The debate about the monetary policy that central banks have pursued since the Great Recession has finally started to take off. This is a necessary public debate, and it should not be confined to central bank technocrats. If, as Clemenceau said, war is too important to be left to generals, then monetary policy is too important to be left to central bank technicians — however intellectually accomplished. Scrutiny of the purpose, objectives, and functions assigned to central banks is an inherently political matter, which elected legislators cannot evade. While fiscal policy has been at the centre of the political debate, questions around monetary policy have largely been left to a niche online or private debate within central banks.
This week, the debate moved into the mainstream with two powerful op-ed pieces in the Wall Street Journal. Martin Feldstein, who was the chair of Ronald Reagan’s Council of Economic Advisers, called for a tighter monetary policy from the Federal Reserve. Ross Altmann, writing about the consequences of the Bank of England’s purchase of financial assets and programme of Quantitative Easing (QE), made the point that, essentially, emergency procedures appropriate for the eye of a crisis have been maintained for too long, after output has stabilised and the economy has been expanding. In the meantime, the Journal’s news columns have been exploring the practical consequences of low and negative interest rates on the viability of banks’ balance sheets.
Political deference and monetary policy
Until now, the only politicians who have taken a serious critical interest in the activities of central banks have been, politically, minor figures. They often had a specialist technical interest, or were long standing American monetary mavericks, such as Ron Paul and Senator Bernie Sanders. The intervention of the British Prime Minister, Mrs May, regarding the distributional consequences of QE, is, therefore, significant.
Mrs May is careful and measured. As she showed in her scrutiny of Hinckley Point, and her relationship with the police when Home Secretary, she is not easily intimidated by complex issues or powerful institutional lobbies. Since the Bank of England Act in 1998, and the creation of the Monetary Policy Committee as part of the Bank’s operational independence, British politicians have deferred to the central bank. Mrs May will not be intimidated into deference.
Mrs May: a Prime Minister who has already examined Britain’s financial system
As a former Bank of England official, she knows the institution well. What is more, at the start of her career, she studied the intestacies of the UK financial system more systematically than most economists and financiers. One of her first assignments as a Bank official was to be seconded to work as secretary to The Committee to Review the Functioning of Financial Institutions, under the chairmanship of the former Labour Prime Minister, Sir Harold Wilson.
The review broadly covered all the major financial institutions, and the associated markets connected with them in the channelling of savings in the economy. Among the institutions were the Bank of England, other banks, finance houses, life insurance companies, pension funds, building societies, and the Stock Exchange, together with the arrangements for export credit. Given the Prime Minister’s interest in improving the performance of British industry, it is worth re-reading the Wilson Committee’s terms of reference:
‘To enquire into the role and functioning, at home and abroad, of financial institutions in the United Kingdom and their value to the economy; to review in particular the provision of funds for industry and trade; to consider what changes are required in the existing arrangements for the supervision of these institutions, including the possible extension of the public sector, and to make recommendations’.
Policy at war with itself?
An important part of scrutinising the monetary policy function of central banks should be the manner in which banks and financial markets are regulated. The rules surrounding their capital, liquidity, and reporting obligations ought to be examined. Well-intentioned regulation to make the banking system more stable may have unintended consequences. There are complex issues that relate to the amount of capital that financial institutions are prepared to deploy to their bond trading books. This can lead to thinner and potentially less liquid markets. Unpicking the consequences of very low interest rates, the inflated cost of financial assets that results from QE, and measures taken to strengthen the stability of the banking system is difficult. This is difficult — but cannot be ducked, if policy makers are to get to the heart of the questions that are central to why very loose monetary conditions, and a massive expansion of central bank balance sheets, have not resulted in a stronger performance by the credit system, in terms of stimulating economic activity. Part of the story appears to be huge central-bank monetary stimulus being vitiated by detailed bank and financial market prudential regulation.
The micro-economic consequences of monetary policy
Monetary policy is normally examined through the lens of macro-economic policy. Yet, the complex interaction between low interest rates and ultra-loose monetary conditions, as sustained for many years, has exposed complex micro-economic questions about the pricing of credit and the incentive to save. Large companies are able to borrow huge amounts at almost zero interest rates, which they then hoard on their balance sheets. However, small and medium-sized firms that do not, in practice, have access to the bond markets find it difficult to borrow. Despite the very low official interest rates, they often find it expensive to borrow, when all the ‘non-interest rate’ transaction costs involved are totted up. In the UK, there also appears to be something of a ‘zombie’ dimension to this. Getting new credit for new projects is, in practice, tough — but existing companies, which struggle with chronic problems, get nursed through their continuing difficulties. Awkward commercial judgements are not brought to a head, and new projects are stymied. This may be part of the explanation for the disappointing rate productivity growth since the Great Recession.
Monetary policy, and its institutions, should not be immune from scrutiny
Given its immense potential influence, it would be surprising if monetary policy did not have side effects on the economy. Most economists accept that an expansive monetary policy was essential to stabilise the economy following the financial crisis in 2008. Loose monetary conditions allowed the Treasury to pursue a gradual and necessary fiscal consolidation. There is an important debate about the extent to which monetary policy is now ‘running out of road’, the potential harmful and counter-productive effects of recent policy, and the extent to which policy should be directed on a higher inflation target, or a broader target, such as money GDP.
Legislators who set the objectives for their central banks, and legislate to decide the functions the banks will perform, cannot resile from considering these difficult issues. The distributional impact that arises from QE — by the inflation of the value of financial assets that principally benefit higher income households — is inherently a political question. Not least because central banks, in expanding their balance sheets to purchase the assets, have the implicit backing of the taxpayer. Central bankers acknowledge that there are distributional impacts that arise from their policies; it is politicians that have to manage them. It is, therefore, reasonable for politicians to intervene in the debate, when the scale of the consequences go beyond the technical, and begins to dominate the functioning of the pension system and household saving. Policy Exchange has pioneered the intellectual scrutiny of non-elected elite power, with its Judicial Power Project. It now looks forward to contributing to the scrutiny of the objectives and functions of the central bank.