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  The present system is obsolete; the real question is what the Bank’s role should now be.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.