Why Government #economic policy is all wrong

The typical thinking in Governments and central banks when it comes to current monetary and fiscal policy can be summarized as:

  • fiscal deficit spending is needed to avoid recession, and kickstart investment, growth and economic activity;
  • lower interest rates are needed to stimulate borrowing and spending by consumers;
  • economies need inflation; persistent low inflation or even deflation is to be avoided.

That this groupthink continues to dominate even after years of practical experience to the contrary, is amazing in itself. More seriously, it is very damaging for our economies and will make economic recovery and future growth delayed and harder.

Government expenditure has to be financed by tax, either now or later. Mostly, Governments opt for the late payment, for two reasons: one is to let someone else bear the political pain of raising taxes and, two, in the hope that the debt will be reduced in real terms by persistent inflation. (So much for the Charter of Budget Honesty.) For the government expenditure to be useful, it needs to add more value than the taxes take out. Invariably, this is impossible. Governments cannot direct central investment and expenditure to more valuable uses than individual people can when making their own choices. This has been shown time and again. Consequently, Government expenditure as a stimulus measure invariably fails. It makes things worse, not better. This is due in no small part to the politician captured by lobby groups through the political process to ‘invest’ money in pet projects.

With monetary policy, central bank manipulation of market interest rates is applied to the interbank loans system. The trading banks get the immediate and initial benefit of a reduced interest charge from the central bank and then, in a competitive world, would pass on their reduced funding costs by lower rates to their own borrowing customers. This policy penalises savers. Savings are essential for economic growth. Savers should be encouraged, not discouraged. Dare I suggest that rather than a ‘glut of savings preventing economic growth’ there is a shortage of savings driven by current Government policy?

Reduced interest rates, and similar policies such as printing money, both increase the money supply, and will be inflationary. However, the inflationary effect is not distributed evenly throughout the economy or at a point in time – it takes time, and goes through a chain of economic actors. The consumer on the street is the last to realise that the money in his pocket buys less than it used to. Meanwhile, the banks had first use of it – free money initially deemed to be of no less value by consumers and hence retains its higher purchasing power.

This delayed mechanism of inflation is why inflation is considered valuable by banks, central banks and governments. If the money supply was doubled instantly, and all prices doubled instantly, there would be no effect on the economy or living standards. Likewise if the money supply were halved and all prices halved instantly, there would be no effect. The frictional delay and the order of who gets first use of the money explains a lot about those arguing for quantitative easing. The best approach to the current economic malaise would be for Government and central bank policy to move away from deliberate policies of quantitative easing, fiscal expansion, helicopter money etc and instead reduce Government expenditure, reduce taxes, allow interest rates to find their own level.

Here’s hoping.