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About the Author
Andrew G. Haldane is the Chief Economist at the Bank of England and Executive Director, Monetary Analysis and Statistics. He is a member of the Bank’s Monetary Policy Committee. He also has responsibility for research and statistics across the Bank. In 2014, Time magazine named him one of the 100 most influential people in the world. Andrew has written extensively on domestic and international monetary and financial policy issues. He is co-founder of ‘Pro Bono Economics’, a charity which brokers economists into charitable projects.
Patrick Minford is Professor of Applied Economics at Cardiff University, where he directs the Julian Hodge Institute of Applied Macroeconomics. Between 1967 and 1976 he held a variety of economic positions, including spells in East Africa, in industry and at HM Treasury. From 1976 to 1997 he was the Edward Gonner Professor of Applied Economics at Liverpool University. He was a Member of the Monopolies and Mergers Commission from 1990 to 1996, and one of the HM Treasury’s Panel of Forecasters (the ‘Six Wise Men’) from 1993 to 1996. He was made a CBE in 1996. He has written widely on macroeconomics and related policy issues.
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Policy Stability and Economic Growth
Lessons from the Great Recession
By John B. Taylor, Andrew G. Haldane, Patrick Mindford, Amar Radia
The Institute of Economic AffairsCopyright © 2016 The Institute of Economic Affairs
All rights reserved.
POLICY STABILITY AND ECONOMIC GROWTH: LESSONS FROM THE GREAT RECESSION
It is particularly nice to be here at the Institute of Economic Affairs (IEA), which I have heard about, studied and looked to for many years. I have had a long interest in how economics is used in policy, the world of ideas and the world of government, and I think this institute has proven over the years how important ideas are for good government. I read, in thinking about this lecture, that the founder of the institute, Antony Fisher, first got the idea when he was a fighter pilot in World War II, flying for the Royal Air Force. He read in the Readers' Digest the condensed version of The Road to Serfdom. He said, 'These are some ideas that I want to promote', and, after the war, he did so and set up this institution. It is a very important institution, and I am happy to be here.
I also admire the IEA's focus on free markets and all the benefits that kind of philosophy gives to people. I like the stress on, if you like, non-partisan issues. Anyone who wants to listen to the benefits of free markets and a free society is welcome. That is what I think a good institution should be all about.
The Great Recession compared with earlier recessions
I want to focus on lessons learned from our experience over the last few years in the financial crisis and the slow recovery from the Great Recession, because I think it is tremendously important to figure out what went wrong and what we can do better in the future: the lessons to be learned.
To me, there is a striking similarity between my country, the US, and the UK in terms of what actually happened. What I am going to present are ideas that came to me from thinking about economic policies in the US and, actually, before that, from thinking about particular kinds of policies in the US – especially monetary policy, which is my expertise, if you like, or my love, and seeing how the problems with monetary policy actually extend to other kinds of policies. I think that these ideas are useful for thinking about the UK as well.
So, let me begin with a description of where we are in the US and in the UK. First, let's take a look at Figure 1. This is a chart of real GDP in the US, and you can see it goes back to before the crisis in 2007. The lower line shows real GDP, the total amount of goods and services produced in a given year in the US, adjusted for inflation. There is a big dip, that is the Great Recession with the financial crisis, and then there is recovery. I have superimposed on that the previous trend of real GDP from 2000 to 2007. You can see the recovery looks like a great disappointment. We have had a recovery in the sense that growth has generally proceeded at a positive rate. Why is it disappointing? It is disappointing because we did not bounce back as we have in previous recoveries.
Now, what about the UK? Let us look at the same kind of chart for the UK, at the behaviour of real GDP since 2007 (Figure 2), before the Great Recession, and then at the recovery, and superimpose on that the trend line from 2000 through 2007.
You can see that the path of real GDP is quite similar to the US but worse, because it is even slower than the trend line before. So, in both of these cases, there has been a disappointing lack of recovery.
One way to think about these recoveries is to compare them with the recoveries from the previous, most recent deep recessions. Focus on the US first. A deep recession took place in the early 1980s. In Figure 3, you can see that real GDP declines, but then it bounces back. If we had seen this kind of recovery this time, we would already be back producing many more trillions of dollars a year.
That is a typical recovery. The same thing is true for the UK. If you look at that same time period in the UK (Figure 4), the bounce-back from recession is much better. This is what should happen in a typical recovery.
So, we had not only this very deep recession, but also this poor recovery: the 'Great Recession' and the 'not-so-great recovery'. The questions are: why the deep recession and why the slow recovery?
I think the answers to both questions are related. The same kinds of things have affected both the recession and then the recovery.
