Fiscal stimulus is not our only option: Economic historians describe the policy as one of “cheap money”. This entailed a commitment to raising prices back to the 1929 level, announced by the chancellor of the exchequer, Neville Chamberlain, at the British Empire Economic Conference in July 1932. It was underpinned by Treasury bill rates at 0.6 per cent and by an exchange rate target that locked in a 25 per cent devaluation compared with the gold standard parity that Britain had been forced to abandon in 1931. This target was enforced by intervention through the Exchange Equalisation Account.
The policy was credible because it was clearly in the Treasury’s interests and it, rather than the Bank of England, was in charge. People therefore expected prices to rise and monetary policy was able to offset the deflationary impact of fiscal retrenchment.
This worked through reducing real interest rates as the expected rate of inflation rose relative to nominal interest rates. Real interest rates were falling from 1932 to 1936, first as prices stopped falling and then as inflation picked up. One channel by which stimulus was transmitted to the real economy was private housebuilding, which increased from 63,000 per half year in September 1932 to 154,000 in March 1935. This was possible because of the absence of strict planning regulations.
The key lesson is that there is scope for monetary policy to stimulate the economy, even though nominal interest rates cannot be cut because they are already at zero. This means that there is an alternative to fiscal stimulus if the economy falls back into recession in 2012. Implementing a “cheap money policy” would, however, mean abandoning the current inflation targeting regime. Today’s equivalent of 1930s policy would imply formally adopting a price level target. The target could be to increase the price level by 15 per cent over four years and to convince the private sector that this will happen while interest rates are held down.
Although inflation has been high recently, the monetary policy committee stresses that it will soon return to and probably undershoot the 2 per cent target, implying that real interest rates remain higher than is desirable at present. The policy would not work if people thought that it would be reversed at the first sign of sustained recovery; the key to success in the 1930s was embedding the belief that prices would rise. The MPC would therefore need a new target that everyone expected to be achieved.
If we recognise that a price-level target worked in the 1930s, could it be equally successful today?
Circumstances may be less favourable now. Politicians would have to choose macroeconomic policy reform, whereas it was forced upon them in the 1930s. Consumers are burdened by debt and struggling to cope with falls in real disposable income, which is a notable contrast with the early 1930s. The eurozone crisis may deliver a bigger adverse shock than anything Britain faced after 1931. The output gap, whose magnitude is highly uncertain, may be much smaller than it was then, so that there is less scope for expansionary policies to raise real output. The chances of success would be greater if planning regulations were relaxed and we could once again envisage building 300,000 houses in a year, but that is politically too difficult...