A successful central bank should be boring, Mervyn King said in 2000, when he was deputy governor of the Bank of England. It hasn’t worked out that way.
Under Mr King (governor from 2003 to 2013, when he became Lord King of Lothbury) and his successor, Mark Carney, it has played an exciting role in public life. It will unavoidably be in the headlines in 2017, too. That’s because the Commons treasury select committee announced that it would investigate whether the Bank had been right to maintain aggressively easy credit conditions since the banking crisis of 2007 to 2009.
No one has asked me to give evidence to the inquiry but here is my unsolicited opinion. The system works fine and shouldn’t be changed. The Bank deserves criticism for its performance — but under Mr King, not Mr Carney, and relating to the pre-crisis period rather than the tough times since 2009. I hope that the MPs give a vote of appreciation to Mr Carney for his conduct of monetary policy and for navigating the economy through perilous times. He deserves it.
Let’s go back to Mr King’s ideal of what a central bank should be. He meant “boring” in the sense of unobtrusive. Thus, he likened the role of a central bank to that of a football referee, whose success is judged by how little the refereeing decisions intrude into a game. Mr King’s argument was that in monetary policy operations a central bank should be transparent and its actions predictable. If consumers, businesses and investors can anticipate the actions of the central bank then they’ll have the confidence to take longer-term decisions. If they can do that they’ll be able to take on more risk in the expectation of greater long-term returns. The overall effect will be to boost growth and raise living standards over the long term.
Unfortunately, Mr King’s tenure fell short of the ideal. His first term as governor coincided with an unconstrained credit expansion and asset price bubble. The most visible victim was Northern Rock, which transformed its business model because credit was so easy to obtain. Formerly a medium-sized bank, it borrowed large sums short term in the wholesale markets and repackaged them into mortgage loans, which it lent long term. It became, in effect, a financial engineering company, making profits on the spread between the interest it paid to other banks and the interest it received from its mortgage customers.
All went well until 2007, when financial confidence collapsed and banks stopped lending to each other. Northern Rock failed. Mr King was culpably insouciant. This was the first run on a British bank for more than a century and the proper course for the Bank would have been to extend unlimited liquidity to the banking system to maintain public confidence. Instead of doing this Mr King worried about the “moral hazard”: that bailing out a bank from its bad decisions might encourage other banks to behave irresponsibly.
From the standpoint of academic economics, Mr King’s view made some sense but rescuing the banking system and the real economy wasn’t an academic question. It needed action first and economic theorising later. That, fortunately, is what the Bank did after the collapse of the US investment bank Lehman Brothers in September 2008. It slashed interest rates to 0.5 per cent — the lowest level in the Bank’s history — and kept them there until August this year, when it cut again to 0.25 per cent. It also mounted a huge asset-purchase programme to flood the financial system with liquidity. The Bank reprised these ideas after the Brexit vote by resuming gilt purchases and pledging additional support to the banking system.
Was this the right course? Yes, absolutely. Because economics is far from being an exact science, it’s right that the MPs’ inquiry should take place but we cannot rerun the past eight years to see what would have happened without the Bank’s easy monetary stance. It’s a reasonable assumption that living standards would be lower but for the Bank’s policies. In a speech this month Mr Carney cited results of simulations using the Bank’s forecasting model: without the monetary stimulus real wages would have been 8 per cent lower — or about £2,000 per worker per year — and 1.5 million more people would have been out of work.
Political controversy arises because easy monetary policy has perverse distributional effects. Put bluntly, savers get clobbered and borrowers thrive. The borrower who benefits most is not the retail customer or the business that needs capital to expand but the government, which issues the gilts that the Bank purchases. A second-order effect is that people who already hold assets — property, equities or bonds — also do well.
All this is true but not really relevant to the MPs’ inquiry. Average wages have been squeezed ever since the crisis: they fell by about 10 per cent between 2007 and 2015 but this isn’t a result of the Bank’s policies; the damage would have been worse without them. The Bank has fulfilled its mandate. It is up to the government to use the tools it retains — in policy for spending, tax and benefits — to remedy inequality.
The question remains whether the Bank is right to target consumer price inflation. I believe it is. The present system took effect after the sterling crisis of 1992. The fact that it has lasted that long suggests at least some merit to it. It replaced abortive attempts by the Conservative chancellors Sir Geoffrey Howe and Nigel Lawson to target successively the monetary aggregates and the exchange rate. The merit of targeting inflation directly is that it’s easily understandable to the public. This is less true of an alternative proposal advanced by some economists, which is to target nominal GDP. Targeting exchange rates has a poor record: it’s an open invitation to traders to mount a speculative attack, like the one that drove sterling out of the European exchange-rate mechanism in 1992.
In short, inflation targeting makes economic sense and it is transparent. Price stability is not the only thing that matters in economic policy but the Bank has done a public service in maintaining it. MPs should express thanks and let Mr Carney get on with the job.