The Bank of England must find a way of slowing demand without bringing the economic recovery to a halt.
Of the Ten Commandments of central banking, the most important is to take away the punch bowl before the party gets started. Perhaps inevitably, few manage to obey. Central banks are invariably too slow to cut rates when circumstance demands – the European Central Bank has waited until the eurozone is almost in deflation before taking action – and too slow to raise them when the economy starts to overheat.
So it appears with the Bank of England, which despite a quite pronounced bounce in the economy, and accompanying recovery in the housing market, has committed itself to not raising interest rates for at least three years – subject to inflation and unemployment thresholds.
Margaret Thatcher’s favourite theorist, Friedrich Hayek, was by no means right about everything. But one of his central insights contains a great deal of truth. It is that expansionary policies in a recession will only postpone the necessary adjustment – and that creating more credit makes the eventual return to reality more painful still.
Today, Britain is being cynically frog-marched into a pre-election credit boom, for which there may eventually be a quite heavy price to pay.
Now, it would be wrong to exaggerate the current state of play. Despite the positive news on growth, the economy remains some distance below pre-crisis levels of output. In some parts of the country, it still feels like a depression. It can therefore be reasonably argued that the Bank of England shouldn’t even consider taking its foot off the monetary accelerator, at least until the economy is back to where it was.
But here’s where the debate gets really interesting. Why is it that output here has come bounding back, even as the world economy slows and the eurozone sinks ever further into the doldrums?
Certainly it has got nothing to do with the Government easing back on its austerity programme; to the extent that there ever was austerity, it is continuing at roughly the same pace as before. Nor has it got much to do with our moving towards a more balanced economy, less reliant on consumption and more driven by exports and investment. In fact, consumption today has an even bigger share of GDP. No, the true explanation is that the credit cycle has turned. Consumers are more confident, so they are borrowing more and saving less.
Behind this turnaround lie three key policy initiatives. Help to Buy has provided crucial support for the housing market. Funding for Lending has hosed the banks down with cheap money, giving them the capacity to start lending again. And the Bank of England’s “forward guidance” has offered households and businesses a degree of confidence that they are not about to be hit by a precipitous rise in interest rates.
As engineered, politically driven recoveries go, it’s quite clever. But it won’t be sustainable much beyond the election unless there is a pretty dramatic pick-up in business investment from here on in. So far, there is very little sign of it.
Having largely lost the argument over austerity, Labour has switched tack to the “cost of living crisis”. This may or may not be politically astute, but unfortunately it is a problem that is even less easily magicked away than a flatlining economy.
Certainly it is not going to be solved by Labour’s economically illiterate mix of price controls on energy and tax incentives to create higher wages. This will only succeed in raising unemployment. Similarly, reversing the Coalition’s attack on benefits, which is also depressing overall household income, would have to be paid for – and negated by – higher taxes.
In truth, there are no easy fixes for falling real incomes, since the underlying cause is endemically poor productivity. In recent years, Britain has become substantially less productive. Output has fallen, but employment has risen; ergo, output per worker – which was already quite low even before the crisis – has been badly eroded.
You cannot spend what you don’t earn unless you borrow the difference. Policy-makers have therefore returned to the old palliative of compensating for stagnating incomes by encouraging an expansion of credit.
Both the Bank of England and the Government believe that with a recovering economy will eventually come an improvement in productivity, real wages, and therefore living standards.
Believe it if you will. An alternative view is put by Fathom Consulting’s Danny Gabay, who thinks there is very little spare capacity in the economy. If that’s true, then Britain’s credit-led recovery will soon cause inflation to spike higher again.
So how could the Bank of England remove the punch bowl without bringing the recovery to a screeching halt? Raising interest rates is not the only tool available. The Bank could also act directly to prick the nascent housing bubble via its newly formed Financial Policy Committee. Some of the committee’s members, alarmed by the speed of the recovery in house prices, are already determined to act, by increasing capital requirements on mortgage lending, or recommending the imposition of tougher loan-to-value and/or loan-to-income criteria. Alternatively, they could simply embarrass the Chancellor by recommending that Help to Buy be scrapped.
A rather better solution all round, though one with few immediate political dividends, is the deregulatory and planning shake-up necessary to bring about a genuine improvement in supply and productivity. Unfortunately, such a course requires a rather braver Government than this one.