Published on 9 Oct 2012

After 20 years, time to change Merv’s medicine?

It is too early for Sir Mervyn King to be demob happy. The process of finding his replacement may be down to “four or five” appointable candidates. But tonight he decided to opine on the two decade anniversary of inflation-targeting.It’s exactly twenty years after Black Wednesday since a formal visible inflation target became the anchor, the fundamental axiom of British macroeconomic policy.

And if the record had ended at 15 years in 2007, then there would be little debate that it would be seen as a rousing success. But the five years of stagnation, or near-depression has cast a doubt on its effectiveness, and of what went wrong.

Sir Mervyn’s central case is a defence of inflation targeting. However, he uttered words that I would never have imagined from a sitting BoE Governor: “It would be sensible to recognise that there may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises.”

The inflation target works in theory because it acts as an anchor, a self-fulfilling virtuous circle where all players in an economy: workers, businesses, the markets, and the government, they all know that the aim is to hit the target, currently set at 2 per cent CPI. Now, the governor says or admits that the anchor is flexible.

 Whilst this is not an abandonment of the target, I do think this will evoke a real political debate about the ongoing relevance of this target. Remember, actually setting the target is a political decision.

Thinkers in both coalition parties have been pondering about a move to a different type of target, a nominal GDP target which involves targeting a bit of inflation and a bit of growth (indeed the Bank, post QE seems to have done this anyway). There are others: a price level target, or an employment/real GDP target which has effectively been adopted in the US by the Federal Reserve.

Alternatively the inflation target could be set higher, at say 4 per cent. Some of the most brilliant minds in economics currently believe a nominal GDP target is the way to go, and that was the mood at the Jackson Hole meeting a few weeks ago.

All of this is wrapped up into the strange world of quantitative easing. Inflation targets sit uneasily with QE. The Bank of England believe that the mere existence of a credible commitment to the target has anchored inflation at 2 per cent, even as £375bn of money has been created out of thin air. Even when inflation topped 5 per cent, it did not stay there, even as electronic printing presses rolled.

 But what if the Bank of England has massively overrated its powers? What if low inflation is explained more by a total absence of wage bargaining power, not the inflation target?

The end result of this debate, is whether politicians in Britain want to engineer near-zero interest rates for years to come, irrespective of inflationary pressures. Today’s sluggish UK numbers from the IMF, ONS and Niesr (albeit an indication of that the recession is over) show just the start of the challenge.

 The first test of this may well come a little sooner than expected, when the first gilts bought under QE start to mature next year. But more on that later.

 For now, Sir Mervyn may have unlocked Pandora’s box. Do politicians have any radical ideas?

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24 reader comments

  1. Philip Edwards says:

    Faisal,

    Of course he wants to move off the “inflation target.”

    He wants that because he has no option if he wants to save what’s left of his “reputation.” Which, an any case, is virtually non-existent.

    Inflation is an inevitable curse of the capitalist system. It always has been and always will be.

    A bit weird you claim he was “a rousing success” up to 2007. He was that much of a “success” he neither saw or warned of the impending disaster.

    In fact “Sir” Mervyn King is nothing but a hired clerk for the establishment. That’s how he got his “title” and that’s how he performed. The man was utterly worthless, as will be his successor.

  2. MD says:

    “And if the record had ended at 15 years in 2007, then there would be little debate that it would be seen as a rousing success”

    Only if you measure success as the ability to pump up debt bubbles, destroy long term jobs and competitiveness and then hang out everybody else to dry to pay off all those who gambled in the bubble.

  3. Peter says:

    “It would be sensible to recognise that there may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises.”

    I should think that about 2003 – 2007 would have been a good time to do this.

  4. Andrew Dundas says:

    Interference with our money is endemic. Here’s the history.
    Labour Government in 1997 originally set the inflation target. They assumed that Retail Price Index was the best measure of inflation and that inflation was a monetary phenomena controlled by variations in basic interest rates.
    Unfortunately, householders and businesses are now spooked by government rhetoric. So that saving is now ‘safe’ and borrowing is ‘dangerous’. Which is balmy because one person’s borrowing is another’s saving! As household spending has fallen, it’s dragged down sales and raised unemployment. Hence our widespread concern about falling living standards and blighted careers.
    Since 1997 we’d moved the inflation target from rpi to the Consumer Price Index, mostly because cpi doesn’t even try to guess the movements in housing costs. The Government is now changing around both those sets of stats so that they can cut pensions and other social benefits.
    Perhaps selection criteria for our next ‘Governor’ will include a willingness to modify BoE policy to suit government needs?

  5. Democorruptcy says:

    King is doing all he can to try pretend we didn’t have a housing bubble due to BOE policies. Low interest rates, savings and labour devalued, etc all to try prop up house prices to pretend they are right. It is an illusion of wealth because the houses are valued in ever increasingly worthless pounds. People should consider that worth in litres of fuel, kwh of energy, etc. Why do political commentators never ask him about a “housing bubble?”. Is it a pre-condition of any interview that it is not mentioned, so he doesn’t have to try deny it? e.g. the cosy chat with Jon Snow?

