Policymakers need to get to grips with the "New Normal"...
THIS WEEK marks the fifth anniversary of the first tremors of the financial crisis in August 2007, writes former bank of England Monetary Policy Committee member Andrew Sentance.
In fact, the warning signs had been emerging before that. The MPC minutes for the meeting of 1st/2ndAugust 2007 read as follows:
"The main news this month in financial markets had been the sharp deterioration in credit markets and the associated falls in equity prices and changes in market interest rates. A trigger for this turbulence appeared to be renewed concerns about the US sub-prime mortgage market, the losses of some prominent hedge funds, and the revisions to the ratings of some mortgage-backed securities; this had led to a reduction in demand for products such as sub-prime mortgage-backed securities and collateralised debt obligations…. It was not clear how far the downturn in financial markets would go, nor how long it would persist."
We now know that the downturn in financial markets was very serious indeed and its consequences are still with us today. But it is not just the scale of the financial shocks which hit major economies from 2007 until early 2009 which is making economic life so challenging at present. There are three other factors which are contributing to the current environment of disappointing growth and volatility which has become the "new normal" for the major western economies.
First, we are in the middle of a big geopolitical transition, as the Asia-Pacific region becomes the dominant force in the world economy – led by the emerging economic superpowers of China and India. The Asia-Pacific region – including Japan, Australia and New Zealand – now accounts for over 30% of global GDP, compared with 22% for the US and 24% for the European Union. No longer are the mature western economies the dominant force in the world economy.
This creates a disconnect between growth in the West and across the global economy more broadly. The world economy is still growing reasonably strongly – powered by Asia and other emerging economies - even though growth in the US and Europe is disappointing. The IMF's forecasts still show global growth in the years 2011 to 2013 in the 3.5-4% range, above the 3.3% long-term average. One consequence has been a climate of much higher and more volatile energy and commodity prices – as successive price surges since the mid-2000s have eroded the low import costs which supported western consumer growth in the 1990s and first half of the 2000s. This erosion of cheap imports is being compounded by the impact of domestic inflation in emerging market and developing economies – expected to average 6% from 2011 to 2013.
The second factor aggravating the impact of the financial crisis is the need for many western economies to make structural adjustments to find new sources of growth after a long period of economic expansion. The UK and many other western economies enjoyed a long expansion which started in the early 1980s and was only briefly interrupted by the early 1990s recession. UK economic growth averaged 3% in the twenty-five years 1982 to 2007, very similar to the growth rate of the previous long expansion which included the 1950s and 1960s.
A key driver of this period of growth from the early 1980s through to 2007, was a process of supply side reform, liberalisation and regulatory change which allowed resources to shift from the manufacturing industries which had powered the 50s and 60s long expansion into the services sector. A key component of this liberalisation agenda was the deregulation of financial services, which broadened the access of consumers and businesses to sources of finance.
The financial crisis has undermined confidence in the ability of banks and financial institutions to operate safely and responsibly in such a deregulated climate. A process of financial re-regulation and reassertion of state control is underway. And in other areas of economic life – employment law, environmental protection, infrastructure development and planning – there has been a tide of re-regulation and increasing government intervention for some time. This creates potential barriers to the adjustment of the economy to the changed economic circumstances since the financial crisis.
The third ingredient contributing to a "new normal" world of disappointing growth and volatility in the major western economies is the difficulties which policy-makers are experiencing in adjusting to new realities. Prior to the financial crisis, an economic policy consensus had developed in the major western economies. As long as economies grew at a reasonable rate, public sector finances could be kept on an even keel and central banks appeared able to steer economies on a steady growth, low inflation course. In 2008/9, governments and central banks adopted extreme and emergency measures to stabilise their economies – very low interest rates, direct injections of liquidity and monetary stimulus, and various forms of fiscal stimulus. Five years on from the onset of the crisis, we are struggling to move away from these emergency policy settings. And there is a danger that persisting with these emergency stimulus policies over the medium term will add to distortions in the economy rather than facilitating the process of structural adjustment.
In the private sector, the fact that policy-makers are struggling to set a clear and credible medium-term direction for policy adds to the general feeling of nervousness and lack of confidence. It makes financial markets jittery and volatile. Businesses are reluctant to invest and hire new workers. And so we are stuck in a negative feedback loop of uncertain policy responses, financial market nervousness and weak private sector confidence. Breaking out of this loop is a key pre-condition of establishing a new and sustained growth momentum.
