Judging by the acres of commentary, this week’s big economic news is set to be the preliminary estimate for fourth-quarter gross domestic product out on Friday.I should be all of a quiver over whether it will be +0.1 per cent growth over the third quarter or –0.1 per cent, or another number that is likely to be revised. But I am not. In contrast, I am fascinated by the latest development in the important UK economic debate.
On Tuesday evening, Sir Mervyn King completed his slow conversion from being an activist on what economists call the “demand side” to a “supply side” pessimist. Where the Bank of England governor once saw monetary policy as a simple tool to reinvigorate spending and bring the level of output back to its previous trend, his speech indicates he now sees the pre-crisis period as infected by unsustainably overexposed bank lending and “unsustainable paths of consumption”.
Forget fiscal policy and the government’s many growth plans – Britain’s most important economic debate focuses on whether Sir Mervyn is right. He might be a lame duck with only five months of his term left to run, and his views on the remit of monetary policy are far less interesting than those of Mark Carney, his successor. But his four-year volte-face represents the crushing of hope and bitter experience of the UK’s post-crisis period.
If he is right, the weakness Britons see all about them reflects a deterioration in the UK’s ability to produce goods and services. If he is wrong, it is little more than a soft patch for the economy.
Distinguishing between supply and demand effects in an economy is difficult because no one can observe either – we can just see how much is spent. And both sides advance good arguments.
If there was a sizeable lack of demand, it should show up in persistently slowing inflation, perhaps even falling prices, and rising unemployment. So the supply pessimists’ strongest argument is that these features are conspicuous by their absence. As Simon Wells, the HSBC UK economist, asks: “If there is so much slack in the economy, why are both inflation and employment so strong?”
But those who argue that the problem is weak demand also have reasonable arguments. Ian McCafferty , the new external member on the bank’s Monetary Policy Committee, claimed last week that businesses have recognised the need for company-specific skills and therefore they are more reluctant than in the past to shed employees, waiting instead for demand to pick up. Supply, in his view, is responsive to demand – so inflation would be less likely to take off once the economy got going again.
There is a further possibility that although weak demand persists, as shown by still high unemployment, its power to lower inflation is curtailed. Possible reasons include the fact that about 1 percentage point of measured inflation comes from government-controlled prices, such as student tuition fees, which are insensitive to the wider economy; and partly because companies are more averse to taking the risk of cutting prices to gain market share.
One big problem of the debate is the fact that people feel the need to jump into the supply-pessimist or demand-activist camps. The two arguments are far from mutually exclusive – but policy makers ultimately have to take decisions, and Sir Mervyn has moved decisively towards worrying about supply.
He talked on Tuesday about the limitations of too much stimulus and the need for improved supply-side policies – because “by raising expected future incomes, they increase the rate of return on new investment and encourage spending, both investment and consumption, today”. If ever there was a supply-side pessimists’ argument – you can have spending today or tomorrow but not both – this is it.
The governor’s new outlook is depressingly pessimistic. But it fits the facts, and it is logical and coherent. I worry, however, that it is too defeatist. Trying to do more with monetary policy – through additional quantitative easing and other measures – seems to offer limited risks and the potential to find that we might live in a better world than Sir Mervyn describes. This does not mean he is wrong to talk about improving fundamentals. But pain-killers are used by the medical profession for a good reason.
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