Tuesday, April 10, 2007

Are UK recessions caused by Failure of Monetary Policy?

This is an interesting question asked by a reader, (thanks Bhavin.)

With regard to the recession of 1981 I think that the cause of the recession cannot be entirely attributed to Monetary policy.

Reasons for Recession in 1981

1. Structural problems in economy late 1970s.

In 1979 inflation was a significant problem in the UK economy. The inflation was primarily cost push inflation. This was a combination of wage push inflation, caused by powerful trades unions and rising oil prices. To reduce this inflation was arguably necessary for the long term benefit of the economy; to reduce inflation of 20% inevitably leads to some slow down in economic growth.

2. Strength of Sterling.

Normally the increased production of oil would be beneficial for an economy. However in the case of the UK it came at an unfortunate time. The discovery of oil combined with high interest rates caused a significant appreciation in the £. This caused real problems for exporters. It was in the manufacturing export sector where the recession was felt most keenly.

3. Monetary Policy

However, despite the above 2 being contributing factors, monetary policy played an important role in the recession of 1981. The government had a Monetarist zeal to try and control the money supply. Arguably this caused real interest rates to be higher than necessary. Therefore monetary policy caused the recession to be deeper and more lasting than necessary. This is a good example of the limitation of using monetary targets, rather than targeting inflation directly.

Causes of Recession 1991.

In my view the recession of 1991 can be attributed almost entirely to a failure of government macro economy policy. By 1987 the economy was in a good position. Supply side policies were beginning to increase competitiveness and structural inflation had been brought under control. The essential problem was that the government allowed itself to get carried away by the perceived success of its supply side policies. Therefore it allowed the economy to grow much faster than the long term trend rate of economic growth. Therefore inflation was almost inevitable. In response to inflation of 10% the government then overreacted by increasing interest rates to 15%. The failure of macro economic policy was highlighted by using the ERM as a tool for reducing inflation, rather than direct inflation targeting. Again the recession was deeper than necessary because they tried to maintain a value of the exchange rate that was higher than necessary.

In short the government made 2 elementary mistakes.

1. Allowed the economy to grow too fast - Boom and Bust

2. By targeting a high value of the exchange rate, they caused interest rates to be much higher than necessary to reduce the inflationary pressures they had created.

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Bhavin said...

Very helpful, thank you Richard!

Richard said...

Your quite welcome Bhavin.

Good luck with your economics project.