Montagu King and the Keynesians, A Short Story
Here’s a story about politics, economics and personalities. Feel free to disagree with my characterisations…
In 1997 Gordon Brown gave the Bank of England independent control over UK monetary policy. This, finally, freed UK demand management from the interference of meddling politicians, who could
neveralways be trusted to inflate a little bit too much if there was an election on the horizon. Brown’s economic adviser at the time was Ed Balls, and they set the Bank a simple nominal target: the inflation rate, inspired by the success of the Reserve Bank of New Zealand.
Everything goes well for ten years. But fast-forward to February 2009, and the UK is in a deep demand-deficient slump. The Bank of England forecast the inflation rate falling to fall below 1% by the end of the year and staying around there for the rest of three year forecast period. Their 2% target is not in sight.
In March 2009 Mervyn King cranked up his printing press to full speed, and promised to print and keep printing until nominal GDP was growing at a speed consistent with hitting the Bank’s 2% target. It was probably the clearest form of “forward guidance” the Bank has ever given. It was the closest the Bank has come to using NGDP as an “intermediate” target. Most importantly, it worked. Over the rest of that year, equity markets soared, gilt yields rose, the CPI rate recovered back up towards 2% much faster than expected back in February.
By the end of 2009, King was on top of the world. He’d avoided the Japan trap, the dreaded deflation. The CPI rate was firmly in his control. Controlling the size of the monetary base worked just as well when short-term interest rates were at zero. Q.E.D.
Then politics came along. The UK government was running a large fiscal deficit – this was King’s fault too, but that’s another story. Having awarded the Bank independent control over UK aggregate demand, the interfering politicians were busy arguing about how much and how fast they should cut the deficit, in fear of hurting aggregate demand.
This was a blatant challenge to the Bank’s independence. King would not sit idly by in that debate. He called for a tighter fiscal stance. He made it absolutely clear that the Bank would offset whatever was happening with fiscal policy to maintain an appropriate path of AD – i.e. to keep hitting the inflation target.
An election came and went, and lo, the deficit stance was tightened (in fact, it was tightening regardless). By the start of 2011 the GDP figures were looking weaker and the CPI rate was drifting upwards, heading well above 4%. When pressed on the deficit policy King re-iterated his support for tightening the fiscal stance.
This was an outrage to Ed Balls. Mervyn King – a mere civil servant – was interfering with government policy, and even had the cheek to claim he had control over UK aggregate demand! Where did he get that idea from? No lesser figure than Paul Krugman himself also expressed his disdain at King’s position, a disdain widely expressed by Keynesians since 2010.
Fast forward to 2013. Mervyn King “successfully” navigates through three years of “tight” fiscal policy, continually missing his CPI target on the up-side and allowing real GDP to stagnate.
He then calls for… supply-side reform. After all, his demand-side policy has been damn near perfect. He’s never undershot the nominal target given to him by the elected government. He allowed “base drift” in the face of supply shocks as a proper flexible inflation-targeter should. He tolerated above-target CPI when growth was weak. What more can you ask of him? Clearly our problems are not demand-side!
So what say the Keynesians? Is it the proper role for a Central Bank governor to call for supply-side reform, even though he may not speak of fiscal deficits or their impact on his ability to perform demand-side stabilisation?
I am waiting to hear the shock and outrage from Ed Balls and other Keynesians, on the unnecessary interference in government policy made by the Bank of England Governor this week.
(I’d also love to hear more about how the UK’s chosen path of demand stabilisation – a 2% inflation forecast-targeting “independent” central bank, has been such as success that so few economists seem interested in changing it.)