Stephen King: The Bank of England needs to look back – and think the unthinkable
Monday 26 January 2009
On 24 October 1930, a report from the British government's Economic Advisory Council was circulated by Ramsay MacDonald, the Prime Minister, to his Cabinet. The Economic Advisory Council consisted of the great and the good of the economics profession, and was chaired by John Maynard Keynes. Its terms of reference were "to review the present economic condition of Great Britain, to examine the causes ... and to indicate the conditions of recovery."
Note the date. This was a year after the Wall Street Crash, a year in which the world had succumbed to a deep recession. The Depression, though, was still to come. The US economy had fallen off a cliff in 1930, but most of the economic losses occurred in 1931 and 1932. The UK economy was only in the early stages of its own downturn. The now-famous Jarrow march didn't take place until 1936.
The Council was particularly worried that the sustained declines in commodity prices of the late 1920s might pave the way for a more generalised decline in prices. The members were vexed by the impact of a falling price level on the government debt burden (which, in real terms, was in danger of rising). They were troubled by the statutory payments to pensioners and to the unemployed which, in a world of falling prices, would become more expensive in real terms. And, in particular, they were worried about social resistance to wage declines.
Their conclusions proved remarkably accurate: "The result of all this is that money costs ... are out of line with money prices. Consequently, producers lose money; they are unable to maintain their former labour forces; and unemployment ensues on a colossal scale." As an economic forecast, that takes some beating. The British government was given due warning in the very early stages of the global Depression that bad news was on its way. It was also offered advice on what to do to minimise the risk. The Council wanted to see a significant easing of monetary policy. However, under the Gold Standard there was little room for flexibility: "The Bank of England cannot, under current gold standard limitations, move far in this direction unless other central banks do the same." The Council was mostly worried about the US Federal Reserve, which was apparently in no mood to go down the road of cheap credit. And ultimately, Keynes and his colleagues were held hostage by the prevailing conventional wisdom: "It is quite a different matter today to go back on the decision then made [the 1925 return to the Gold Standard]. We think there would be grave objections to such a course, because of its reactions on our international credit ..."
Two conclusions stem from all this. First, policymakers had plenty of warning about what was going to hit them. Second, the warnings weren't immediately acted upon – either because the remedies weren't seen to be credible or, alternatively, because they were deemed unacceptable in an international context.
A year later, the UK did leave the Gold Standard. History is kind in its treatment of this apparently cataclysmic event. Britain's departure, after all, provided a cushion for the economy at a time when the rest of the world was plunging into economic despair. The UK's downswing was, in the event, a much more modest affair than America's. However, this didn't stop the UK Government defaulting on its First World War debt in 1932, leaving many domestic investors worse off. Nor did it stop those Jarrow marchers. The UK's relative out-performance still left the economy on its knees for much of the decade.
And the lessons for today? The UK hasn't been hamstrung in its monetary actions through attachment to any form of gold standard, and its actions have not been constrained by an unwilling Federal Reserve. Ben Bern-anke, after all, knows more than almost anyone else about the Great Depression and is a big believer in early monetary action to stave off economic crisis. Unlike the 1930s, then, there has already been a series of dramatic interest rate cuts around the world. Most countries have recognised the importance of fiscal measures to protect the broader economy from the effects of the credit crunch.
There are, though, some obvious negatives. In the desperate search for an answer, the wise men of the Advisory Council were happy to consider policies which, in the normal run of events, would have been ruled out. For example, they wondered whether the commitment to free trade was still appropriate in an environment of mass unemployment, and considered the merits of tariffs. The modern-day equivalent of this debate is, surely, the decision by the British government, among others, to inject huge amounts of capital into the banking system in exchange for a vague promise that dom-estic bank lending will be supported. Given that overall bank lending is simply too high, the result is a restriction on cross-border capital flows which, indirectly, may have the same impact on trade as tariffs did in the 1930s.
And now that we've more or less reached the end of interest rate cuts, there is a crying need for a revolution in central bank thinking, equivalent to the rejection of the gold standard in the 1930s. Central banks surely need to give consideration both to the price and the quantity of credit, rather than focusing on price alone. Currently, the quantity of credit in the global financial system is simply too limited whereas, earlier in the decade, the quantity was way too high.
Rather than thinking of policies influencing the quantity of credit as conventionally unconventional, or unconventionally unconventional, or whatever other weird formulation Mervyn King, the Governor of the Bank of England, chooses to use, it would be far better to argue that central bank policy was adapting to the mistakes of recent years, in particular by recognising that, in a world of global capital flows, the interest-rate weapon on its own is insufficient to guarantee lasting economic stability. My guess is that most people would regard this as an entirely sensible observation but, by describing non-interest rate policies as unconventional, the danger is that these quantitative policies do not have the desired positive impact on people's expectations.
And finally, as the UK discovered in the 1930s, there are limits to what a small island on the edge of Europe can deliver in terms of economic recovery if the rest of the world is in a mess. Even if the US delivers a huge fiscal stimulus, its own banking system will still struggle. Even if both the US and the UK are happy to embrace quantitative monetary easing, the eurozone nations may attempt to stick to the equivalent of a 1930s gold standard mentality. Meanwhile, with Tim Geithner, President Obama's choice for Treasury Secretary, accusing China of manipulating its currency, the risk of a major trade dispute between the old and new titans of the global economy is rising at an alarmingly rapid rate.
Stephen King is managing director of economics at HSBC
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