Stephen King: Does the Bank of England know something the rest of us don't?
They can prevent the worst economic outcomes. They cannot create the best
Monday 10 August 2009
T he loss of a quarter of a million jobs in the US is greeted with euphoria by investors. An announcement that the Bank of England is pumping an additional £50bn into the UK economy is, by contrast, greeted with despair.
The difference relates, of course, to expectations. Fewer-than-expected Americans lost their jobs. More money than expected was pumped into the UK banking system. We end up judging outcomes relative to our collective expectations, on the basis that our expectations are, in some sense, the best unbiased guides to future events.
In turn, this allows us to reach quick conclusions about the meaning of a particular financial event. With "only" a quarter of a million job losses in July, it appears the US labour market is beginning to improve.
If the Bank of England is injecting another £50bn of cash into the economy via its quantitative easing programme, this presumably implies that our collective expectations about the UK economy were wrong. Despite encouraging signs from the housing market, from equity markets and a host of other indicators, the Bank of England's Monetary Policy Committee apparently knows something about the parlous state of the UK economy that the rest of us have failed to detect. Rather than a pre-emptive move designed to drag the UK economy forcibly out of recession, the Bank's actions end up being described, instead, as a sign that the economy is still very vulnerable to ongoing recession.
Financial investors, however, make bets on the tiniest slivers of information. Imagine the debate between boom and bust is decided with a pair of weighing scales.
Earlier in the year, the vast majority of information suggested an ongoing bust and the scales were, thus, heavily weighed down on one side. As the year has progressed, the information has become increasingly balanced. The scales have suddenly shifted. There are still ongoing worries about recession but, on balance, those worries have been offset by increasing signs that the monetary and fiscal medicine handed out over the last couple of years is beginning to work.
It's at this point that life becomes tricky for policymakers. They have to think not only about the cyclical factors which influence recovery readings from one month to the next but also about structural factors which will govern any recovery's staying power. The patient who's been bed-ridden for a year doesn't simply take a course of drugs before springing out of bed and heading to the nearest nightclub. Instead, there has to be a protracted period of physiotherapy to make sure that atrophied muscles begin to work again.
The same philosophy applies to recoveries. Again, think about the scales. If the scales are evenly balanced between recession and recovery, it wouldn't take much to shift the argument. Another small sliver of information could be enough.
At this point, its worth distinguishing between the real and financial aspects of the improvements we've seen through the course of the year. In real terms, there has most definitely been some sort of pick up. Production and exports are rising, inventories which, previously, had been pared to the bone, are now showing signs of being rebuilt.
In financial terms, the picture is a little less convincing. Equity markets, of course, have staged an impressive rally and if that, in turn, indicates a return of long-lost confidence, that's undoubtedly a good thing. For the Bank of England, however, there are residual worries. As Mervyn King's letter to the Chancellor of the Exchequer points out, "Underlying broad money growth has picked up since the end of last year but remains weak. And though there are signs that credit conditions may have started to ease, lending to business has fallen and spreads on bank loans remain elevated."
Financial markets tend to be directional. Either economic conditions are getting better or they're deteriorating. Yet it's also possible that economic conditions simply undulate around a rather depressed mean. Signs of recovery may, therefore, overstate an economy's underlying economic health. The evidence from previous episodes involving nasty financial shocks seems to support this pattern.
The Scandinavian economies suffered unduly in the early-1990s. At the time, the UK wasn't much better. In the early-1980s, the US suffered from Paul Volcker's self-imposed credit crunch. On each of these occasions, there were false dawns, inappropriate extrapolations of supposed recoveries and, ultimately, disappointment. The most extreme example, of course, is Japan which, through the 1990s, experienced many moments of hope, all of which were dashed on the rocks of financial implosion and economic stagnation. Western policymakers console themselves with the idea they've learned from Japan's errors. The key lesson, apparently, is that Japan was slow in cutting interest rates at the beginning of its lost decade, and too quick to raise them thereafter.
It's this second mistake which western policymakers are keen to avoid. The temptation to raise rates at the first sign of recovery is always strong. It's a temptation that mostly should be resisted unless there are clear signs of inflationary excess.
Today, that simply isn't the case. Moreover, the case for keeping interest rates low and pumping additional money into the economy rests on the idea that the financial system is in some sense broken.
Arguably, the reason we are seeing green shoots is precisely because a crumbling international banking system has, in effect, been replaced by the activities and efforts of central banks. Should they walk away, fledgling recoveries might curl up and die.
If, therefore, central banks know something which markets don't, it's the extent to which the central banks themselves are keeping our economic system on life support.
Unfortunately, even when the act of life support finally ends, I don't think we'll return to the conditions of the 1990s. Growth will be lower for a very long time, held back by ageing populations, increased regulation, growing protectionism and excessive debts. Central banks can prevent the worst economic outcomes from occurring. They cannot create the best economic conditions. They are only responsible for monetary policy. They are not magicians.
Stephen King is managing director of economics at HSBC
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