Holtham, Gerald, The Independent (London, England)
The world is round and so, it seems, is the world of economic policy-making. By heading off in one direction you can reappear from the opposite one. Consider the way that the UK is currently running monetary policy.
In 1979, if not before, we abandoned the belief that monetary and budgetary policy should be used to manage the level of demand in the economy so as to smooth out fluctuations in real growth and activity.
The orthodoxy of the day was that the economy was basically stable and the government itself was responsible for most of the fluctuations; it should set medium or long-term objectives and ignore the cycle. The objective of monetary policy was to reduce the rate of inflation. Inflation was caused by too much money chasing too few goods, and the government could control the money supply.
This led to the UK's monetarist phase in which the idea was to keep a monetary aggregate growing at a stable rate. The government's responsibility began and ended there. There was no need to forecast what the economy would do next, no need to worry too much about economic models or economic analysis. Move monetary instruments in view of the current state of the economy? What an error! Adapt them to the supposed or forecast state of the economy in the future? Hubristic folly!
This approach went out of style when the government proved unable to control a monetary aggregate in the early 1980s, but monetary policy was still tight enough to plunge the country into the deepest recession of any large country in the Organisation for Economic Co-operation and Development in that cycle. What was thrown out, as a result, was the faith in monetary targeting but not the faith in running the economy on automatic pilot. Fiscal policy was confined to the tram-lines of the Medium Term Financial Strategy. Monetary policy was unconfined for a while, but another rule was sought, and found - this time, fix the exchange rate.
Stability in the ERM
In an open economy with free capital flows, so the story goes, if monetary policy was too lax, the exchange rate would depreciate. If the policy was too tight, and the government was not allowing as much credit and money creation as the economy needed, the exchange rate would appreciate. After all, the exchange rate is just the price of this country's money in terms of other currencies. Stabilise the price and you must be producing just the right amount of money.
So international monetarism succeeded the domestic variety and monetary policy was returned to automatic pilot. Before and during the period of the European exchange rate mechanism, the sole objective of monetary policy was to stabilise sterling against the mark.
It would be tedious to repeat the story of how that new orthodoxy collapsed, but at its root was the same problem as confronted the original monetarists. Yes, governments are often a source of instability and, yes, politically induced fluctuations in monetary policy can be a problem. But they are not the only problem. If there is some other shock to the system, which alters the equilibrium real exchange rate or the demand for money as an asset, mechanically sticking to the target can lead to fiasco. A reasonable guideline becomes a menace when treated as an iron law.
After the pound was blown out of the ERM, the Government adopted an inflation target. The rhetoric of long-term stability and the avoidance of fine-tuning were retained but the reality is utterly changed. It would have been possible to treat the inflation target in a mechanical way, too. In other words, if inflation is in the target range, change nothing; if below, lower interest rates; if above, raise them.
Of course, if you did that, you would not keep inflation continuously in the target zone. There would be a lag between the policy response to an overshoot or undershoot and the return …
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Publication information: Article title: Seat-of-the-Pants Economics. Contributors: Holtham, Gerald - Author. Newspaper title: The Independent (London, England). Publication date: October 3, 1994. Page number: Not available. © 2009 The Independent - London. Provided by ProQuest LLC. All Rights Reserved.
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