I conclude that the Bank of England is a benign organisation that can create the right monetary environment within which the UK economy can function effectively. Apart from this it cannot do anything to benefit the real economy i.e. it cannot promote economic growth, create a net increase in employment, boost investment etc. However it does have immense power to create harm and damage to the economy if it gets its monetary policy wrong and decade by decade there are many examples of its mistakes.
Montagu Norman the Bank`s Governor said “I think that the disadvantages to the internal position (of going back to the pre-war gold parity) are relatively small compared with the advantage to the external position”, Macmillan Committee, Minutes of Evidence, Question 3332. At the same time the Cunliffe Report recommended a return to gold at the pre-war rate.
During the war the money supply had been expanded by approximately half. Therefore to achieve a stable relationship between money in circulation and gold the Bank of England had to reduce the money supply to an approximation of its pre-war level. To comply with this the Government achieved successive yearly budget surpluses and the surplus currency was destroyed. It was thought that the contraction of money supply would lower prices and incomes at a rate consistent with maintaining full employment. After the event it can be seen that prices and incomes did fall by about a third but because of rigidities in wage rates, unemployment began to rise. The government returned to gold in April 1925 but it soon became clear that prices had not fallen by enough and a further deflation of prices and wages would have to take place. Most advisors thought this would be easy to achieve although a lone voice, J.M. Keynes, pointed out that wages had stopped falling in 1923 and unemployment had risen in excess of 10% (unemployment finally reached 22%). Industrial disputes, typified by the General Strike of 1926, continued and a decade of economic and social problems resulted. In retrospect the best advice would have been either not to have returned to a gold standard and let the currency depreciate or to have devalued the £ against gold at a post war rate consistent with notes already issued.
Moving quickly on to the 1970`s as the 1930`s problems were caused by a mistake made at the Federal Reserve in not supporting the Bank of the United States when it had liquidity problems after the Wall Street Crash. This led to a systemic crash of banks across America, a 30% monetary contraction and the Great Depression. After the Bretton Woods Agreement in 1944 the Gold Exchange Standard constrained Bank of England monetary activity as it had to maintain a fixed rate of exchange and inadvertently this forced it to pursue tight monetary policies. Unfortunately this was not sustained and in June 1972 a new era of monetary instability was opened up.
Keynesian economics requires monetary policy to be supportive and accommodate the decisions made in the Treasury regarding fiscal policy. Through a series of fiscal deficits the government tried to buy economic growth and the Bank was required to accommodate this with loose monetary policy. Whether it was weak or just obedient it allowed a monetary expansion that caused inflation to peak at just under 30% p.a. This would not have happened if the Bank had pursued a policy to target low inflation. As inflation is always a monetary phenomenon, then by definition, it requires more units of money to be used in the same number of transactions and the Bank has total responsibility and almost total control over the number of monetary units in the economy. The monetary problems of the 1970`s were caused and aggravated by poor and damaging monetary policies.
Almost unnoticed an important debate took place about whether monetary demand should be managed using interest rates or quantity of money (cash) base controls. It was, and still is, a lengthy debate for another time, but it is possible to manage monetary demand precisely using cash controls and this therefore allows you to leave interest rates free to be determined by market forces and this in turn will produce less disruption to the financial system. The main problem of managing quantity of money is if all other Central Banks are using interest rate controls. In a debate I had with the Bank of England I explained that interest rates were not a necessary requirement for managing monetary demand and the response I got was “John could be right, but if he is then every Central Bank in the world has got it wrong” and I am prepared to argue that they have got it wrong. The main problem about using interest rates to control monetary demand is that as the Bank forces rates above and below a free market rate then it starts to create distortions in the financial system and these damaging distortions did not become obvious until the deviation we are currently experiencing.
It was the financial crisis of 2006/7 that exposed the mistake of using an interest rate policy to manage aggregate monetary demand. The collapse of Lehman Brothers, mismanaged by the Federal Reserve, caused a worldwide contraction in bank lending and in the UK it caused a contraction in monetary demand that threatened deflation. To avoid this the Bank started by reducing Bank rate from a base of 5.75% to 0.5%. The hope was that lowering rates would boost lending and expand the money supply. This did not happen so the Bank adopted plan B which was to boost the money supply directly by QE, and this was, at the time, the correct policy as it avoided deflation by increasing the money supply at its core.
It is now obvious to many people that low interest rates are not solving any problems and, even worse, they are creating big problems by inflating asset bubbles. Bubbles in share prices, bond prices and house prices are concealing some price inflation as they are not included in the inflation basket, and as always happens with bubbles they will eventually burst.
A 0.5% emergency rate of interest since 2009 has not done what was expected which is why a further emergency solution, QE, was tried. Of course the UK is not alone in keeping rates near zero as the Federal Reserve, ECB and Bank of Japan are all at similar levels and this is producing one more headache for the Bank that it does not seem to be able to solve on its own. Rates need to rise or in current jargon normalise. This means a Bank Rate of around 3%. This produces the following questions to worry about:-
- How many mortgage holders will be unable to service and repay their mortgages?
- How will a government heavily in debt at £1.6 trillion be able to service its debt and finance new debt?
- What will be the effect on the exchange rate?
It is this last question that is the most immediate problem. We have seen that just talking about rate rises creates volatility in FOREX markets and all Central Banks, worried about domestic instability, are talking about imminent rises to normalise rates. The Federal Reserve is probably the only Central Bank that could go it alone and its rate of 0.25% is currently below the UK rate.
It is my suggestion that a recovery plan will need all the main Central Banks to act together and thrash out a rate rise policy that will limit the effect on the exchange rate and allow them to focus on the domestic problems that will result from normalisation
In the past I have made it clear that the Bank of England needs to pursue its policies without transparency, particularly in regard to the timing of its actions. However I firmly support an open debate over policy outcomes and a more humble Bank of England that is prepared to both discuss and learn from its past mistakes.
John Hearn 9/8/2015