Tear up the Rule-Book: It’s All about Borrowing

If we didn’t know it before last week, we surely do now. The economic policy landscape has changed. People will have different views on the period before the summer of 2007 – the longest run of non-inflationary growth in the modern era – but we are not going back there, at least in terms of policy.

Then, monetary policy was all about small changes in interest rates, a quarter-point at a time up or down for Bank rate, and those small changes had big effects.

Now, as we saw on Thursday, the big monetary policy decision was not on interest rates but whether the Bank of England’s monetary policy committee (MPC) would extend its £125 billion programme of asset purchases, so-called quantitative easing.

As I touched on here last week, the debate was whether to do it now or delay for a fuller discussion in August, when new economic projections will be available.

The MPC chose to delay, which does not necessarily mean this unconventional policy is over but does point to the beginning of a wind-down, consistent with evidence that the economy has stabilised. On fiscal policy – tax and spending – we have moved from what was supposed to be a rules-based approach; meeting the “golden” and “sustainable investment” rules. Those rules: only borrow to invest over the cycle and keep public sector debt below 40% of gross domestic product were creaking long before the financial crisis, particularly the golden rule.

Now they have been replaced with a much more simple rule – get borrowing down from its current crisis level of 12.4% of GDP, £175 billion. All those debates about where we were in the economic cycle, so important when we had a golden rule, are now irrelevant for fiscal policy, though they may have an important role elsewhere, which I will come on to.

How easy will it be to pursue this new and very simple fiscal rule? The political fog may lift during the party conference season though we may have to wait longer.

Alistair Darling appeared to suggest last weekend he would be looking at a freeze on public sector pay but quickly “clarified” his remarks. David Cameron ran a mile when asked whether he would freeze the pay of public sector workers. The votes of 6m public sector workers are too important to trifle with, it appears.

The Tory leader’s promised “bonfire of the quangos” was a damp squib, even before the mid-week rains. If we are to have the biggest cuts in departmental spending in at least a generation, and possibly since the Geddes axe of the 1920s, both main parties are tiptoeing towards them.

Public sector median full-time earnings are £523 a week, against £460 for the private sector. But suggestions pay should be frozen have produced a near-hysteriacl response. The argument for restraint is well put by John Philpott, chief economist at the Chartered Institute of Personnel and Development.

One way or another the public sector’s £158 billion salary bill has to be frozen or reduced. The more public sector workers resist pay freezes, let alone reductions, the more than burden will fall on jobs.

Perhaps the biggest change in economic policy of all, however, arises from last week’s regulatory white paper from Darling, and the response to it from George Osborne, his Tory shadow, which opened up the clearest blue water between the parties we have so far seen.

The Tories have moved a long way on the Bank. The party opposed independence in 1997; now it wants to make Mervyn King the most powerful governor in 315 years of Bank history, with control over both monetary policy and banking supervision. Though he is no doubt flattered, my sense is that he feels it is probably a bit too much.

Darling would leave supervision with the Financial Services Authority and beef up the tripartite system with a new Council for Financial Stability (CFS) consisting of the Bank, Treasury and FSA holding regular meetings and publishing minutes.

Either way, this will represent a new era, or perhaps a revised version of a very old era. In the old days, and I am only talking about the 1950s, 1960s and 1970s, controlling the banking system was an important part of macroeconomic policy. Policy instruments with exotic names like the supplementary special deposits scheme, the banking corset, were used.

They disappeared as a result of a genuine bonfire by an earlier Tory leader, Margaret Thatcher. Once exchange controls were abolished in 1979, most direct and indirect limits on bank lending went too. Operating monetary policy solely through interest rates may appear to have been around forever but it has not.

Financial stability policies will from now on have an important macro component. After all, part of the new framework will be what is known in the jargon as macroprudential regulation.

Somebody, the Bank if it get the powers from the Tories, the CFS in the case of Darling’s proposals, will have to make decisions on where the economy is in the cycle, and whether there is a danger of overheating in economic growth and asset prices. The banks would be forced to rein in lending by a counter-cyclical tightening of capital requirements and possibly other measures in addition. Used properly it could be as powerful a tool as interest rates.

It could also dampen the need for big interest rate changes. The more the strain is being taken up by other instruments, the less the work for interest rates. It goes without saying that it would be an odd set of circumstances if the Bank was simultaneously tightening capital and reserve requirements and cutting interest rates.

But it will increase the need for accurate economic assessments. Reversing interest rates changes is easy and quick enough. Changing bank capital and reserve requirements will be much more cumbersome.

All this is some way down the road. For the moment, the challenge is to get enough lending into the economy. Though the Bank has introduced uncertainty into its future intentions on QE, so far a big expansion of its balance sheet has not led to an acceleration of lending. The luxury of deciding what to do about excessive lending will come later, possibly much later.

But it is a new era. There is only one direction for fiscal policy. Monetary policy and financial stability policy will become closely intertwined. We used to think it was simple. It isn’t now.

PS: The credit crunch has been dreadful for many businesses but has provided a mini boom for publishers. Amazon has at least 50 credit crunch books listed. In some cases the connection is tenuous but its list is by no means exhaustive.

What’s worth reading? I shared a platform at the Oxford Literary Festival with Tetsuya Ishikawa, author of How I Caused the Credit Crunch. The book has been “novelized” to avoid possible legal comebacks but it is well regarded.

John Calverley, now with Standard Chartered, is one of those who can say “I told you so”. He wrote Bubbles and How to Survive Them in 2004 and now has When Bubbles Burst. I liked Panic: The Story of Modern Financial Insanity, is Michael Lewis’s eclectic selection of pieces on this and other financial crises.

As an inside account of derivatives, Gillian Tett’s Fool’s Gold, told from the perspective of J P Morgan, is hard to beat, particularly on the crisis’s build-up.

Others include Alex Brummer’s The Crunch, Graham Turner’s The Credit Crunch, Hugh Pym and Nick Kochan’s What Happened?, Paul Mason’s Meltdown and Philip Augar’s Chasing Alpha. If you would like a title showing a Heathcliff-like Vince Cable gazing out into the gloom, The Storm is for you.

So plenty of summer reading material and it is a sobering thought that books will be appearing on this crisis for years. J K Galbraith’s The Great Crash has been selling well since first published in the mid-1950s. Ben Bernanke’s collection of essays on the Great Depression came out in 2000. It’s an ill wind.


Originally published at David Smith’s EconomicsUK and reproduced here with the authors’ permission.

One Response to "Tear up the Rule-Book: It’s All about Borrowing"

  1. John Henderson   July 17, 2009 at 9:01 am

    Horns in, deflate the debt, start again. Trouble and distress stories yes, but no worse than we’ve got, and at least we’d have a clean sheet. All debt must be paid or morality goes out the window; immoral solutions such as inflating it away create further immorality in all spheres of life: remember “economics” used to be called “moral philosophy” and was about how a country might live at some ease with itself, not about a ‘spiv’ culture where the most dishonest and ‘must haves’ thrive.Morality and economics cannot be divorced for long without serious ramifications.