Stephen King: The economic horrors facing central bankers

My occasional trips to the US can sometimes involve strange experiences. Admittedly, it's partly my fault; or, at the very least, my parents' fault. It's my name, you see. It's the trigger for many a joke about whether The Shining is better than Carrie, or whether I'm on the verge of finishing my next novel.

Remarkably, many of these "comedians"think I've not heard the joke before. And, because many of them work for Homeland Security in various US airports, I feel obliged to laugh: the alternative - a full body search - is not terribly appealing.

My name also conjures up expectations that anything I may say on economics is likely to be a horror story. And, much as I'd like to avoid this stereotype, I sometimes cannot stop myself.

Last week I visited a number of US cities, talking about the outlook for the global economy and America's role within it. I warned of the perils of ever-increasing current account deficits and the dangers of a sudden rise in the risk premium on financial assets. Although markets have done well and the US economy has continued to expand, this kind of argument tends to trigger unease among investors. It's almost as if people are expecting Jack Nicholson to appear, holding a bloodied axe, screaming: "Here's Johnny!"

The difficulty facing investors and policymakers lies in working out the most relevant yardsticks for economic performance. We've had it drummed into our heads over the past 20 years that price stability is the ultimate macroeconomic objective; so much so that this aim is enshrined in the constitutions of most central banks.

The good news is that the objective of price stability has been broadly achieved. Few countries seem haunted by the ghost of inflation past. With weakened unions, greater capital mobility, genuine central bank independence and ageing populations that have no interest in seeing their savings wiped out through inflation, it looks as though the inflationary turbulence of the 1970s and 1980s will become no more than a fading memory.

Does this mean that we are living in an era of macroeconomic stability? I doubt it. Stability at the domestic level, for example, has not necessarily been mirrored by stability internationally. As Mervyn King, the Governor of the Bank of England, said: "The aim of central banks to make monetary policy ... more boring needs to be complemented by a collective effort to bring boredom to the international monetary stage." In other words, there are international limits to the influence of national central banks, and of national policymakers more generally.

Part of this is an issue about perception. Who is to blame, for example, for the growth in the US current account deficit? The Americans argue that the main culprits are the Europeans and the Japanese, who have made poorly judged, domestic economic policy decisions leading to persistently weak demand, and Asian central banks, who have unfairly manipulated their currencies. The Europeans see the Americans as the main culprits, a group of people seemingly addicted to debt in all its various forms (and, from my experience, also addicted to Stephen King jokes). The Chinese see themselves as scapegoats; blamed for imbalances that cannot really be their fault alone (does anyone really think that a revaluation of the renminbi will make all the difference when the dollar's precipitous decline against other currencies has barely dented external imbalances?).

All these countries and regions have come close to achieving price stability. This raises a key issue: if central banks have done their job on price stability, why worry about the international implications of that achievement? If all countries have reached their inflation targets, do external imbalances matter?

External imbalances tell us something about domestic savings and investment patterns across countries. A country that saves more than it invests will run a current account surplus: it will be exporting capital. A country that invests more than it saves will run a current account deficit: hence it will be a capital importer. So, if central banks are concerned about external imbalances, they are also expressing concern about savings and investment behaviour; not necessarily in their own country, of course, but around the world as a whole.

This, however, puts central banks in a peculiar position. Why should they be concerned about saving and investment behaviour if their various targets for price stability have been met? The answer lies in the dual role played by interest rates.

Interest rates can be manipulated to create equilibrium in the money markets. Too low a level of interest rates will lead to excessive monetary expansion and, hence, higher inflation: too high a level of interest rates will do the opposite. Interest rates can be manipulated, however, to create equilibrium in the capital markets. Too low a level of interest rates will lead to excessive capital spending; too high a rate will lead to excessive saving. And, in a world where inflationary expectations are remarkably low and stable, it is this second function of rates that is likely to be the more important.

Imbalances between savings and investment will potentially reveal themselves in two broad ways. External imbalances provide one sign of danger. A country that persistently borrows from abroad will eventually find itself borrowing simply to repay the interest on previous loans, a less than healthy outcome. Domestic asset price bubbles provide another sign of danger. A bubble is typically associated with a combination of a high expected future return and a low current borrowing cost. In these circumstances, leverage becomes attractive on the rapidly appreciating asset, leading to domestic borrowing and, through the balance of payments, borrowing from abroad.

In other words, central bankers who express concern about external imbalances are also, implicitly, expressing concern about domestic savings and investment behaviour which, in turn, is likely to be influenced by inappropriate levels of real interest rates giving rise to bubbles.

This is hardly a surprising outcome: the biggest challenges to macroeconomic stability in recent years have come from unstable current account positions and excessive asset price gains, not from inflation. It suggests that policymakers are increasingly thinking about resource misallocation, not from a product and labour market perspective, where inflation is the major problem - but from a capital market perspective, where asset prices and exchange rates are the problems. This creates uncertainty with regard to monetary policy intentions. Should UK interest rates rise because of a short-term pick-up in wage demands or should they fall because of a longer-term risk of falling house prices? (see charts).

That central bankers have nightmares about external imbalances tells us that the horrors facing them are not encapsulated in the outlook for inflation alone. It may well be that domestic price stability is the only thing that central banks are mandated to achieve. But policymakers know well enough that there is always the danger of a mad axeman popping up at an inconvenient moment, ready to hack to pieces the inflation-targeting framework which has served the world economy so well.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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