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The Bank of England must do more than fight inflation
The real question is not who will take over at Threadneedle Street, but whether we need a new job description
21 Aug 2012
Stephen King, Group Chief Economist
Should you fancy a flutter, there isn't much to choose between the supposed front-runners to be the next Governor of the Bank of England. Paddy Power is offering odds of 7-4 for Adair Turner, 9-4 for Gus O'Donnell and 5-2 for Paul Tucker.
Those of you who remain unconvinced can always bet on one of the outsiders. As I write, you can get 300-1 on Fred Goodwin and 1,000-1 on Harry Redknapp.
For all the hype over Sir Mervyn King's replacement – much of which now seems to focus on the need for saintly perfection – one thing has been forgotten. While we might be familiar with the job title, are we happy with the job description?
The Bank of England has two core purposes: to ensure price stability and to contribute to financial stability. Given the UK's economic performance in recent years, it could be argued that it has scored rather poorly in both.
The pursuit of low and stable inflation is neither a necessary nor a sufficient condition of lasting prosperity.
But is this the fault of the Bank or a reflection of a government-imposed inflation-targeting mandate based on a now defunct economic orthodoxy?
In the years before the financial crisis, the Bank had an exemplary record in achieving its inflation target. But this didn't prevent the crisis. Why have things gone so badly wrong? Is it the fault of the Bank's incumbents? Have they been victims of circumstance? Or was the job description itself misguided?
Certainly, Sir Mervyn has had his critics. As the crisis took hold, some thought him preoccupied with moral hazard even as the financial system was threatening to collapse around his ears. In Back from the Brink, Alistair Darling admonishes him for his "blatant bid [in 2009] to take over the regulation of the banks ... but, whether Mervyn liked it or not, the design of the regulatory system and the primacy of the Bank ... are matters for the Government, not the Bank".
Circumstances most certainly played a role. The UK's collapse was hardly an isolated incident. Without the American sub-prime crisis, the UK might never have experienced such an alarming meltdown. Commercial banks both here and abroad have hardly covered themselves with glory. And, despite the Bank's noble attempts to kick-start the economy through quantitative easing and other associated "miracle remedies", the eurozone crisis has made an imminent UK recovery all the more unlikely.
Yet the job description has hardly helped. Since being granted its independence in 1997, the Bank's main monetary task has been to achieve price stability, as stated in the Bank of England Act 1998. This boils down to "an inflation target of 2 per cent ... The inflation target is 2 per cent at all times ... the Government believes that low and stable medium-term inflation is a prerequisite for economic prosperity."
Well, up to a point. No one would advocate rampant hyperinflation as a "cure-all" for our economic woes nor would anyone with any economic nous argue for sustained deflation. Unfortunately, however, it has proved all too easy to believe that with the achievement of low inflation, our macroeconomic problems are over.
It is, however, a foolish belief.
The US had low inflation in the 1920s, yet achieving price stability did little to prevent the Wall Street Crash or the Great Depression. Japan had low inflation in the 1980s yet this did not prevent enormous land and stock market bubbles that duly burst, leaving the Japanese to face two lost decades. John Maynard Keynes hardly mentioned inflation in his General Theory yet he was, surely, writing about serious macroeconomic problems.
In itself, low inflation is desirable. The single-minded pursuit of low inflation, however, can create all manner of distortions that, in turn, threaten our prosperity.
Take, for example, the situation before the onset of the crisis. In the early years of Bank independence, the UK was importing large amounts of deflation from China and other emerging nations thanks to the impact of outsourcing on the price of manufactured goods. Rather than simply accept that inflation would undershoot for a while, the Bank offset lower imported inflation with higher domestic inflation. To do so, monetary conditions were left excessively loose, helping to stimulate a housing boom.
Later on, as global deflationary pressures dissipated, the Bank raised interest rates hoping that sterling would appreciate on the foreign exchanges and bring lower import prices. The policy worked, but there was an unfortunate side-effect: higher interest rates attracted hot money from abroad, leading to excessive credit creation and looser lending standards, sowing some of the seeds of the crisis.
The pursuit of low and stable inflation is neither a necessary nor a sufficient condition of lasting prosperity. To be fair, the Bank had no real choice – it was attempting to fulfil its price stability mandate. But we now know that the mandate wasn't good enough. We need to know not just that inflation is low and stable but also why it is low and stable.
All of this suggests that the job description must change. At the moment, the remit of the Bank's Monetary Policy Committee (MPC) requires the Governor to write a letter to the Chancellor of the Exchequer only when "inflation moves away from the target by more than 1 percentage point in either direction".
That encourages the complacent view that achieving price stability is both necessary and sufficient for lasting economic prosperity. Either the letter writing should be dropped altogether – it is already something of a charade – or the process should be completely reformed, so that the Governor regularly has to answer three key questions: (i) is inflation at, or close, to target? (ii) if yes, has this achievement been accompanied by widening financial imbalances (excess credit growth, deteriorating balance of payments position etc)? (iii) what actions are additionally required to deal with said imbalances?
Those drafting the mandate might also want to think about measures of inflation that best capture excess credit creation, suggesting a role for asset prices, notably house prices.
Such an approach provides a bias in favour of low inflation but also recognises that our economy is a complex system that cannot possibly be simplified into a "yes or no" answer on inflation alone. After all, if the next Governor only had to answer that question, even Harry Redknapp, a man known primarily for his soccer management skills, could do the job.
Stephen King originally wrote this article for The Times newspaper, published on 21 August 2012.