Warwick Lightfoot: How to stimulate the economy and avoid a slump

Yesterday we published Andrew Haldenby's view that a fiscal stimulus would prolong the recession.  Today Warwick Lightfoot presents an alternative view.  Warwick is an economist and was Special Adviser to the Chancellor of the Exchequer from 1989 to 1992.

The freezing of the banking system and the collapse of the international credit markets has resulted in an economic crisis unlike any since the 1930s. For most of the time since Lord Keynes published his book, The General Theory of Employment, Interest and Money, his legacy has been an irrelevance, if not a menace to public policy. The economy most influenced by his thought was the British economy, and its management in the 30 years that followed the end of the Second World War was an object lesson in relative failure. I have played my part in helping to explain Why Keynes is dead and why he should stay dead.

Keynes and the kiss of life
Things are different today. Keynes has a lot to say. We are in a recession. It will probably be a long recession. In fact as a result of the collapse of an effective banking system, there is a risk that a long and deep recession could turn into a genuine slump in output, with GDP falling by 5% or 6%. This would do huge damage to people in their everyday lives and immense damage to the medium term trend rate of growth of the British economy.

Usually monetary policy and changes to interest rates are the effective tools of macro-economic policy. Essentially it is a practical and empirical matter. In normal circumstances monetary policy is much more powerful than fiscal policy, because it influences every consumption, investment and saving decision. Changes in taxation and spending take time before they are implemented and often, because of the delays involved have a pro-cyclical rather than an anti-cyclical effect.

Why monetary policy will not work at the moment
The position today is different. Monetary policy cannot work because the banks do not have the balance sheets and the confidence to operate normally. There is a disconnection between lowering official policy interest rates, and people and businesses being able to borrow. The broad money supply is falling in real terms for the first time since the early 1980s. Inflation is not our problem, slumping output is the problem and monetary policy is not in a position to help. Even when it does work normally, it operates with a long and variable lag of about 18 months.

Britain needs a fiscal stimulus now
Fiscal measures need to be taken to prevent the recession from turning into a slump. A recession cannot be avoided. It is the consequence of difficult changes that will have to be made to consumer and company behaviour as a result of the damage done to the supply of credit. Along with falling house prices and negative wealth effects that are affecting households. A slump, however, can be avoided. In the present circumstances the polices needed will include a large fiscal stimulus and changes to the conduct of the management of government debt and monetary policy.

A fiscal stimulus needs to be large in cash terms, if it is to have any impact on a £1,400 billion economy. It needs to be at least 1.5%  to 2% of GDP. The measures should be assessed against three criteria: Timely; Targeted; and Temporary. The three Ts. It needs to have an immediate impact. It needs to be targeted on getting money spent as soon as possible and ideally, at helping people who are being directly hurt by weakening economic activity. It should be one-off in its impact on the public finances.

Taking account of new research from American economists
The cash sum involved will have to be about £20 to £25 billion if it is to have any effect. Ideally it should be in the form of one-off tax rebates to individuals and to companies, with basic taxpayers receiving rebates of around £900. In 2001 there is clear evidence that President Bush’s tax rebate worked as part of his fiscal stimulus package. As a result, in America the balance of mainstream economic opinion about the efficacy of fiscal policy has changed. Martin Feldstein and Michael Boskin - the economists who chaired President Reagan and President Bush’s Council of Economic Advisers - now advocate fiscal stimulus as a tool of macro-economic policy.

A cash stimulus on the scale needed will aggravate the UK’s large structural budget deficit. A tax cut funded by offsetting expenditure or tax measures, would vitiate the whole purpose of the stimulus. The budget deficit will have to increase. A rebate has the advantage of not changing the underlying budget arithmetic apart from the one-off rebate.

Changes to government debt management: Under-fund the deficit
Given the problem presented by a collapsing money stock the Government needs to take further monetary measures. Instead of covering its deficit by issuing gilts, putting upward pressure on long-term interest rates through crowding out and raising the debt service component of public expenditure – that currently stands at £30 billion or a little over 2% of GDP – the government should monetise part of the deficit. This would help to recapitalise the banks and maintain the effective money stock. It also has the added benefit of avoiding future public expenditure. If bonds are not being issued, debt service charges will not have to be paid, which will help to contain the long-term costs of a fiscal stimulus package.

The future: Public spending control and more effective monetary policy
The immediate task is an effective stimulus; the long-term challenge will be to construct a fiscal policy that is realistic in terms of expenditure, borrowing and taxation. The balance between taxation and borrowing will be a second order matter compared to the much more important issue of the total level of public expenditure. Along with a proper financial framework that controls public expenditure, the UK will have to look again at the construction and implementation of the Bank of England’s inflation target, because domestic monetary conditions have plainly been too loose, despite the fact that the reported inflation target appeared to be met.