Stephen King: If this is World Cup economics, who will be our global referee?

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The Independent Online

Our economies are faced with a mysterious threat. Policymakers know about this threat, although they're not quite sure what to do about it. The threat can broadly be described as "the rest of the world" or, more informally, "it's somebody else's fault".

Here are a few choice words from central bankers over the past few weeks. Mervyn King, the Governor of the Bank of England, said on 14 June that "... there are many risks and those have been bought [sic] into sharp focus by the recent financial market turbulence. And, just as for England in the World Cup, the threats come from the rest of the world." (Given that his speech was to a Scottish audience, I wonder whether Scotland is now seen by the Bank of England as a major threat to lasting English price stability).

Last Thursday, the Federal Reserve was also at it. Ben Bernanke, the Fed chairman, was talking about the effects of higher energy prices. In his words, "although the rate of pass-through of higher energy and other commodity prices to core consumer price inflation appears to have been relatively low in the current episode ... the cumulative increases in energy and commodity prices have been large enough that they could account for some of the recent pick-up in core inflation." Inflation may, therefore, have gone up in the US, but the fault lies elsewhere.

And, if that wasn't enough, a speech on Friday by Donald Kohn, another Federal Reserve governor, once again highlighted the uncertainties created by "the rest of the world". He said: "Quite naturally, the greater integration of the US economy into a rapidly evolving world economy has affected the dynamics of inflation determination. Unfortunately, huge gaps and puzzles remain in our analysis and empirical testing of various hypotheses related to these effects."

To be fair to Mr Kohn, he finished his speech with the following observations: "In the end, policymakers here and abroad cannot lose sight of a fundamental truth: in a world of separate currencies that can fluctuate against each other over time, each country's central bank determines its inflation rate." In other words "the rest of the world" may be a threat, but doesn't diminish a central bank's own responsibilities in controlling inflation.

The problem with the view that the "rest of the world" is a threat is not that it is untrue but that it has always been true. The idea that, all of a sudden, the rest of the world has turned up on the radar screen when, hitherto, it really didn't matter for economic performance is patently absurd. To use the rest of the world as an excuse is really a way of central bankers saying that they don't fully control domestic economic outcomes: even if their intention is to take responsibility for economic performance, lots of things are happening that are beyond their control. This, inevitably, creates a tension: central banks have the job of achieving price stability but lots of the factors that influence changes in the price level are not controlled by our monetary masters. Mr Kohn may be right in arguing that central banks have their own responsibilities for controlling inflation, but it would be wrong to conclude that they can always achieve their goals.

Part of the problem lies with the definition of price stability. In a vague way, we all know what is meant by an inflation target of, say, 2 per cent, but pinning this down into something that serves as a target for central banks to achieve is a bit more difficult. Which measure of inflation should be used? How should sudden increases in energy prices be treated? Over what time horizon should the inflation target be met? How far should inflation be allowed to deviate from target?

Not easy questions to answer, particularly when "the rest of the world" is lurking, ready to trip up even the most conscientious of central bankers. Inflation targeting may have given the impression of a newly-scientific framework, one more reliable than in the past, but central bankers, like the rest of us, can easily be caught out by unforeseen events.

Few central bankers anticipated the gains in energy prices in recent years: had they known that oil prices would rise to $70 per barrel, perhaps they would not have left interest rates so low for quite so long. Few central bankers would have anticipated the degree to which capital mobility has allowed companies to tap into cheap labour in hitherto inaccessible parts of the global economy. Few central bankers would have been quite so confident that US house prices would make the extraordinary gains seen in recent years, particularly in the light of the 2000-01 stock market crash.

To suggest, though, that these uncertainties are purely the result of events taking place in the "rest of the world" is obviously silly. For every country, the rest of the world matters but, equally, for every country, the rest of the world is a slightly different thing. For the US, the UK forms part of the rest of the world and, for the UK, the US is part of the rest of the world. Are we really descending into a tit-for-tat policy debate, with each country blaming every other country for economic difficulties? And why is it that, when things are going swimmingly, it's always the result of wise choices from domestic policymakers with no credit whatsoever given to the rest of the world?

Perhaps I'm being overly harsh. A better distinction for policymakers to use, though, would be to highlight the difference between global events - those that affect all of us - and local events - factors that may be specific to only one country. Both are important. Neither need be entirely exogenous. During his Scottish speech, Mervyn King suggested that "during the fastest three-year period of world economic growth for a generation, monetary policy around the world may simply have been too accommodative. In the main industrialised regions - the US, euro area and Japan - official interest rates were very low for a long period." But why exclude the UK from this comparison? By our own standards, interest rates have been very low in recent years. And the UK's policy mix after the stock market crash was remarkably similar to that of the US.

As for local factors, UK wages have been remarkably subdued in recent years, doubtless helped by greater immigration and, by the same token, a greater threat of capital emigration. But these "rest of the world" themes are only a part of the story. Companies react differently to energy shocks these days: as the chart shows, UK retailers have reacted to energy price increases by reducing their labour costs, a laughable idea 30 years ago. And people react differently: a growing number of over-fifties are returning to work, doubtless disillusioned with their pensions. This increase in labour supply helps explain why wage gains have remained moderate.

The world economy has become more integrated in recent years and, as a result, nations have become more dependent on one another. In that sense, "the rest of the world" matters more than in the past. To blame "the rest of the world" for local challenges is, though, the wrong approach. If anything, the problem lies with the absence of a credible global economic policy referee - a revamped IMF or other such organisation. Without a referee, we all find it too easy to blame everybody else for our own economic difficulties.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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