Ben Southwood is Head of Policy at the Adam Smith Institute.
Earlier this week, Professor Scott Sumner of Bentley University gave the Adam Smith Institute’s annual Adam Smith Lecture in Westminster. He called for inflation targeting to be scrapped and replaced with a mandate for the Bank of England to target total spending instead. Professor Sumner may be the most important economist you’ve never heard of – and here’s why he matters.
Between 1993 and 2008, the Bank of England’s policy of flexibly targeting inflation (annual 2 per cent growth in the consumer price index), produced a stable economy. Aggregate demand (total spending in the economy) ticked along, growing 5.5 per cent on average each year, and this translated into steady improvement in the amount each person produced, which in turn translated into extra take-home pay, extra money for government projects, and higher overall living standards. This went on for 15 years, across the developed world, and deserves its name “The Great Moderation”.
Stable spending is important because of unexpected changes in spending cause recessions. Between 2006 and 2007 nearly all of the USA’s housing bubble popped, and employment in construction industries crashed. But because the path of total spending remained stable, all this meant was a redistribution of workers from construction to other activities, with total employment seeing barely any change. However, when total spending fell during 2008 unemployment rapidly rose toward 10 per cent. Relatively free market economies are excellent at dealing with creative destruction in particular sectors as long as the economy is steady overall.
Between the middle of 2008 and today, annual consumer price inflation has reached 5.2 per cent twice, and remained above target for 47 consecutive months. However, even though the BoE allowed inflation to go way above target, total spending in the economy was anaemic. Not only did it fail to make up for the sharp deviation from the long pre-recession trend (for the first time in modern British history), it failed even to make up the pre-recession rate. It climbed up to 5 per cent directly after the recession, but crashed back, almost to zero in 2013, and even now is growing under 5 per cent per year.
CPI targeting is policy because it’s believed that a) the public understand it, and b) it has a stable link with total spending. But under half of the population can tell you who sets the base interest rate, and the public regularly guess that inflation is double what it really is. And as for the stable link, we have seen that when it most matters – when the economy is buffeted by huge financial and commodity shocks – CPI targeting fails to stabilise spending. Even with stable spending there would have been a reduction in productivity, pay and living standards, but it would have been muted substantially, while there would have been no need for unemployment and underemployment of labour and capital.
It seems clear, then, that neither of these explanations are convincing reasons to stick to CPI targeting. It doesn’t do to argue that central banks (sometimes) cannot control total spending because not only is there a huge and growing academic literature refuting that, as well as a few natural experiments (the Eurozone on the one side, Japan on the other), but controlling total spending is the way that central banks are supposed to be able to control consumer price inflation!
What’s strange is that the Bank of England surely knows all this, and it may even privately accept some of the concerns I’ve raised. It’s true it doesn’t set its own policy regime, but the people at the Treasury who do are extremely smart and knowledgeable as well. Professor Sumner has a theory that central bankers follow the consensus opinion of elite macroeconomists. So I can only hope that they listen to people like Michael Woodford, basically the world’s most influential macroeconomist, who has literally written the book on monetary theory, and who, in a paper at the end of last year, showed that nominal GDP targets (i.e. total spending targets) can get around both the problem of supply shocks and the problem that interest rates cannot go below zero.
Monetary policy may seem dry, but it has the power to put economies on life support, or if done correctly, bring them back to life.