Other people, of course, have different views, and I want to touch on those briefly. One view is this: 'What do you expect? We had this deep recession. The economy is not going to bounce back that fast.' However, the charts comparing previous recoveries in the US and UK illustrate that is not the case. Figure 5 provides more evidence. It shows the speed of recovery for all of the deep recessions associated with a financial crisis in the US going back to the 1880s. The top horizontal line is the average growth rate in the first two years of all of those recoveries: the average is about 6 per cent. The lower line shows the growth rate during the recovery after the recent financial crisis: this was about 2 per cent. This is easily the worst recovery after a financial crisis.
So, it really is not correct to say that recent experience is what you would expect from a financial crisis: something else is going on.
There are other explanations. One theory that has been offered more recently runs as follows: the income distribution has spread and widened, and this leads to slower growth because people at the lower end of the income distribution consume more as a fraction of their income than those at the top, and they are getting relatively less than before. It is argued that this leads to less consumption and less growth.
But this does not fit the data either. The fast US recovery in the 1980s was during a period when saving rates were higher than they have been recently.
The principles of good policy
So, there are various possibilities that people have offered for this experience, but the conclusion that I have come to is that there has been a problem with policy, and that policy is really the key to understanding what went wrong both leading up to the crisis and since the crisis.
So, what is good policy?
The first principle of good policy is that we should have a situation where families, entrepreneurs and everyone else are free to make decisions within a clear policy framework that is predictable, so you know what is going on, what the government is going to do, and you have some sense of the future. Secondly, policy should be based on a strong rule of law. Thirdly, there should be strong incentives for people to do things that improve their own welfare, and the welfare of society. Fourth, those incentives should largely come from the free-market system.
Of course, there is a role for government, and this is the fifth principle: that this role for government should be limited in the sense that the government's role is based on some reasonable cost-benefit analysis. When the cost-benefit analysis indicates that the government should do it, that's fine. Otherwise, the private sector should do it.
What I have observed in thinking about recent events is that we sometimes adhere to these principles of good policy more closely, and sometimes we deviate from them.
First, consider the US. As I look at the US, I see these shifting winds of economic freedom. In the late 1960s and 1970s, we were shifting away from these principles. Monetary policy became quite unpredictable and was known as 'go-stop'. It led to a lot of inflation and a lot of unemployment. Fiscal policy was quite erratic. We had a lot of Keynesian stimulus packages. This was true under both parties: Republicans and Democrats.
We had wage and price controls for the entire economy. How is that for trying to avoid the market system? We had a large increase in the number of regulations during that period, and a large increase in the scope of government.
I come to this from the monetary-policy side, and that is where I see these shifts in policy most of all.
Performance was not very good during this period; we had high inflation and high unemployment in the US.
What about the UK? Some of you remember what it was like. It was not so good in the 1970s. You had high inflation, high unemployment and a lot of problems. I think that, if you look at the policies, you will see similarities. They're not exactly the same, but monetary policy and fiscal policy had the same sort of problems that I have described in the US.
Then, we saw a change. Again, I am first thinking about the US. We saw a change in policy. Monetary policy became more predictable: less go-stop, more rule-like. I'll come back to that in a minute. Fiscal policy moved away from the Keynesian stimulus packages. It basically tried to get the tax system right and not change it too much. We made a huge effort in this time to reduce the amount of regulations.
The change began in the late 1970s, and it continued in the 1980s. Ronald Reagan became president and Paul Volcker was appointed Chairman of the Federal Reserve by Reagan's predecessor, Jimmy Carter: a democrat.
So, there was a change. What happened? Performance was remarkably good during this period. Economists call this the 'Great Moderation'.
The UK was not too dissimilar. There was a change in policy. Think about how monetary policy began to change. Think about how fiscal policy began to change. Think about how trade union policy began to change.
Then, finally, during this more recent period, there has been a veering away from these principles. Here, I am thinking mainly about my country. In the US, I saw monetary policy in 2003, 2004 and 2005 hold interest rates too low for too long. This was a deviation from the more predictable policy of the 1980s and 1990s. Fiscal policy again became more short-term Keynesian, which it tends to be to this day. Regulation increased – I will talk more about that in a minute.
Now, what about the UK? Here, it seems to me, there is more research to be done, but there is a similarity: certainly with respect to monetary policy, and also with respect to other kinds of policies, including regulatory policy.
This is an important story to understand more fully, for what it suggests is that we should go back, in some sense, to the kind of policy that emphasised markets more, emphasised the rule of law and emphasised the predictability of policies with a limited role for government.
Monetary policy: to the Taylor rule and back
So, given that background, now let me give you some details to fill in the blanks of these broad, even gross, generalisations. I want to spend most of my time on monetary policy, which is my favourite area of study. I am going to first illustrate these changes with some simple graphs.
