Can the Bank of England hit any target?
- 18 December 2012
- From the section Business
I have one or two thoughts about whether the Bank of England should adopt a target other than pure inflation - although the definitive piece on this debate initiated by the governor-elect of the Bank of England, Mark Carney, is here, by my colleague Stephanie Flanders.
To start with probably the least important aspect of all this, I am surprised by how little emotion has been sparked by Mr Carney's remarks, that there might be a case for replacing narrow inflation as a target with nominal GDP target, or the cash value of annual economic output.
The point is that for more than 25 years, from the 1970s, the supposed great economic failure of the UK was in its propensity for rapid price rises. That, at least, was the conventional consensus view of the centre ground of British politics.
So it is difficult to exaggerate the pride of the last Labour government that rampant inflation appeared to have been consigned to the dustbin of history, as a result - or so it was claimed - of two decisions: first, that of the Tory chancellor Norman Lamont to set an inflation target; and second , that of Labour's chancellor Gordon Brown to give autonomous control over hitting that target to the Bank of England.
Lest we forget, until the great crash of 2007-8, it was widely believed that the Bank of England's performance had been world class: inflation was in check, providing the necessary price stability for businesses, households and government to make rational investment and spending decisions.
These were golden years. Or at least, that was what most thought.
Many now see this era as a fools' paradise - during which pretty much everyone had an exaggerated faith in the stability of the economy, such that banks lent too much, many businesses and consumers borrowed too much, and the government fooled itself into thinking that tax revenues flowing in from a debt-fuelled boom would be sustainable.
Or to put it another way, it turns out that this new stability in one form of prices, consumer price inflation, did not deliver broader stability.
There was massive inflation in asset prices, especially in commercial and residential property, and a hideous and dangerous explosion of the accumulation of debt: an analysis by McKinsey, which I've mentioned here many times before, shows that the aggregate of household, business, government and bank debt increased from less than 200% of GDP in 1987 to a record 500% of GDP in 2008, and hasn't really fallen since.
This economic failure is not exactly a secret. And perhaps the new government's most significant financial reform has been an attempt to prevent this particular horse bolting again: it has set up a so-called Financial Policy Committee at the Bank of England, which will soon have formal powers to prevent banks lending too much in the next boom.
And that may be where a few of you snort contemptuously. Because right now, the big problem for Britain is not that banks are lending massively too much, or that households and businesses are borrowing too much. It is that all of them are trying to improve their finances. They are all, to use the hideous jargon, attempting to deleverage.
Banks are trying to shrink the loans and investments on their balance sheets, relative to the capital they hold as protection against losses. Many households are struggling, even with interest rates at record lows, to repay existing debts. Many consumer-facing businesses or commercial property businesses with big debts are - to use the phrase of the moment - zombies.
Also, to state the bloomin' obvious, although the government is still borrowing near record amounts, it too is desperately trying to deleverage, by squeezing public spending.
Or to put it another way, this general and widespread sense that the UK's aggregate debts have become too great has been the great dampener on the economy: it is what has kept Britain in a technical depression, with the economy limping along and the overall level of GDP still well below the peak of early 2008.
Now here's the thing: it is very difficult to know how long this growth-dampening era of deleveraging will endure.
What we do know is that despite the general sense that debts are too high, the impact of deleveraging to date has simply been to shuffle debts from one part of the economy to another: private sector debts have fallen a bit, but they have been offset by a rise in public-sector debts; the net effect has been that aggregate debts are more-or-less what they were, or around 500% of GDP.
So if the urge to deleverage is the new and somewhat depressing (in both senses), deflationary and overwhelming economic reality, the question that follows - and is broadly the one raised by Mr Carney - is whether inflation targeting provides the right kind of stability for this era.
As some have queried, the kind of stability delivered by inflation targeting today may be the stability of the grave yard.
