Stephen King: Regime change happens in economies, too - and it's human beings who are to blame

Every so often, economists and policy makers think they've found out how to conduct macroeconomic policy correctly. At the end of the 19th century, the Gold Standard proved to be rather popular. There are those who still dream of its return. But there are also those that believe that the reintroduction of the Gold Standard after the First World War was an unmitigated disaster. The UK's decision to return to the Standard in 1925 certainly didn't help Winston Churchill's reputation. And America's decision to loosen monetary policy at the time in order to prevent the dollar and gold from rising against a profoundly weak sterling helped fuel the run up in stock prices that gave way to the Wall Street Crash.

Every so often, economists and policy makers think they've found out how to conduct macroeconomic policy correctly. At the end of the 19th century, the Gold Standard proved to be rather popular. There are those who still dream of its return. But there are also those that believe that the reintroduction of the Gold Standard after the First World War was an unmitigated disaster. The UK's decision to return to the Standard in 1925 certainly didn't help Winston Churchill's reputation. And America's decision to loosen monetary policy at the time in order to prevent the dollar and gold from rising against a profoundly weak sterling helped fuel the run up in stock prices that gave way to the Wall Street Crash.

In the 1950s and 1960s, the Gold Standard was re-born in a different guise: the Bretton Woods exchange rate system. This time, the dollar was the anchor of the system although, because the dollar was still convertible into gold at a fixed rate, the Gold Standard philosophy was still, implicitly, being embraced. But policy makers in the 1950s and 1960s thought they had learnt from the mistakes of earlier decades. They had their new tools of Keynesian demand management - particularly fiscal policy - that could be used to regulate the domestic economic cycle and ensure that unemployment would never again get out of hand. And, unlike the Gold Standard, the Bretton Woods system was designed to allow the occasional realignment of exchange rates.

In reality, though, the system was, to say the least, a little inflexible. Countries didn't mind the occasional revaluation - that was a sign of virility - but they certainly didn't like the idea of a sudden devaluation. Devaluation was an indignity. It indicated a lack of economic potency that doubtless brought back to leaders' minds their first few humiliating fumblings with the opposite sex when, even if the mind was willing, the body was limply less than able. As a result, currency adjustments didn't happen very often and countries simply protected their economic interests through the copious use of capital controls. Eventually, balance of payments disequilibria blew the system apart, leaving countries cast adrift without any kind of nominal anchor against inflation.

And so monetarism was born. As Bretton Woods reached its natural, if somewhat painful, conclusion, policy makers were already searching for other options. The proponents of monetarism launched a blistering attack on the conventional wisdoms that grew up in the 1950s and 1960s. Using the "fooling all the people all of the time" adage, they argued that policy makers simply couldn't lift output permanently above its long-term, supply-constrained, ceiling and that attempts to do so would lead only to higher inflation.

It didn't take long before the monetarists ended up with the strangest of bedfellows. As the late Lord Callaghan famously said in 1976: "We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy."

Of course, not everyone was seduced by monetarism - at least, not directly. Continental Europe preferred to construct a European version of Bretton Woods, with the Exchange Rate Mechanism being formed in 1979 following the earlier failure of the European Monetary Snake. Nevertheless, European countries eventually found themselves pursuing a "monetarism by proxy" policy via the Bundesbank, which emerged as the natural forerunner of the European Central Bank.

Monetarism itself eventually proved to be a disappointment. No one quite knew how to control the money supply and, even if they did, any confidence to be had in a predictable relationship between money supply and, say, nominal GDP was swiftly undermined. The truth is that monetarism over-simplified the ways in which an economy operated and, by doing so, allowed its own credibility slowly to be diminished.

Yet the legacy of monetarism is still with us. And so, for that matter, are the legacies of the Gold Standard and of Bretton Woods. All three approaches attempt to stabilise some sort of nominal objective - either the domestic rate of inflation or, via the exchange rate, the external rate of inflation. And most countries these days run their macroeconomic policies with either the internal or external price objective in mind. If it's the Bank of England or the European Central Bank, it's explicitly the internal objective, through the use of an inflation target. If it's the Federal Reserve, it's implicitly the internal objective: there's no specific inflation target but the control of inflation takes priority over the Federal Reserve's other objectives. And if it's the Chinese or other countries within a modern day dollar bloc, it's the external objective that matters.

The lesson from these earlier periods, though, is that regimes designed to achieve economic stability don't last. But why do they go wrong? Too often, it's because we refuse to behave in the manner the regime requires of us. In the 1920s, countries simply didn't - or couldn't - accept the rigours associated with a fixed currency: in the UK, the 1926 General Strike was a sign that the population simply didn't support the regime.

In the 1960s, the full employment "guarantee" led to a belief that wages and prices could be set at any level: the government could always hit its full employment target through the use of fiscal policy or, if push came to shove, devaluation. And, in the 1980s, the belief that monetarism worked led, in some cases, to a serious mis-reading of economic conditions: the most obvious example was Nigel Lawson's failure to spot the overheating of the UK economy at a time when inflation itself was, by earlier standards, relatively low.

So if economic regimes fail, what are the risks associated with today's arrangements? If there's a problem with inflation targeting, it lies with the inevitable loss of focus on the balance sheet positions of different sectors within an economy. I've often argued that the need to hit a precise inflation target will sometimes lead a central bank to cut interest rates to levels which encourage excessive borrowing in certain parts of an economy. In recent years, for example, unusually high levels of corporate saving both in the UK and the US (see charts) have led to excessive consumer borrowing, encouraged by low interest rates and rapid house price gains. Without that consumer borrowing, inflation might have been too low.

This approach leads to inconsistencies that simply cannot be sustained. Consumers borrow not only because interest rates are low but also because the anticipated gains on their main asset - their house - are high. If either of these changes, the willingness to borrow may be sharply curtailed. In the process, the economy as a whole simply runs out of puff. And, by doing so, once again inflation is in danger of being too low rather than too high.

I'm not sure what will replace inflation targeting. History, though, suggests that the search for successful macroeconomic regimes is seemingly endless. All regimes break down because we collectively seem to spot their weaknesses and behave in ways that undermine the ambitions of our policymakers. In the 1920s, it was resistance to real exchange rate adjustment. In the 1960s and 1970s, it was a willingness to negotiate silly wage increases. And, at the turn of the century, it may be our willingness to take on absurd amounts of debt, in the false belief that inflation targeting regimes have made our assets - dare I say it - as safe as houses.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com