Political leaders must set out credible plans to tackle the next downturn

The time for action on macroeconomic policy is now

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Okay, fair enough, there’s a lot going on right now. With a fraught election campaign in full flow, and our future relationship with the EU still up in the air, you can be forgiven for taking your eye off preparations for the next recession. But boom and bust hasn’t gone away. So while the sun isn’t exactly shining, our political leaders shouldn’t forget about fixing the roof.

Recessions are a time of severe economic hardship, so being ready for the next one matters a lot. In an average recession, the economy shrinks by around four per cent. That might not sound a lot but it is the equivalent of around £3,000 for every household in the UK. On top of that the number of unemployed people increases by one million on average. And what makes all this worse is that the brunt of recessions is normally felt by those on lower incomes.

Policy plays a crucial role in limiting the damage. For instance, in the aftermath of the financial crisis, the Bank of England’s Monetary Policy Committee (MPC) slashed its short-term policy rate, and started buying government debt on an industrial scale in an effort to reduce longer-term interest rates too (so-called Quantitative Easing, or QE). The fiscal floodgates were also opened, with the deficit rising to its highest level since the war. Without all this support from macroeconomic policy, with the bulk of the boost coming from monetary policy, estimates suggest GDP could have been 12 per cent lower. So while the financial crisis was certainly very bad, it could have been a lot worse.

Unfortunately the same trick won’t work next time we have a recession. When it arrives—and it will, possibly sooner than we might hope given evidence of slowing growth at home and abroad—conventional monetary policy won’t be much help. The key reason for this is the long-term decline in interest rates we’ve seen across the world. This has seen around $13 trillion dollars’ worth of sovereign debt trading at interest rates of less than zero, which essentially means financial markets are paying for the privilege of funding governments. The world’s central banks have thus found it difficult to raise rates since the crisis. The Bank of England is no exception—its policy rate is mired below 1 per cent. And because rates can’t be cut significantly into negative territory (as the availability of cash limits how far people will be prepared to accept losing money on their deposits in the bank) there is much less capacity to cut rates than in previous recessions, when the average cut was 5 percentage points.

So with standard monetary policy close to its limits, how do we make sure the next recession doesn’t become a depression?

Here, the key thing to understand is that the answer is not likely to come from Threadneedle Street. The Bank of England does have options—it could restart QE, and even expand the range of assets that it buys. But the problem is the low interest rate environment means that there isn’t much scope to bring longer-term interest rates down either. So buying more assets isn’t likely to help all that much either. All in, rate cuts and asset purchases are only likely to deliver about a quarter of the stimulus our economy would need to combat an average recession.

This is big challenge for how we do macroeconomic policy. We rely on central banks to manage economic fluctuations, leaving fiscal policy to concentrate on delivering sustainable public finances. But if monetary policy can’t deliver, we need to rethink our approach and allow fiscal policy to play a more prominent role.

The most pressing priority here is to rewrite the rules for fiscal policy to recognise that, come the next recession, the Treasury, more than the Bank of England, will need to do the heavy lifting. This ups the ante on announcements the major parties are making on how they would run fiscal policy.

So how are they doing? Unfortunately, despite setting out largely sensible day-to-day spending curbs, we do not have details of how the main parties would run their policies in a recession. The exception here is Labour which says it would suspend its fiscal rules if the MPC restarted QE. But by not explaining how it would return to its rules afterwards, the proposal runs the risk of leaving the country without a fiscal anchor when it is needed most. Still, this is better than the Tories or Lib Dems who have not even set out detailed proposals.

A wider public debate about these issues is long overdue. But this will only start in earnest when policy makers on all sides are open about the problem. The Bank of England has a role here too – it could be more open about the constraints it would face in a recession (although such an admission would need to be managed carefully to avoid jitters in financial markets). What is clear is that burying our head in the sand and hoping for the best isn’t the answer either because a recession is a question of when, not if. It’s understandable that politicians are reluctant to talk about handling the next recession in an election campaign. But if we don’t take this opportunity to make sure we’re ready for the next downturn, it will be our families and businesses that pay the price.

This article was originally published in Prospect Magazine