Figure 6 shows the inflation rate in the US going back to the mid 1950s. You can see how it increased and decreased. The great inflation period was the bad period, and then it got better.
Monetary policy is also indicated on the same chart, along with several snapshots of interest rate levels set by the Federal Reserve (Fed).
In Figure 6, there is also a horizontal line drawn at an inflation rate of 4 per cent. In 1968, the interest rate (federal funds rate) was 4.8 per cent, just a smidgeon above the inflation rate: not really enough to contain the inflation, not enough to put downward pressure on inflation and not enough of a tightening of policy to lead to price stability. Lo and behold, inflation rose and continued to rise until there was a change.
Then, if you look following the change in the policy environment, you can see the same inflation rate, 4 per cent, and the federal funds rate was almost twice as high at 9.7 per cent. That was quite a different policy.
The shift in policy involved a move from a stop-go stimulative type of policy, which backfired, to one that was more sensible, focused on price stability, and the inflation rate was much lower. In addition, the unemployment rate came down. Now, if we continue this line of argument, we can see the veering away from good policy. I have drawn a line in Figure 6 at an inflation rate of 2 per cent and, again, note two interest rate decisions of the Federal Reserve. The first one was in 1997, when the interest rate was 5.5 per cent. That is the kind of interest rate that would tend to contain things: prevent inflation from rising, or prevent overheating or a search for yield or uncertainty. Then, see what was decided in 2003: the same inflation rate, roughly the same state of the economy, about the same level of capacity utilisation, and the interest rate is only 1 per cent.
This is a different policy, and this is the kind of change I am talking about. There is a shift in policy that you can see, I think, very clearly. Now, fortunately, there is more information to go on than just looking at these examples. What there is to go on is actually sometimes related to the so-called Taylor rule. Now, I have a problem. I wish it wasn't called the Taylor rule, because every time I mention it, I lose all credibility. Nobody believes what I say. People say: 'Well, the guy's just trying to promote his own rule.'
So, I am going to refer to other people's research on the rule. This will be more objective. Figure 7 shows actual policy as indicated by the federal funds rate from 1965 to 1995 in the solid line, and policy as suggested by a Taylor rule using the dashed line.
This uses a picture actually produced by the Federal Reserve in 1995.
It can be seen that the interest rate was volatile in the 1960s and 1970s, but generally quite a bit below the Taylor rule. Then, you see the change I mentioned, with Paul Volcker coming in and Alan Greenspan replacing him. You see quite a bit of change. Now, we are going to the so-called good period I'm talking about, where policy is more rule-like, and you can see a surprising (to many people) correspondence between performance and this rules-based measure. During the last part of the period, there is an especially close correspondence.
So, that is a description of moving from a go-stop, non-rule-like policy to a rule-like policy. Then, look what happened. We have a period in 2003–5 when the interest rate gets very low. The Taylor rule guideline says it shouldn't be so low, and there is this gap. People began to write about it at the time. Figure 8 is a picture from The Economist magazine back in 2007. Its writers wrote in the term 'Taylor rule', not me, so I'm still maintaining some objectivity. You can see the gap between the actual interest rate and the Taylor rule. It is a huge gap.
So, that is the context. If you look at research and you look at the analysis, you can see that there was a change in the policy environment. The harm from this, of course, is that very low interest rates can cause a boom in the housing market, which I think they did. They can cause a search for yield and extra risk-taking, which I also think they did. Low interest rates may also have had something to do with regulators looking away when they saw extra risk-taking in commercial banks and other financial institutions. In any case, that seemed to happen at the same time.
So, these issues are important, and that is why I argue that part of the explanation for what happened is this deviation from rules-based policy and, in this case, from a simple policy rule.
Just to show you that this is not only relevant to the US (and before I come back to the UK), take a look at Figure 9, which was drawn up by the Organisation for Economic Co-operation and Development (OECD). It shows some of the striking international impact of deviations from the Taylor rule.
What Figure 9 tries to do is accumulate all of those gaps between the interest rate and the rule (that is, between non-rule-like and rule-like policy). It accumulates those gaps over a period of time from 2001 to 2006 (horizontal axis), and, on the vertical axis, it shows you how much of a housing boom there was in these countries. These countries are all in the euro zone, so the UK is not here. With only one interest rate for those countries, some are going to be closer to the rule and some are going to be further away. If you look at the ones that are further away (Ireland, Spain and Greece), you can see the effect. Those countries are away from the rule because the rates for those countries were too low at the time, and that added to the bubble-like behaviour that eventually led to the problems in those countries.
Excerpted from Policy Stability and Economic Growth by John B. Taylor, Andrew G. Haldane, Patrick Mindford, Amar Radia. Copyright © 2016 The Institute of Economic Affairs. Excerpted by permission of The Institute of Economic Affairs.
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