Many critics of the coalition government’s “Plan A” argue that it should deviate from deficit reduction plans to instead stimulate growth via additional infrastructure spending. Recent advocates of this view include the authors of a paper from the National Institute of Economic and Social Research and the LSE’s John van Reenen, writing on this site.
But government spending is not the most effective way to return the economy to growth. When coupled with the right regulatory reforms, regulating the supply of money is still our best bet.
The first point to make about calls for infrastructure spending is that it is not really a critique of Plan A at all. Deficit reduction plans do not generally control infrastructure spending. It is justified by the long-term needs of the economy and considered to be largely self-financing because it permits additional output, which will in turn generate further revenue.
The main constraint on infrastructure spending is the overall planning and approval process. Thus the plans for Heathrow and other airport expansions are not held up by Plan A but by an apparently endless dispute between the interested parties.
In the same spirit, no one would argue for an open-ended commitment to spend on any suggested infrastructure project. The Chinese government has recently supplied us with an object lesson in why this would be dangerous. In response to the 2008 crisis, it gave orders to the state-owned banks to lend aggressively for any infrastructure investment plans produced by state firms and regional governments. This has produced substantial excess capacity, including a lot of unused housing stock and “ghost towns”, and many of these loans may prove unrepayable. Policies to generate large unneeded infrastructure spending are potentially destabilising to the economy.
I take it that none of the critics want this sort of policy. John van Reenen stresses the need for the LSE growth agenda with its supply-side reforms; this is really not controversial among economists. The problem, as always with the supply-side, is in the organisation of the political process to deliver these reforms. This is a difficult task at the best of times, and the fact we have a coalition government makes agreeing on anything politically even more challenging.
However, many critics (Olivier Blanchard, IMF chief economist, would be one) argue for a different approach. They believe that public spending should be generally increased or taxes cut when in a recession, and vice versa - what the IMF euphemistically calls “support for growth”.
But there are two main difficulties in using fiscal policy as a tool for economic management. First, it is slow to act because of the lags in both getting the policy agreed and then in implementing it.
Second, and more seriously, it cuts across medium-term needs: we undertake spending because it is required for recognised durable reasons, and we levy taxes as part of a framework within which businesses and people can plan. If we vary from this programme, we both undercut these needs and we also make it hard to adhere to the long-term plan.
For example, if spending is increased it is hard to reverse this decision for political reasons; tax cuts are equally hard to undo. When the time comes to reverse the action, people object and politicians come under pressure.
In the context of Plan A, it would be all too easy for no progress to be made at all if cuts to programmes were not made systematically according to a steady programme. Imagine if they were put off now, only to be “implemented” suddenly “when the recession was over”; one can easily see why any Treasury would worry that they would never take place at all.
Where’s the credit?
So, if fiscal policy cannot rescue the economy, what should we do?
It is widely argued by advocates of stimulus spending that monetary policy cannot be effective at “the zero bound” (where interest rates are virtually zero, as they are now) because rates cannot be cut any further. This is not the case.
What we now know is that while official interest rates paid on government paper are indeed exceedingly low, interest rates and associated charges for private credit are as high as ever. In fact the complaint of small businesses is that they can barely get credit at all.
To combat this, the Bank of England has opted for “Quantitative Easing” (QE) to increase money supply and bank credit. In principle, increasing the supply of bank reserves ought to have an effect in increasing bank credit and deposits via the usual “money multiplier” (the ratio of total money supply to currency plus bank reserves).
However, QE has been a huge disappointment in this respect: as reserves have been injected, so regulation of “risky credit” by the banks has been greatly intensified, and the money multiplier has collapsed. The latest round of international banking regulations, known as Basel III, means banks now have to keep a higher ratio of capital to risk-weighted assets. Following the Vickers Report, the UK has actually strengthened regulation beyond the Basel requirements, asking for higher capital ratios, and a ringfencing of investment and consumer banking. This happened at just the time when QE has been deployed; the one has neutralised the other and the banks have not expanded credit.
In the UK, a variety of new schemes have attempted to resolve the clash: so far funding for Lending Schemes 1 and 2, giving banks further incentives to lend to small businesses, and now also the mortgage guarantee scheme.
But these attempts to loosen regulation by the back door are not enough; we must entirely rethink banking regulation and overall monetary policy.
Personally I would emphasise a return to more traditional monetary policy, targeting both inflation and money supply. Then banking regulation could be returned to a more general microeconomic aim of preventing outright bad practice. Current regulations mean marginal capital-raising needs are discouraging banks from lending to small and medium enterprises. With different regulations, we would already see QE having its intended effect.
It remains the case that, if we could remove these distortions, monetary policy is the fastest and most effective way to combat the business cycle. We should not undermine the process of getting our public accounts back into order through poorly founded demands for increased spending.