Gerard Lyons: It is past time the Bank of England’s record received closer democratic scrutiny

9 Aug

Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.

Higher inflation, a prolonged recession and rising unemployment. That was the bleak forecast from the Bank of England last week when it released its quarterly Monetary Policy Report.

Alongside it, the Bank hiked policy rates by 0.5 per cent from 1.25 per cent to 1.75 per cent. The rate hike pleased few. With inflation at 9.4 per cent and forecast to exceed 13 per cent, monetary policy appears too loose.

But, if the economy faces recession and with external influences driving inflation, it can be asked: why is the Bank hiking aggressively?

Importantly, the Bank’s forecast is based on the assumption of no further fiscal action. But it is likely there will be further fiscal stimulus from the next prime minister to alleviate downside economic risks.

Monetary policy leaves much to be desired. It is not a new problem, but because the Bank is independent it has tended to avoid the rigorous scrutiny it should receive.

Sometimes it seems as if the Bank has become effectively an offshoot of the Treasury. It oversees and chairs every selection committee to choose the Court of the Bank, governor, deputy governors and members of every policy committee. The mandarins recommend to the chancellor who should be governor or deputy governors.

There is effectively a revolving door from the Treasury to Threadneedle Street. Three of the Bank’s five deputies used to be at the Treasury.

This is hardly a recipe for tackling groupthink. External members hardly seem to be chosen for their diversity of thought.

Some commentators are up in arms that Liz Truss wants to hold the Bank to greater scrutiny. Apparently this is seen as a threat to its independence. What rubbish. Politicians are not going to set interest rates. The Bank will thus remain independent.

Increased accountability should be welcomed and its mandate should be reviewed to see if it’s best suited to the economy’s changing needs.

Ironically, the Bank’s actions last year hardly displayed independence when it engaged in £450 billion of Quantitative Easing (QE), matching increased government spending and the wishes of the Treasury.

Crucially, the Government could have funded itself through the markets, where borrowing rates were very low. What commentators often miss is that the Bank didn’t need to print £450 billion and should have said no.

Instead, if it was doing its job, the Bank should have embarked upon a tightening phase. With inflation hitting 0.7 per cent last February it was clear it would rise, monetary growth was rapid and the economy looked set to rebound solidly. The economy would have coped with monetary tightening. Instead the Bank did the opposite and eased through QE.

This isn’t being critical with the benefit of hindsight, these points were made at the time.

Sadly, the rot set in some time ago. We effectively moved to an era of cheap money in the wake of the 2008 global financial crisis. Rates justifiably fell towards zero as a result of that crisis, but the problem was that they should have been returned to normal. They weren’t.

This led financial markets to not price properly for risk. A mis-allocation of capital followed. Zombie firms stayed afloat. Cheap money fed asset price inflation, including rampant property prices.

It was not just policy rates, though. The Bank’s balance sheet exploded because of its asset purchases, with QE distorting gilt yields and the Bank even strayed into buying corporate bonds.

Its actions, through low policy rates and a bloated balance sheet, have not helped in the present inflation shock.

To be clear, this is largely an external inflation shock driven by supply chain problems and higher fuel prices. There is not much the Bank could do about this.

But its actions last year exacerbated the inflation shock and also left the economy in a difficult situation. This is not fully appreciated. Because it eased last year as opposed to tightening, policy is far from where it should be. But if the Bank tries to overcorrect now, the economy will suffer.

Two wrongs do not make a right. The first wrong was the inappropriate monetary policy last year. The second would be to try and make up for that now.

It is commonplace to hear that even if policy had been tighter last year inflation now would not be much lower. What this fails to appreciate is that if last year’s QE had not occurred, and if policy rates had risen, then not only would the economy have coped, but also policy would be closer to where it should be. As a result there would likely be fewer economic casualties, in terms of lost output and job losses, to rates having to tighten now.

Also, at the press conference, one deputy governor stressed that inflation had averaged two per cent over the last twenty-five years, as if this offered protection to being held to account now.

It’s ironic (and telling) that the Bank is keen to stress the external influences pushing inflation higher now, while overlooking the global influences that previously kept inflation low.

China’s entry into the World Trade Organisation in 2001 was perhaps the single most important factor keeping global and British inflation low. In the City, the CPI was nicknamed the ‘China Price Index’.

A year ago, I asked which ‘p’ would the rise in inflation be: pass-through, persist, or permanent? I thought the Bank was wrong to believe it would pass-through quickly. I felt it would persist. It doesn’t look like it will be permanent, with financial markets recently expecting global inflation to ease next year.

But for an institution with one job to do – keep inflation low – the risks were clear then.

The global nature of the current inflation shock naturally should make the Bank move carefully. The speed, scale and sequencing of rate hikes and reversal of QE via Quantitative Tightening needs to be sensitive to how the economy performs and responds.

As with other European countries we face not only the energy price hike but also, as with the US, a tight labour market too. Thus the Bank needs to be mindful of second-round inflation effects, where firms are able to pass on higher costs to maintain margins and higher wages trigger a wage-price spiral.

Interestingly though, the nature of our inflation shock is not that of an overheating economy; this not only vindicates the case for a more proactive fiscal stance, but also suggests the Bank move gradually.

In the financial markets the Bank is suffering from a credibility gap. Despite the fact it hiked rates this winter, before the US, its poor communication has not helped – and whereas the Federal Reserve is now seen as ahead of events, the Bank is viewed as playing catch-up. The strength of the dollar too has led to sterling, like the euro, appearing vulnerable.

The dismal nature of the press conference stood in sharp contrast to the Fed, who while also facing a tough time are both realistic and reassuring.

