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Headroom for economic recovery
Samuel Brittan The Financial Times 19/03/10

During the past decade and a half there has been an over-riding economic objective in many countries - with the notable exception of the US - in the shape of consumer inflation targets, usually of about 2 per cent. I must confess to being sceptical about the sufficiency of such targets from the outset.

My underlying reservation was that during the longest period of stable prices in history under the pre-1914 gold standard there were considerable year-to-year variations in inflation - in the UK ranging from negative numbers to 5 or 6 per cent. Stability over a lifetime was the best long-term bet; in the meanwhile, short-term variations could act as a safety valve. But there were plenty of other cautionary arguments, above all the extreme dependence of most inflation-targeting regimes on highly fallible estimates of the "output gap" - that is, how far an economy was from capacity levels.

But despite these objections, the inflation targeting regime seemed to be working during the period known as the Great Moderation, when most industrial countries managed to combine low inflation with only moderate fluctuations in economic activity. But then, from the onset of the financial crisis in 2007 and the subsequent recession, these regimes broke down in a spectacular fashion. It is important to be clear about what went wrong. The inflation targets were more or less achieved; and they are still in place. What broke down was the doctrine, spelt out in dozens of central banker speeches, that their pursuit would also bring reasonably stable economic growth and at least moderate asset-price bubbles.

It is vital that any new regime incorporates the low inflation philosophy and does not throw out the baby with the bath water. The proposal of Olivier Blanchard, the International Monetary Fund's chief economist, to raise inflation targets to 4 per cent is the perfect example of how not to proceed. If we can go from 2 to 4 per cent, why not from 4 to 6 per cent or from 6 to 8 per cent and so on?

The alternative to inflation targets has long been known. It goes by the ungainly name of nominal gross domestic product. This is just the familiar GDP, but before adjusting for inflation. A nominal GDP objective was for long championed by the British economist James Meade, although it was implicit in many other proposals. I have often thought that its name is the main obstacle to its acceptance and have suggested paraphrasing it as a national cash objective.

The basic idea is that monetary and fiscal policy cannot "manage" demand and output in real terms, as so many postwar experiences demonstrated. What it can endeavour to do is to maintain the growth of cash spending by an amount sufficient to sustain normal growth if costs and prices remain stable. It is a fairly subtle compromise between an output and an inflation target. If the nominal GDP target is, as is likely, just over 5 per cent per annum, then if there is no inflation it is equivalent to an output target of that amount. But if inflation rises to 5 per cent the emphasis shifts to bringing it down, even at the cost of temporary stagnation of real output.

A huge advantage of this is that it lessens dependence on forecasts. If politicians overestimate the trend of output growth then inflation will rise and policy will automatically become more restrictive. If they underestimate it, policy becomes more expansionary. A nominal GDP target is, however, no guarantee against an asset bubble; and if one is sceptical of the claims made for bank regulation, then monetary policy may sometimes have to take asset prices into account even at the expense of other objectives.

There are a great many operational questions to be tackled, although no more than with other strategies. The most important questions are two. First, whether nominal GDP objectives should be at national or international level. The second is what to do about an inflationary rise in nominal GDP that arises from outside the industrial world, say another oil price explosion.

I had originally thought that there should be a period of reflection on such questions before installing a new regime to replace or supplement inflation targets. But I have been impelled to a sense of urgency by Giles Wilkes's Centre Forum paper on the Bank of England's policy of quantitative easing, "Credit where it's due". He has a number of sensible proposals for making this easing "a more effective stimulant and not just a tonic for the City". But at the top of his list is an explicit target for "nominal growth". This might counteract fears that the easing will be withdrawn before it has become effective - and I would add depressing talk of higher bank capital ratios and national fiscal tightening. Something needs to be done to create headroom for economic recovery.

UK nominal GDP at the end of last year was perhaps 15 per cent below its earlier trend line. This was not a cause of the recession, but a reflection of it. It did however indicate that there was a lot of room for continued stimulus before hitting the inflation buffers.

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Contact - samuel dot brittan at ft dot com