The UK is in recession. The estimate of a decline of 0.5 per cent in the third quarter, after stagnation in the second quarter, ends the debate. This is the beginning of a lengthy and, quite possibly, deep recession. How long and how deep? The answer depends on what the authorities do.
This is the moment at which David Blanchflower, an external member of the monetary policy committee and professor of economics at Dartmouth College in the US, is entitled to say “I told you so”. Prof Blanchflower has voted for a cut on every occasion since October 2007. In retrospect, he was right to push strongly in this direction, usually against majority opinion on the MPC. His views on the economy deserve respect now.
Prof Blanchflower laid them out this week in aspeech delivered, quite appropriately, at Keynes College, University of Kent*. In this, to his credit, he avoids crowing too loudly. His principal points are that, first, the UK economy is likely to follow a downward path similar to that of the US; second, the risks of a sustained rise in inflationary expectations are non-existent; and, finally, the consequences of “constrained credit conditions” on an economy with rapidly declining asset prices are likely to prove devastating.
Thursday’s report from Nationwide that house prices dropped 14.6 per cent in the year to October underlines the last danger. Prof Blanchflower also relies on his experience as a labour economist to argue that the risks of a pass-through of higher prices of imports to price expectations were always small. Now, with collapsing commodity prices and the onset of the recession, the danger is falling prices, instead. Despite unprecedented recent intervention by governments, led by the UK, further tightening of credit has occurred. Even Charles Bean, deputy governor of the Bank of England for monetary policy, describes what is happening as “possibly the largest financial crisis of its kind in human history”.
So what is to be done? The starting point has to be monetary policy. My increasingly strong view is that the MPC must, at this juncture, rethink its stance from scratch. It cannot make sense for US rates to be at 1 per cent, while the UK’s are 4.5 per cent. In present circumstances, I would like to see UK rates down to 2.5 per cent.
Obviously, there is some risk of a further sterling collapse. In current circumstances, this has to be ignored. In fact, determined action may strengthen sterling, not weaken it. In his Mais lecture on Wednesday, Alistair Darling, the chancellor of the exchequer, helpfully gave the MPC the green light to ignore short-term inflation overshoots. He went out of his way, instead, to stress that the Bank enjoys “discretion about the horizon over which inflation is brought back to target”.**
So long as the Bank enjoys room to cut interest rates, it seems unnecessary to take any large discretionary fiscal actions, particularly since the fiscal position is sure to look ghastly. The chancellor states rightly that “to increase borrowing in a downturn is sensible”. He is right, too, to argue that the UK’s stock of debt is low by the standards of large high-income countries. But the deficits are large and sure to become far larger. Against this background, the absence of a clear strategy for returning to a more sustainable position in the medium term is a worry. Such a strategy is promised for the forthcoming pre-Budget report. It must be good. The UK cannot presume indefinitely on the patience of its creditors.
Both the Bank and the Treasury will also need to examine what they would do if official interest rates fell to zero. This looks highly likely for the US and is conceivable for the UK. That would be the moment for “helicopter money”, with cash sprayed around like confetti.
More pressing than discretionary fiscal action is getting the banks to lend. This is why they have been helped, in the first place. Unfortunately, their marginal cost of funds, plus required margins, is above rates they are expected to charge. This is why sharp cuts in official intervention rates are vital. Beyond that, the government may be forced to encourage direct lending by the Bank of England to large non-financial corporations or to offer temporary partial guarantees of loans to small businesses or households. The government must also understand that it may have to recapitalise the banks again. What is being raised so far is some 1 per cent of the combined assets of the principal banks. As the crisis unfolds, the needs could prove far bigger than that.
These are historic times. Given the origins of the crisis in the collapse of an asset price bubble and consequent disintegration of the credit mechanism, the way the recession will evolve remains obscure. The authorities must now focus all their attention on reducing its likely scale. But then they must ask themselves how such a gigantic mess occurred. On this the Mais lecture is silent. Yet every important safeguard failed. A government in power since 1997 cannot ignore this grim truth forever.