Congratulations to the Ralph G. Hawtrey Chair of Monetary Policy! Making my way through some of the references from George Selgin’s monograph “Less than Zero” recently, I ended up reading a transcript of a Chatham House discussion from 1929 on “The International Gold Problem”. The transcript is a bit rough in places, but whole thing is a fascinating read; here’s a contribution from Hawtrey to add to Scott’s collection:
Mr R. G. HAWTREY: In my view one of the most serious evils arising from fluctuations in the value of the currency is the trade. Whatever the causes of the trade cycle may be, one thing is common ground to every one, and that is that the trade cycle include the fluctuation of the price level combined with a fluctuation of productive activity. The two go together. Fall in price were due to increased production and the rise in scarcity, no further explanation would have to be looked for. But in fact the fall coincides with diminished production and the rise with increased production. The total value in money of the output of the world is increased both by the percentage by which prices rise and by the percentage by which the physical volume of production rises. Likewise, the subsequent fall in the price level is superimposed on the shrinkage of production. These wide fluctuations in money value of output are clearly a monetary phenomenon. A fall in the price level due to monetary causes brings about business depression and unemployment. The depression of the ’eighties, following the general adoption of the gold standard and the heavy fall in prices from 1873 onwards, supplies a well-known example.
More than eight decades later and it is now a minority view that the “wide fluctuations in the money value of output” … i.e. nominal GDP since 2008… are “clearly a monetary phenomenon”!
State-of-the-art monetary theory in 1968 from Milton Friedman:
Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction.
State-of-the art monetary nonsense in 2014 from Martin Wolf:
High-income economies have had ultra-cheap money for more than five years. Japan has lived with it for almost 20.
From this weak start Mr. Wolf goes on to conclude that it is necessary either to have “big government” or to “wipe out the rentiers”:
Low interest rates are certainly unpopular, particularly with cautious rentiers. But cautious rentiers no longer serve a useful economic purpose. What is needed instead are genuinely risk-taking investors. In their absence, governments need to use their balance sheets to build productive assets. There is little sign that they will. If so, central banks will be driven towards cheap money. Get used to it: this will endure.
Cheap money? If only. Meanwhile, Gavyn Davies is worried about those naughty capitalists taking, erm, excessive risks:
The case for macro prudential controls is straightforward . During economic upswings, the behaviour of the financial system can become destabilising. Banks’ balance sheets are flattered by the expanding economy and low interest rates, so credit supply expands aggressively. This fuels the boom until risk taking becomes excessive, and even a moderate rise in interest rates produces a financial crash. Direct intervention in the financial system to head off these problems early, through increased capital and liquidity standards, seems to be justified.
So concerned is Mr. Davies that we might have a recession…
While an interest rate rise might be compared to firing a shotgun, macro prudential measures might be closer to a rifle shot. However, the separability of the two weapons raises many issues and difficulties. Both may need to be fired simultaneously in order to get the job done.
… that we might need a little bit of a recession to keep those risk-takers under control. What a fine mess this is.
HT: Marcus Nunes
We need an name for a macro model in which changes in house prices drive changes in aggregate demand. I am going to suggest “Londonism” because this idea seems to be a metropolitan obsession, though better suggestions would be welcome. I will continue be snarky, annoying, and contrarian in my neutral slash positive view of rising nominal asset prices.
This is the Guardian from June 2008, when the UK was already in recession, though we didn’t have the GDP figures to show that yet:
Amid City fears that the Bank of England’s decision yesterday to peg the cost of borrowing at 5% could push the economy into recession, the Halifax, Britain’s biggest mortgage lender, reported that the cost of a home fell by 2.4% in May, wiping almost £5,000 off the cost of an average house.
Back in 2008 those naive City economists didn’t realise that when house prices fall, people can buy more houses. That’s how it works, right? Falling prices mean housing is “more affordable”, rising prices mean “less affordable” houses? No? Am I missing something?
Remember also that monetary policy was “doing all it could” to prevent the global financial crisis from escalating into a UK recession, but yes, Bank Rate continued to be pegged at 5% all the way to October that year. The Graun continue:
Last month’s decline marked the seventh fall in nine months. In the past three months, prices have dropped by 6.1% – faster than at any time since the bank began publishing data in 1983. The biggest fall during the downturn of the early 1990s was the 3.8% decline between August and October 1992, a period which included Black Wednesday.
Wait, there is some link between recessions and changes in house prices? What can it be? Find me a Londonist… Mr. Bootle?
Roger Bootle, economic adviser to Deloitte, said the 8% drop in house prices since their peak was likely to turn into a fall of 20% by the end of 2009, with knock-on effects on consumer spending. “The UK economy is on course for a very deep and prolonged economic downturn, if not an outright recession,” he added.
Ah, there we go. “Knock-on effects” from falling house prices. Mr. Bootle was right about the “outright recession”, but I’d suggest the Bank of England is right about the cause.
