How should we respond to the next recession?

One would expect that when faced with a crisis of the magnitude experienced during and since the crash in 2008, authorities would coordinate their response. However, as Alfie Stirling points out in the latest Institute of Public Policy Research’s (IPPR) Policy Paper, “policymakers in control of the UK’s two main macroeconomic policy levers have essentially been engaged in a tug of war”.  

Monetary policy has been unprecedentedly expansionary while on the other hand fiscal policy has been contractionary in its pursuit of austerity. Public spending has been cut from 45.1% of the gross domestic product (GDP) in 2009/10 to around 38.9% in 2016/17 while at the same time, the Bank of England has pumped £445bn into financial markets and interest rates have reached their lowest levels ever. This reveals deep weaknesses in the UK’s policy framework.

What’s worse, the main instrument used to overcome the consequences of the crisis, as interest rate manipulation became ineffective, Quantitative Easing (QE) – has widened inequality by boosting the price of property and financial assets, delivering outsized gains to the already-wealthy.

Based on historical experience, there is a recession in the UK every ten to fifteen years, which raises questions as to what the policy response will be when the next crisis hits. During previous downturns, the Bank of England has had the option of cutting interest rates, delivering a stimulus to the economy. But with the bank rate expected to reach only 1.5% by 2023 according to the Office of Budget Responsibility’s (OBR) projections, there are fears that interest rates will not have time to settle high enough above the Effective Lower Bound (ELB) in time for the next crisis. The ELB is the level of interest beyond which lowering the rate stops being effective in producing stimulus, incapacitating conventional monetary policy.

The IPPR report proposes three areas in which policymaking could be reformed in order to overcome the inefficiencies it is currently facing:

1. On the fiscal front, new rules are needed to ensure that government does not overspend during good times and that it does not underspend during bad. Borrowing for current spending should be balanced over a rolling five-year period and separated from borrowing for investment which should have a target as a percentage of GDP. Among other suggestions, the report proposes that fiscal and monetary policy should be coordinated, with the Bank of England being able to request a temporary suspension of fiscal rules when monetary policy is no longer effective.

2. The Bank of England’s mandate should be reviewed to include targets other than inflation such as unemployment or nominal GDP. This would ensure the correct estimation of the appropriate monetary responses. Efforts should also be made for interest rates to settle at a level high enough above the ELB giving the necessary space for reductions in response to the next crisis.

3. Perhaps the most exciting proposition in the report is the creation of a National Investment Bank. Under normal circumstances the NIB would be funded by bond issuances, however it would be possible for the Bank of England to purchase its bonds in secondary markets allowing for indirect money financing of the bank’s operations.

This would provide an alternative to dispense stimulus in the economy that is more targeted, certain, and measurable than QE. It would also be more democratic as its high-level investment mandate would be given by the Department for Business, Energy & Industrial Strategy.

IPPR’s new paper is a welcome addition to the growing body of literature making the case for alternatives to quantitative easing. Click here to read our paper summarising the characteristics of the main proposals.