    When he was Deputy in Feb 2003 just before becoming Governor in June the same year:

    ##
    “The Bank of England has surprised City analysts by cutting interest rates by one quarter of a percentage point

    After 14 months on hold, rates have been cut to 3.75%, taking borrowing costs to their lowest level since 1955.

    The move surprised City analysts, who had thought that the Bank would maintain rates at 4% to keep a lid on the housing market and general inflation.
    House prices last month were 24.9% higher than in January 2002, Halifax, the UK’s biggest mortgage lender, said on Wednesday.

    “This…

    1. Andrew Dundas says:

      ER, the Pound’s exchange value rose much higher under Labour and our internal inflation averaged below the current 2.5%.

      Looking back, we might say that the British Pound rose to too high an international value and that some devaluation (as the current Government) was necessary.

  6. Philip says:

    I think the point was that had King retired in 2007 he would have been seen at the time as a roaring success. However, in retrospect he would have been seen to have presided over a credit bubble, especially in housing, which was almost certain to end in disaster. It’s spotting such things & doing something about them is what I’d expect the Governer of the bank to be doing. The fact that he didn’t means that by 2007 he’d already shown he was unfit for his job. And now, so it’s said, his successor will be Paul Tucker who cosied up so closely to Barclays and the LIBOR rate rigging, passing on messages from the Treasury in sufficiently ambiguous terms so he couldn’t be pinned down. And where was Tucker in the period up to 2007? King’s right-hand man! Obviously the man for the job!

  7. duggie73 says:

    Any chance of naming the brilliant economists favouring nominal GDP as a target?

  8. nick says:

    Mervyn King should have resigned long ago.
    The inflation is still rising and the compound effect of inflation and low returns on savings/pensions have decimated growth.

    King does not care about economy and growth, he only cares about retaining house prices. Short termism and stagflation is the name of the game.

    Resign now Mervyn. Do us a favour.

  9. Charles Jurcich says:

    “The first test of this may well come a little sooner than expected, when the first gilts bought under QE start to mature next year. But more on that later.”

    Yes interesting. Currently the BoE have received well over £20Bn in income from its holding of gilts. In the US, this money is passed back to the treasury and any principal is used to purchase more debt to maintain the Fed’s stock of government debt.

    In the UK though I presume that the treasury is not claiming this because it might be seen as against our EU treatise, even though I understand this £20Bn plus is legally due back to the treasury.

  10. Democorruptcy says:

    My earlier comment, re 2003 when the BoE surprised the markets by cutting rates with HPI at 24.9% and inflation already over target, was cut off.

    From “This”:

    “This is one of the biggest gambles any central banks has done – cutting rates when house price inflation is close to 30% and inflation is already above target,” said John Butler, UK economist at HSBC.

    “It is true to say [the Bank is] playing with fire.”

  11. Y.S. says:

    How to wipe out debt? …. With high inflation.
    With high inflation no point in keeping hold of money… you buy property.
    With high house prices you get into a boom ….followed by bust.
    Now if we all went out and bought something we didnt need, the economy would be booming. Time we all bought a big wide screen TV, followed by a call to wonga.

  12. Sage Against the Machine says:

    You cannot fix a problem caused by debt with more debt; you cannot borrow your way out of a debt. The proposition is incontrovertible, but the extent to which it damns all responses to the financial crisis thus far is rarely appreciated, even (or perhaps especially!) by the so-called experts. The key consideration missing from all mainstream analysis of the situation is the fact that pretty much the entire money supply is created as bank credit (a euphemism for debt) incurred when businesses or consumers take on bank loans. If you are somewhat incredulous of this fact and want independent confirmation, you can find corroborating statements from industry insiders, as well as much additional information at http://www.positivemoney.org.uk. What does issuing virtually the entire money supply as a debt imply? It makes global financial meltdown pretty much inevitable.

    The “boom and bust” Gordon Brown famously promised us “no return to” is a consequence of the means by which money is supplied to our economy. Banks issue “credit” to consumers which then circulates in the economy and stimulates production. Bank loans, like buses at bus stops, tend to arrive together. This is the…

  13. enlightenedape says:

    The Government of any economy can always create full employment in that economy without adverse inflationary, deficit or debt consequences simply by borrowing from its Central Bank and spending the money employing workers to create investments. I am sick and tired of hearing ignorant or dishonest politicians complain that the interest costs on borrowed money prevent the Government borrowing more money. Every pound of Government debt bought by the Central Bank is a pound of Government debt that is cancelled. Government borrowing from its Central Bank is like borrowing from yourself, ie. it’s not borrowing at all. When the Central Bank buys Government debt the Public Purse becomes both debtor and creditor because the Government debt and the Central Bank are both properties of the Public Purse. The debt then becomes both owed by and to the Public Purse and thereby cancelled. The Government can thus borrow as much as it likes from its Central Bank at no capital and no interest cost whatsoever. The Bank of England is thus effectively cancelling British Government debt whenever it participates in “Quantitative Easing”, and this is why UK Government Borrowing interest rates…

