On January 25th Mervyn King, the governor of the Bank of England gave a widely publicised speech in Newcastle. (video here, transcript here) King recognised that the economy was in difficulties, noting that workers’ incomes in Britain are no higher now than they were in 2005. He remarked that, ‘one has to go back to the 1920s to find a time when real wages fell over a period six years’.
But he was broadly supportive of the Coalition government’s policies:
The UK economy is well-placed to return to sustained, balanced growth over the next few years as a result of a fall in the real exchange rate combined with a credible medium-term path of fiscal consolidation.
The governor’s support for the government flows from his assumptions about who should pay for the collapse of the financial sector in 2007-8:
…one way or another, the squeeze in living standards is the inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies.
The Bank of England can lower inflation by increasing interest rates and thereby slow the pace of recovery. Or it can leave interest rates low and allows inflation to reduce real incomes. Either way, we have to accept that our standard of living is going to deteriorate – after all, someone has to pay for the financial crisis and it isn’t going to be the financial sector:
The idea that the MPC [Monetary Policy Committee] could have preserved living standards, by preventing the rise in inflation without also pushing down earnings growth further, is wishful thinking.
And, he noted, ‘monetary policy cannot be based on wishful thinking.’
The British Prime Minister David Cameron made much of the governor’s comments. In an exchange with Ed Miliband at Prime Minister’s Questions on January 26th he gloated that he would rather take advice from the Governor of the Bank of England than from the Leader of the Opposition.
But is it wise to take economic advice from the head of the Bank of England? After all, it is by no means clear that the Bank had the faintest idea what it was doing in the years before the financial crisis. Eddie George, the governor of the Bank of England from 1993 to 2003 told the House of Commons Treasury Select Committee in 2007 that:
In the environment of global economic weakness at the beginning of this decade… external demand was declining and related to that, business investment was declining … We only had two alternative ways of sustaining demand and keeping the economy moving forward – one was public spending and the other was consumption.
We knew that we were having to stimulate consumer spending. We knew we had pushed it up to levels which couldn’t possibly be sustained into the medium and long term. But for the time being, if we had not done that, the UK economy would have gone into recession just as the United States did.
The decision to keep interest rates low fed into an expansion of household borrowing and a boom in house prices. The lightly regulated banks generated vast profits and bonuses in the period after 2003 on the back of the Bank of England’s decision to stave off a recession. As Robin Ramsay has pointed out, the banks used low interest rates to engage in a round of reckless speculation while they blew bubbles in commercial and residential property. The result, as Mervyn King noted in his speech last week, was a gigantic increase in the size of the financial sector’s liabilities:
The indebtedness of the financial system doubled, from 3½ times GDP in 1998 – already high by international standards – to over 7 times GDP in 2008. To appreciate the scale of that increase, even if the financial sector were to cap its debt at today’s level, it would take more than a decade for growth in the economy to return indebtedness relative to GDP to its 1998 ratio.
The financial crisis in the UK that began in 2007 and the recession that followed in 2008 are both directly tied to central bank policy. Those who berate the British people for spending above their means should bear in mind that they were only doing what was expected of them by the governor of the country’s central bank. The terrifying debts of the UK banking sector are inseparable from monetary policy over the last decade.
The Bank of England’s understanding of what was good for the country dovetailed with the desires of the banks to expand their lending. The result is before our eyes. Re-balancing the economy will be painful, but the pain must be shared equitably. And unless the rest of us want to work as gardeners and maids for a resurgent financial class we had better come up with a plan for growth that combines state investment with reform of the enterprise. This in turn will require an open and honest debate about the financial sector and its relationship with the institutions of the state, a debate conducted with the minimum possible amount of tear gas.
Those who are responsible for setting monetary policy played an important role in incubating the current crisis. Though they are doubtless well-meaning and dutiful they cannot be taken seriously as the arbiters of economic policy. They are not sensible stewards of the national interest. They are the representatives of private capital in the state administration. A Prime Minister preening himself on the Bank of England’s support either doesn’t understand the situation or else is happy to line up with the City against the rest of us.
It is wishful thinking to imagine anything else. And we have had enough wishful thinking in recent years to last us all a lifetime.