Did the Bank of England cause the boom and bust?

The Bank of England Did interest rate cuts create a dangerous risk appetite?

How much were central banks, notably the Bank of England and the US Federal Reserve, to blame for the financial boom and bust that's landed us with years of economic stagnation?

To date, most of the blame has been attached to the recklessness of bankers and myopia of financial regulators, such as the Financial Services Authority.

But central bankers have typically been tarnished only with failing to see or shout loudly enough about all that excessive and under-priced lending that took place in the run-up to the crash of 2007-8, rather than having directly contributed to it.

Which is why a recent speech by Paul Tucker, deputy governor of the Bank of England, is so striking. Under the racy title of "National balance sheets and macro policy: lessons from the past", he says there is evidence that cuts in central banks' policy rate, what's known as the Bank Rate in the UK, contributed to the lethal process of investors taking ever greater risks to earn a miserly increment of extra return.

He doesn't put it quite like that. What Tucker says is that "the possibility that monetary policy can affect risk premia should be taken seriously". But it amounts to the same thing.

And he also makes two related points. First he says research suggests that "for all major asset classes the principal drivers of fluctuations in asset returns are shifts in risk premia rather than in expected cash flows" - or, to put that in cruder terms, the price of assets such as shares and bonds responds more to changes in investors' appetite for risk than to their rational calculations of the future stream of dividends to be paid by companies, or the extent to which rents on properties are likely to rise.

Secondly he says that "shifts in risk premia are key factors in macro-economic fluctuations". Or to put it another way, if banks are lending too much too cheaply, that can lead to boom and bust. Doh!

All of which he describes as a "big deal".

The 'financial Martin Luther'

Hmmm. I know some of you will be wondering why there has apparently only recently been an outbreak of common sense at the Bank of England.

But it is important to understand that central bankers and economists can be theological. And built into their financial theology, built into their forecasting models, is that interest-rate changes by the likes of the Bank of England have no impact on risk premia - and Tucker is now saying that is almost certainly wrong.

Think of him as a sort of financial Martin Luther, recognising that the financial priesthood at the Bank of England may not have been as infallible as it thought.

Now under the traditional theology, if the Bank of England cuts its overnight bank lending rate because it fears inflation is falling too far below target, and markets believe that what the Bank of England is doing is credible (ie the policy change will work), that should have no impact on the real yield on ten-year government bonds - which is another way of saying it should have no sustained impact on the real interest rate when borrowing for ten years.

But that theory turns out to be not the way that the world actually works.

Analysis by the Bank of England shows that when it cuts its short-term interest rate, that leads to a significant reduction in the implicit ten-year interest rate that is unrelated to changes in inflation expectations: the cut in the Bank Rate brings down the long-term real interest rate, which is something it is not supposed to do (a pillar of central bank theology is that monetary policy is not supposed to affect real economic activity or relative prices, such as relative interest rates).

There could be two explanations for the way that cuts in short-term nominal interest rates reduce long-term real interest rates. First, investors may believe that the world has become safer and more stable, and are therefore prepared to take more risk.

Or - and this appears to be what is actually happening - when short-term interest rates are cut, investors become so desperate for income that they are prepared to take disproportionately greater risks by lending and investing for longer periods to obtain a little bit more return.

To use the jargon, when the Bank of England and the Federal Reserve cut interest rates in the years before the 2007/8 crash, they exacerbated what became known as the search for yield - or the propensity of investors to take increased risks for only marginally higher rewards.

And, of course, the central banks also inadvertently encouraged the associated and reckless practice of the banks to manufacture all those newfangled and dangerous new products, the CDOs and so on, that responded to investors' greater appetite for risk.

A couple of conclusions follow from this. First, that the Bank of England and the Federal Reserve should accept their share of the blame for the unsustainable lending bubble that was pumped up in the years before the crash (unless you think that theological blindness for what they were doing is a legitimate excuse).

Second, that the reform of the Bank of England by the Chancellor, George Osborne, to create a new Financial Policy Committee that sits alongside the existing Monetary Policy Committee may be sub-optimal.

A single super-committee?

Tucker's analysis implies that the distinction between delivering financial stability and monetary stability is an artificial one.

If he is right that changes in the Bank Rate are an important determinant of risk premia - and to be frank all evidence and common sense is with him on this - then maybe the tool kit for delivering financial and inflationary stability should not be divided between two committees, whose activities could be mutually destructive (even when both are chaired by the governor).

