Time to rethink the Bank of England

It seemed a great idea at the time.  Independent central bankers managing our economy on a strictly technical basis, preventing politicians from mis-managing it for short-term ends.  Alas, even if this was not an illusion then, it surely is now.  Central bankers across the world are becoming politically controversial.  Meanwhile their policy decisions, be they changes to the interest rates under their control or buying bonds (“quantitative easing” – QE), either have no effect on the real economy or do not have the effect intended.  But the recent coverage of the Bank of England’s latest interest rate decision shows than most observers are still stuck in the old narrative.  The present system is obsolete; the real question is what the Bank’s role should now be.

Monetary policy, as now conceived, arose in the 1980s, after confidence in economic policy collapsed, amid a toxic combination of high inflation and high unemployment in most countries.  Out of this wreckage came the idea that the economy at large responded to changes in the money supply, which influenced the decisions people made in output and employment, and in prices and wages.  By managing the money supply we could manage the overall economy.  And what was more, we could make this a relatively objective, technical process, by limiting growth to what the economy was able to produce, and keeping inflation into a nice, tidy band.  Fiscal policy, taxes and public spending, were pushed into a relatively minor role, and became politically suspect.  A new economic orthodoxy grew, sometimes called neo-Keynesianism, with Economics students given new sets of diagrams to learn, while economic modellers translated this into more complex mathematical equations.   Then, in 2007, it all went horribly wrong.  Two basic problems are now quite evident.

The first is trying to understand how exactly monetary policy works.  Its advocates had always been vague about this, their case based mainly on historical correlations rather than actual, practical mechanisms.  To the public, policymakers talked about printing presses, as if it was all about the number of banknotes printed and put into circulation…which was clearly nonsensical in a modern economy.  During the 1990s the process focused on the setting of interest rates, with the central bank using its power as banker of last resort to manage interest rates on the overnight deposits made by commercial banks, a process which indirectly affected the supply of money.  While I was studying economics at UCL (in 2005-08) our lecturers admitted this was pretty thin.  Long term interest rates were more important, and yet the central bank’s influence over these was marginal.  More important, as electronic money and “shadow banking” exploded, it was not at clear how central banks were supposed to manage the volume of money supply at all; even defining it became impossible.  The whole thing completely fell apart in 2007 when the interbank market seized up, leaving the central banks’ instrument of management broken.  The central banks pulled their levers one way, and yet the actual supply of money, in practice if not in statistical definition, went the other.

The second problem with monetary policy is more fundamental still.  Real people and markets don’t respond to changes in money supply as they theoretically should.  The main effect of policy changes seems to be on the prices of shares and property – not the amount people consume.  So loosening policy merely inflates asset prices, having little effect on output, prices and employment.  Alan Greenspan, the US Federal Reserve’s previous chairman even seemed to make a virtue out of this – suggesting that strong share prices helped sustain investment and consumer demand.  But this leads central bankers into a very dark place, as the Economist’s Buttonwood column has recently pointed out.  What on earth are central bankers doing trying to manipulate asset prices?  Surely asset prices should be set by a properly functioning free market?

So central banks have comparatively little influence on the real economy, and what influence they do have is mainly on asset prices, rather than on employment and consumer prices.  Accept this and you quickly see that asking them to manage inflation as we do in the UK (or inflation and employment, as in the US) is absurd.  It may not even be healthy to confine inflation to a narrow band – there can be perfectly good reasons why it is right to allow inflation to run ahead at a particular time in a particular economy, or, indeed, to let the supposedly wicked deflation to run.  Central banks’ role should be much more limited.  They should control seigniorage (profits made on the creation of currency) and ensure that the markets for money are orderly.  And that’s about it.  Even managing exchange rates is toxic, as the Swiss are finding.

This is the best reason for raising interest rates in the UK (and US) at present.  They are so low that money markets can’t do their job properly – it is much healthier if savers can expect some rate of return.  And, frankly, asset prices are too high anyway.  Not that anybody on the Bank of England’s MPC seemed to offer anything like this reason for raising rates in their  minutes.  George Osborne still seems to believe that the Bank can help him out if fiscal policy seems to be too tight.  The level of denial remains astonishing.  The game goes on; it’s not going to end well for the Bank, I fear.

Megatrends – where will we be in 2030?

