Thirty years ago 364 economists signed a round robin letter, published in The Times, criticising the Thatcher government’s policies and warning they would deepen the recession.
The signatories, Britain’s economic establishment including a youngish Mervyn King, who had no idea he would later find himself governor of the Bank of England and defending a Conservative-led government’s aggressive fiscal tightening.
By comparison with that missive, last weekend’s “Plan B” letter from 52 academics, the vast majority of whom are not economists, was a pale shadow and read like a plea for more university funding.
There is, however, a thread that links the two. Both were barking up the wrong tree, and in a similar way. Let me explain.
In 1981, the 364 became figures of fun because their letter coincided with the start of a nine-year recovery. This was because, as some have admitted, their focus was on fiscal policy – tax and spending – ignoring monetary policy.
So, while fiscal policy was tightened in the austerity budget of 1981, monetary policy was relaxed, with a two-point cut in interest rates (from 14%) announced in the budget. Monetary policy was the key.
What could stop it in its tracks, and result in prolonged stagnation, is not the fact that taxes have gone up and government spending is being reduced. That will affect the balance of growth and, as I explained recently, take the edge off recovery. Instead of 3% or so in coming years, growth may be closer to 2%.
The real problem, and the one that could do more serious damage, is on the monetary side. The weakness of money and credit is striking. The “broad” money supply measure, M4, was growing at an annual rate of 17.5% just over two years ago. In the past 12 months it has fallen 0.9%.
Adjusting for lending to the financial sector (other financial corporations) ther slowdown is less pronounced but nevertheless significant. Before the crisis this measure of M4 was typically growing by between 10% and 12% a year. The latest annual growth rate is just 1.5%.
Lending to businesses has been negative – falling – since the early part of 2009 and remains so, down over 4% on a year ago. Larger companies can bypass banks and access markets directly, smaller firms cannot. Lending to them is down an annual 6% according to the Bank.
It is not just business lending. Monthly mortgage approvals, including remortgages, are just over 90,000, less than a third of pre-crisis peaks. The credit channel may not be broken but remains badly damaged.
Some would say there was too much credit pouring in before the crisis, and that is true. But there is plainly too little now.
The Bank used to think M4 growth of 9% a year was consistent with economic growth of 2.5%-3% and hitting the inflation target. That may have changed as a result of a shift in the velocity of money but not that much. 1.5% M4 growth is inconsistent with sustained recovery and chronically weak credit growth will hold back growth.
Responding by boosting government spending or cutting taxes is at best oblique, at worst irrelevant, like trying to fix a leak in the roof by replacing the windows. What the economy needs is s sustained private sector-led recovery, and what that needs is an adequate supply of credit.
As it happens, I addressed this problem in a column written in April 2008, before the worst phase of the financial crisis.
I wrote that interest rates had to be slashed aggressively, that the authorities had to pump in liquidity and do whatever else was necessary to stabilise the banking system. But, and this is where I parted company from what subsequently happened, I also said the government and the Bank should consider direct lending into the economy. If the banks were not prepared to lend enough to support recovery, the authorities would need to do so.
Since then, the Bank and Treasury have danced round the problem without getting to the solution. The Treasury concluded its Project Merlin deal with the banks but, in the end, it will founder because there are two sides to a lending decision.
Every banker will say he has money to lend but is not getting enough lendable propositions. Every small business and mortgage borrower turned down will say the terms on which funds were available were unacceptable. Vince Cable can exhort and threaten until he is blue in the face but it is hard to see this changing soon.
As for the Bank, it denies it now but journalists got the impression in March 2009 that the purpose of quantitative easing (QE) was to stimulate bank lending.
According to the Bank now, that was never the idea. While QE would lead to banks holding more reserves and that “might” mean more lending, “if banks are concerned about their financial health, they may prefer to hold the extra reserves without expanding lending”.
So, while the International Monetary Fund suggested last week more QE (and temporary tax cuts) might be needed if growth grinds to a halt, that would be a bad idea. It does not solve the problem of dangerously weak credit growth.
The only person who has said much publicly on this is Adam Posen, the monetary policy committee’s Japan expert. Though I do not agree with him in his regular vote for more QE, which would be a futile gesture, he was early on to “the likely failure of lenders to support recovery”. He, like others, would have preferred it if QE had not been conducted overwhelmingly by the purchase of government bonds. Policy has failed to get credit flowing.
Can it do so? The answer always comes back that civil servants and central bankers are not well qualified to make lending decisions. Fortunately, there are plenty of bankers on the government’s payroll. It should not be beyond the wit of officials to find ways of using this expertise, and the government’s leverage over the banking system, to get credit flowing at a pace that will sustain a decent recovery. That is the real Plan B Britain needs.
My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.
This post originally appeared at David Smith’s EconomicsUK and is reproduced here with permission.
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