Perhaps there should be a single monetary and financial stability super-committee.

Robert Peston Article written by Robert Peston Robert Peston Economics editor

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  • rate this

    Comment number 14.


    " if you were clever why would you get paid a couple of hundred grand to regulate it rather than hundreds of millions by being in it?"

    The same reason we have teachers, doctors, police and so on. Some people have scruples. Those numbers are of interest to people without them.

  • rate this

    Comment number 13.

    All possibly true in a deregulated economy, but I think there was at least supposed to be regulation to put a cap on risk. I still blame the regulators, in our case the FSA, for not doing their job - and of course the governments that were supposed to be in charge of them.

  • rate this

    Comment number 12.

    The Bank of England does not feel it has done anything wrong. The real problem is that it is accordingly likely to repeat its mistakes going forwards.It is shown here by an excerpt from a speech by David Miles.

    "What is the right (policy) trajectory back to a more normal setting? "

    Should have thought of that before you did it David...


  • rate this

    Comment number 11.

    No, it's not the BoE's fault. They were limited to playing Whack-a-Mole with a dubious stat (CPI). The blame lies with the naive and cowardly politicians who failed to step in and regulate when it became obvious things were getting out of hand (in about 2001, if you were watching house prices in the SE). Essentially, what we've witnessed was a failure of democracy itself.

  • rate this

    Comment number 10.

    No. The decision to move the measure of inflation by GB was the key moment. Excluding rampant house price inflation from the target for inflation meant too low interest rates for too long and caused a bubble.
    So no, it was Gordon done it not the BoE.

  • rate this

    Comment number 9.

    Is he saying that the financial system is ever so slightly broken?

    I believe there's a term - "fit for purpose" - that doesn't seem to register amongst the banking community or regulators.

  • rate this

    Comment number 8.

    Try reading some of Andrew Smithers' work - he was arguing that the central banks were stoking up trouble over 10 years ago. Too bad Mr Smithers isn't on the MPC.

  • rate this

    Comment number 7.

    When dealers and speculators can make billions on sentiment alone contributing massively to GDP without having to make or touch a single real thing it seems entirely reasonable to suggest that the models are broken. When money is the main raw material of UK financial industry and it is so overweight in it , then monetary policy cannot be independent of the real economy.

  • rate this

    Comment number 6.

    Economics and finance are, whether we like it or not, a "social science", and investors are always aware that "how the market is feeling" is as important as pure maths. Time for the Bank of England (and others) to catch up and to put this psychology in mind, plus the psychology of us ordinary folk - who economically are feeling very vulnerable at the moment - when deciding economic policy!

  • rate this

    Comment number 5.

    The BoE knows full well that theywere
    a key player in creating the credit boom.
    HOWEVER, the problem is essentially in
    = how the level of economic activity
    and the related money supply is measured.
    The current method for measuring these
    is FLAWED and HENCE the signals
    used by BOE to SET THE BANK RATE
    are leading them to make ERRORS.

  • rate this

    Comment number 4.

    Most central bankers lack any deep understanding of psychology. The incentives for the "search for yield" will inevitably drive reckless and irresponsible behaviour by bankers, mortgage brokers using 'other people's money.' Similarly, faced with relatively low costs and lax rules for borrowing many people will exceed their spending limits by rash purchases. Central banks were part of the problem.

  • rate this

    Comment number 3.

    We're never going to be able to effectively regulate the financial services sector as those in it are much cleverer than those who regulate it.

    After all, if you were clever why would you get paid a couple of hundred grand to regulate it rather than hundreds of millions by being in it?

  • rate this

    Comment number 2.

    It is undeniable that in the run up to 2008 conditions were patently 'frothy' in the mortgage market, corporate M&As, asset prices, government spending rises etc.
    King has a reputation for caution which in this case goes both ways - perhaps he was seduced or bullied by Brown's 'end of the cycle' rethoric.
    Most of the bankers and CEOs were - trouble is we pay the Governor to protect us from that.

  • rate this

    Comment number 1.

    So what he is saying is 'basically, we didn't know what we were doing, we don't know what we are doing and if we try this thing, it might work, or it might not'

    brilliant, give that man a gold plated pension (oh, he already has one)

    the blind leading the stupid springs to mind.


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