Mark Pack recently wrote an article in Liberal Democrat Voice about how badly awry political predictions went in 1992.  Politics, an interaction between adaptive and opportunistic parties is inherently unpredictable.  What about the economy?  The big trends (“megatrends” I will call them, to contrast with “microtrends” in fashion a couple of years back) of the 1990s were technology (internet and mobile phones) and globalisation, especially the rise of China and India.  I may be mis-remembering, but these unfolded more or less as predicted if you discard the excitable froth.  But these trends have played out.  What does the future hold for the British economy.  What will 2030 look like?

First megatrend.  The era of cheap imports is over.  Chinese and Indian costs were so low in some industries that ours could not compete; many jobs were lost in manufacturing, especially.  These jobs were replaced by well paid jobs in more up-market and high tech businesses (including finance) and by a lot of poor quality service jobs too.  On average, Britain prospered, but inequality grew as well.  The economics of this (the law of comparative advantage, to talk technical) is notoriously difficult to pick up intuitively.  But, as the developing economies prosper, their cost advantage erodes.  We saw this with South Korea and Taiwan; it’s now happening to China and India, whose costs are rising rapidly.  There doesn’t seem to be a huge pool of undeveloped countries to replace them at the bottom of the market.  Bangladesh, Pakistan and various African nations might rise to it, but they don’t seem to have the political stability or governance required.  The good news is that the steady stream of job losses will diminish, especially at the lower value end, and jobs will even be repatriated.  The bad news is that our overall living standards will stagnate, since we no longer get the boost from consuming cheap imports.

Second megatrend.  Energy costs are going up.  The range of predictions ranges from the serious to the apocalyptic.  Demand for energy of all sorts, but especially oil, grows as developing countries develop.  There are plenty of energy sources, but to increase overall supply means tapping into energy that’s much more expensive to get.  The consequences of this are quite profound (this is a favourite topic of the Economist Buttonwood blog, like here and here).  This will prove a major drag on living standards and we will have to invest huge sums in both new energy sources (especially alternative energy) and energy conservation (especially our homes).  Something analogous may be happening in food and agriculture.

Third megatrend.  The work force will stagnate.  The baby boomers are retiring, or at least want to wind down; most mothers that want to are already working for as many hours as they want, rather than staying at home with the children. Immigration is coming down, as we fret about the social consequences, and anyway we don’t provide such an attractive proposition to immigrants, as the economies of east Europe steadily catch up.  And productivity has reached such levels that many question the need to work so many hours, and crave a better work-life balance.  This puts a strong damper on the economy, although it’s not all bad.  More leisure, if people want it, is a sign of economic success, not failure.  The problem is if publicly funded benefits are supporting leisure that is not earned (by artificially low pension ages, for example)…though my feeling is that this is less of a problem in Britain than elsewhere.

This is pretty negative stuff.  So what about the fourth megatrend: the continued advance of technology?  This is very difficult to read.  One article I read recently suggested that current technology trends are rather ephemeral: smartphones and social networking don’t have the power to change things like the internet and mobile phones did.  But we can’t know; the Economist carried an interesting article last week on how print technologies are transforming manufacturing industry.  We have to invest a lot of hope in technological change to help meet the other challenges.  Which means we must understand how technological advance works.  It’s disruptive; the law of diminishing returns slowly kills off the current industry leaders (look at Pfizer closing down its R&D outfit because it doesn’t pay any more).  The process is disruptive and favours the nimble, be it glitzy Silicon Valley start-ups, or earnest German family businesses.

So where am I going with all of this?  The trends that shaped our economy in the last 20 years are coming to a halt or reversing.  We face major challenges which mean improvements to standards of living are most likely to come from technological innovation and a more equal distribution of wealth.  Some of the trends of the last 20 years, growing inequality and companies retaining a bigger share of profits, may well go into reverse.  Bad news for share prices.

What should governments do?  First promote innovation – and the key point is to make it easier for smaller and medium sized companies to get cheap finance; which means big changes to our banking system.  Second, energy policy will be critical; even if you are a climate change sceptic, there remains a lot of value in low carbon policy as cover for dealing with rising energy costs.  Third, the public demand for “fairness”, however impossible to define, is here to stay.

Economists may fret about stagnant income, but this doesn’t have to end badly.