Written by Sir John Redwood
Sir John Redwood has given us his kind permission to re-publish this article (in three parts). It was published in his Diaries but he also asked us to credit CapX and the Centre for Policy Studies. Read Part 1 here and Part 2 here
In 2005-9 the UK went through an even more extreme boom/bust cycle than that in 1989-92. The so-called independent central banks and Bank Regulators presided over a big build up in lending to both public and private sectors, and to a huge expansion of derivatives, future and options which added to the levels of financial gearing in the system. Many people and institutions raised doubts or objected, but treasuries and central banks assured us all was well.
In the UK both the Conservative and Liberal democrat Opposition parties argued there was too much debt. The official reply from the central bankers and treasury ministers was the financial world was now a lot more sophisticated. The extra credit was an acceptable risk, with better controls thanks to all the special financial instruments. They allowed commercial banks to greatly expand lending without proportionately expanding their capital. In due course general inflation started to rise, to reinforce the inflation of asset prices which was well embedded.
Central banks then decided they needed to control the inflation by throttling back the credit. They started to hoist interest rates, This sent shudders through the debt and derivative laden markets. The central banks lectured the financial world that they needed to rein in their excesses. Doing so in public and demanding immediate change speeded the collapse. Soon some of the largest institutions were illiquid with questions over their longer term solvency. The central banks left the squeeze in place long enough to threaten the whole system, before relenting and pumping cash into the banking markets to avoid a complete collapse. Once again the technocrat bankers and regulators had been given their head, and once again their judgements had proved faulty.
The Bank of England also showed a poor understanding and a lack of political sensitivity over the Brexit period. It took an active role in supporting Remain in a strongly and evenly fought referendum. In general elections the central bank wisely keeps out of economic disputes and does not mark the homework of the leading parties. On this occasion it decided to intervene on the losing side by producing a series of ill-judged forecasts alongside the Treasury to try to help Remain.
Its famous short term forecasts of what would happen if we simply voted to leave were proved wrong in most respects in the two years that followed a Leave vote. The economy did not sink into recession. House prices did not crash. Unemployment did not soar. The Bank followed this unfortunate political and economic judgement by following an erratic monetary policy after June 2016, before settling on a generally negative policy of tightening monetary conditions to slow the economy.
Governor Carney arrived at the Bank of England from Canada with a new approach. He told us all he was going to give forward guidance on interest rates to avoid shocks to the markets. On three occasions he prepared us for a rate rise, only finally to cut rates when he did want to make a change. This was not helpful, and reminded us of the limits of the technocratic approach to Central banking. Immediately after the Referendum vote markets fell then rallied strongly. A few weeks later the Bank of England cut interest rates and loosened money policy, driving the pound down. In the following spring the Bank then decided to start tightening money which eventually slowed the economy markedly by the end of 2019. There was no obvious rationale for any of this.
The Euro – a currency in search of a country to back it
The Euro is the ultimate technocrat dream. Here is a currency and a central bank with considerable economic power that is not answerable to any single country or government. The president of France or the Chancellor of Germany cannot dismiss or even influence the President of the ECB. No member state can legislate to change the rules and guidance which govern it. The founding Statutes for the Bank represent a triumph for the German view. The European Central Bank will not fund the deficits of individual member states in the way a single country central bank can do in extreme conditions. The ECB can insist on the common EU rules governing state debts and deficits which need to be controlled under the Treaties. If an individual member state borrows too much then it will have to pay more for its next borrowings or will need to raise taxes or cut spending instead. The inflation target will be observed and is an average rate across the whole zone.
When the Germans and the other financially strong Northern states consented to the Euro they assumed the disciplines of the scheme would gradually make the southern states more like the north, as they had hoped for their ill-fated ERM. Instead the unimaginable happened. The world banking crash as replicated by the ECB and Euro regulators left the EU economy weak and with little inflationary pressure. The ECB ended up with zero interest rates and persistent high levels of state debt with little growth.
The German/Dutch surpluses on balance of payments accounts left the south short of Euros.The northern states refused to send them grants out of their tax revenues in the way stronger parts of a single country currency union do to help weaker parts . So the ECB allowed the Target 2 balance system to massively expand. This was meant to be a facility where a surplus state would make a short term deposit at the ECB which could be lent on to a deficit state, to clear overnight or weekly imbalances. Instead this became a semi permanent massive set of loans, with Germany currently depositing €930 billion with the ECB matched by large borrowings by Italy, Spain, Greece and Portugal, all at zero interest.
The technocrats have created another unstable edifice. Italy and others wants the EU to issue EU bonds to direct money paid for by all taxpayers in the Euro area to be spent in the places that need it most. So far the northern states refuse, so the ECB does the best it can to ease Euro shortages in the south. When the newly elected President of the ECB Mrs Lagarde let slip in a news conference that the Bank did not think it needed to ensure Italy could borrow at low rates related to Germany’s, the markets sold off Italian bonds rapidly. Shortly afterwards her remarks were clarified, and it turned out the relative cost of Italian debt was a matter of concern. The price of the error combined with the new needs of the time was an additional €750 billion of bond buying by the ECB, with more Italian and Greek bonds as part of the mix.
What makes a successful central bank
A successful central bank reads the cycle well and is sensitive to the economic and fiscal policy being followed by the government that backs it. The last 50 years have seen wild swings in approach, from allowing too much credit to being too tough on credit and inflation. These boom bust cycles have been augmented by the strange architecture of the ERM and Euro.
The current virus crisis is generating better signs of collaboration both in the USA and the UK between central Bank and government. This is welcome. Now they need to read the cycle wisely. All the time we have lock down they need to provide a lot of joint offset or stimulus. When we get to the recovery phase they need to gradually reduce stimulus at an appropriate pace. They need to allow enough cash and credit to extend the recovery phase without allowing so much that we have a worrying rise in inflation.
There should be no restraint on people in a democracy discussing these policies and being critical if they wish. They are all judgements which have a big bearing on jobs and prosperity. By all means encourage expert debate, but recognise the experts do not always agree. I am all in favour of evidence based decisions. I admire successful expertise. I also think decisions are usually better founded if there is informed scrutiny of why and how they were made.
We should beware of the siren soundbite. The ERM did not deliver a “golden scenario” as promised. The Euro has not so far delivered the solidarity and stability its advocates often urge. At a time when monetary policy is being expected to deliver even more in difficult circumstances, the ECB needs to talk seriously to its EU Commission government about burden sharing, joint financing and banking stresses within the zone. Meanwhile it is good to see the USA and UK entering a new era of collaboration between central banks and governments, which needs sufficient debate and exposure to help it deliver better results than the era of so-called independence.
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