Macroeconomics Seminar with David Miles

A truly extraordinary change in macroeconomic policy-making is happening in the UK as the government seeks to avert what is looking worryingly like the new Great Depression. That was the view of David Miles, Chief Economist of Morgan Stanley expressed during a Keynes Society seminar last night.

The enormous policy response has deep Keynesian roots and is profoundly different from the reaction to the recession of the early 1930s. The colossal increase in the size of the fiscal deficit is partly be design and this, accompanied by a 4% cut in base interest rates and a 25% devaluation of sterling represents a huge stimulus to demand equivalent to over 5% of national income.

What does this mean for the short term prospects of the British economy? The uncertainties are pervasive because the scale of the policy stimulus is a direct consequence of a number of forces of negativity most of which link directly to the fall out from the banking crisis aka the credit crunch.

Two powerful but competing headwinds

It boils down to a question of two forces - the depressive effects of a collapse in bank lending and a sharp fall in asset prices, versus a government (together with the Bank of England) that has pulled vigorously most of the policy levers that it can get its hands on.

David Miles considered the two competing forces:

The bad news:
1. The economy is in recession and the downturn has been exceptionally sharp
2. Domestic and overseas sources of demand have slowed sharply
3. Bank lending – between banks and to corporates and households – ground to a halt in the crisis of confidence that hit in October and has not recovered.
4. Companies are being quick to cut production and employment

And then the good news:
1. There has been a massive, and recent, policy response.
2. The monetary and fiscal stance is set to be highly stimulative - policy interest rates are at lowest in history, sterling has fallen 25%; the fiscal deficit could be 8% of GDP in 2009.
3. More direct measures to encourage bank lending are likely to be announced

His overall view?

That the collective power of the stimulus applied to the UK economy will take effect during 2009 and that the huge level of personal sector debt (much of it in mortgages) financed at variable rates of interest will help to reduce the debt-service burden of over 10 million people who have a mortgage and that this should help to stabilize consumer spending even though confidence has nose-dived with sentiment surveys recording historic lows around the turn of the year.

On his assessment, the huge sterling depreciation (given that the UK economy is highly open ... exports and imports together account for almost 2/3rds of GDP) is worth around an extra 3% of GDP and will have more of an impact on aggregate demand than lower interest rates and the budget deficit combined.

His current forecast is for

1. UK GDP to fall by 1.3% this year and recover by 2% in 2010 (more optimistic than the IMF)
2. Household consumption to hold up reasonable well (down 0.5% this year)
3. Employment to fall by 2% and the unemployment rate to move higher to around 8% of the labour force
4. Inflation to fall (a short period of deflation is highly likely) but rebound to 2.5% in 2010 partly because of the lagged effects of sterling's depreciation

Fiscal deficits and possible crowding out

David Miles then focused his attention on the size of the budget deficit - likely to be more than 8% of GDP this year equivalent to annual borrowing in excess of £130bn. The Labour Government's original target for government debt was to keep it close to or below 40% of GDP. The best guess is that this will now rise to between 60 and 70% of national income and this does not include the scarcely credible scale of financial support to the banking industry.

The budget deficit is “eye-wateringly" large - certainly bigger than at any point since the end of the Second World War But the good news seems to be that a flight to quality among institutional investors has encouraged a rising demand for government bonds, a higher market price and therefore a drop in the yield on bonds. If real interest rates stay low during this period of huge government borrowing, the risks of the budget deficit crowding out investment within the private sector of the economy are much reduced, and the size of the fiscal multiplier will be greater than some pessimistic commentators are predicting. Real interest rates on ten year government bonds are currently close to 2% (and dipping lower) – they have been much higher in the past.

Contributions from the floor included questions on the importance of expectations in driving consumer spending decisions even though interest rates are close to the floor, and also the effects that weak global demand will have on UK exports even though sterling is now offering a big competitive boost to the UK export sector.