Dr Budd's policy options for the next Chancellor

'The new incumbent of No 11 will find that his political reputation is determined by the question of whether unemployment can indeed continue falling without triggering inflation'

When Dr Alan Budd was appointed chief economic adviser to the Government in 1991, I asked him what objectives he had for his tour of duty. He said that he would feel satisfied if, over the next five years, unemployment could be consistently brought down, and - much tougher - if the average rate of inflation could be held below the rate of growth of output during his term.

Dr Budd will not retire until November 1997, which incidentally means that an incoming Chancellor will have the immense benefit of his advice in the crucial first few months of office, but it is already clear that both of his objectives will come remarkably close to being achieved. On present forecasts, the average inflation rate from 1992 to 1997 will be 2.7 per cent, only fractionally above the 2.3 per cent rate of growth in real GDP. By any previous post-war standard for the UK, this is a remarkable achievement. Furthermore, unemployment has fallen sharply, and now stands at well below the 1991 level.

Does this mean that the UK has now found the ultimate secret of macro- economic management - the ability to reduce both inflation and unemployment at the same time? This was the subject tackled by Dr Budd in his summer lecture at Sheffield Hallam University, entitled "Conflicts in Economic Policy". His observations are worthy of much more attention than they have so far been given.

Dr Budd specifically tries to answer the question whether it is possible to have policies which reduce inflation and unemployment simultaneously. In doing this, he abstracts from the very short-run lags that are inherent in the economic cycle. Because inflation tends to lag about two years behind unemployment, there have been periods in each cycle where unemployment is falling while inflation pressures are not yet rising, and indeed we may have observed just such a period recently.

But we have now passed the period in which these vagaries of cyclical timing can be relied upon to deliver the happy combination observed since 1992. For the next Chancellor, something more fundamental will be needed if unemployment is to continue declining without any rise in inflation. The new incumbent of No 11 will find that his political reputation is determined by the question of whether unemployment can indeed continue falling without triggering inflation. If the answer to that key question is "yes", then GDP growth will be strong and the next Chancellor may well be able to deliver tax cuts and/or public expenditure increases during his term of office. If the answer is "no", then GDP growth will be modest, and tax increases and/or expenditure cuts will be the order of the day.

This is where Dr Budd's lecture, slightly amended with a little poetic licence to suit today's argument, becomes relevant. He argues that the answer to the key question depends on two distinctions: the first between the short-run transitional effects of policy changes and the long-run equilibrium effects; and the second between cases where "structural" policies are used along with demand management, and cases where they are not.

This gives rise to four distinct cases, each with a different answer to the crucial question. The four cases are illustrated in the accompanying table, which I have called the "Budd policy matrix". Future macro-economic policy makers should keep it on their bedside table for handy reference.

Before examining the individual segments of the matrix, a couple of definitions are necessary. On the horizontal axis, the short-run, or transitional, period is defined as the period of two or three years in which the initial adjustment in the unemployment rate is imposed by an easing in fiscal or monetary conditions. The long-run, or equilibrium, result refers to the eventual consequence of the policy adjustment, once it has had time to become fully absorbed. On the vertical axis, structural policies refer to supply side measures, including reforms to the labour market, and to the tax or benefit system, especially to reduce the cost of employing people on low wages. Such measures to increase effective supply in the economy may or may not be used in conjunction with measures to reduce unemployment by boosting demand.

Now for the answers in the Budd box. In the short run, the answer is unambiguous - policies to reduce unemployment will, in all likelihood, increase inflation. This will certainly be true if demand management is used alone, since the mechanism by which unemployment falls involves the creation of a boom in output first. Even if structural policies are used as well, they are unlikely to work in time to offset the inflationary effect of the boom. So Dr Budd cannot offer much near-term solace to politicians embarking on a programme of demand stimulus to reduce unemployment.

In the long run, however, the situation is a great deal more hopeful. If only demand policies are used to create jobs, the answer becomes ambiguous. As we have already seen, inflation may initially rise. Some economists argue that even a temporary rise in inflation automatically impairs the functioning of a market system, and that this eventually makes it harder to keep unemployment down. Others argue the reverse, claiming that the supposedly transitional benefits of lower unemployment tend to become permanent because some categories of the jobless are rehabilitated back into the labour force, with the result that the "natural" or structural level of unemployment comes down as demand expands.

This leaves the final segment of the table, the only one in which the answer is unambiguously optimistic. In this segment, the government adopts the active labour market and other measures to accompany an increase in demand. These measures, given time to work, increase the supply potential of the economy, thus allowing unemployment to decline in the long run for any given rate of inflation. In this box, GDP growth exceeds its trend rate while unemployment comes down. This fills the Exchequer's coffers with revenue, and gives the Chancellor the luxury of choosing between boosting public services and cutting tax rates.

The present government has persistently tried to push itself into this box, but has all too often found itself inhabiting one of the other segments, either because of the need to recover from short-term policy mistakes (for example, the 1988-89 inflationary episode), or because the supply side measures have not been powerful enough to offset the adverse impact on structural unemployment of two deep recessions.

But the next Chancellor has a very good opportunity to inhabit the happy top right-hand segment of the Budd box. To do this, boldness is needed on the supply side - more labour market reform, amendments to tax policy, training and so on. If this boldness is forthcoming, then the Chancellor has every right to ask the Bank of England to deliver a reasonably easy monetary policy to ensure that the aggregate demand is strong enough to absorb the extra supply.

More structural reform along with a moderately expansionary monetary stance is the recipe that can make Gordon Brown succeed, should Labour win. It is, of course, the structural reform that is the difficult part of this, and I will return to it repeatedly in this column in the run- up the election.