Who will end this financial insanity?

by Stephen King, Group Chief Economist and Global Head of Economics and Asset Allocation

Monday, 29 June 2009

Mervyn isn't happy with Alistair because Alistair's housekeeping doesn't quite add up. Adair isn't happy with Mervyn because Mervyn wants to play with Adair's regulatory toys. Alistair doesn't trust Mervyn because he suspects Mervyn is sneaking off to tell George all of Alistair's secrets. Mervyn is irritated because Alistair refuses to show Mervyn his new White Paper. But George is full of cheer because he thinks Mervyn is his new best friend. That, I think, is the human aspect of the rumpus that's unfolded over the past few days. Personalities aside, the row reveals obvious tensions in the UK's monetary, fiscal and regulatory framework.

The first source of tension is linked to the introduction of quantitative easing (QE) by the Bank of England. The Asset Purchase Facility, through which QE operates, focuses mostly on the purchase of gilts. The demand for gilts is, thus, greater than normal, leaving gilt prices higher and yields lower. The Asset Purchase Facility should persuade pension funds and insurance companies to relinquish some gilt holdings to the Bank of England for newly created cash.

The Bank hopes the cash will be invested elsewhere, thereby boosting money supply through the economy, whether or not the commercial banks are willing or able to increase their lending. But with gilt yields lower, the cost to the Government of excessive public borrowing is also lower. The pressure to rein in public spending or to increase taxes is tempered because the interest costs on existing government debt have been reduced. When the scheme was originally set up, Mervyn King, the Governor of the Bank of England, sought assurances from Alistair Darling, the Chancellor of the Exchequer, that the Government would not borrow any more as a result of the scheme. Given that the subsequent Budget showed a persistently deteriorating fiscal position, at least judged by the relentless increase in the ratio of government debt to GDP, it's possible the Bank feels the Government reneged on its side of the deal.

Frankly, none of this is particularly surprising. With the introduction of the Asset Purchase Facility, the distinction between monetary and fiscal policy became increasingly blurred. The Bank of England needs to take a lot more interest in the Government's borrowing decisions because those decisions have an impact on gilt yields. Now that gilt yields are effectively set by the Bank rather than the market, it's effectively the Bank's job to give the Government's wrists a slap if borrowing is running out of control. This was never going to be easy.

The second source of tension stems from the relationship between Lord Turner's Financial Services Authority (FSA) and the Bank. Ever since the late Eddie George, the then-Governor of the Bank, came close to resigning in 1997 when Gordon Brown took the Bank's banking supervisory powers and handed them to the new FSA, the Bank has never been entirely happy.

Then the financial crisis revealed an inherent flaw in monetary and financial arrangements which suggested the Bank's decade-long sulk was partially justified. In Mr King's Mansion House speech a few days ago, he said: "Inflation targeting is a necessary but not sufficient condition for stability in the economy as a whole. There is a broad consensus that our traditional policy instruments need to be augmented by a 'macro-prudential' tool-kit."

This raises big questions. Which institution, ultimately, is responsible for stability in the economy? This sounds an issue concerning macroeconomic policy, so the responsibility should rest with the Bank. But crises of confidence at the macroeconomic level can stem from crises of confidence at the company level, as we saw in the UK with Northern Rock and in the US with Lehman Brothers. Maybe it's an issue for microeconomic policy which, within the financial sector, sits more easily with the FSA.

There is a simple way to deal with this. The Bank should have overall responsibility for economy-wide financial shocks but it would be simple for the FSA to be involved in all relevant discussions and policy decisions. With the Bank accepting that price stability is no longer a sufficient condition for economic stability, this collective approach would be a welcome step. It would be an improvement on the pre-credit crunch arrangements when the Bank focused on the control of inflation and the FSA worried about the balance sheets of individual companies while systemic risks were foolishly ignored.

The third source of tension runs deeper. The Bank is proud of its independence. Yet its independence is not guaranteed. The Governor is appointed by the Crown (10 Downing Street). The external members of the Monetary Policy Committee are appointed by the Chancellor. And the MPC's mandate is set by the Government. After new legislation this year, the Court of the Bank of England - the equivalent of a company board - is no longer chaired by the Governor but by a non-executive appointed by the Chancellor.

If the Bank's job is to deliver price stability and broader economic stability, it will inevitably clash with the government of the day from time to time. That is the true test of an institution's independence. In some ways, the public spat between the Chancellor and the Governor is a healthy part of delivering good economic policy. Indeed, the Governor would probably argue he was following in the footsteps of Bundesbank presidents never afraid to give German Chancellors and finance ministers a public dressing-down when required.

And the Bundesbank would never have turned on the printing press. But whether the Bank of England did so voluntarily is neither here nor there. What matters is that the policies of the Bank of England and the Treasury are inextricably linked. UK policy now will work only on a co-operative basis. Until this essential point is recognised, the danger of public squabbles, undermining the credibility of all our economic policy arrangements, remains high. Presumably, George is secretly smiling.