Comment: Fiscal policy back in fashion as recession deepens

Governments are terrified by repeated failures to stop recession. Fiscal
policy ­ public spending, tax cuts, big borrowing ­ is now seen as the
salvation. The new Keynesianism contains valid elements, but is fundamentally a
dangerous simplification.

Rates
The co-ordinated interest rate cut on 8 October, involving six central banks,
was well executed and well received by the media. But the markets dismissed it.
Recession has deepened in all the major developed economies. China is not in
recession, but its slowdown is much worse than predicted. Inflation, though
high, disappeared as a policy issue. The new concern is deflation in 2009, due
to recession and plunging oil and commodity prices. The call to further action
is irresistible.

Only weeks after the 8 October synchronised cut, the main central banks moved
again, this time separately.

The Fed cut rates to 1%, matching the low point seen in 2003-04. The Fed will
probably cut again soon, to a new low of 0.5%; a move to zero is clearly
possible if the recession worsens. The European Central Bank disappointed the
markets by cutting rates to only 3.25%, reinforcing its poor reputation as being
most likely to respond too late and inadequately. Even Japan, which is also in
recession and has a rate already near to zero, cut rates from 0.5% to 0.3%.

Britain acted most dramatically.
The
Bank of England, trying to repent for its earlier excessive hard
line, slashed rates from 4.50% to 3%, much more than anyone predicted. Time will
tell whether this was wise or irresponsible. But further UK cuts are likely in
the coming months, at least to 1.5%, and possibly to 1%.

The collapse in sterling highlights the UK’s vulnerability and speculative
attacks against Britain could worsen, if plans for a big fiscal package are
reckless.

Borrowing
The UK has taken the lead in promoting internationally agreed Keynesian policies
as the best way of averting a slump. In very dire circumstances, more borrowing
is vital and unavoidable. Reduced tax receipts and higher benefits automatically
swell budget deficits. Huge banking bailout packages will further inflate
borrowing. The question is how much additional discretionary borrowing is it
safe and sensible to incur. The option must be kept open, but, to avoid major
setbacks, we must proceed with extreme caution.