28 August 2011

John Llewellyn: Our economic future has already been decided by the past

Writing for the Observer, John Llewellyn says that although events move fast these days, economies also beat to a slower rhythm. Every decade since the second world war has had its distinctive characteristics, and each has served to shape its successor.

The 1950s were shaped by the re-integration of soldiers into civilian employment, reconstruction, and a more systematic management of demand. Exchange rates had been pegged. International trade grew rapidly. Public debt fell markedly. Economic growth got under way.

The 1960s seemed a golden era. The OECD was formed amid optimism that a new US-led world of free trade and capital movements would be much better than the old one. Animal spirits were buoyant. OECD economies grew fast: 5.3 per cent per year on average.

But problems were building. With policy focused on demand management, prices were drifting higher: inflation doubled in the OECD over the decade. And inflation differentials were causing currencies to become misaligned. Sterling had to be devalued in 1967 by a seemingly massive 14.3 per cent.

The 1970s, very much the product of the decades that preceded it, were a game-changer. Differentials in international competitiveness had become so serious that, in 1971, the US suspended gold convertibility: the fixed exchange rate system was dead. In 1973-74, the price of oil quadrupled. Accommodating fiscal and monetary policies, in combination with wage indexation, took inflation into double digits. Deficits soared, while real interest rates became strongly negative.

By the time of the second great oil shock, in 1978-79, policymakers had come to realise that they needed to reappraise their policies fundamentally: inflation control became the priority. Fiscal and monetary policies were tightened, the exact opposite of the earlier response. OECD growth slowed, averaging 3.7 per cent per year.

The 1980s opened with real interest rates and unemployment soaring and output and inflation slowing. More fundamentally, however, they brought the realisation that OECD economies had a deeper problem: they had become unable to adjust efficiently to the changes in demand and production that the high price of energy required. Attention had to be paid not only to aggregate demand, but also to supply.

In 1982, under German exhortation, OECD countries began to see structural policies as the solution to supply-side rigidity. Liberalisation was on its way. But liberalisation went beyond the economic: Paul Volcker, the Fed chairman who had brought inflation down, was fired, and anti-regulation Alan Greenspan was appointed. OECD growth slowed yet further, to 2.8 per cent.

The economic liberalisation begun in the 1980s proved constructive: it had been well thought through, and probably helped in the absorption of two shocks soon to hit: the IT revolution and the rise of China. But financial liberalisation, by contrast, had not been anything like fully thought through.

The 1990s saw the institutionalising of inflation targeting, and inflation, indeed, continued to slow. Financial liberalisation and deregulation, however, gathered pace. Faith was placed, not least by chairman Greenspan, in the supposed ability of markets to self-regulate. Credit and leverage grew rapidly. Stock markets boomed. And the decade produced its share of crises: Europe's exchange rate mechanism in 1992; the Asian blow-ups of 1997; and the Russian default of 1998. OECD growth averaged 2.5 per cent over the decade.

The 2000s saw matters come to a head. Financial innovation pushed on to the point where, for example, more than half the world's debt securities were being deemed "risk-free" by the ratings agencies. Inflation-targeting central banks not only disregarded asset-price inflation, but cut rates to limit corrections in financial markets, such as the dotcom bust in 2001. OECD GDP growth between 2000 and 2007 averaged just 2.6 per cent.

The rest, as they say, is history: history that in 2008 brought the largest crisis since the 1930s. The response – massive fiscal and monetary expansion – staved off the worst, and now most western economies seem to be experiencing a recovery, of sorts.

But don't hold your breath. To the extent that the future continues to be determined by the past, the west is in for a tough decade. Deleveraging, by households and governments, is almost certain to continue. Financial regulation will be tight. Capital will probably flow less freely. OECD growth has slowed every decade since the 1960s: why should that change now?

Emerging markets may continue to grow briskly, if they can come to depend more on domestic demand and less on exports. However, they are nowhere near large enough yet to drive the much larger economies of the US and Europe.

All is not a counsel of despair. On balance, post-war economic policy has done much more good than harm. But there are limits to what more can be done. Unless more or less everything suggested by economic history turns out to be bunk, the die for the coming decade would seem, in important part, already to have been cast.

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