All shook up! Economic policy in a post-crisis world

By Andrew Sentance, Senior Economic Adviser

Before the financial crisis, economic policy for the major western economies seemed relatively straightforward. Economic growth tended to fluctuate around a reasonably steady rate accompanied by low inflation. Central Banks adjusted interest rates to keep economies on track and their interventions appeared to be effective.

Healthy economic growth also helped the planning of public finances. It provided a steady source of additional tax revenue – supporting increases in public spending innew nor key services like education and health while keeping deficits under control.

However, this regime has been disrupted by two key developments since the mid-2000s. First, strong growth in Asia and other emerging markets has started to exert significant upward pressure on energy and commodity prices. That has added to inflation and squeezed spending power in western economies and made the challenge of steering economies along a steady growth, low inflation course much more difficult.

Second, the financial crisis created a major recession from which most western economies are struggling to recover. There has been a double whammy – the impact of the recession itself and the withdrawal of a key engine of growth from the financial sector. For over two decades from the 1980s, growth in the western economies was sustained by dynamic and deregulated financial markets which opened up new opportunities for consumers and businesses. The financial system is now much less supportive of growth as banks seek to repair their balance sheets. And the natural caution of lenders and investors in the wake of the crisis is being reinforced by a re-regulation of the financial system.

These developments are combining to create a difficult recovery accompanied by volatile economic and financial conditions – which is the “new normal” for the UK and other major western economies for the time being. And these characteristics of the economic climate are not short-term. They are likely to persist into the mid-2010s.

The initial reaction of economic policy-makers as the financial crisis hit in 2008/9 – quite rightly – was to fight it with all means available.  Interest rates were cut to historically low levels and unconventional monetary policies – such as Quantitative Easing in the UK – were implemented. Budget deficits were allowed to expand. And governments injected capital into troubled banks to  stabilise the banking system.

But though these policy interventions were justified in the short-term, they cannot be used to sustain growth in the longer term. Government deficits need to be reduced to ensure sustainable debt levels. And the continuation of highly stimulatory monetary policies risks creating some combination of high inflation and permanently distorted financial markets.

Policy-makers face the challenge of making a difficult transition from the emergency policy settings which were adopted in the depths of the financial crisis, and returning to more sustainable economic policies. This involves recognising the limitations of demand stimulus as a means of securing sustainable growth and putting more weight on supply-side policies which seek to improve the business climate through tax reform, lighter and more efficient regulation and strategic government support for infrastructure, education and research.

For the time being, economic policy-making is “all shook up”. The stable policy framework which existed before the financial crisis has disappeared, but a new framework for managing economies in the “new normal” has yet to emerge.  Businesses and financial markets are going to have to live with this uncertainty for a while as economic policy-makers adjust to the new realities of the global economy in the aftermath of the financial crisis. But policy-makers can help address this lack of confidence by recognising the need for a return to more sustainable policies and making the transition clearly, confidently and effectively.

This is a summary of a presentation given by Andrew Sentance at the IEA State of the Economy Conference on 23rd February 2012. For Andrew's full presentation click here.

Contact: Andrew Sentance  |  Tel: +44 (0) 20 7213 2068