We’ve been running the economy hot — and are about to pay the price
ohn Maynard Keynes famously wrote that “practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist.” Yes: new trends in economic thinking can be wrong. That’s what seems to be happening now. The rapid rise of inflation over the last year has put a serious dent in one new theory: the idea that “running an economy hot”, in particular by being more tolerant of higher inflation, can lead to permanent increases in living standards.
We need to understand some economic history to see why this matters. The conventional wisdom since the Eighties was best put in Chancellor Nigel Lawson’s 1984 Mais Lecture. Before then, macroeconomic policy — essentially interest rates and government borrowing — had been used to try to drive growth, while microeconomic policy — mainly government programmes and regulation (including price and wage controls) — was targeted at controlling inflation and keeping unemployment low.
By the late Seventies this mix had failed miserably, with high inflation, rising unemployment and slowing growth. So Lawson reversed all that. Government borrowing and interest rates should be focused on low and stable inflation, low unemployment and sustainable public finances, while the underlying growth rate of the economy could only be improved by better microeconomic policies such as a more efficient tax system, better skills and infrastructure, more competitive markets and investment in new technologies. For more than 20 years both theory and evidence strongly supported this new consensus. But more recently two developments have created a new critique. The first development is a global and still largely unexplained slowdown in trend productivity growth that seems to have started around the turn of the century but was temporarily masked by the debt-fuelled boom years of the Noughties. The second was the sluggish global recovery from the 2008 financial crisis, with slow growth and a weak recovery in employment in the US and Europe.
The UK experience after the financial crisis was more nuanced, but perhaps brings out the key challenge more starkly. In Lawson’s terms the UK recovery was extremely successful: job creation grew very rapidly to a new all-time record employment rate, unemployment fell to multi-decade lows, inflation averaged around its two per cent target, and the public finances returned from crisis point back to sustainable health. But in microeconomic terms the data was much less impressive — productivity growth remained stubbornly low.In the US and much of Europe productivity growth also disappointed, but the jobs recovery was much weaker too, particularly for the disadvantaged. This was a major driver of the new critique of economic orthodoxy that has been hugely influential in policy circles, especially within the US Federal Reserve. This critique recommends running the economy and the labour market hot for as long as possible until inflation rises above target.
This new approach clearly has some social and economic benefits, which are already apparent. For example, the US labour market struggles to benefit low-skilled groups unless unemployment is very low and firms are forced to compete for workers. We have also seen inflation expectations move higher, allowing interest rates to start rising and giving central banks more ammunition to cut rates again when the next downturn comes — a concern when global interest rates are stuck near zero.
But some economists have argued that using fiscal and monetary stimulus to run the economy hot would also help solve the productivity problem by encouraging investment and therefore increasing real incomes. On this count the strategy isn’t working — even in the US where wage growth is accelerating the fastest, inflation has risen faster and real incomes are falling. Increased uncertainty and the prospect of higher interest rates seem more likely to depress new investment than boost it.
On balance then, Lawson’s distinction between macro and micro policy isn’t defunct after all. The only sustainable way to raise productivity growth and increase living standards is still the hard, slow microeconomic work of improving our skills, our infrastructure, our tax system and adopting new technologies.
Rupert Harrison is a former chair of the Council of Economic Advisers and a multi-asset portfolio manager at BlackRock