I enjoy reading the Hansard achives from the 1930s… what an amazing resource. It is not hard to find parallels to modern-day debates about macro policy. The following quote is from David Mason MP speaking in Parliament in July 1934 during a debate which appears to be mostly about monetary policy:
It is rather interesting to see how complete is the analogy in many respects between that period of history after the Napoleonic Wars and the period through which we are now passing. Of course, there is the difference of time, and increases of population and so forth, but there were inflationists and deflationists, paper money men and bullion men just as there are now, and it is curious and interesting to find, if one will take the trouble to read up the Debates in this House, comments and statements made almost similar to those that are being made to-day.
I believe that, if His Majesty’s Government would announce in due course that they were prepared to set up an inquiry into the monetary system and into monetary policy, they would be astonished at the flame of enthusiasm that they would arouse throughout the country, especially among the younger people. They are not satisfied with world conditions as they are to-day; they are not satisfied with any policy of going back to 1924 or 1914; they feel that the productive capacity of the world is immense, but that it is not being utilised owing to the defects in the monetary system, which should facilitate the exchange of goods and services all over the world.
I love that clarity. So many today talk about monetary policy only in terms of borrowing and lending or banks or interest rates… how about sticking with “facilitating the exchange of goods and services”? A little later from Loftus, here is that history we’re repeating:
We know the effect which, as my hon. Friend the Member for East Aberdeen has pointed out, deflation has had upon our people; and we know also that to-day the economic problem is linked with the political problem. In Yugoslavia you have revolutionary discontent. Why? There is deflation. In Italy under the surface there is revolutionary discontent, Why? Deflation. In France, riots and revolutionary discontent. Why? Deflation. What was that bloody business in Germany the other day caused by but the pressure of deflation constantly driving down the standard of living? That was the main cause.
The loci of the riots and deflation only a little different this time around.
Chris Giles reports that the Chancellor is wavering:
George Osborne is cooling on the idea of changing the Bank of England’s inflation target to one aimed at the amount of spending, top Treasury officials have told the FT. The chancellor now thinks there is sufficient leeway in a “flexible” inflation target for the central bank to boost growth.
The chancellor, who met Mark Carney, the BoE governor designate, for a drink on the sidelines of the World Economic Forum in Davos on Thursday night, is worried that Mr Carney accidentally set up unrealistic expectations of a revolution in monetary policy in a December speech.
The chancellor still wants the new BoE governor to be more active in ending economic stagnation, but does not believe that the bank needs to target nominal gross domestic product to ensure such a change.
Aides to the chancellor say he thinks a move to make the inflation target more flexible is likely to be sufficient, even if that might require a change in the annual remit given to the BoE.
That is depressing. Here is how the OED on-line dictionary defines the word “policy”:
a course or principle of action adopted or proposed by an organization or individual
The monetary policy regime we’ve had in the UK since 2008 has been highly discretionary. It has not been based on principles. If Osborne thinks the Bank of England needs a more “flexible” target – more discretion – he has the analysis completely backwards.
Back in 2007 if you thought about which people you wanted running central banks, you’d come up with guys like Mervyn King, Ben Bernanke and Lars Svensson. Uber-smart macroeconomists with impeccable academic credentials. If all that results from the current debate about monetary policy is that we appoint central bankers we think are really smart, and give them discretion to “do the right thing”, market monetarists have mostly failed.
Some say we need tight money to get inflation down. Some say money is already easy and we need loose fiscal policy. I say, if it walks like a duck and quacks like a duck, it’s probably a duck. The above chart looks like a severe failure of demand-side policy in the United Kingdom over the last five years. Severe failures like this happen when we have the wrong monetary policy. Not because fiscal spending was a couple of % of GDP too low, or taxes were a couple of % of GDP too high.
The failure of 1970s is also obvious in that chart; pushing demand up faster and faster for ever-decreasing returns. But does 2008-2013 look anything like the 1970s? No; quite the contrary. It looks like we have compressed demand tighter and tighter. Yet here is Mervyn King last week:
In assessing the current [monetary policy] framework, however, there are two factors that should not be ignored. First, the primary responsibility of any central bank is to ensure stability of the price level in the long run. To drop the objective of low inflation would be to forget a lesson from our post-war history. In the 1960s, Britain stood out from much of the rest of the industrialised world in trying to target an unrealistic growth rate for the economy as a whole, while pretending that its pursuit was consistent with stable inflation. The painful experience of the 1970s showed that this illusion on the part of policy-makers came at a terrible price for working men and women in this country. The battle to bring inflation expectations down was long and hard, and involved persistently high levels of unemployment. Wishful thinking can be indulged if the costs fall on the dreamers; when the costs fall on others, it is unacceptable.
Look at the words he chooses to use: “unrealistic”, “painful experience”, “illusion”, “terrible price”, “wishful thinking”, “the dreamers”. This is an unrepentant defence not just of the 2% inflation target as the optimal policy regime, but of UK demand management on his watch. He’s saying “this is as good as it can get, buckle down and take your medicine”. It is this or the 1970s!