  14. enlightenedape says:

    The Bank of England is thus effectively cancelling British Government debt whenever it participates in “Quantitative Easing”, and this is why UK Government Borrowing interest rates are so low. The same is true of any Government with its own Central Bank and its own currency. The low interest rates have nothing to do with the competance of National Governments as they often like to pretend. The Central Banks which are engaging in “Quantitative Easing” are thus playing their part to solve the Economic Crisis but the Governments which are failing to spend money to invest are not. They should invest or go.
    The problem with the Eurozone is the disconnect between the ECB and the National Governments it serves. This has been partially solved by the ECB promising to buy Eurozone Governments’ debts, but the problem remains the conditionality of the bailout terms. Until the interest charges are reduced to near zero (which is where the interest charged to a Government by its Central Bank should be in accordance with “Quantitative Easing”), the ECB and the Troica cannot be taken seriously as being committed to finding a solution to the Eurozone Crisis. The effective…

  15. enlightenedape says:

    The effective interest rates being charged to Greece and other bailout countries are nowhere near zero. They need to be.
    For too long Governments have been blind (deliberately?) to the political and constitutional nonsense that a Central Bank should be “independent” of Government. The Central Bank is the property of the Public Purse and should always act in the interests of the Public Purse and the Public Interest generally. It is the political failure to make this so that enables Governments like Cameron’s to rationalise their refusal to spend on investments that is causing the prolongation of this Economic Crisis.
    As for Romney’s test of Public Programs – is it worth borrowing from China to pay for them – this is patent nonsense for the above reasons – the Government can borrow from itself for no interest and no capital charge at all. When are people going to wake up?
    (For the avoidance of doubt or confusion the Central Bank is defined as “that public body entitled to ‘print’ or create money, and which owns the ‘printed’ money together with the profits (eg interest) derived from it”)

    Government borrowing from the Central Bank spent on creating investments…

  16. enlightenedape says:

    Government borrowing from the Central Bank spent on creating investments does not cause inflation either, because the new “printed” money is backed up by the real value of the investment. Only spending on consumption is capable of causing inflation, and then only if there is no return in taxation from that spending as a result of the multiplier. Because of Keynes’ multiplier and “animal spirits” the Government needs to create only a fraction of the total jobs represented by the unemployed. The Government needs to do only enough to restore confidence in job security; the multiplier and “animal spirits” will do the rest.
    In other words, any unemployment present in an economy is a deliberate act of will of the Government of that economy because a Government can always create full employment without adverse inflationary, deficit or debt consequences simply by borrowing from its Central Bank and employing workers to create investments.

    Much has been said about the need to “rebalance” the National Economies because of the imbalance in trade. However, imports are not in themselves a bad thing if that is what purchasers want to buy. Sooner or later imports and…

  17. enlightenedape says:

    Sooner or later imports and exports must come back into balance where an economy has its own currency in floating exchange. In the end the exchange rate will adjust so that imports become expensive and exports cheap because in the end there is no point in a foreign exporter accumulating other currency unless he is going to spend it; when a foreign exporter finally decides he has accumulated enough other currency, that currency will fall in value.
    The problem in the Eurozone is that the single currency prevents the devaluation of Bailout Economies relative to the other more competitive Eurozone Economies. However, in the short or medium term at least, there is no reason why the Bailout Economies should not simply invest as described above. This would provide full employment in the Bailout Countries, transfer of money to the Bailout Countries from the ECB as investment, and therefore solve the problem.

    So, what is the solution to the Economic Crisis generally. Well, it certainly is not “Austerity”. As far as I am concerned the solution is obvious. So long as there is involuntary unemployment in the economy it is the duty of the Government to Borrow money from the…

  18. enlightenedape says:

    So long as there is involuntary unemployment in the economy it is the duty of the Government to Borrow money from the Central Bank and to spend that money investing in the economy by employing workers to create new investments. The failure of the Government to require the Central Bank to act in the interest of the Public Purse and in the Public Interest generally is in effect a failure of the Government to account for public money. In the final analysis this failure to account would include all of the assets which the Government and Public Purse could have obtained by investing in the employment of all the unemployed and underemployed in exchange for “printed” money. When is the Government going to be held to account for these missing Public assets?
    If there is a concern about “rebalancing” the economy then the investments should concentrate on investments which export. An obvious and classic example could be spending on increasing energy production. Energy production counts as an export because it reduces imports even if there is no direct export of energy; a cancellation of an import is an effective export. It has the added advantage of increasing National energy…

  19. enlightenedape says:

    Energy production counts as an export because it reduces imports even if there is no direct export of energy; a cancellation of an import is an effective export. It has the added advantage of increasing National energy security. Borrowing from the Central Bank and spending should continue until there is no involuntary unemployment or underemployment.
    There are no adverse inflationary, debt or deficit consequences of such a policy.

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