Central Banking Hubris

Policymakers seem to see themselves as Masters of the Universe. They are not...

IN 2009, when we were rocking and reeling in the wake of the financial crisis, the actions of central banks played a key role in stabilising economies and laying the foundations for economic recovery, writes former Bank of England Monetary Policy Committee member Andrew Sentance.

But in many economies, including the UK, the recovery has been disappointing. This has contributed to the view that central banks need to "do more" to stimulate economic growth.

Central bankers themselves have encouraged this view. In the US, the Federal Reserve has embarked on successive rounds of Quantitative Easing (QE) and has recently committed itself to keeping interest rates at their current extremely low levels until unemployment falls below a key benchmark level. Mark Carney, the Governor of the Bank of Canada who takes over at the Bank of England this Summer, told us at Davos that he did not think central banks were "maxed out" in terms of the stimulus they could provide to support economic growth.

And, last week, we found out from the MPC minutes that the current governor of the Bank of England and two of his MPC colleagues were keen to go down the same track. They voted for further QE purchases of government bonds in the hope that this would lead to higher output growth. This is despite the fact that previous asset purchases have already led to an accumulation of a third of the UK national debt in the vaults of Threadneedle Street.

There is a danger we are falling into a similar trap which ensnared the major western economies in the decade before the financial crisis. Private sector bankers, who believed themselves to be "Masters of the Universe" fuelled a global credit boom which went spectacularly bust in 2007/8. Now, there is a danger that we are putting excessive faith in new "masters of the universe" – the ability of Central bankers to sustain economic growth through the magic of money creation.

These policies are not working because they do not address the main reasons why the major western economies – including the UK – are currently locked into a low growth cycle. The key forces underpinning slow growth lie predominantly on the supply-side of the economy. Western economies enjoyed a long growth boom from the 1980s until the mid-2000s underpinned by three main forces – easy money, cheap imports and confidence in the ability of central banks and governments to keep economic growth and inflation on a steady course. All three of these conditions have been undermined by recent global economic developments.

First, we are no longer in a world of easy money. The banking system has been traumatised by the experience of the financial crisis, and regulators are now encouraging banks to be much more cautious in their approach to lending. Second, the world of cheap imports – driven by low energy prices and the entry of low-cost producers like China into the world economic system – has also come to an end. It has been replaced by repeated upward shocks to energy, food and commodity prices as the growth in Asia and other emerging market economies becomes more self-sustaining.

A third factor underpinning growth in major western economies before the financial crisis was confidence in the private sector that governments and central banks could maintain stable economic conditions. That private sector confidence has been replaced by a prevailing mood of uncertainty and lack of confidence in which companies and consumers feel reluctant to commit themselves to major new projects and expenditure.

Monetary policy cannot recreate these pre-2007 conditions. Extremely low interest rates may support growth by providing respite to borrowers for a while. But when savers start to adapt to low interest rates, they too cut back on expenditure. Over a long enough period of time, the short-term boost to economic activity fades away.

The same is true of Central bank purchases of government bonds. They push down longer-term interest rates and boost confidence – which can support economic activity for a while. But once the medium-term consequences of these policies become clearer they are likely to be a drag on economic growth. Pension funds suffering low returns turn to their sponsoring firms for a top-up – reducing the funds available for business investment. Savers recognising that their longer-term income has been hit start to cut back expenditure.

This is not a new insight. Economists have long recognised that monetary policy can help smooth out short-term fluctuations in our economy. But a deliberate policy of excess monetary expansion will ultimately lead to inflation or other financial imbalances, which then needs to be corrected.

So how does this apply to the current situation facing the UK economy? The perception in the UK is that the performance of our economy has been disappointing. That is true in relation to past growth trends – GDP growth in the quarter century before the financial crisis averaged over 3% per annum and we have struggled to achieve growth of around 1% since then.

But other aspects of our economic performance have been more positive. The UK labour market has been very flexible, helping to support employment – and this week we saw another set of positive jobs numbers. Total employment in the UK is around 600,000 up on a year ago and over half of this growth is in terms of regular full-time employment.

UK economic growth also looks much better in relation to our peer group when we take into account the period before the economic crisis. As the chart above shows, going back to 2000, the UK is second among the G7 economies in terms of the growth of GDP per head of population – which is a widely used measure of broader living standards. We are just behind Germany, which appears to be the superstar western economy in the aftermath of the financial crisis. But on this key measure we are ahead of the US, Japan, Canada (Mark Carney, take note) and other European economies.

Where the UK looks less good is in terms of very recent growth performance and inflation. But in my view these failings are connected. We have acquiesced to a relatively high rate of inflation driven by a weak pound, which in turn squeezes consumer spending. The much hoped-for benefit of sterling devaluation for the UK economy has not materialised. But that should not be a great surprise. The last time the UK experienced a large devaluation in its currency, from the mid-60s to the mid-70s, it ushered in a period of dismal economic performance. We seem to be repeating the mistakes of the past in hoping for the quick fix of a weak pound to help our underlying growth performance.

The fact that UK inflation looks set to continue above target for at least the next couple of years will add to the concerns of holders of sterling. As the chart shows, the Bank's forecasts have persistently underpredicted inflation since the financial crisis. So it is not surprising that the markets greeted the votes of Mervyn King and his two other MPC colleagues for more QE by dumping sterling once again last week.

So what is the way forward for the UK and other western economies? We need to recognise that growth will be disappointing in relation to past trends and that major structural adjustments are needed in our economies. But expecting central banks to sort out these problems is looking in the wrong direction. Monetary policy is a short-term palliative. But the longer we cling on to the hope it will boost longer term economic performance, the more likely it is that we will delay the necessary changes to our tax system, business regulation, infrastructure plans and education and skills policies which will ultimately be needed to deliver a return to healthy growth in the UK economy. 

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