Economic Commentary: Time to rethink the 1980s consensus

Ever since the mid-1970s, governments in Britain, and indeed in most of Europe, have consistently maintained that macro-economic policy - or more particularly demand management through monetary and fiscal means - should be aimed solely at the control of inflation. It is time to reconsider this virtually universal European consensus.

Until the early 1970s, in the post-war heyday of Keynesian economics, governments used demand management to control output and unemployment, with inflation periodically attacked through incomes policy. But the monetarist intellectual revolution of the early 1970s, and the widespread appearance of double- digit inflation in the developed economies, took its toll on this old consensus.

The replacement consensus of the 1980s reached its high-water mark with Nigel Lawson's Mais Lecture in 1985, which explained that demand management in future would be aimed only at providing low inflation, with growth and unemployment being left for supply-side policies. But virtually all government economic statements after James Callaghan's watershed speech to the Labour Party Conference in 1976 ('Comrades, I tell you in all candour that governments can no longer spend their way out of recession') come from precisely the same intellectual stable.

Essentially, the theoretical underpinning for the 1980's consensus assumes that some form of market clearing mechanism exists in the economy such that there is a unique unemployment rate consistent with stable inflation. If unemployment is cut below this 'natural' rate, then inflation will not just rise but will accelerate until unemployment reverts to its starting point. This implies that governments will not be able to influence either output or employment over the medium term, so they might as well focus on inflation. Now most theoretical macro-economic models, both monetarist and non- monetarist, produce this result.

MODERN DICHOTOMY

As long as governments believe in what I will call the 'modern dichotomy' between output and inflation (though it is not clear how different it really is from the 19th-century 'classical dichotomy' that was attacked by Keynes in the 1930s), then macro-economic policy is relegated largely to a matter of technique. Since the ultimate objective of low inflation is pre-determined, there is no question of having to mix output and inflation objectives in any complicated way.

This still leaves considerable room for debate about the appropriate techniques for controlling inflation, and on this issue there has indeed been much variation in the past 20 years. Domestic monetary targets, the ERM, and the pragmatic mix of monetary and exchange rate objectives used by Nigel Lawson are all examples of different ways of forcing a 'nominal straitjacket' onto the economy.

These manoeuvrings have been widely criticised by analysts as betraying a deep inconsistency in economic management, but lying beneath each twist and turn has been a coherent approach, based on the modern dichotomy. Any inconsistency was second order, merely about the means of manipulating a model on which everyone basically agreed.

This may all seem highly abstract, but in fact it has had crucial practical consequences. The most important is that it has ruled out of order any debate about the trade-off between unemployment and inflation. Since the conventional wisdom says that unemployment is pre-determined by the supply side of the economy, it has made no sense for anyone respectable to argue that a little more inflation might be a good thing; by definition, there can be no long-term employment gain to set against the extra inflation. This is why this government has been able to navigate through two exceptionally deep recessions while claiming that the first priority must always be to get inflation down. It also explains why the Opposition has barely been able to lay an intellectual glove on them.

This is not all. Because the modern dichotomy contends that monetary policy should be aimed only at the technical matter of controlling inflation, it becomes possible to argue that the whole process should be taken out of political control, and that some form of outside agency should be found to impose the nominal straitjacket on the economy. After all, since no sane person can believe in higher rather than lower inflation, why should the technical means by which inflation is controlled be the subject of vulgar political dispute? Surely it should be delegated to some form of 'auto-pilot', like an independent central bank or, in the case of the ERM, to the Bundesbank.

But all of this logic is only as powerful as the theoretical model upon which the entire edifice rests. And recent events have not been kind to this model. The longer the current recession has dragged on, the more difficult it has been to argue that the costs of any programme of disinflation are only temporary. It has seemed increasingly likely that the recession was not only involving a temporary deviation in output below its trend, but was permanently moving its trend lower.

LOST MOTIVATION

This can happen in several ways. Increases in unemployment can become permanent as the jobless lose the ability or motivation to re-enter the labour force. Declines in investment can reduce the stock of plant and machinery. And the size of the manufacturing sector can shrink, making future demand growth unsupportable without a balance of payments crisis.

Many would now claim that one or more of these effects (they are called 'hysteresis effects' in economic theory) explains why unemployment stayed so high during the economic recovery of the late 1980s, and it is possible that the same effects are at work again now. If so, then the reduction in inflation in the past two years may have been won at the cost of a permanent loss of output and jobs, which is the very opposite of what the modern dichotomy would imply.

It will be fascinating to watch in the next few years whether the modern dichotomy can remain the benchmark model for government policy in the UK and the rest of Europe. Admittedly, there is not much sign yet of its demise on the Continent, where countries like France and Spain still seem eager to delegate their monetary policy to a mixture of the ERM and newly created independent central banks, which will shortly be established in both countries. Perhaps it is not too surprising that this should be the case in economies which have not yet fallen into a deep recession in the early 1990s, though things could change as the European recession begins to bite.

But it could happen more dramatically in Britain. Although the Treasury officially continues to insist that low inflation remains the only objective of government policy, the Prime Minister now speaks as if the regeneration of output growth is his prime target. And there is an increasing consensus in the public debate that further declines in inflation are not worth the sacrifice of one extra job.

If this mood solidifies, the chances of winning a consensus for rejoining the ERM or creating an independent Bank of England will be very remote. That will drive an ever-widening wedge between the dominant economic philosophy in Britain and in the rest of Europe. It may even open the way for the first real macro-economic debate between British political parties for over a decade.