To put it another way, our ability to repay our debts would be enhanced if only wages, and profits and tax revenues, were growing. And since debts are fixed in nominal terms, they become less burdensome in a time of inflation (or at least the right kind of inflation) so long as interest rates don't rise.
For that reason, many business people are not anti-inflation zealots. They would love a bit of what you might call proper inflation - not the kind we have had recently, in which living standards have been squeezed by jumps in energy or food prices that cuts consumers' spending power, but the sort we haven't seen for years, pay rises.
If they thought the Bank of England could deliver a rise in what people earn relative to the nominal value of their respective debts, they would vote for that.
The problem is that it is not clear the Bank of England can deliver that, or at least not in safe way.
Because the lesson of history appears to be that once widespread doubts begin to arise about the commitment of the authorities - the central bank, or government, or both - to maintain the intrinsic value of the currency, it is not long before we are all bumping along in that infamous handcart to hell.
Although the devaluation of sterling we've seen in the last few years - caused by a near-zero official interest rate and the massive money creation of quantitative easing - has probably been healthy, especially for exporters, more extreme degradation of the currency would bring risks.
That is particularly true for a country like the UK where banks and government depend on the confidence of investors to refinance big debts.
So it would be a bit previous to say that controlling inflation no longer matters.
And there's another problem, which is that even the unconventional measures taken to date by the central banks of the stagnating west bring risks.
Arguably all those purchases of sovereign and official debt by the Bank of England and US Federal Reserve, and purchases of such debt by eurozone banks with the benefit of subsidised loans from the European Central Bank, have created potentially dangerous bubbles in government bonds.
What is to be done?
Is there any prospect of a serious recognisable economic recovery until a greater proportion of our debts are repaid or written off?
The current governor of the Bank of England seems to believe that the best hope is to force the banks to recognise properly the losses they are likely to make on tens of billions of pounds of loans to over-extended borrowers, households and businesses, and then force the banks to rebuild their loss-absorbing capacity by raising new capital.
That might represent a very speedy route to full nationalisation for Royal Bank of Scotland and Lloyds: private-sector investors would probably be unwilling to inject a substantial amount of new capital into these two semi-nationalised banks, which means taxpayers would foot the bill.
For the avoidance of doubt, the chancellor has already vetoed a public-sector recapitalisation of the banks. He feels, I am told, that it would be career suicide for even an additional penny of government money to go into either of them.
Which leaves what might be called the Turner option, or the Bank of England writing off a sizeable portion of the £375bn it has lent the government, to give the chancellor the fiscal space to stimulate the economy by cutting taxes or boosting public spending.
Here's how Lord Turner, at the same time as Mark Carney was musing about changing the inflation target, came out of the closet on turning government debt into cash. It is a synopsis of a talk he is giving at Cass Business School in early February:
"With interest rates close to the zero bound, conventional monetary policy loses its power. Unconventional policy levers, such as QE have been deployed, but they may also face limits. And sustained low interest rates and QE can themselves create distortions and financial stability risks.
"Two questions now need to be considered: (i) whether the target of monetary policy should change - for instance from inflation to nominal GDP (ii) whether additional unconventional tools of policy, such as some overt money finance of fiscal expenditure, might be available and required to ensure that the chosen target is met."
How dangerous would it be to convert government debt into money?
Very dangerous if it was seen to be a precedent that could turn into a habit
Perhaps a risk worth taking, Lord Turner is likely to argue, if it is a one-off injection of fuel into the flat engine of the economy.
There will be many who view any such forgiveness by the Bank of England of government borrowing as anathema.
But the virtue of stirring up controversy in this way is that it highlights that the debate over appropriate targets for the Bank of England may be to miss the point.
It is all very well redirecting the Bank of England from one target to another, but that's pretty fatuous if the Bank of England doesn't have any bows or arrows.
The problem may not be the Bank of England's target but whether there are really any appropriate tools available to seriously counteract the pernicious, growth stymying impact of deleveraging, the urge to repay debts.