So what is the way ahead? The first step towards identifying the right policy approach is recognising the nature of the problem. And too much of the policy discussion so far has focused on one dimension – the aftermath of the financial crisis and the problems in the banking sector. Yes, this is very important. But the reason why major western economies like the UK are struggling to recover their pre-crisis growth rates is that other factors are at play, which are having much broader and complex economic effects: the geo-political shift to the Asia-Pacific region, and the impact that this is having on energy and commodity prices; structural readjustment in western economies; and the need for policy-makers to rebuild confidence and credibility in the aftermath of the crisis.
The second key point to recognise is that we are not dealing with a simple problem of demand deficiency in western economies, even though that is the way the current situation is conventionally analysed by many commentators. There is plenty of demand in the world economy. World GDP in 2012 is expected to be 17.5% up in Dollar terms on its 2008 peak, and nearly 25% up on the 2009 trough. And if demand is so weak, why has global growth been consistently above its historic average since 2010? Why has inflation been relatively high in so many countries, including the UK? And why are energy and commodity prices so high?
So those who argue that the solution is to inject bigger and bigger amounts of stimulus are basing their analysis on a mis-diagnosis. They are also advocating a return to the conditions which created the financial crisis in the first place. Advocating more borrowing and money creation as a way out of our current problems is actually an argument for returning to the conditions of the mid-2000s which precipitated the financial problems we are struggling to recover from.
The third key conclusion is that disappointing growth for western economies, accompanied by financial volatility and bursts of energy and commodity price inflation, is likely to be the environment we face for the next 3-5 years. So economic forecasts, public spending plans and private sector expectations need to adjust to this "new normal". But that does not mean we all need to hunker down and endure a prolonged era of austerity. There will be growth opportunities in the economy – driven by technology, social trends, growth in Asia and emerging markets, and the restructuring of the economy. Don't give up on growth – just recognise that it will not come in the same areas which benefited from the past debt-fuelled expansion, including property and housing construction.
Finally, what should policy-makers in the UK and other western economies be doing to encourage a return to stronger and more sustained growth? I am sure the answer does not lie in more stimulus. Some of the most successful western economies in recent years – Canada, Germany, Sweden – are those which turned their back on stimulatory policies most quickly. There is no quick fix. The policies which will deliver economic success over the medium term are those that will help economies adjust to the realities of the "new normal" world.
So, here is my policy agenda for the UK for the next 3-5 years. First, stick with the government deficit reduction programme in terms of its general shape and direction. But ensure that the detailed composition of government spending and tax policy is much more supportive of wealth creation. Infrastructure spending has borne a disproportionate share of public spending cuts. Also, benefit recipients have seen their payments indexed for inflation while the wages of public sector workers have been frozen. Though the focus on deficit reduction is correct, the detailed implementation does not seem to be supportive of economic growth over the longer term.
Second, the MPC should change the focus of monetary policy – away from perpetuating the emergency policy stance which we established in 2008/9, towards a medium-term exit policy – of gradual and well-anticipated interest rate rises. Needless to say, continued injections of QE act in the opposite direction – perpetuating the view that lazx monetary policies can continue indefinitely. Another shift needed in monetary policy is a stronger emphasis on a stronger exchange rate to shield the UK from successive bursts of energy and commodity price inflation. We've seen little benefit from the current policy of exchange rate depreciation, as the UK's manufacturing base is too narrow and specialised to benefit from a short-term cost advantage. Meanwhile, a weak exchange rate has menat that rising import prices have squeezed consumer spending – over and above the impact of rising oil and commodity prices.
Third, we need a stronger emphasis on supply side policies to help the UK economy to adjust to the realities of the "new normal" world. These policies should include: (1) Reducing the burden of regulation on normal business activity, including reforms to the planning system and employment law (including freezing the minimum wage); (2) Reforming the tax system by spreading the base of taxation, reducing rates, and shifting the burden of tax to spending rather than earning wealth; (3) Helping the labour market adjust by providing unemployed workers with the skills and opportunities they need to enter the world of work; (4) A much greater recognition within government of how well-meaning policy initiatives can make life more difficult for business. An independent competitiveness watchdog or regulator should be appointed to enforce this approach.
The world which has emerged since the financial crisis contains many challenges for the UK and other western economies. The key to managing these challenges, however, is not to look back to the policies which worked in the past. These policies were based on over-optimistic views of growth potential, an unrealistic approach to public finances and an excessive belief in the ability of central bankers to stabilise our economic affairs.
We need to shed these views which are rooted in a pre-2008 world, and focus on the future challenges. In the western world, the future belongs to highly competitive and flexible economies, which do not look to devaluation to address underlying competitiveness problems. Sound public finances and low inflation are still important pre-conditions for economic success in this new environment. But they are not enough. The key ingredient is the effectiveness, productivity and efficiency of the supply-side of the economy. That is where UK policy-makers now need to focus.
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