Policy Stability and Economic Growth

Lessons from the Great Recession

John B. Taylor

• Publisher: London Publishing Partnership
• Year: 2016
• ISBN:
  9780255367219
• Edition: 1

John Taylor is one of the foremost economists of our generation. His ideas were implemented in central banks across the world during the period of price stability, economic growth and financial stability that followed the 1980s. Of course, this period culminated in the financial crisis of 2008, which was followed by a very slow recovery, which, eight years on, can hardly be said to be complete. This short book presents Taylor's view of the financial crisis and its aftermath as expressed in the 2014 F. A. Hayek Memorial Lecture. He believes that the rules-based monetary policy that he espoused broke down in the run-up to the crisis and afterwards. Furthermore, other aspects of policy became erratic and discretionary to the point that the rule of law could be said to be under threat. According to the author, these problems contributed to the crisis and to the slow recovery – indeed, they were a major cause. Two commentaries follow John Taylor's lecture. One is by Patrick Minford and the other is by the Bank of England's Chief Economist Andrew Haldane and Amar Radia. Both recognise Taylor's immense contribution to economic theory and policy. The commentaries are themselves an important contribution and they are followed by a response from John Taylor which addresses the issues raised by the commentators.

1. Policy stability and economic growth: lessons from the Great Recession
   Introduction
   It is particularly nice to be here at the Institute of Economic Affairs (IEA), which I have heard about, studied and looked to for many years. I have had a long interest in how economics is used in policy, the world of ideas and the world of government, and I think this institute has proven over the years how important ideas are for good government. I read, in thinking about this lecture, that the founder of the institute, Antony Fisher, first got the idea when he was a fighter pilot in World War II, flying for the Royal Air Force. He read in the Readers’ Digest the condensed version of The Road to Serfdom. He said, ‘These are some ideas that I want to promote’, and, after the war, he did so and set up this institution. It is a very important institution, and I am happy to be here.
   I also admire the IEA’s focus on free markets and all the benefits that kind of philosophy gives to people. I like the stress on, if you like, non-partisan issues. Anyone who wants to listen to the benefits of free markets and a free society is welcome. That is what I think a good institution should be all about.
   The Great Recession compared with earlier recessions
   I want to focus on lessons learned from our experience over the last few years in the financial crisis and the slow recovery from the Great Recession, because I think it is tremendously important to figure out what went wrong and what we can do better in the future: the lessons to be learned.
   To me, there is a striking similarity between my country, the US, and the UK in terms of what actually happened. What I am going to present are ideas that came to me from thinking about economic policies in the US and, actually, before that, from thinking about particular kinds of policies in the US – especially monetary policy, which is my expertise, if you like, or my love, and seeing how the problems with monetary policy actually extend to other kinds of policies. I think that these ideas are useful for thinking about the UK as well.
   So, let me begin with a description of where we are in the US and in the UK. First, let’s take a look at Figure 1. This is a chart of real GDP in the US, and you can see it goes back to before the crisis in 2007. The lower line shows real GDP, the total amount of goods and services produced in a given year in the US, adjusted for inflation. There is a big dip, that is the Great Recession with the financial crisis, and then there is recovery. I have superimposed on that the previous trend of real GDP from 2000 to 2007. You can see the recovery looks like a great disappointment. We have had a recovery in the sense that growth has generally proceeded at a positive rate. Why is it disappointing? It is disappointing because we did not bounce back as we have in previous recoveries.
   Figure 1. Great Recession and not-so-great recovery (US)
   
   Now, what about the UK? Let us look at the same kind of chart for the UK, at the behaviour of real GDP since 2007 (Figure 2), before the Great Recession, and then at the recovery, and superimpose on that the trend line from 2000 through 2007.
   Figure 2. Great Recession and not-so-great recovery (UK)
   
   You can see that the path of real GDP is quite similar to the US but worse, because it is even slower than the trend line before. So, in both of these cases, there has been a disappointing lack of recovery.
   One way to think about these recoveries is to compare them with the recoveries from the previous, most recent deep recessions. Focus on the US first. A deep recession took place in the early 1980s. In Figure 3, you can see that real GDP declines, but then it bounces back. If we had seen this kind of recovery this time, we would already be back producing many more trillions of dollars a year.
   Figure 3. US recession and recovery in early 1980s
   
   That is a typical recovery. The same thing is true for the UK. If you look at that same time period in the UK (Figure 4), the bounce-back from recession is much better. This is what should happen in a typical recovery.
   Figure 4. UK recession and recovery in early 1980s
   
   So, we had not only this very deep recession, but also this poor recovery: the ‘Great Recession’ and the ‘not-so-great recovery’. The questions are: why the deep recession and why the slow recovery?
   I think the answers to both questions are related. The same kinds of things have affected both the recession and then the recovery.
   Other people, of course, have different views, and I want to touch on those briefly. One view is this: ‘What do you expect? We had this deep recession. The economy is not going to bounce back that fast.’ However, the charts comparing previous recoveries in the US and UK illustrate that is not the case. Figure 5 provides more evidence. It shows the speed of recovery for all of the deep recessions associated with a financial crisis in the US going back to the 1880s. The top horizontal line is the average growth rate in the first two years of all of those recoveries: the average is about 6 per cent. The lower line shows the growth rate during the recovery after the recent financial crisis: this was about 2 per cent. This is easily the worst recovery after a financial crisis.
   Figure 5. Growth rate in first eight quarters of a recovery from previous recessions with a financial crisis (identified by year recession began)
   
   So, it really is not correct to say that recent experience is what you would expect from a financial crisis: something else is going on.
   There are other explanations. One theory that has been offered more recently runs as follows: the income distribution has spread and widened, and this leads to slower growth because people at the lower end of the income distribution consume more as a fraction of their income than those at the top, and they are getting relatively less than before. It is argued that this leads to less consumption and less growth.
   But this does not fit the data either. The fast US recovery in the 1980s was during a period when saving rates were higher than they have been recently.
   The principles of good policy
   So, there are various possibilities that people have offered for this experience, but the conclusion that I have come to is that there has been a problem with policy, and that policy is really the key to understanding what went wrong both leading up to the crisis and since the crisis.
   So, what is good policy?
   The first principle of good policy is that we should have a situation where families, entrepreneurs and everyone else are free to make decisions within a clear policy framework that is predictable, so you know what is going on, what the government is going to do, and you have some sense of the future. Secondly, policy should be based on a strong rule of law. Thirdly, there should be strong incentives for people to do things that improve their own welfare, and the welfare of society. Fourth, those incentives should largely come from the free-market system.
   Of course, there is a role for government, and this is the fifth principle: that this role for government should be limited in the sense that the government’s role is based on some reasonable cost-benefit analysis. When the cost-benefit analysis indicates that the government should do it, that’s fine. Otherwise, the private sector should do it.
   What I have observed in thinking about recent events is that we sometimes adhere to these principles of good pol...