Stephen King: Central bank coxswain can't fully trust the crew

Bubbles and busts play around with people's expectations of future economic performance
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The Independent Online

"We are seeking to engineer a modest slowing in consumer spending growth in order to make room for an increase in investment and exports as business conditions improve here and abroad." Charlie Bean, the Bank of England's chief economist, doesn't give speeches very often. Last week's - excitingly titled "Some current issues in UK monetary policy" and presented to the Institute of Economic Affairs - was therefore worth waiting for.

"We are seeking to engineer a modest slowing in consumer spending growth in order to make room for an increase in investment and exports as business conditions improve here and abroad." Charlie Bean, the Bank of England's chief economist, doesn't give speeches very often. Last week's - excitingly titled "Some current issues in UK monetary policy" and presented to the Institute of Economic Affairs - was therefore worth waiting for.

A lot of column inches have already been used up dissecting the contents of his speech, so I don't really want to add a lot more at this stage. However, the opening quote of this article does reveal a few things about the Bank's philosophy which, perhaps, require some further investigation. The Bank sees its role as a manager of other people's behaviour. A bit like the coxswain in a rowing race, the Bank both barks out orders (or, in this case, gives genteel speeches) and has a well-trained hand on the tiller.

Unlike a boat race, though, the Bank can't always see where it's going. Perhaps the economic climate is foggy. Or, where the economic river bends, there's uncertainty beyond. More likely, though, perhaps the Bank of England has, in the shape of the great British public, an unreliable and poorly trained crew. Being a coxswain is fine if you know that your crew will behave themselves. Should they not obey your instructions, however, you can end up with all sorts of problems. Could the economy be sunk not because the Bank's navigation was poor but, rather, because consumers and others were looking at a completely different map or, alternatively, didn't fully understand the Bank's instructions?

Central bankers, inevitably, like to think they can steer an economy through both smooth water and rapids: that, after all, is their job. However, I think there is a major problem with this philosophy, associated with collective delusion and the emergence of financial and economic bubbles.

Let's go back to the late 1990s and take a look at the US equity bubble. Back then, a series of beliefs was upheld that gave the impression that life would be relatively easy. The first belief was the existence of a "new paradigm", the idea that the US economy, in particular, had embarked upon a higher long-term growth rate. The second belief was that, in the absence of inflation, there was a lot more flexibility on monetary policy: should things go wrong, the central bank could always launch an effective monetary lifeboat. The third belief was that gains in asset prices were somehow justified by the first and second beliefs.

All of this might have been true but it didn't help very much: the equity bubble collapsed, the monetary lifeboat failed to prevent a recession because companies found their debt levels suddenly too high, and the jury is still out on whether the subsequent recovery has been built on firm foundations. So what went wrong?

At this point, perhaps I should provide my own definition of a bubble. I would say that a bubble exists when the collective set of growth expectations contained within a particular asset market are ultimately inconsistent with the longer-term performance of an economy, and that people borrow too much on the back of this collective delusion.

The rules of compound interest come into play at this point. Let's say, for example, that at the peak of the US equity bubble, people expected the US economy to expand at 5 per cent per year in real terms and let's also assume that real, inflation-adjusted, returns on assets are equal to the growth rate of the economy (yes, I admit to chronic over-simplification but it helps for the purposes of the argument). So, if an individual wanted to have savings of $100,000 in 10 years' time, he or she will need to start off with a lump sum of $61,391 (i.e. taking $100,000 and dividing by (1.05)10), assuming that only the interest income is re-invested, that income from other sources is entirely spent and that inflation is absent.

Then the central bank comes along, takes a look at these expectations and concludes that they're a bit racy. Perhaps there are a few signs of inflation. Or perhaps the bubble is leading to excessive growth of debt. Maybe monetary policy is a long way from "neutral".

Whatever the reason, monetary policy is tightened with the aim of slowing the economy and, importantly, changing people's expectations about what's likely in terms of medium-term economic performance and financial returns. It may, of course, still be the case that the new paradigm story holds. Perhaps growth can average 3.5 per cent per year - lower than the delusional 5 per cent returns previously expected but still higher than an earlier, say, 3 per cent average return. What then happens? Well, for the person who's hoping to have savings of $100,000 in 10 years' time, he or she will now need to start off with a lump sum of $70,891 (i.e. taking $100,000 and dividing by (1.035)10).

And, of course, if that person hasn't got those savings, either he or she will have to save more out of current income or, alternatively, to lower aspirations about his or her future level of wealth, which might reduce that person's willingness to hold debt today. Either way, the reduction in expectations about future growth leads to a significant shift in current saving and borrowing patterns which implies that, although the central bank wants to achieve a growth rate of 3.5 per cent, there's a very good chance that growth will come in a lot lower as savers and borrowers re-assess their own financial positions.

Almost by definition, bubbles and busts play around with people's expectations of future economic performance and, through the laws of compound interest, have a sizeable effect on macroeconomic stability today. Attempts to stabilise an inflation rate over the medium term are fine but, in the process, they sometimes threaten the creation of bubbles, even if central banks had no intention of creating those bubbles in the first place. I doubt the Bank of England expected house prices to rise so swiftly over the last three years, during which time valuations have become extraordinarily stretched. I doubt, also, that the Federal Reserve expected equity prices to rise so swiftly in the second half of the 1990s. But the central bank coxswain should never fully trust the crew: they have a habit of behaving in unexpected ways, perhaps because it's never easy to separate the probable from the only vaguely possible.

If you don't believe me, it's worth referring to the results of a study by Professor Robert Shiller of Yale University and Karl Case of Wellesley College, published by the Brookings Institute last year. The authors surveyed recent homebuyers in a number of US states and discovered that, as a general rule, these proud new homeowners expected home prices to rise by 12-16 per cent per year for the next 10 years.

Lucky them: in 10 years' time, a $100,000 house would be worth more than $370,000. Given, though, that inflation is low and that, over the long term, real house price inflation in the US has averaged not much more than 1 per cent per annum, these homebuyers seem to be living in a very strange world indeed.

If monetary tightening forces them to change their minds, to "get real", they're going to have very different attitudes towards savings and debt. Apply that argument to the economy as a whole and you can begin to see why central banks find economic cycles more difficult to manage than they would like to admit: faced with the delusion of crowds, the laws both of unintended consequences and of compound interest can lead to outcomes very different from the ones that central banks had planned for us.

Stephen King is managing director of economics at HSBC stephen.king@hsbcib.com

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