On the basis which theory says we should judge the stance of monetary policy under “flexible IT” – the deviation of forecast inflation from desired inflation, the Bank of England has found the “discretion” to fail abysmally – and yet the Governor insists everything is just fine.
The “discretion” of central bankers is a problem which echoes around the world. The ECB – which has never even hit the ZLB – uses tight money to depress Eurozone AD and force sovereign governments to do supply-side reform. The Bank of England throws multi-billion-pound bungs at the banking sector (aka the “Funding for Lending Scheme”) in the name of “creditism”. The Bank of Japan refuses to even try hitting the inflation target set by the newly elected government. Lacking any sense of irony, the Riksbank has set out to “prove” that household debt “causes” an AD collapse, by explicitly running tight monetary policy in response to the growth of household debt – to Svensson’s evident disgust.
None of this should be an acceptable state of affairs in a modern democracy. Institutions run by unelected technocrats should not have free reign to depress the economy as they see fit. The “flexible” inflation target offers them that freedom. We cannot and should not rely on finding “heroic” Central Bankers riding in from the West to bravely rescue us when the current round of “heroic” Central Bankers has thrown the economy off the cliff.
It seems the righter-wing end of the Conservative party has had a think about their party’s 2015 electoral prospects, looked at the GDP figures, and gone into a little bit of a panic. Not necessarily a bad thing. What is their plan?
Liam Fox today gifted a stream of “nasty party” quotes to the Guardian sub-editors, allowing them to concoct headlines with the words “slash” and “welfare” carefully arranged to maximize the righteous indignation of their readers. David Davis last week made a speech calling for a government “growth strategy” – and the growth strategy that he and Fox have in mind is no more and no less than “radical” supply-side reform.
Davis and Fox remember that Thatcher won elections, and Thatcher loved supply-side reform. So they revert to this primitive ideal of Thatcherism which says “supply-side reform wins elections”.
But they have forgotten that a good part of Thatcherism was demand-side, with the adoption of monetarist targets for the broad money supply aimed at providing lower, and stable inflation. Cobham’s book on UK monetary policy makes the point that this was more an evolutionary change than a revolution; monetary targets had been used but completely ignored in the 1970s; after the targets were made more explicit in the 1980s, they were still ignored or revised when policymakers found that convenient.
Regardless, the demand-side policies under Thatcher brought down nominal GDP growth from an average annual rate of 16% in the 1970s to 9% in the 1980s. Some volatility remained with inflation and NGDP soaring in the first years of the decade and another (less severe) spike at the end during the “Lawson Boom”. The intervening period saw marked stability in nominal GDP, real GDP and inflation. Lawson’s abortive ERM experiment was another unnecessary screwup, but the subsequent adoption of inflation targeting in 1992 set the stage for 16 years of stable growth.
My point is not to elevate the record of demand management under the Tory governments of the 1980s, a record which is certainly not above criticism. But it was generally a lot better than what came before. Davis’ idea of a “growth policy” is simply to pretend the demand side does not exist, or in his words:
when I talk about a growth policy, be clear that I am not talking about an exercise in Keynesian demand management.
He is similarly dismissive of Japan’s experience with “suppressing interest rates to zero”. Milton Friedman keeps on turning in his grave.
Davis does come out in favour of government-funded infrastructure spending, but purely for its benefits in improving the supply-side and long run growth. This support is conditional; it must only be infrastructure spending on things David Davis thinks are really good. Which apparently means that high speed rail is out, and gigabit broadband is in, because South Korea has gigabit broadband and therefore, um, handwaving here. I’m not sure Davis has fully grasped the Hayekian critique of central planning embraced by Thatcher.
The (short) list of supply-side reforms which Davis deems necessary for growth may well (or may not) be sensible ideas. Jonathan Portes is surely correct to point out that an “easy win” from supply-side reform would be to relax the immigration rules tightened under the Coalition, a subject which the likes of Davis and Fox are curiously silent on. But supply-side reform will not help escape from the demand-deficient slump we are in. UK nominal demand growth has been weaker over the last four years than any other period on record, and there is no obvious recovery imminent.
For these politicians to abandon any consideration of demand policy right now not only contributes to their party’s electoral suicide, but is a repudiation of the Thatcherism they claim to admire. Monetarism’s “second counter-revolution” offers an escape from what might be considered “Keynesian” demand management, but the Tories have little time to embrace it.
Here is the graph of the headline UK CPI rate, and the Bank of England’s median forecast for the CPI rate looking 3 years out. The latter is a roughly what the MPC aim to adjust when setting the monetary policy stance, as per Lars Svensson’s “target the forecast” methodology. If the forecast is nailed to 2%, go and watch the tennis. Otherwise, adjust the monetary policy stance until the forecast is at 2%.
The last recession, and the ongoing double-dip are shaded.
Is it chance that the failure to hold the forecast at 2% was preceded both times by a spike up to 5% on the current CPI rate?
And then.. is it chance that both episodes of failure are associated with a recession? Correlation, but no causation? Admittedly it would better to look at some measure of nominal demand growth here, not just falling real GDP.