In the last few weeks a number of politicians and right-wing commentators have attacked Mark Carney, Governor of the Bank of England, either for his conduct during the referendum campaign or for the policies he has overseen while at the Bank.
These attacks are misguided. There is an important debate to be had about the nature of central bank policy in Britain and elsewhere – indeed, a debate about the very existence of central banks – but, with some notable exceptions, few of Carney’s critics seem to be aware of it.
There are two main criticisms of Mr Carney: one, that the Bank of England’s policy of quantitative easing has done more harm than good by driving up asset prices; and two, that the Bank of England’s forecasts before the EU referendum were inappropriate. I will only discuss the first of these here – the second is a political complaint, not an economic one.
The first of these criticisms has been made on ConservativeHome by Alex Morton, formerly of the No 10 Policy Unit; by the Spectator’s James Bartholomew and Fraser Nelson; by William Hague in the Telegraph; by Michael Gove MP in today’s Times (£); and by the Prime Minister herself during her party conference speech.
Morton says that:
There are disagreements among liberals about how fast and far to raise interest rates, but there is broad agreement that the current low rates are a distortion of the market and need to go. There is no way that zero and negative interest rates are a ‘market’ creation. In addition, it was the excess of debt caused by too low interest rates (again set by government via Central Banks) that many liberals (rightly) blame for the financial crisis in the first place.
The first of these points is simply false, as far as economics goes. Among Austrian-school economists (who Morton seems to favour, given his second point) as well as many others there is concept called the “natural rate of interest”, which is the rate that we would expect to emerge if the market was left alone and the cost borrowing and lending was determined entirely by the supply of loanable funds (like bank deposits) and demand for loans.
At this rate we expect the monetary framework for the economy to be neutral – neither too inflationary nor too deflationary. If interest rates were set in a free market, this is what the rate would be.
If we have a central bank that sets the base rate for the cost of borrowing, we want it to try to set its rate as close to the “natural rate” as possible. If it sets it lower, too much borrowing will occur and inflation will rise; if it sets it too high, money will be too tight and a deflationary recession will occur.
So Morton’s point seems to rest on the assumption that the natural rate of interest could not be zero or negative. There is “no way” this is the case, he says, though he does not provide any evidence for this claim. As far as I know he never has, despite frequently claiming that monetary policy is too loose.
As David Beckworth, a free market economist in the Milton Friedman mould, says, the question of what level the natural rate of interest is at is the crux of the whole debate:
The answer to this question would go a long ways in ending much confusion. If the answer is yes, then it would not be true that Fed has been 'artificially' suppressing interesting rates as many have claimed. Nor would it be true that the Fed has been enabling the large budget deficits with low financing costs for the treasury department. Finally, it would reveal that U.S. monetary policy has not been that loose despite the Fed's various QE programs.
Beckworth argues that the gap between potential and actual economic output in the US since the 2008 crisis, which is to a large extent mirrored in the UK (which has seen better employment growth but worse economic growth than the US), is indicative of a negative short-run natural interest rate. “Given the large amount of slack during the crisis,” he says, “it seems reasonable that the market-clearing nominal interest rate could have turned negative during this time.”
Has it stayed negative? Seemingly, yes. Using two (admittedly crude) proxies for the natural rate, Beckworth shows that both suggest that the natural rate seems to have turned sharply negative in 2008 and stayed there for many years, only beginning to recover recently. Similar estimates do not exist for the UK but for Morton to claim that there is “no way” that the same is true for the UK as the US is baseless.
James Bartholomew’s broadside against Carney (in which he demands that Carney resign!) similarly makes heroic assumptions about what the stance of policy should be with little more than hand-waving to justify his claims.
Fraser Nelson, Michael Gove and Theresa May all object that quantitative easing in particular has driven up asset prices, thus worsening inequality. But they misunderstand why asset prices can rise dramatically after new QE is announced, but GDP only rises slowly.
It is not because QE money is like treacle, that slowly drips down from banks through financial assets to ‘real people’. QE buys bonds from banks, giving them a newfound cash injection and pushing up the prices of bonds marginally, which causes them to rebalance their portfolios to other assets. But this is not what drives up asset prices.
