The complex relationship between policy-making and economic performance comes under the spotlight this week, with the assertion by US economics expert Edward Nelson that the UK's improved economic performance in the past 15 years has been the result of better understanding by policy-makers of the economy's structure.
In the Economic Journal, Nelson, now at the Washington-based Federal Reserve Board, argues that UK macroeconomic policy since the second world war can be split into two eras, and that it was the overhaul of doctrine in 1979 that marks the break between the old era and the modern.
The "old doctrine" viewed inflation as a non-monetary phenomenon. That is, inflation was believed to be insensitive to policy actions that restrained the volume of aggregate nominal spending in the economy; rather, it was believed to be driven by factors that monetary policy could not affect. Old doctrine also viewed UK aggregate demand as essentially insensitive to interest rate policy. The new doctrine instead viewed both demand and inflation as very responsive to monetary policy.
From 1979 onwards, Nelson argues, policy-makers accepted that the UK monetary authority could essential determine the UK inflation rate over the medium and long term. "The crucial underpinning of UK inflation targeting is therefore an overhaul of doctrine - a changed view of the transmission mechanism."
And it was this improvement in understanding by policy-makers, rather than any changes in the priority given to price stability, that led to the improved UK economic performance over the past 15 years, says Nelson, with a regime of inflation targeting that began in 1992.
Nelson also argues that the present recession should not discredit the framework of targeting inflation, pointing out that fluctuations in inflation continue to be "relatively minor" compared with those in the 1970s and early 1980s. He also says the framework gives policy-makers a sound basis from which to pursue "large-scale monetary actions" to tackle the downturn, without abandoning the goal of price stability.
Charles Goodhart, professor emeritus of banking and finance at the London School of Economics, agrees with most of Nelson's findings, but disputes Nelson's suggestions that the consideration given to unemployment and inflation remained constant, whichever government was in power, from the late 1960s onwards.
"I find it hard to believe that the objectives of Harold Wilson and of Margaret Thatcher were identical," writes Goodhart. Rather, he argues that politicians will give more weight to either unemployment or inflation based not on economic policy per se, but on "whichever of these two evils the electorate has recently found more disturbing".
But in general, Goodhart agrees with Nelson, that a focus on keeping inflation low "is desirable".
From Bubb's Blog
From Whitehall Watch
