Tony Dolphin is the chief economist at the Institute for Public Policy Research (IPPR); the following is an edited version of a chapter from IPPR’s forthcoming book, “Complex New World: Translating new economic thinking into public policy” – see here for more
Traditional economics has not solved the problem of the boom-and-bust cycle. When Keynesian policies dominated, recessions were frequent and shallow; in the neoliberal period, they have been less frequent but deeper.
Macroeconomic policy in the post-war period, whether Keynesian or neoliberal in nature, has failed to achieve lasting economic stability because it has been based on the idea, drawn from traditional economics, that the economy can be forecast in the short-term, and that the effects of policy changes on the economy are predictable
Neither is true. Economic policymakers are unable to foresee ‘unpredictable’ events like the 2008 crisis.
The current crisis clearly points to failures in the way we conduct macroeconomic policy in the UK. The measures on which policy is set – output growth and inflation – were too narrow to foresee the crisis. In 2006 and 2007, the MPC’s models told it consumer price inflation was likely to stay close to its target rate if interest rates were nudged slightly higher, from 4.5 per cent to a peak of 5.75 per cent.
Meanwhile, policy-makers were turning a blind eye to a financial bubble that had been developing for years. The policy-making framework, busy with tinkering, was too narrowly focused.
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Despite the economic crisis of 2008, the way monetary policy is conducted has barely changed for 15 years: the government sets an inflation target, and the Monetary Policy Committee of the Bank of England adjusts its short-term interest rate – and more recently implements quantitative easing – to meet this target.
And, once the deficit is eliminated, fiscal policy will continue to be run in the way that it has been for the last 30 years: governed by arbitrary targets and largely insensitive to the economic cycle.
Yet a simple reading of history suggests greater attention should be given to asset prices – particularly those of houses – and to oil prices since all four of the major recessions experienced in the UK in that last 40 years have been preceded by large increases in the price of oil and a period of rapid gains in house prices.
While the effect policy made in the UK can have on oil prices is limited, policy makers should nonetheless be aware of the risks they can pose to the economy.
Similarly, controlling house price inflation may not always be easy, but if future surges in prices could be prevented – perhaps through the imposition of maximum loan-to-value ratios – it would probably do far more to reduce the risk of a future recession in the UK than minor adjustments to interest rates designed to keep consumer price inflation close to 2 per cent.
At the very least, house prices should be given the same weight in policy deliberations as consumer prices.
The narrow focus of policy was based on traditional economics, and its models of rational behaviour at the level of the individual. But for predicting the aggregate picture, these models have time and time again proved inadequate because they do not take account of the complexity of behaviour on a macro scale.
There is an urgent need for a better conceptual framework for the ‘macroeconomic problem’ to be developed.
History shows that narrow, rules-based approaches to macroeconomic policy do not work for long; it is time for policy makers to abandon their narrow models and develop a more complex understanding of the impact of policy interventions.