Monetary policy has evolved away from the flawed procedures of the past, says David Smith. But as yet unforeseen economic storms will be the true measure of the new framework.
The latest fad among historians is developing 'What if' versions of history - looking at how historical episodes might have developed under different, but entirely plausible scenarios. What if, for example, the assassination plot against Hitler had succeeded, or John F Kennedy had decided to cancel his trip to Dallas that fateful day in November 1963?
We can play this game too in economics. What if Ted Heath's Conservative government of 1970-74, faced with the then daunting prospect of one million people unemployed, had set its face against reflating the economy? More recently, suppose the then chancellor Nigel Lawson had slammed on the brakes after the 1987 election, stopping the boom in its tracks and avoiding the subsequent damaging recession? Would Margaret Thatcher in such circumstances have ever been overthrown? Would we now be looking at a revitalised Labour party in government with a parliamentary majority big enough to guarantee at least a couple of terms in office?
The errors of the past
The story of British economic policy has been one of trial and error, with usually rather too much of the latter. The key mistakes have come in the setting of monetary policy - gauging the level of interest rates appropriate to the circumstances - and have then been compounded by errors in fiscal policy. These mistakes have marred what should have been a much better performance for Britain's economy, certainly over the past 15 to 20 years. What has been gained through welcome changes in microeconomic policy - supply-side reforms - has all too often been thrown away with wrong-headed macroeconomic policy decisions. The question now is whether Britain is evolving a macroeconomic framework that will make the big errors a thing of the past, guarantee a stable environment for business, and allow the genuine supply-side improvements to show through.
The road to the present
Monetary policy, where most of the serious past errors have been made, has seen far-reaching changes over the past five years. It began, of course, in September 1992 with another good old-fashioned macroeconomic policy mess, the collapse of the centrepiece of the then government's policy framework and membership of the ERM. The response was to give the Bank of England specific responsibility for reporting on and forecasting the path of inflation, and for advising, publicly, on the interest rate changes necessary to achieve the government's inflation target, which the outgoing government managed to achieve in the final month of the last parliament.
Although initiated under the chancellorship of Norman Lamont, these arrangements ran, for the most part, with Kenneth Clarke at the helm. Hence the monthly meetings between Clarke and Eddie George, the Bank's governor, became known as the 'Ken and Eddie show'. Whether or not the two men were responsible for it, the chart shows that the arrangements have coincided with a period of low, stable inflation.
The natural consequence of this, but something that neither Clarke nor John Major as prime minister favoured, was full operational independence for the Bank. In other words, if the Bank is reporting on and forecasting inflation, and recommending the changes necessary, why not go the whole hog and let it set rates, without recourse to the chancellor? This, which was a only medium-term aim of the Labour party, was instituted, ahead of schedule, in May. The Bank has a new nine-member monetary policy committee (albeit with four of its members appointed by the chancellor), charged with the important task of deliberating monthly on rates and the responsibility for implementing decisions.
Monetary policy has thus evolved into something where the errors of the past should not be repeated, or at least not on the scale of previous mistakes. This does not, of course, mean there will be no foul-ups. Robin Leigh-Pemberton (now Lord Kingsdown), governor during the Lawson boom of the late 1980s, was candid enough to admit that, left to its own devices, the Bank would not have conducted policy very differently from that carried out by the chancellor of the day. Then again, plenty of people worry that, with the Bank in charge of interest rates, there is a danger of overkill, so concerned will it be to keep to the inflation target of 2.5%. These are all matters to watch closely.
Framework for the future
The other big danger, of course, is that the current chancellor, having deprived himself of the ability to use interest rates to boost the economy will resort to tax and spend, with equally risky consequences. Here, the checks and balances are less rigorous. Thus, he will set fiscal policy in order to try and meet the golden rule, which is that the budget deficit, defined as the public sector borrowing requirement (PSBR), should match government capital spending over the economic cycle. A prudent government, in other words, will borrow only to invest. Since net capital spending by the Government is targeted to run at around £6 billion annually over the next few years, this is a very tight constraint. To put it into perspective, the PSBR has averaged nearer £30 billion per annum over the past few years.
It is hard to argue with these changes as an alternative approach to policy, as a way of avoiding the errors, and the boom and bust, of the past. It would be wrong, however, to think that the new Government has discovered the holy grail of trouble-free economic policy. While much economic turbulence has been caused by what the tennis commentators call unforced errors, some of it has been down to events or shocks. The test of the new framework is not how it copes in calm weather, but whether or not it can deal with the inevitable economic storms that are unleashed on any government.
David Smith is economics editor of the Sunday Times.