Osborne must row back from one of the biggest blunders since the war

Our economics editor David Blanchflower takes the Chancellor to task.

David Blanchflower

I have a candidate for the next chief economist at the Bank of England. Simon Wren-Lewis is an Oxford professor and fellow of Merton College. He began his career as an economist in the Treasury, then moved to the National Institute of Economic and Social Research, where he was head of macroeconomic research. He was also the principal external adviser to the Bank of England on the development of its current and previous core macroeconomic models. Simon has published widely and has all the credentials, in contrast to the current incumbent, Spencer Dale, who has little academic reputation and few publications. Dale’s term is up next year.

This matters because once again the Bank of England’s Monetary Policy Committee, in its May inflation report, was overly optimistic, even though it downgraded its growth forecast. It suggested that growth in 2014 could be as high as 5.5 per cent and ruled out the possibility of zero or negative growth. It claimed that the risks to inflation are balanced and ignored the risks to the downside from the crisis in the eurozone. In my view, the Bank should have done more monetary easing. Indeed, this was confirmed by the International Monetary Fund (IMF) in its latest review of the UK economy on Tuesday 22 May. It said that if monetary stimulus did not work, the UK should introduce a fiscal stimulus involving temporary tax cuts and infrastructure spending, such as I have been advocating.

At a subsequent press conference, Christine Lagarde, the IMF managing director, called on the Bank of England to pump more money into Britain’s flagging economy and to consider a further cut in interest rates to stimulate growth. This is hugely embarrassing for the Chancellor, George Osborne, who can no longer claim that the IMF supports his austerity garbage.

Errors of the era

Something needs to change in the forecasting vaults of the Bank of England. A review of forecasting by David Stockton is welcome but what is needed, above all, is a full examination of why the Bank failed to spot the big one – the worst financial crisis in a century. There are strong grounds for replacing the feeble court of directors, as Andrew Tyrie, the Tory MP and chair of the Treasury select committee, suggests, with a body that would provide proper oversight.

In a recent blog post (mainlymacro.blogspot.co.uk), Wren-Lewis argues that the 2010 Budget should rank as one of the UK’s biggest macroeconomic policy errors since the Second World War. I agree with him. “The Conservative Party opposed the government’s counter-cyclical fiscal policy following the recession,” he writes. “They bought the idea of expansionary austerity, which many have pointed out contradicts basic macroeconomic theory in a liquidity trap. There can be no excuse that the right policy was new, untried and radical – the appropriate policy was simple and well understood. When a government chooses to ignore mainstream academic theory and the economy suffers as a result, it has made a major error and it should be held to account for that.”

Wren-Lewis argues that there have been only two errors of similar magnitude in the UK over the past 30 years and both have involved monetary policy. The more recent was the decision in 1990 to enter the European Exchange Rate Mechanism at an overvalued rate of 2.95 Deutschmarks to the pound. The other was the brief adoption of money targeting in the early 1980s. Once again, tightening of policy was required to reduce inflation but the adoption of money targets led to deflation that was both too sharp and uncontrolled. A common feature of all three episodes, he argues, is that they caused increases in unemployment that were unnecessary.

All three of the major errors he identifies were made by Conservative chancellors and derived some of their appeal from simplistic macroeconomics. In 1980, it was the idea that there is a simple and reliable link between some measure of money and inflation. In 1990, it was that the medium-term equilibrium real exchange rate is always equal to the rate of purchasing power parity. And most recently, it was that private-sector demand would automatically replace public-sector demand and/or that monetary policy in the form of inflation targeting is always capable of stabilising demand.

Stuck in the danger zone

The latest data is extremely worrying and suggests that the UK economy might well be at another downward turning point. Of particular concern is the huge drop in Nationwide’s consumer confidence index, which fell by 9 points in April. By contrast, consumer confidence in the US, which has not imposed austerity, rose to the highest level in four years. The Thomson Reuters/University of Michigan sentiment index for May climbed to 77.8 – the highest since January 2008 – from 76.4 the previous month. Inflation is now falling again.

It appears that Osborne has committed a major macro-policy error that has resulted in a flatlining economy. The European Commission’s forecast of what will happen to the debt-to-GDP ratio in the main EU countries (reported in the adjacent table) is particularly interesting. If true, which seems plausible, this would represent for the UK a 19 per cent increase since 2010 (95/80), behind only Spain, Ireland and Portugal. So much for “taking the UK out of the danger zone”.

David Blanchflower is economics editor of the New Statesman