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The bad old days of fine-tuning Samuel Brittan: The Financial Times 13/02/04 There is now on the table a suggestion by the British Treasury that threatens to take us back to the fine-tuning of the 1970s, when high unemployment was combined with double-digit inflation. There is a romantic monetarist myth that what went wrong was that governments of the time cynically or simple-mindedly prodded their central banks into an excessive expansion of the money supply. In fact that was not how economic advisers thought at the time. Their main focus was on activity and employment, which did not seem in the least over-full. They therefore underwrote the reluctance of governments to restrain demand by any means and concentrated their efforts on pay and price controls - flatteringly called incomes policies - to hold inflation back. It was only when these had been tested to destruction that governments reverted to orthodox monetary and fiscal policies; but by then inflation was so high that, in the UK, the financial squeezes involved unemployment in the low millions. Milton Friedman's main contribution to this debate was, in my view, his concept of a "natural" rate of unemployment, which puts limits on how far increased spending can bring down the jobless total without setting off an accelerating inflation. The name was unfortunate and was soon replaced by the more anodyne "non-accelerating inflation rate of unemployment" or Nairu. This in turn was replaced by the closely related but still more anodyne concept of the "output gap". When output is too high to be sustainable and inflation is threatening to accelerate there is a positive gap. When it is too low there is a negative gap. Interestingly, Friedman himself refused to give any estimate either of the Nairu or the output gap. He wanted to avoid "the pretence of knowledge". He saw these concepts as expositional devices to show why we could not spend ourselves into target rates of full employment - as was well explained by James Callaghan, the former prime minister, in his landmark speech to the 1976 Labour party conference. In current terminology the root problem of the 1970s was an over-optimistic idea of the output gap. This way of putting it is supported by several reputable econometric papers. One from the Bank of England* suggests that in the mid-1970s the negative output gap was overestimated by a remarkable 7 per cent of gross domestic product. The moral from such episodes is the need for some nominal framework for policy that does not depend on knowing the sustainable level of employment at any particular period. Such a framework can take many different forms, including the currently fashionable inflation targets, my own preferred objective for nominal GDP, or a link to a currency with a record of low inflation like the former D-Mark. Unfortunately the army of mainstream economists began making estimates of the output gap and devising policies depending on whether it was positive or negative. This was the purpose of the so-called Taylor rule so frequently cited in central bank literature. Now the economic adviser to the British Treasury, Ed Balls, has, in a speech in York on January 26, trailed the following proposal: if forecasts suggest that the output gap will exceed 1-1½ per cent of GDP, the chancellor should either introduce corrective fiscal measures or explain to parliament why he has not done so. Make what you like of the proviso that this should be "subject to our two existing fiscal rules". The suggestion originally arose in relation to the Treasury study of British euro membership. One of the biggest obstacles to this is that, as there is one single monetary policy for the whole of the euro area, an individual government would lack weapons for dealing with "asymmetric shocks" affecting its own country. This apparent deficiency has provided a re-entry route for advocates of fiscal fine-tuning who want governments to use it to supplement the monetary policies of the European Central Bank. My own view is that if member countries cannot live with ECB policies without such retrogression, they are not part of a natural monetary area and should not take part. "Gap" estimates already play an excessive role in the analysis of independent central banks. But at least they do not have the temptation to exploit such estimates for purposes of re-election that finance ministers who control fiscal policy would have. My fears are increased by a sinister proposal at the end of Mr Balls's speech for a "regular Treasury stabilisation report, produced on a quarterly or six-monthly basis, which would take over from the Bank of England Inflation Report as the prime domestic document in which the government analysed economic developments". This could destroy the whole framework that Mr Balls himself earlier worked so hard to establish. For the moment euro governments are likely to discard the British proposal as just another example of an outsider trying to rewrite club rules. But looking further ahead, European politicians might see some advantage in having them written into a new stability and growth pact. And the British government itself, even if it remains outside the euro, might still want to introduce the proposal. Those who will not learn from history are condemned to repeat it. * E. Nelson and A. Nicolov, UK Inflation in the 1970s and 1980s, Bank of England, 2001
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