In fact, it is the fact that the monetary base has been expanded that is doing most of the work: buying bonds from banks is just a way of getting that base expansion into the economy, and the process would work just as well (probably better) if bonds were purchased on the open market rather than from banks in particular.
Expanding the money supply, if the natural interest rate is below zero, is the best way of avoiding a deflationary recession if the Bank’s own rate is stuck at zero. This is, at least, the Milton Friedman and FA Hayek view. Over-loose monetary policy cannot create growth, but over-tight policy can destroy growth.
So if we do a round of QE and it helps us to stay on the growth path, what should we expect? GDP to grow better than previously expected for a few years, for one. And that is what all serious estimates of the impact of QE in Britain since the crisis have found – that QE prevented between at least 0.75% and 1.5% of GDP from being destroyed needlessly by over-tight policy. Some studies put the estimate even higher.
And what would we expect to happen to asset prices in the event of a 1% boost to GDP? We would expect them to rise by a lot more than 1%, because (eg) share prices reflect the value of firms for many years into the future. Google’s share price reflects expectations that it will be profitable for many years; if something happened that made investors think that it would be (say) 1% more profitable every year for many decades, it would become vastly more valuable.
In this reading, does it make sense to blame QE for exacerbating inequality? No. Because QE simply avoids over-tight policy, it is about avoiding needless destruction of wealth rather than ‘propping up’ share prices as many people claim. If it makes us all richer, by avoiding a needless recession, it doesn’t matter that it makes some richer than others. Objecting to it is like objecting that the fire brigade exacerbates inequality, because rich people’s burning homes are more valuable than poor people’s burning homes.
Where Gove does have a point is in saying that central bankers are fallible, and often guilty of groupthink. This is a serious problem, and it is this rather than low interest rates that I suspect was one major cause of the financial crisis.
And the true natural rate of interest is hard to determine. (One reason it is so silly when people insist that it is obvious that rates should rise.) But the solution is not to give politicians the job of setting monetary policy instead – their incentives and understanding of economics are even worse than those of central bankers.
In fact, I would prefer if Mark Carney’s job and the Bank of England itself did not exist at all. State-backed central banks are not an essential feature of modern capitalism, and are associated with less competitive banking systems and more banking crises overall than so called ‘free banking’ systems.
Under ‘free banking’, banks must restrain themselves because there is no taxpayer-backed bailout of their bondholders or depositors to save them if things go wrong. Banks are free to issue their own money, backed by whatever their customers want – maybe gold, maybe a basket of commodities, maybe nothing but the confidence that someone will accept it as money in the future (like Bitcoin).
The evidence seems to be that these systems are more stable than central bank-backed systems, and the Scottish experience with free banking in the 18th and 19th Centuries was a remarkable success, with Adam Smith himself (WoN, II.2.41) attributing the country’s rapid catch-up with industrialising England to, in part, its free banking system.
But it would be a mistake to equate the ‘liberal’ or free market position on monetary policy with one that is always fixated on raising interest rates or stopping QE. Under free banking in Scotland, banks expanded their balance sheets (that is, they did their own version of QE) and cut rates during times of recession, precisely because the natural rate of interest was low or perhaps even zero or less.
This is the system I would like most. Failing that, I would like a central bank that mimics this as much as possible – one based on rules about when and how policy should be loosened and tightened, rules that made policy close to what a free banking system would do.
Having someone like Mark Carney in the job, and a Monetary Policy Committee of wise men and women, is a third- or fourth-best solution, if that. If we must have a central bank, it should be predictable and automatic. The role for ‘wise men’ is in designing the rules, so that inflation is predictable and avoids distorting policy by making it too tight or too loose.
But most of Carney’s critics have missed this whole debate, and their own proposals to drastically tighten monetary policy – uninformed by economic thought or history – would be ruinous. Though they claim to criticise ‘wise men’ they are really just offering their own wisdom instead, which in light of the evidence is even worse than Carney’s. Instead of trying to offer themselves up as better players, they should be trying to change the game.