Stephen King: A more cautious approach to public finances will help to limit future risks

Running the economy is no easy task. Sometimes, I get the impression that policymakers think there is some magic formula which, once unlocked, will allow strong growth, low inflation and full employment to continue indefinitely. But for chancellors and governors past, present and future, there is no simple answer.

Under the last Conservative government, an inflation target was introduced. Inflation had been the main bugbear of the UK economy for many years and there was, understandably, a strong sense that its removal would, once and for all, put the UK economy on the straight and narrow. Following their election in 1997, Labour's leaders cemented Britain's anti-inflation credentials by making the Bank of England independent, an apparently revolutionary idea even though other countries had lived with independent central banks for many a year.

With monetary policy now de-politicised, it was easy to be seduced by the idea that there would be "no more boom and bust". Certainly, there was a sense that the control of inflation would unlock the secrets of economic stability. In a speech to the Society of Business Economists in 2007, Mervyn King, the Governor of the Bank of England, said "the main challenge facing the MPC is to keep doing whatever is necessary to keep inflation on track to meet the target". The subtext of this statement is obvious: if inflation is kept under control, economic instability should be kept to a minimum. Given what followed, it's not so obvious that the achievement of price stability, on its own, is quite so economically-rewarding after all.

With the next general election looming, we may find ourselves with another policy wheeze potentially as revolutionary, at least to UK eyes, as the decision to grant the Bank of England its independence.

The Conservatives are promising to create an Office for Budget Responsibility. It won't have quite the same policy-setting powers enjoyed by the Bank of England but, staffed by a team of noted fiscal experts, it would be duty-bound to pass judgement on a government's fiscal plans, scrutinising the assumptions and projections which make up any fiscal decision.

This seems a sensible idea. Alongside the excessive borrowing of households and the excessive lending of banks, the other lesson from the crisis is that the Government, too, borrowed excessively. I'm not complaining about the necessary Keynesian fiscal stimulus, which was delivered as the crisis unfolded. The inappropriate fiscal deterioration happened earlier. The Treasury constantly redefined the economic cycle, making the so-called fiscal rules as tough as jelly. The Chancellor chose not to intervene too heavily in the City because big bonuses brought in big tax revenues. After all, without those bumper City tax revenues and increased amounts of government borrowing, Labour's cherished public spending projects would never have got off the ground.

Had an independent fiscal body been able to scrutinise the Government's arithmetic, perhaps we'd now find ourselves in a more favourable fiscal position, with less need to start slashing public spending. Nothing, however, is guaranteed. The Institute for Fiscal Studies' 2007 Green Budget noted that "by announcing £6bn of new tax increases and pencilling in an £8bn cut in public spending since the 2005 election, the Chancellor has followed our advice from earlier Green Budgets...we see no need for further tax increases at present, as long as he is able to stick to his PBR spending projections....If history is any guide, at some point the Treasury's fortunes as a fiscal forecaster will take a turn for the better." All fine and dandy but, given subsequent events, mostly inaccurate, even though the IFS is full to the rafters with fiscal experts.

Fiscal sustainability depends on an extraordinarily uncertain future path for the economy. If that path suddenly veers off in an unexpected direction, the fiscal outlook can alter dramatically. During the good times, when revenues are plump and social security benefits are low, governments look heroically prudent, even when they're not delivering budget surpluses year-after-year. During the bad times, governments simply look fiscally incompetent (and incontinent).

Even with an Office for Budget Responsibility, then, the chances of getting fiscal policy right may not be particularly great. Fiscal plans depend on projections about the future path of the economy and those projections, in turn, depend on knowing where the economy is within the economic cycle. All forecasters struggle to provide answers. The Bank of England may be independent of political influence, for example, but its central projections of economic growth, and the extremes on either side, proved particularly wayward in the first half of 2007. Back then, the worst that was likely to happen to the UK economy was a slowdown in growth to a little under 1 per cent in 2009. It now looks as though the economy will shrink between 4 and 5 per cent. You don't see forecasting errors much bigger than that.

The Bank of England was not the only institution that failed to see the scale of the crisis about to unfold. The opening sentences of the IMF's Spring 2007 World Economic Outlook offered the following thoughts: "Notwithstanding the recent bout of financial volatility, the world economy still looks well set for continued robust growth in 2007 and 2008. While the US economy has slowed more than was expected earlier, spillovers have been limited.... Overall risks to the outlook seem less threatening than six months ago but remain weighted on the downside, with concerns increasing about financial risks." Put another way, while the IMF was aware of unease within the financial system, it was never in a position to be able to forecast what was about to unfold.

Creating apolitical institutions is certainly a useful way of removing political bias from policy decisions. But all institutions, whether or not they have particular political affiliations, share the same basic problem. The future is uncertain. Economists come up with forecasts and projections but, for the most part, these assume business as usual. Business, however, is sometimes distinctly unusual. And those economists who do spot the unusual are often treated as crazed mavericks. Consensus hugging is a comfortable hobby.

There are some important lessons to be drawn from this episode. Independence from political interference does not guarantee economic stability. Central bankers, like the rest of us, are fallible. The future is not easy to predict. There are no "quick institutional fixes" to solve the problem.

The complacent answer is simply say that "stuff happens" or, to be more precisely Marxist, that capitalist economies always have been, and always will be, unstable. I wonder, however, whether more can be done. Politicians and policymakers too often take the good times for granted, often in the mistaken belief that their wise policies are part of the reason behind rapidly-rising incomes. A casual look through history, however, suggests recessions are unfortunate, infrequent, but persistent features of the economic landscape. Good public policy should ask two questions. First, what strains and stresses within the economic system might be the cause of the next recession? Second, what might policymakers do to insure against that risk. For both the US and the UK, at least part of the answer would have been a much more cautious approach to public finances in the mid-years of this decade.