Monday, October 27, 2008

A Tale Of Two Letters

Another recession, another letter
Yesterday's Sunday Telegraph published a letter from 16 eminent economists. Arguing against the government's forthcoming "Keynesian" public spending splurge, they say:
"The Government cannot know how to use an expansion in expenditure that would not risk seriously misallocating resources.

Furthermore, public expenditure has already risen very rapidly in recent years, and a further large rise would take the role of the state in many parts of the economy to such a dominant position that it would stunt the private sector's recovery once recession is past."

Instead, they argue for looser monetary policy and tax cuts.

Unsurprisingly, we agree 100%. For taxpayers, one of the most worrisome aspects of the credit crisis is that governments will spend further shedloads of our money on a series of half-baked public works programmes. They will talk about investing in infrastructure to lift our national productivity, but in reality - as these 16 economists say - they will crowd out the business investment we actually need for sustainable prosperity.

This letter is of course a deliberate echo of that famous economists round robin sent to the Times in the depths of the 1981 recession.

As you will recall, the 1981 letter was signed by 364 economists who between them represented virtually the entire UK economics establishment at the time. They ripped into Thatcher's tough anti-inflation policies, calling for an end to fiscal restraint and the abandonment of monetarism. They reckoned Thatcher was driving the UK economy into a deep and prolonged slump (see this IEA paper for the 1981 letter, its signatories*, and some excellent analysis).

Fortunately, Thatcher ignored those 364 economists, and we know the rest: the UK embarked on the most prosperous 25 years in our entire history.

But, you may ask, if all those learned economists were wrong in 1981, why would this lot be any righter now?

A good question. We really are in uncharted waters, and there is an argument for saying we need to use all our engines, sails, oars, anything, to get us out as quickly as possible.

But against that, pretty well everyone now agrees lower interest rates would help, and with Bank Rate still at 4.5%, we've by no means exhausted our firepower there. A serious cut in interest rates should surely be tried before public works projects. Especially since the latter would take months, or more probably, years to get going.

Clearly big interest rate cuts are what the markets are expecting, which is why sterling is dropping like a stone. And we should recall that during the thirties, what rescued the UK economy from a US-style depression was not Keynesian spending, but a significant loosening in monetary policy - in particular, the decision to leave the Gold Standard in 1931 which brought a big fall in the value of sterling.

So bring on more rate cuts. Yes, there are inflation risks: consumer prices are increasing far too fast for comfort. But the price indices are a rearview mirror. And there are few signs that prices are spilling over into wage increases - on the contrary, some private sector workers are even voting for pay cuts (although most certainly not in the tax-funded public sector).

Now, I have to say as a retired saver with a monetarist bent, I am very nervous about cutting interest rates, especially as year-on-year monetary growth remains quite buoyant. But given where we are now, and given the alternatives, the fact is there are no riskless options.

Beyond that, tax cuts must be the way to go. They could be implemented pretty well immediately, putting money directly into empty pockets, and allowing us to decide how it should be spent.

Yes, there's always the argument that tax cuts in a downturn might get saved rather than spent. But, apart from the fact there's very little hard evidence that happens, the cuts could be directed in ways that are likely to give us the biggest bang in terms of supporting GDP - cuts in business taxes spring to mind, and Sam Brittan has suggested a cut in VAT, which would not only support consumer spending, but would also help whack inflation.

Let's hope the government and a particularly important signatory* to that 1981 letter read the S Telegraph letters page.

*Footnote - the signatories to the 1981 letter included some names we are very familiar with on BOM: Mervyn King, Nicholas Stern, Peston's Dad, and even the Prof himself, Willem Buiter. Just goes to show.


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