All central banks in advanced economies find themselves not just facing an awkward bend in the road of monetary management but confronting a confusing crossroads where understanding what is happening, the risks involved in their actions and navigating a sensible course of action is difficult.
A need for fresh thinking
In some respects, the monetary and economic hiatus central banks are having to look at is analogous to the breakup of the Bretton Woods Fixed parity regime fifty years ago in 1971. The inflation targeting regime that appeared to work so well during the years of the great moderation in the 1990s and early 2000s has run out of road and the unconventional monetary remedies that central banks led by the Federal Reserve Board have tried to use since the Great Recession have come to the end of their usefulness as the UK’s House of Lords Economic Committee has noted in a report published on quantitative easing this summer.
The benefits of a different perspective
What makes Huw Pill’s appointment intriguing is the many years he spent working at the ECB in the 1990s and in the early years of the ECB’s operation at the millennium epoch when its distinctive approach to central bank practice was developed under the direction of Ottar Issing the former chief economist of the Deutche Bundesbank. This win pillar approach continued to take account of money and its role in the economy when other central bank, such as the Federal Reserve and the Bank of England lost all practical interest in it.
The construction of the euro-zone has in many respects been a monetary misadventure. The countries that composed it from the start did not approximate to an optimal currency area – having a single monetary policy that was appropriate for all its constituent parts was almost impossible and reconciling the needs of the German economy with the rest of the euro-zone – was always going to be difficult. It was not helped by a fundamental lacuna at the heart of its construction, the ambiguity about the role of the lender of last resort and how it would be performed in a crisis. Yet the ECB as an institution has navigated these difficulties with great professionalism and interesting examples of technical innovation such as widening the range of collateral that the central bank would use in its open market operations particularly in a crisis, something that other central banks would later turn to.
The distinctive intellectual legacy of the Bundesbank
The ECB benefitted from the intellectual legacy of the Bundesbank. A legacy helpfully exemplified in Fifty Years of the Deutsche Mark: central bank and the currency in |Germany since 1948 published under the direction of Otmar Issing in 1998. The key part of that legacy was how the German central bank responded to the international monetary crises of the 1970s and the inflation that went with it. German economists had contributed little to the academic counter reformation and the monetary critique of the Keynesian macro-economic consensus – that was led principally by American economists such Milton Friedman, Anna Schwartz, and Robert Meltzer – but the central bank policy practitioners at the Bundesbank understood its practical implications for policy better than their international colleagues.
The result was that the Germany economy navigated the great inflation of the 1970s much better than other advanced economies such as the US, France, and the UK. The Bundesbank set monetary targets. In the 1970s and 1980s a distinctive feature of West German monetary practice was also the use of reserve requirements as a tool of direct monetary control limiting the supply of money. A similar technical device was used by Paul Volcker at the Federal Reserve, the targeting of non-borrowed reserves to break American inflation between 1979 and 1982.
Understanding money is difficult but ignoring it is a mistake
Many central went on to use monetary targets and abandoned them when institutional changes resulted in chequing and current accounts started paying interest resulting in them becoming savings accounts and no longer being transaction balances raising the demand for money scored in these forms of accounts and diminishing the information that such measures of money and liquidity offer policy makers about spending in their economies. These changes made it much more difficult to appreciate what was going on in terms of liquidity, but monetary analysis albeit difficult remained useful and ignoring it risked potential trouble both in terms of inflation and asset price bubbles and with them the stability of the banking system. UK experience both in the 1980s and in the 2000s offers lessons in the dangers of ignoring the role of money in formulating policy.
By chance when central banks need all the intellectual resources available to them to understand what is happening now at a time when their economies are exhibiting higher inflation than they were forecasting and monetary conditions are very loose, the one central bank the ECB that continued to look formally at the role of money has under Christine Legarde’s leadership announced that it is abandoning it.
The Bank of England has a wholly discretionary monetary policy that it carries out to meet an inflation target set by the Treasury. Its central approach is an assessment of how much spare capacity there is in the economy to generate an estimate of the so-called output gap. It uses interest rates and open market operations along with asset price purchases to pump sufficient liquidity into the economy to ensure that there is enough demand to close any apparent output gap and to lower demand it is too great. This Keynesian output gap model approach is very similar to the approach of the Federal Reserve. The UK central bank over the last two decades has also shared with the US central bank a bias to run the economy as close to full capacity as possible. That bias played a key part in the asset price bubbles and loose monetary conditions that destabilised the banking system in 2007.
The Bank of England’s distinctive platform and intellectual opportunity
The Bank of England would benefit having a contrasting perspective from an economist like Huw Pill who may be able to offer a different point of view. In the past the Bank of England has benefited from the lustre of its economists such as Charles Goodhart and Mervyn King. There should be an opportunity for its Governor and new Chief Economist to offer a leading and critical analysis of present international central bank practice and a commentary on the big questions that modern central banks face.
The Bank of England attracts greater interest than its role within the international economy would normally imply. This arises from the fact that in many respects by accident it presides over the world’s largest international financial market and from its distinctive institutional history as the world’s first central bank.
The Bank of England founded in 1694 is not the oldest central bank that is the Swedish Riksbank, but it was the first major central bank to develop the techniques that we associate with managing a financial centre. These include stabilising day to day financial flows in money markets and acting as a lender of last resort in financial crises. These were the practices of the Bank of England codified by the editor of The Economist Walter Bagehot in his book Lombard Street.It also invites interest because the Bank has been at the heart of many of the great historical debates and episodes of crisis that central bankers explore in framing their understanding of present policy dilemmas. These include the bullion controversy, the debates about the real bills’ doctrine, the stabilisation of the international gold standard and the role of cheap money, investment, and inflation. The contributors to these controversies were often intellectually powerful personalities that continue to compel attention today, such as David Ricardo and Maynard Keynes. To stimulate an international debate the Bank of England has a ready stage – the London financial markets and a vivid legacy to draw on and attract attention.
Offering analysis and policy explanation a compelling and cogent manner
There is also a specific local matter where a new economist with a fresh perspective may help. Over the last twenty-five years across the UK public service the presentation of policy has increasingly been oblique. Documents of policy and analysis become exercises in recording process rather the exemplification of analysis, rationale, and purpose. Both the research departments of the ECB and the regional reserve banks that make up the Federal Reserve System offer good examples of the manner, in which monetary events, analysis of economic conditions, the character of the choices involved in policy and the controversy surrounding them can be cogently explained. It would be worth looking at this dimension of the Bank of England’s work.
Accompanying research note that explores the challenges that modern central banks have today coming soon.