’s] asset purchase facility is economically inefficient as it requires the government to borrow money to fund these coupon payments”. That’s true, but if the government was borrowing from the private sector, those coupon payments would nevertheless have to be made.
Put another way, it is now a lot cheaper – in the short term, at least – for the Treasury to borrow from the Bank of England than from the rest of the economy, a distortion that only serves to undermine the separation of monetary church from fiscal state.
Does this matter? Those who think the output gap is still excessively large will doubtless argue that a bit of “backdoor” QE will only benefit real economy activity, without any impact on inflation. However, the more the public begins to believe central bank independence is a convenient chimera, the greater the risk that inflation will, eventually, pick up, whether or not there is plenty of spare capacity.
In itself, higher inflation during a slump need not be a problem. Prices rose swiftly during the New Deal, thanks to Franklin Roosevelt’s twin-track policy of bigger budget deficits alongside America’s exit from the gold standard. But Roosevelt’s objective was merely to restore the US price level to where it had been before the onset of depression, thus allowing debtors to repay their debts without the pain of deflation.
This time round, however, we simply do not have the excuse of deflation to explain why the distinction between monetary and fiscal policy is becoming increasingly blurred. The suspicion must be that governments are increasingly looking for ways to avoid making tough fiscal decisions. While the public debate focuses mostly on “stimulus versus austerity”, governments may, instead, be looking for ingenious ways of cooking the fiscal books. That’s all very well, but the cost may ultimately be the return of monetary instability – the age-old answer to excessive government borrowing.
Stephen King is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research
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