Although it leaves interest rates at a historic low, there was much that was familiar about last week’s monetary stimulus from the Bank of England. As well as the interest rate cut, the governor, Mark Carney, also announced a further £60bn of quantitative easing on top of the £435bn the Bank has already injected into the economy.
What’s new, however, is an emerging political consensus that in the face of weak growth, we also urgently need a loosening of fiscal policy to complement these monetary levers. In stark contrast to the fiscal hawkery of George Osborne, Philip Hammond has signalled his willingness to deviate from his predecessor’s tough spending targets. This potentially marks a highly significant and long-overdue shift in the government’s macroeconomic approach.
It cannot come too soon. In the wake of the European referendum vote, the economy’s warning lights are blinking in earnest. Business and consumer confidence is down and the Bank of England has lowered its growth forecast for 2017 to just 0.8% and predicted a rise in unemployment and inflation.
Some of those who supported Brexit accuse economists of irresponsibly talking the economy down, of looking for negative signs where they do not truly exist. This is fantasy economics: while we do not yet have firm data on economic output post-Brexit, forecasters are drawing on reliable indicators that have always been taken seriously. Every reputable forecaster has predicted lower growth as a result of Brexit. The question Hammond and Carney are grappling with is not whether the economic adjustment to a post-Brexit world will be painful, but how painful it will be. While the rate cut and further round of quantitative easing may provide some relief, there are serious risks with relying too heavily on monetary policy as a salve.
First, it is unclear how much an impact a cut in the rate of just a quarter per cent will have. Since 1975, the bank has cut rates by five percentage points on average during monetary loosening cycles. With interest rates barely hovering above zero, there is only so much action it can take. Second, monetary stimulus risks worsening economic inequality. Quantitative easing pushes up asset prices and cutting interest rates pushes up inflation. Rising prices are likely to have an impact on low-income households the most.
Hammond must learn from Osborne’s mistakes. Osborne’s stubborn commitment to austerity meant he relied far too heavily on action from the Bank of England to boost the economy in the short term, at great cost. And he took his eye off improving long-term productivity – output per hour worked, one of the key engines of economic growth – altogether.
He put too much emphasis on deregulation and too little on improving incentives for businesses to invest and innovate. Subsidies for growth industries such as low carbon energy were slashed, R&D grants were converted to loans and controversial but critical infrastructure projects such as HS2 and additional runway capacity were kicked into the long grass.
Productivity growth fell sharply after the financial crisis and has never recovered. Productivity in Britain is now 18 percentage points lower than the G7 average. This holds back wage growth and living standards. Hammond urgently needs to change course. We need to see an increase in government spending to support the Bank’s measures from last week, aimed at boosting short-term demand. And, just as critically, Hammond needs to prioritise improving the long-term capacity and productivity of the economy, which will undoubtedly be affected for the worse by Brexit, and the uncertainty about Britain’s trading relationships with the rest of the world.
This will require Hammond to reverse some of his predecessor’s policies in his first autumn statement. There are a number of options to boost short-term demand. But the strongest case is for a set of policies that offsets the negative impact of quantitative easing on inequality. Hammond should put a stop to Osborne’s freeze on working-age benefits and reverse his cuts to universal credit. This will have a double benefit. Not only will it boost the economy by putting extra cash in the hands of hard-up families more likely to spend it, but it will offset some of the particularly pernicious impact rising prices will have on the poorest households.
But in 2016, it is much clearer than in 2008 that our economic woes go much further than lacklustre demand. Hammond needs to take advantage of the fact that government borrowing costs are now at a historic low and invest in measures designed to improve Britain’s long-term competitiveness. This must mean much greater investment in strategic infrastructure: transport, energy and broadband. Rather than sticking to Osborne’s across-the-board cut in the corporate tax rate, a move that benefits only profitable businesses whether or not they are investing or growing, Hammond should invest in boosting investment allowances, R&D grants and in expanding access to finance for high growth-potential businesses. He should shift course from Osborne’s strategy of focusing on the mass expansion of poor-quality apprenticeships for the over-25s and instead focus spending more on higher-level apprenticeships for the under-25s and on improving other forms of vocational and technical education.
Labour could play an important role in holding the Treasury to account. But to do so, it will need to engage with the detail of economic policy rather than throwing out ever-larger numbers for what it would be investing were it in government. To do the latter is to fall into a trap. Without giving any detail on what vast sums of cash would be spent, it reinforces the idea of Labour’s fiscal irresponsibility and it ignores the fact that quality is more important than quantity when it comes to measures to improve productivity.
The British economy has paid a high price for Osborne’s stubborn refusal to deviate from his austerity agenda. Hammond’s signalled change in approach could prove to be one of the most significant macroeconomic policy shifts in recent years and is to be welcomed. But it is too soon to rejoice at the Conservative party’s apparent conversion from its dangerous fiscal hawkery. There is still time for them to make the same mistakes.
