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Britain's policy echoes Habsburg decline
Samuel Brittan The Financial Times 23/11/12

It is difficult to plough through the Bank of England's recent inflation report and associated Monetary Policy Committee minutes without being reminded of a slogan current in the last years of the Habsburg empire: "The situation is hopeless but not desperate." Or was it the other way around? In any case, the main message of the report is that the outlook is gloomy and the risks are on the downside, but nothing much can be done about it.

I ended my first extended essay on economic policy, more decades ago than I like to think back, by remarking: "The unKeynesian belief of some leading Treasury men that there is little the government can do to secure full employment in the face of adverse world forces is not encouraging." All I would have to do now is to add the BoE, which has become more of an independent influence on policy, to the critique. As the UK is now a much smaller part of the world economy than when I first wrote these words, it should be easier to chart an independent course - but apparently not if you are a British policy maker.

The growth of real gross domestic product is expected to be below its trend average until well into 2015, even allowing for the much-vaunted Funding for Lending scheme. As we are starting from a very depressed level, output in that year is expected to be below its pre-crisis 2007-2008 level. If that is not stagnation, I do not know what is. I do not claim to have any idea what Keynes would be saying today but I can hear him turning in his grave.

The inflation outlook is a little less gloomy. After rising towards 3 per cent in the next few months, it is expected to fall back towards the target 2 per cent some time in 2014. But even that forecast is hedged with qualifications. Inflation can be buffeted by volatile commodity price movements; there is a big question mark over domestic productivity movements and uncertainty "about the extent to which idiosyncratic influences, such as tuition fees and domestic energy bills will continue to impart upward pressure".

I have a suggestion that could put the Bank of England governor or his successor a little out of his or her misery. Inflation targets were first introduced into the UK by Norman Lamont, the chancellor, in 1992, after the UK was forced out of the European Exchange Rate Mechanism. The idea was to reassure economic agents that the UK was not about to embark on an inflationary spree. Today the dangers are different and it would be sensible to move to a target for domestically generated inflation alone.

The separation would be neither easy nor non-controversial, but it could be attempted by any competent national income statistician. The BoE's own charts show that inflation would have been both less volatile and less off-target measured in this way. One great attraction is that it would hold public servants responsible only for those things they can influence. Neither the chancellor nor the BoE governor would have to resign if the Strait of Hormuz were blocked or if there were an outbreak of hostilities in the South China Sea.

The BoE has reacted to strictures about relying too much on fallible forecasts by moving towards what has been called "the taxonomic approach to economic policy" - in other words, listing possibilities as non-committally as possible. This tends to be based on "flow of funds" analysis. The basic idea here is that if you take the main sectors of the economy - households, business corporations, the public and external sector and one or two others - net flows between them sum by definition to zero. So if you have an idea of either likely or needed changes in one or two sectors, you have a handle on the others.

I have always been profoundly suspicious of this type of analysis, even though it appeals to many economists as a way of bypassing doctrinal disputes. The trouble is that it says nothing about the level of output at which the zero balance is achieved. Nor - sound money advocates please note - does it tell you the level of inflation. For all I know, the financial balances summed satisfactorily to zero at the height of German hyperinflation in the 1920s.

I mention this because flow of funds analysis is the basis of a recent BoE article that tries to give substance to all the rhetoric about "rebalancing the economy". It is, as one would expect, full of ifs, buts and maybes. Its tentative conclusion is that both the public and the external sectors need to improve their balances, while both the corporate and the household sectors could in time run their balances down. I am reminded of Cambridge arguments years ago, when Professor Austin Robinson used to dissect the British balance of payments, while Milton Friedman, then on a visiting sabbatical, thought all the authorities needed to do was to float the pound and maintain a stable monetary policy. He was not in the least bothered by budget deficits. Need I say where my sympathies lie?


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