Sunday, November 30, 2008

A Nobel Prize for Cameron?

The Conservative Party's official stance on the economic downturn is that "It is now vital that we restore stability to the British economy and responsibility to our public finances. Unfortunately, Brown's economic mismanagement means we can’t offer big upfront net tax cuts like some other countries" (party website: http://www.conservatives.com/Policy/Where_we_stand/Economy.aspx). So, no intervention to stimulate demand, except hoping the Bank of England will quickly cut interest rates.

Nobel Prize-winning economist Paul Krugman sees things rather differently: because of the banking system seizing up, interest rate policy has become ineffective and banks won't lend whatever central banks do (we're in a liquidity trap). Here's what Krugman says about the US situation:

"Ben Bernanke can’t push on a string – but he can pull, if necessary. Suppose fiscal policy ends up being too expansionary, so that real GDP “wants” to come in 2 percent above potential. In that case the Fed can tighten a bit, and no harm is done. But if fiscal policy is too contractionary, and real GDP comes in below potential, there’s no potential monetary offset. That means that fiscal policy should take risks in the direction of boldness."

The UK is in a similar position to the US: our banks are not lending, and although the Bank of England base rate still has further to fall, the rates at which banks borrow and lend will remain much higher, diminishing the usefulness of Bank actions. Tried to get a mortgage lately?

So what's left is fiscal policy, and Krugman's powerful point is that it's better to err on the side of recklessness, not caution, because only the former has a fall-back option. If Cameron can come up with a theory as to why fiscal policy can be contractionary without making the situation much worse, than I hope someone nominates him for next year's Nobel.