A policy vacuum

Leadership in international economic policy is severely lacking at present, and the consequences could be severe.
A remarkably disturbing analysis from the Bank for International Settlements (BIS) last week received very little coverage. The BIS, the central bankers' bank, drew attention to the vacuum in economic policy created by the fact that the rest of the world can no longer rely on the US as (to use a phrase from previous BIS annual reports) "importer of last resort".

As the BIS states, the fashion for policies of "structural reform" is all very well but unless other countries supplement such reforms with "more expansionary demand management policies", it is an open question whether domestic demand will expand elsewhere, notably in continental Europe and Japan, after a long period of weakness.

An illustration of the way economic debate has almost become stultified is provided by the latest edition of the Organisation for Economic Cooperation and Development's (OECD) bi-annual Economic Outlook (published in June).

At a time when many policymakers are becoming seriously concerned about the lack of room for manoeuvre with monetary policy - because interest rates are getting closer to zero - the OECD baldly states: "There seems to be little room for manoeuvre left for fiscal policies beyond the use of automatic stabilisers."

Automatic stabilisers are the mechanism by which the economy to a certain extent - but only to a certain extent - is self-stabilising. Thus in a slowdown, unemployment benefits rise, a process that alleviates the downward pressure on the economy; and, during a boom, tax receipts shoot up, thereby taking some of the steam out of excess demand.

A problem in the past was that some governments chose to cut taxes in a boom, thereby prolonging the overheating of the economy. In technical terms their so-called stabilisation policy was anything but; indeed, it has been what economists call "pro-cyclical" - exacerbating the cycle, not dampening it.

But the fact that there has been bad behaviour in the past does not justify eschewing the use of tried and tested fiscal weapons when an economy is as depressed as the continental European economy - most notably Germany - is now.

Moreover, however great the fashionable concern about the impact on government budgets of pensions and ageing populations in the medium to long term, the real crisis - economic stagnation and rising unemployment - is upon Europe now.

In order to arrive at the medium to long term policymakers should surely be concentrating on the short term crisis. It has come to something when there is greater recognition of the crisis on the part of inflation-conscious central bankers than there is at the OECD - once a fine Keynesian body!

The Federal Reserve Board in the US has switched its concern from inflation to deflation, keen to avoid falling into the deflationary trap that has ensnared Japan. But US policies have brought their own risks, particularly for Europe.

The Bush administration has deliberately pushed down the dollar to boost exports and stoke economic growth. That may be fine and dandy for the US, but a weaker dollar hurts European exports, stifling growth in the eurozone. In effect, the US is exporting deflation.

This economic unilateralism is part and parcel of Washington's current overweening confidence, but it is a dangerous game. By pursuing its own interests regardless, the US risks destabilising the global economy.

The retirement of Wim Duisenberg as president of the European Central Bank does not help matters. Given the US policy he should be all the keener to reduce interest rates and encourage a civilised relaxation of the stability and growth pact. He is doing neither.

· William Keegan is economics editor of the Observer