http://www.telegraph.co.uk/finance/5...be-tested.html
The Bank of England's resolve will soon be tested
The vital moment of the crisis is approaching
No wonder everyone is so confused about where the economy is heading. A couple of weeks ago, the predominant view was that the worst of the global downturn was over. The economy seemed to have stopped contracting, the stock market had rebounded, commodity prices were surging again, and there were even tentative signs of a thaw in the credit markets.
Policy action around the world – unprecedented in size and scope – seemed to be working as prescribed. Perhaps we had even had too much of a good thing, with the real danger not deflation and depression, but overly loose monetary and fiscal conditions that would sow the seeds for another bout of overheating.
Well, a couple of weeks is a long time in the markets, and in recent days those sentiments have gone sharply into reverse. Around the world, the economic data range from soggy to deeply alarming. Commodity prices are falling once more, and risk aversion has returned to the capital markets.
What should we make of these wild swings in sentiment? And what's the long-term prognosis for Britain? Is it policy-inspired inflation that we must fear most, as markets seemed to be suggesting just a little while back, or a Japanese-style decade of deflation and zero or negative growth?
Certainly, there are lots of reasons for pessimism. The possibility of a "double-dip" recession, where after a brief and barely perceptible resumption of growth, the economy resumes its downward trajectory, seems quite high. Whatever rebound is taking place, both in Britain and abroad, is largely based around firms' inventories. After the violent slashing of last year, a more normal pattern of orders and supply has been re-established; production lines are functioning again, albeit at a slower rate.
Unfortunately, this provides only a short-lived, one-off boost. Eventually, any underlying weakness in demand will reassert itself, and the economy will start contracting again.
There are also two longer-term reasons for pessimism. One is the global nature of the financial and economic crisis we've just been through. Normally, banking crises are localised affairs, with sufficient growth going on elsewhere to cushion and eventually extricate the afflicted region. Today, the problem is universal.
Yet the main reason for gloom is the scale of the fiscal consolidation that has become necessary to pay for Labour's profligacy. Deep cuts in public spending and/or tax rises will crimp growth for years. There is also an extreme overhang of private debt, which must similarly be addressed through higher saving. Neither of these adjustments are incompatible with resumed growth, but they certainly make it more difficult.
Whatever its colour, the next government will have to take some extraordinarily unpopular decisions. Attempting to inflate our way out of the problem, the traditional fall-back of Labour governments, offers no kind of solution. Inflation is socially divisive, because it destroys savings alongside debt. The profligate are rewarded, and the prudent punished. To the extent that wages lag behind prices, and disposable incomes become depressed, it is tantamount to higher taxation anyway. What's more, it raises interest rates for years to come.
Yet despite all these gloomy observations, the situation is not beyond repair. We can only forecast the future by reference to the past – and though it is certainly possible that the British economy will continue on down the road to hell in a handcart, it still doesn't look the way to bet.
In recent history, there has only been one example of an advanced economy falling into a deflationary debt spiral – that's Japan, which has its own, unique structural issues. Even during the Great Depression, America was actually growing strongly from the mid-1930s, though the scale of the contraction had been so extreme that output didn't return to previous levels for another five years.
In any case, it is vital that policymakers don't repeat the mistake of the US Federal Reserve in 2003/4, when exceptionally loose monetary conditions were maintained for too long, helping to stoke the credit boom of subsequent years.
Stimulating a sluggish economy with easy money is like trying to move a large weight with a piece of elastic. For a long time, nothing happens, so the authorities pull harder and harder. Then, all of a sudden, the weight shifts, and with startling speed hurtles towards them and smacks them in the face.
Rarely has the Bank of England faced a more formidable policy challenge. Withdraw its support too soon, and the Bank risks snuffing out the recovery. Leave it too late, and it will only succeed in storing up an even worse crisis for the future.
Over the past three years, the Bank seems to have been persistently behind the curve, both on the up and the downside of the economy. For all our sakes, the Bank desperately needs to get its judgment right this time. The point at which it starts raising interest rates again may still be some distance off, but if I'm right that deflation isn't as much of a long-term risk as the markets suppose, this unpopular action will have to be taken while unemployment is high and still rising. A major test of the Bank's resolve, as well as its independence from the politicians, looms.
