Stephen King: Economists go back to Victorian values

It's funny how the controversial gradually gets sucked into the mainstream. You only have to think about the history of pop music to recognise that the boundaries of acceptability gradually shift over time.

Lucy in the Sky with Diamonds was banned when it was first released, yet no one today seems too bothered about John Lennon's homage to hallucination. Frankie Goes to Hollywood's Relax was eventually banned when Mike Read, a BBC Radio 1 DJ, read the lyrics and realised that Frankie's idea of relaxation was more than just a nice cup of tea followed by an afternoon nap. Today, though, Frankie offers no more than a bit of 1980s nostalgia.

And, the other day, I noticed a poster on the Underground advertising a "greatest hits" compilation from the Stranglers as a possible gift for Father's Day. I have nothing against the Stranglers - in fact, I rather like them - but there's something slightly odd about children buying their fathers an album with songs about the perverted thoughts of dirty men ("Peaches") and, if the lyrics mean anything at all, the use of heroin ("Golden Brown").

The same is true in economics. I'm not suggesting that all economists are drug abusers - even if their forecasting records suggest that, at times, they really must be smoking something - but once-controversial views become acceptable, and once-acceptable views become laughable.

No one these days would advocate a full-employment policy as the centrepiece of a macroeconomic strategy but that's what everyone used to do in the 1950s and 1960s. Everyone these days believes in free and open markets, but that certainly wasn't the view 30 years ago. After all, it was only in 1979 that the UK controversially abolished exchange controls and, throughout the 1980s and early 1990s, many European countries persisted with the use of capital controls of one sort or another.

Put another way, we're all children of our times. Those of us in our forties and fifties are obsessed with inflation because inflation was the formative economic experience of our childhood and teenage years. Those policymakers who were in charge in the 1950s and 1960s had the Great Depression as their formative economic experience: for them, Keynes was the answer, even if many of his ideas are not considered mainstream today. And, back then, the main opposition to Keynes came from Germany, where hyper-inflation, not depression, had been the formative experience. The Bundesbank's anti-inflation credentials were no accident.

Economic ideas evolve. What may seem mainstream today might seem oddly quirky in a few years' time. Will we get to a point when the commitment to open markets and to inflation targeting will seem laughable? Will we reach a stage when globalisation is forced into reverse? Or a period where the toolkits designed to ensure overall macroeconomic stability begin to fail us?

Because economics is a science - or, at the very least, because it uses scientific method - it might seem reasonable to assume that we should, over time, get better at running economies. Yet the long-run evidence does not provide a huge amount of support for this assertion. The Victorians and Edwardians thought they had discovered the secret of economic success and, for a while, they had. Yet the period that followed - from the beginning of the First World War to the end of the Second World War - was a period of broad economic failure: unemployment, inflation, protectionism, stagnation. The 1950s and 1960s offered a new alternative: a mixture of laissez-faire economics and state planning, a view that governments should control the economic "commanding heights" and a perception that, at last, Keynesian governments had founds the means by which the extremes of capitalism - in the form of nasty output shocks - could be avoided through active monetary and fiscal policy. These views, of course, came crashing down as inflationary pressures began to build in the late 1960s and then exploded in the 1970s.

So where are we now? In many ways, we've gone back to the late 19th century. Obviously sensibilities have changed - I doubt that Relax would have been popular with the Victorians, although their penchant for opium suggests that the Stranglers might have enjoyed a cult following - but the economic philosophies that we see today - liberal markets and a belief that fast growth is the best way to overcome poverty - are a throwback to those times. Meanwhile, modern-day inflation targeting is, in many ways, little different to the sound money practices followed under the Gold Standard.

To recognise this is also, perhaps, a useful starting point in thinking about the challenges to the latest version of the status quo. Many still believe in the Gold Standard, but arguably the monetary regimes that existed during that period were insufficiently flexible to deal with the productivity shocks of the time.

A similar argument can be made today. Faced with rapidly improving productivity, perhaps prices should fall relative to wages, profits and nominal interest rates. This kind of "good deflation" might have taken place in the second half of the 1990s had central bankers allowed it to happen: its prevention, though, may have left real, inflation-adjusted, interest rates too low, paving the way for bubbles in equities and, more recently, housing.

Faced with rapidly rising energy prices, central bankers have, more recently, become anxious about higher inflation. But what if the rise in prices isn't matched by a rise in wages? If so, perhaps price gains should be regarded not so much as an indicator of ongoing inflationary pressures but, rather, as a useful way of squeezing real incomes and, therefore, of reducing spending power: after all, higher energy prices should, other things equal, make energy-consuming nations worse off. By raising interest rates aggressively, might the squeeze in incomes simply be amplified, leading to a more pronounced downturn?

And how about liberal markets? Why did nations, their people and their policymakers lose faith with liberal markets at the turn of the 20th century? If countries were so rich, how did we end up with the rise of Communism, Fascism and Nationalism?

This is hardly the place to start a lengthy thesis on the collapse of the liberal order of the late 19th century. What's important to stress, though, is that the old liberal order wasn't true for all time: it did not represent the end of history. And nor will the new liberal order. There are some obvious parallels. Like the late 19th century, newly economically franchised nations are vying for a more important role in world affairs and greater access to scarce raw materials. The "old guard" is worried about job losses. And while the new liberalism has led to the biggest single period of poverty reduction in the economic history of the world - take a look at the growth rates of China and India to see why - one side-effect may have been the widening of income disparities within countries: the US and China are good examples. The rise in protectionist pressures in recent years is one knee-jerk reaction to this process: an idea that seemingly had its day seems to be returning to political acceptability.

To preserve the success of recent years, more attention needs to be paid to the income and wealth distribution consequences of globalisation within countries, and more thinking is required about appropriate monetary regimes during periods of broad price stability. It's not just in pop music that ideas change and, it's not just in pop music that ideas can sometimes change for the worse: let's hope that the world economy isn't heading towards a Bay City Rollers phase.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com