|The central lesson of macroeconomics of the past 40 years has been that low interest rates and deficit financing cannot increase the medium-term growth rate of economies, but if used to excess can lower it. That is a lesson we are at risk of forgetting.
The Great Depression of the late 1920s and 1930s spurred two great economic schools. One focused upon how to prevent such a depression from occurring again, and considered mainly monetary policy and banking regulation – today we call them "monetarists". The other focused on how to use direct government action (deficit financing and public works) to recover from a depression relatively painlessly (and in particular without mass unemployment) once it had started – today we call them "Keynesians".
For many years governments influenced by these two great schools, in different countries at different times, practised their policies outside the scenario for which they were originally devised – we had no serious widespread banking crisis or depression in the developed world from the 1930s until present times. The events of the Credit Crunch and Great Recession of 2007 onwards have been the first real test of these theories in their intended environment.
Monetarists said we must not allow the money supply to collapse or bank runs to get out of control, so we bailed out the banks and printed money furiously. Keynesians said that to escape from depressions we should run large budget deficits and perhaps also raise public spending, so we ran huge budget deficits and spending surged. It's failed.
Eighty years of PhD theses and journal papers full of maths have not told us how to avoid a financial crisis turning into a massive depression, nor how to escape from such a depression without mass unemployment once it begins.
It's harsh to be too critical of macroeconomics for this. We don't get many goes at observing a once-in-a-century financial crisis and it is inevitable that each crisis will have its individual features, so it's very difficult to draw general lessons. Perhaps there isn't any way either to avoid financial crises turning into depressions or to escape from them straightforwardly once they begin, or perhaps we just got something wrong this time that we don't currently understand. Maybe in another three or four centuries we'll be better placed to say.
In the meantime, though, there are some much better understood lessons of macroeconomics, based on far more regular observations, that we risk forgetting. Probably the central one is this: macroeconomic policies (interest rates, money printing, running deficits etc) cannot increase the medium-term growth rate of economies but, if used to excess, can decrease it. Ever since the notion of the use of macroeconomic policies became popular in the 1930s, governments have wanted to believe they could be used to make economies grow faster over the medium term.
Maybe that would come with consequences, but they might be consequences policymakers would be prepared to accept. In 1958, the New Zealand economist William Phillips produced his famous "Phillips curve" detailing the supposed trade-off between inflation and unemployment, later also seen as a trade-off between inflation and growth. Perhaps higher growth and lower unemployment could be delivered at the expense of just a little more inflation? In the 1960s many governments experimented with exploiting the Phillips curve in this way.
By the late 1970s, most governments had learned their lesson. Running high deficits and allowing high inflation might produce short-term gains, but medium-term growth and unemployment would actually be much worse than if inflation were kept low and budget deficits kept under control. From the 1980s through to the mid-2000s this was the consensus: extremely low interest rates and very high budget deficits can boost short-term growth, but cannot increase medium-term growth. If you have a medium-term growth problem, therefore, low interest rates and high budget deficits cannot be the solution. Instead, you should seek to do three kinds of things: first, normalise your interest rates and budget deficit to medium-term-sustainable levels, so that you stop damaging your growth rate even more; second, reform the way the government spends money, especially on public services and welfare, so that government incentives do not drive people away from productive activities towards unproductive ones; third, liberalise and deregulate industries so that private sector innovation can work around the economy's problems to find medium-term sustainable solutions.
These were not lessons based on speculation about one special event decades ago, as with theories about the Great Depression. They were based on detailed theory validated in repeated practice around the world over decades. They worked. Since 2007, however, in the UK at least, policymakers appear to have forgotten these key tried-and-tested lessons. They have become so fixated on doubling up and doubling up again in the attempt to apply failed theories about the Great Depression to the Great Recession – printing more and more money; bailing out banks more and more and yet more; running huge deficits and pushing off ever into the future the date at which budgets will balance – that they are completely ignoring the successful lessons of the past 40 years.
Why are interest rates still essentially zero and policymakers still urging yet more money printing and yet more "flexibility" in inflation targets, when rates have already been zero for four years? Because in their hearts, policymakers want to believe that monetary policy can increase growth and that growth may be higher if inflation is a little higher. Why is George Osborne planning to run a £120bn deficit in 2013/14 having run a £120bn deficit in 2012/13 and a £120bn deficit in 2011/12? Because in his heart, he wants to believe that running such vast deficits will make the economy grow faster.
But it's now six years since the financial crisis began in 2007, and five years since the current depression began. Few serious analysts believe the UK will average much above 1.5pc average growth per year over the next five years, and many think it will be much lower.
We do not have a short-term growth problem, of the sort that running high-budget deficits or low interest rates can help with. Talk of the need for a "stimulus" misses the point – the worry isn't the next three months; it's the next five years.
Forgetting the lessons of the past 40 years of macroeconomics may have terrible consequences in due course – high inflation; mass unemployment; perhaps even sovereign default. Policymakers need to stop trying to apply theories about the 1930s that don't work, and start applying the well-trodden rules of the 1970s-2000s that do.