The Bank of England's resolve will soon be tested
The vital moment of the crisis is approaching
No wonder everyone is so confused about where the economy is heading. A couple of weeks ago, the predominant view was that the worst of the global downturn was over. The economy seemed to have stopped contracting, the stock market had rebounded, commodity prices were surging again, and there were even tentative signs of a thaw in the credit markets.
Policy action around the world – unprecedented in size and scope – seemed to be working as prescribed. Perhaps we had even had too much of a good thing, with the real danger not deflation and depression, but overly loose monetary and fiscal conditions that would sow the seeds for another bout of overheating.
Well, a couple of weeks is a long time in the markets, and in recent days those sentiments have gone sharply into reverse. Around the world, the economic data range from soggy to deeply alarming. Commodity prices are falling once more, and risk aversion has returned to the capital markets.
What should we make of these wild swings in sentiment? And what's the long-term prognosis for Britain? Is it policy-inspired inflation that we must fear most, as markets seemed to be suggesting just a little while back, or a Japanese-style decade of deflation and zero or negative growth?
Certainly, there are lots of reasons for pessimism. The possibility of a "double-dip" recession, where after a brief and barely perceptible resumption of growth, the economy resumes its downward trajectory, seems quite high. Whatever rebound is taking place, both in Britain and abroad, is largely based around firms' inventories. After the violent slashing of last year, a more normal pattern of orders and supply has been re-established; production lines are functioning again, albeit at a slower rate.
Unfortunately, this provides only a short-lived, one-off boost. Eventually, any underlying weakness in demand will reassert itself, and the economy will start contracting again.
There are also two longer-term reasons for pessimism. One is the global nature of the financial and economic crisis we've just been through. Normally, banking crises are localised affairs, with sufficient growth going on elsewhere to cushion and eventually extricate the afflicted region. Today, the problem is universal.
Yet the main reason for gloom is the scale of the fiscal consolidation that has become necessary to pay for Labour's profligacy. Deep cuts in public spending and/or tax rises will crimp growth for years. There is also an extreme overhang of private debt, which must similarly be addressed through higher saving. Neither of these adjustments are incompatible with resumed growth, but they certainly make it more difficult.
Whatever its colour, the next government will have to take some extraordinarily unpopular decisions. Attempting to inflate our way out of the problem, the traditional fall-back of Labour governments, offers no kind of solution. Inflation is socially divisive, because it destroys savings alongside debt. The profligate are rewarded, and the prudent punished. To the extent that wages lag behind prices, and disposable incomes become depressed, it is tantamount to higher taxation anyway. What's more, it raises interest rates for years to come.
Yet despite all these gloomy observations, the situation is not beyond repair. We can only forecast the future by reference to the past – and though it is certainly possible that the British economy will continue on down the road to hell in a handcart, it still doesn't look the way to bet.
In recent history, there has only been one example of an advanced economy falling into a deflationary debt spiral – that's Japan, which has its own, unique structural issues. Even during the Great Depression, America was actually growing strongly from the mid-1930s, though the scale of the contraction had been so extreme that output didn't return to previous levels for another five years.
In any case, it is vital that policymakers don't repeat the mistake of the US Federal Reserve in 2003/4, when exceptionally loose monetary conditions were maintained for too long, helping to stoke the credit boom of subsequent years.
Stimulating a sluggish economy with easy money is like trying to move a large weight with a piece of elastic. For a long time, nothing happens, so the authorities pull harder and harder. Then, all of a sudden, the weight shifts, and with startling speed hurtles towards them and smacks them in the face.
Rarely has the Bank of England faced a more formidable policy challenge. Withdraw its support too soon, and the Bank risks snuffing out the recovery. Leave it too late, and it will only succeed in storing up an even worse crisis for the future.
Over the past three years, the Bank seems to have been persistently behind the curve, both on the up and the downside of the economy. For all our sakes, the Bank desperately needs to get its judgment right this time. The point at which it starts raising interest rates again may still be some distance off, but if I'm right that deflation isn't as much of a long-term risk as the markets suppose, this unpopular action will have to be taken while unemployment is high and still rising. A major test of the Bank's resolve, as well as its independence from the politicians, looms.
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