Is the Bank of England doing enough?

  • 30 May 2012
  • From the section Business
  • comments

Nearly everyone with a vote on UK monetary policy thinks it's doing enough to support the economy: The Bank of England's Monetary Policy Committee voted 8 to 1 against injecting more money into the economy last month.

But the International Monetary Fund and a number of other respected economists - including that lone voice on the MPC - think the Bank should be doing more. Who is right?

The true answer to that question is we will never know, since we will never know what might have happened if the Bank had done something different.

But I realise that's not going to satisfy any of you - nor should it. That's because the question at the heart of the dispute between the IMF and the Bank of England could scarcely be more important for Britain's economic future: how much room does the UK have to grow?

Growth has been a big disappointment over the past few years. The trouble for the Bank of England is that inflation has been pretty disappointing as well.

The Bank has not let above-target inflation prevent it from following historically loose monetary policies - including £325bn in quantitative easing - because it thought that the inflation was temporary and not domestically generated.

But most members of the MPC also seem to think the economy has been permanently damaged by the crisis, and that this damage puts a limit on how much the Bank - or anyone else - can sensibly do in the short term to revive growth.

In an interview for the Aberdeen Press and Journal at the weekend, the Bank's chief economist, Spencer Dale, said it would not be appropriate for the BoE to restart its quantitative easing programme if supply-side problems, rather than a lack of demand, were the reason for the UK's weak economic recovery.

Are supply-side problems to blame for Britain's feeble growth and relatively high inflation?

Or, put it another way, did the crisis cause structural changes to our economy which mean we will struggle to grow very fast in the next few years, and that a lot of the output lost in the recession is gone for good?

I've debated this several times. For its part, the Office for Budget Responsibility thinks damage to the supply side has played an important role. In fact, it was the OBR's more pessimistic view of Britain's supply side that forced the chancellor to announce an extra two years' spending cuts in the Autumn Statement last November.

The OBR can point to some important evidence in their favour: business surveys consistently report companies saying they do not have much spare capacity, or room to grow, despite the fact that our economy is now 4% smaller than it was at the start of 2009, and some 13% smaller than it would be now, had it simply continued on its pre-crisis trend.

Labour productivity - output per head - has also been astonishingly weak. If that had rather continued as before, it would now be 10% higher. On its own, that could suggest that our economy has become permanently less productive as a result of the crisis: because, for example, credit now costs more or because it was the relatively more productive parts of the economy that were worst hit by the recession.

For these and other reasons, the OBR (and many others) think the economy only now has room to grow - spare capacity - of around 2.5% of GDP.

In other words, nothing like the 13% we would have, if all the ground lost in the recession was still there for the taking.

In recent days, two serious economists have launched strong arguments against this "supply side pessimism". The first is Bill Martin, professor of economics at the Centre for Business Research at Cambridge, who has updated the paper I discussed in that earlier blog. The other is David Miles, who made a thoughtful speech on the subject last week, having cast that one vote in favour of more quantitative easing last month on the MPC.

Both of these are well worth a read: they marshal very powerful evidence in their favour. Mr Miles is particularly interesting on the monetary policy side of the story, which he thinks has been made more complicated by the fact that a given amount of spare capacity now seems to have a smaller downward impact on inflation than in the past.

As he notes, this means that getting rid of inflation could be more painful for the economy than in the past - but it also means that the cost of keeping policy "too loose", in terms of higher inflation, could be a lot smaller than before.

Each come at the subject from a slightly different direction, but they end up in a similar place, which is that even if we don't know exactly how much spare capacity the UK has, we can be confident that it is very significant, and confident that it is not going to stick around forever.

The slower the economy recovers, the greater the long-term damage of this crisis will turn out to be. On that point, these two economists are crystal clear. And so, for that matter, was the IMF in last week's report on the UK.

Neither Prof Martin nor Mr Miles draw explicit conclusions for fiscal policy: they are not among those who are openly calling for Mr Osborne to move to a Plan B (though I don't think Bill Martin would oppose it).

But they do implicitly share the IMF's view, that the Bank of England and the Treasury could be doing more actively to promote growth - including through direct efforts to ease the supply of credit to firms.

The latest minutes suggest that the rest of the MPC is also mindful of the long-term damage that might come from this prolonged period of slow growth.

But speeches from other members of the MPC such as deputy governor Charlie Bean suggest that it would take a "significant deterioration" in the economy, perhaps as a result of the eurozone, for a majority to vote in favour of more QE.

And the Treasury does not appear to be planning to accelerate any of its growth initiatives, as a result of the IMF's recent warnings.

If these two economists are right, both the Bank and the Treasuiry might need to be less pessimistic about the underlying state of the UK economy - and more optimistic - and urgent - in their efforts to help.