The narrow focus on demand

This is my latest column for Fund Strategy

The initiatives announced at the annual Mansion House dinner reminded me that there is also a monetary side to economic policy (see box, below). My recent cover story (June 11) on the “phoney war” over economic policy focused instead on the fiscal side of the discussion.

Looking at the monetary policy debate – or rather the lack of it – reinforces my point about the common ground shared by the main parties. Both sides support an activist monetary policy, both say little about the real economy and both assume that insufficient demand is the key underlying problem.

Indeed, monetary policy is officially out of political hands as the key decisions in this area have been outsourced to the Bank of England. In effect, politicians of all parties have largely abdicated their responsibility for monetary policy.

Government generally confines itself to ratifying the decisions made by the Bank. Schemes for credit easing, in which the Treasury directly subsidises bank lending, are an exception.

In broad terms the coalition’s policy includes three elements: curbing public spending, running a loose monetary policy and reducing debt. In the short term, as I argued in my cover, its public spending cuts are relatively small while public debt is increasing. The only area where policy is being true to its rhetoric is where it is not officially in charge: monetary policy.

Indeed, the Mansion House speech by George Osborne, the chancellor, embodied the contradictions in the government’s policy. On one hand, he condemned the build-up of debt as a key problem: “The common theme is an underlying problem of excessive debt – banking debt, government debt and private sector debt.”

On the other hand, the finance for lending scheme he announced, where cheap loans are extended to businesses and individuals, will lead to an increase in debt.

In contrast, Labour also says it would curb government spending, but it would do so slightly later than the Conservatives. It would also probably have placed marginally less emphasis on monetary policy if it had been re-elected in 2010. However, it is never possible to be certain what would have happened if history had taken a different turn.

Labour has not spoken against quantitative easing (QE) or other monetary initiatives in principle. The main thrust of its criticism is that monetary measures cannot do their job if the government does not get the fiscal side right. It argues that businesses are often too nervous to make use of the credit extended by such schemes.

The differences between the two parties on the relative balance between fiscal and monetary policy in some ways reflects earlier academic debates. John Maynard Keynes was sceptical about the impact of monetary policy on a stagnant economy while for Milton Friedman, a monetarist, it was key.

Friedman, who died in 2006, is particularly interesting to consider as he is often seen as the doyen of free market economics. In many respects he favoured a minimal state that limited its activities to running the army, courts and police while providing a monetary framework.

Yet in some important respects he was closer to the mainstream than was often realised. First, he was in favour of activist state intervention in the monetary sphere. It is likely that in the current environment he would have approved of such measures as low interest rates and QE.

This is in contrast to the other main school of free market economics, ’Austrians’ such as Friedrich Hayek, which is much more sceptical about monetary policy. Indeed some of its adherents even call for the abolition of central banks and for competing currencies within nations.

Friedman also tended, like the Keynesians, to see economic problems as largely located in the demand side of the economy.

The challenge, therefore, was to keep monetary policy loose to boost demand when it was most needed. In contrast, during boom times, monetary policy should be much tighter.

Contemporary economic debate is even less polarised than the Friedman-Keynes debate suggests. Labour has come to accept that monetary policy plays a key role while the Conservatives, despite their occasional free market rhetoric, accept a large role for fiscal policy. The debate between them is at the margins of policy rather than on any core assumptions.

In particular, both start from the premise that the key economic problems relate to demand. They assume that if only businesses and consumers become more confident the economic cycle could turn positive. Keynesians in ­particular emphasise the large amounts of spare capacity in the economy that could be utilised with a sufficient fiscal boost.

But if the problem is located instead on the supply side – that is, if it relates to production rather than consumption – it would lead to fundamentally different conclusions. Monetary and fiscal measures would be insufficient to tackle the causes of the slump. A more fundamental restructuring of the real economy would be needed.

I will look more closely at this aspect of the discussion in next week’s column.

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[Box] Special measures

Even before the introduction of quantitative easing (QE) the authorities were using monetary policy in an attempt to boost the flagging economy. This is a selective list of some of the main initiatives.

April 2008 – In the aftermath of the collapse of Northern Rock the Bank of England launched a scheme to allow banks to swap high quality securities for Treasury bills.

March 2009 – The base rate was reduced to an historical low of 0.5%; the level at which it remains. At the same time the first round of QE was announced.

October 2011. Second round of QE.

November 2011. Credit easing plan announced but few details available.

February 2012. More QE announced.

March 2012. The Treasury launched its National Loan Guarantee Scheme or “credit easing”. It is designed to provide £20 billion of government-backed loans for small businesses.

June 2012. Two more sets of monetary measures announced at the Mansion House dinner on June 16 by the chancellor and the governor of the Bank of England. One will encourage lending to business and households while the other will increase extra liquidity to the banks.