How to respond to a future recession?

Bank of England Image copyright Reuters
Image caption The Bank of England may find it hard to cut interest rates during a future recession

Economic policy has been central to the election campaign so far - with battles fought over public spending, taxation and living standards. With the Conservatives making their "long-term economic plan" and the need for deficit reduction a central issue and Labour responding with the "cost of living crisis" this is hardly a surprise.

But despite the prominent place of macroeconomic policy in the public debate, there are many questions that have not been discussed - questions that could well become very important in the next five years.

In the longer run, Britain's productivity performance and the future of the supply side of the economy (things like education and skills policy, infrastructure and how the labour market works) will all be crucial to our growth and living standards.

The various parties have very different visions of how these policies should work - but supply-side policies can take a decade or more to really be felt. In the coming five years there may well be an important role for the more traditional "demand side" macroeconomic tools of monetary and fiscal policy.

Earlier this month the IMF's chief economist Olivier Blanchard wrote on how economic policy has changed since the 2008 recession and considered some of the lessons learned. The discipline of macroeconomics is continually evolving and Blanchard set out literally dozens of pertinent questions on fiscal policy, monetary policy, financial regulation and other topics.

It is perhaps too much of a stretch to hope that these topics - important though they are - would feature more in the UK political debate. But here's one question that has received very little attention: what happens if we get hit by another recession in the next five years?

Image copyright EPA
Image caption The IMF's Olivier Blanchard has written extensively on macroeconomic policy

Unconventional policy?

Between 1992 and 2008, the UK economy grew continually. That experience may have lulled UK policy makers (and the wider public) into a false sense of security. From the late 19th until the late 20th Century, recessions were a relatively common occurrence.

While especially severe crises, like 2008-09, might only come along once every 70 or 80 years, recessions have generally happened around once a decade.

The last recession ended in 2009 and, if history is any guide, the UK will be due one at some point in the second half of the 2010s.

Severe recessions in the UK:

Quarter 2, 2008 - Quarter 3, 2009: Drop of GDP of 7.2%

Quarter 3, 1990 - Quarter 3, 1991: Drop of GDP of 2.4%

Quarter 1, 1980 - Quarter 1, 1981: Drop of GDP of 4.6%

Quarter 2, 1975 - Quarter 3, 1975: Drop of GDP of 1.8%

Quarter 3, 1973 - Quarter 1, 1974: Drop in GDP of 3.3%

Quarter 3, 1961 - Quarter 4, 1961: Drop in GDP of 0.5%

Of course we may get lucky - but planning on getting lucky is to stretch the definition of the word "plan".

If the UK were to be hit by another downturn in the next five years then the macroeconomic toolkit looks much less useful than previously. There are two traditional responses and both may struggle to offer as much economic support as in 2008.

One answer to a recession is to use fiscal policy to support demand - either by increasing spending or by cutting taxes. This can be done automatically (through allowing the welfare bill to rise and taxes to fall as happens naturally in a recession) or via a discretionary stimulus.

The problem with that approach this time would be that the ratio of government debt-to-GDP is already very high. In 2008, pre-recession, the UK government's debt ratio was around 45% of GDP. It was a similar level before the early 1980s recession and much lower heading into the 1990s one.

If a recession were to hit in the late 2010s (regardless of who was in power) the debt ratio would already be at around 75%. This could certainly restrain the room for fiscal policy to provide much support.

That would be more manageable if monetary policy could pick up the slack with a more aggressive response. But that too - in conventional terms - seems unlikely.

Image caption How should the UK respond if it were to face another downturn?

Ahead of the 2008 recession, the Bank of England's base rate was 5.5%, it was cut all the way to 0.5% and has remained there since. In the early 1990s base rate fell from almost 14% to 6% and in the early 1980s form 17% to 10%.

If the financial markets are to be believed then, by the late 2010s, the base rate will be around 2.5-3%. In other words, there will be much less room to cut it.

So the response to any recession in the 2010s will no doubt feature more "unconventional monetary policy" - more quantitative easing (electronically creating money to buy bonds) and interventions like the Funding-for-Lending scheme (which aimed to provide cheap loans to banks to extend their own lending).

As Tony Yates - an economics academic and former Bank of England staffer - has argued (as part of a longer series of his "grumbles" about the national economic debate) "more work needs to be done to formalise the use of unconventional monetary policies next time".

In other words, if we are hit by another recession in the late 2010s and policy makers are once more forced to rely on "unconventional policy" then they face a choice. They can essentially make up the rules as they go along (like last time) or have thought it through in advance.

Hopefully this debate will not be necessary - the UK will not face a recession in the next parliament. But if it does, then we may regret the lack of planning and debate that has marked the campaigns so far.

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