Evan Davis

What Should the Government do about the Spending Boom and the High Pound?

There is pretty widespread agreement that the best thing a Chancellor can do is prevent the nation from slipping back into the boom-bust cycle. It was Kenneth Clarke's mantra, and it is one chanted regularly by Gordon Brown. Since the stop-go days of the 1960s, it has been clear that macroeconomic instability has been at least one cause of Britain's long term relative economic underperformance.

But the new stability-oriented consensus is facing its first serious challenge. An apparent surge in consumer spending. Because that surge is occurring just before the Government has managed to get its fiscal house in order (remember that tax rises and ultra-tight spending rounds bite more in later years, than this) the Government is contributing to the general overheating too. When public and private spending surges, there is not much that can be done. Either, we live cut other forms of spending (most obviously investment and exports); or we allow the boom times to roll for producers, and simply watch them put up their prices to reap the benefits.

So far, the authorities have tended to take the view that in order to stick to the stability precept of all policy-making, we have to curtail spending somehow; and if that means high interest rates, a high pound, and falling exports -- so be it. One does not need to worry about the precise chain of economic events - the net effect of them all is that boom in one place ends up causing a squeeze elsewhere. That looks like a tough but clearcut decision: if the economy soars then shoot it back down to earth.

In fact, the decision over what to do is far more arguable than that. It is quite possible that the spending boomlet occurring around us is a temporary phenomenon, caused by building society windfalls. It is quite possible that those receiving them are rationally spending their increase in personal wealth on new fridges, cars or sofas which will last them for quite a few years.

The problem is essentially about what a government -- or central bank programmed to maintain stability -- should do when unstable, temporary shocks disturb the economy. It is all right to insist on stability but -- as these windfalls remind us -- life is not always stable. And instability was not always the fault of some silly Chancellor, or some poor policy decision. German unification, oil price hikes, financial deregulation, poor harvests, earthquakes -- a whiole host of things can lead to temporary instability. The difficulty for governments is to decide what to do in response to them.

Do you squeeze the economy in response to a temporary shock? For example, if we have a booming fridge industry in response to the windfalls, do you impose pain on the people selling canned drinks to keep some overall balance? If you do, you can end up bankrupting the latter, for the sake of a temporary problem. If you do not, then you can end up with inflation, and once its back, it may be hard to get rid of.

However, if we really do believe this boomlet is temporary it maybe that we ought not be too worried about a short-term pick up in inflation. That might just be the economy's way of dealing with a short-term shock. Maybe policy-makers should refuse to respond to the boomlet, and should let inflation and the balance of payments worsen as the economy overheats. The problem will obviously be self-correcting once the spending goes away again. Temporary boomlets are necessarily a cause of instability - governments can do nothing about that, and should not lose sleep over it.

On the other hand, there are reasons to justify some action. It may not be a temporary boomlet - it may be an irrational exuberance, allied to excessively lax growth in the money supply, booming world stock markets and a sense of optimism that inflation has been permanently beaten.

It may also be that the rational extra spending of building society windfall recipients has yet to be matched by a rational extra saving of non-building society windfall recipients. After all, those of us not getting free shares are actually a little poorer as a result of the demutualisation process, as the rates of interest we face are now set to be a little less attractive than they were (profit-making banks have to offer slightly worse rates than non-profit-making mutuals). We should, in theory, save a little more as a result of that. We are clearly not doing so.

It may also be that spending has an infectious quality -- that even though I may not want to spend, if everybody else does, I cannot help it. If my friends all want to eat out at expensive restaurants, then I inevitibly end up doing so. In that case, dampening down our collective 'lemming-type' behaviour is a sensible government response.

None of this designed to say that the current policy is wrong, or that interest rates should or shouldn't go up further. It is all merely designed to show that giving the economy a smooth ride is inherently a far harder task in rocky seas than merely having the will to steer the ship properly.