In a recent speech the governor talked of how, “the long-run anchor for UK equilibrium interest rates, will remain low.” He was referring to r-star, the neutral level for policy rates after allowing for inflation. This should concern us, given the distortions caused by low policy rates since 2008.

It should raise questions as to whether we will learn anything from the prolonged period of cheap money? Learning from policy mistakes suggests that whenever the economy stabilises, rates should then settle even higher for future monetary stability.

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The ‘wage-price spiral’ explanation for inflation is a dangerous myth with serious consequences

29 Jun

Ryan Bourne is Chair in Public Understanding of Economics at the Cato Institute.
“If wages continue to chase the increase in prices then we risk a wage-price spiral,” said Boris Johnson last week.

The Prime Minister was speaking in the context of the wage demands of rail workers and public servants, following Bank governor Andrew Bailey’s call for private wage restraint more broadly.

Invoking this spectre is convenient for central banks and governments looking to shirk culpability for rising prices. But it risks blaming the victims of economic mismanagement as its cause.

The idea that wage-price spirals cause inflation – that higher prices lead to higher wage demands, which beget further higher prices and then higher wages again and again – is a long-standing myth, and a dangerous one given it can lead to such misguided policy.

Economically, showing that wage demands do not create inflation is fairly simple. Take a hypothetical company with a big, unionised workforce. Suddenly the union demands a competition-busting 20 percent pay rise, and the firm reluctantly acquiesces, raising its prices to compensate.

For a given level of total money expenditure in the economy (what we might dub “aggregate demand”), the business’s higher relative price loses some custom. As the business cuts back on production in lieu of higher prices, workers are laid off.

Yet this increases the pool of labour available to other firms, reducing wages elsewhere. Lowering costs of production, this greater worker availability ultimately feeds through into lower prices for other businesses.

In other words, without an increase in economy-wide spending, workers in one firm demanding wage hikes don’t generate price rises across the board. Inflation cannot originate from certain trade unions or greedy workers at particular companies.

It is a monetary phenomenon, of too much aggregate money expenditure (demand) chasing too few goods (supply). Why, then, does the idea of a “wage-price spiral” causing inflation persist?

As Milton Friedman wrote in 2005, for individual firms, it will no doubt seem as if the link between aggregate wages and prices is obvious. A manufacturer or a retailer will certainly observe that they must raise prices because of their own rising (or expected) expenses, just as workers will feel they must demand higher wages because of rising prices.

But their respective intuitions beg the question: what caused the rising wages or prices they are responding to? At some stage there must have been an overall increase in demand bidding up some price or workers’ money wages.

The process of other prices (and wages) adjusting to this higher aggregate spending in the economy creates the appearance of a near-term causal feedback loop. But as Friedman concludes, “the ultimate source of the increase in price has been an increase in monetary demand.” You cannot get further inflationary pressures from pay demands unless monetary forces accommodate them.

Worrying about wage-to-price passthrough after a period of excessively expansionary policy is therefore akin to lamenting gravity as the cause of hurtling to the ground after someone has thrown you from a plane. Encouraged by politicians such as Johnson, the wage-spiral concept encourages businesses and workers to blame each other, mistaking the consequences of inflation for its origins.

True, major supply-shocks to energy and food, as well as excessive monetary stimulus, have driven up inflation this time. Sustained inflation, though, can only come from excessive growth in money expenditures, requiring either a rapidly growing money supply or excessive money velocity. It cannot be caused by trade unions.

That is why in recent weeks the monetarist Tim Congdon has allied with left-wingers, such as Grace Blakeley, to dismiss Johnson and Bailey’s calls for wage restraint as “wicked.” To urge the working classes to bargain against their interests in the face of macroeconomic mismanagement is not just a losing proposition, but a mistake that could create a clamour for bad policy.

One risk is that it leads businesses and consumers to misdiagnose the issue, taking political pressure off Bailey to check any further inflationary pressure.

The bigger problem is that, as an inflation control strategy, voluntary wage restraint is futile: suppressing price or wage signals will not tame the monetary impulses, but will create ad hoc shortages and resource misallocation, perhaps even emboldening calls for price and wage controls.

Friedman analogised restraint of individual wages to quell inflation to the attempt to deflate a giant balloon by pressing down gently on one small corner of it. In an environment of higher money expenditures relative to output, all the self-sacrifice of certain workers on pay would do is leave employers with more money left over to bid up prices elsewhere. The aggregate inflationary impulse remains.

Blakeley and others err for the same reason in blaming “greedy corporations” and price mark-ups for inflation. Even if some businesses “exploit” the confusion of inflationary periods by jacking up prices, in the absence of higher spending, they cannot themselves raise aggregate prices.

What we are seeing is instead fairly intuitive. Excessive aggregate demand relative to supply pushed up prices, which tend to be less sticky (more flexible) than wages. This drives up mark-ups and profits, with wages then eventually adjusting to the higher spending levels over longer periods.

All this is not to say that overly aggressive union or worker pay demands in the face of inflation cannot be dangerous from a macroeconomic perspective. The risks they bring, however, are unemployment and job dislocation, not inflation.

As I’ve previously written, the most defensible argument for “wage restraint” is if Bailey believes that inflation expectations right now are too high. If workers think that inflation will be higher than the Bank’s eventual outturns, and so demand higher pay, then the result would not be higher inflation, but more layoffs, as workers price themselves out of jobs.

Even if firms ultimately resist such wage demands, in fact, a world where workers feel like they are going to get less than they expect may cause a fall in the employment rate as more people opt to work less. The very best case for Bailey and Johnson’s call for wage restraint then is not to interrupt a “wage-price spiral” that risks generating more inflation, but to urge wage restraint to help anchor inflation expectations and prevent a future fall in employment.

It’s extremely generous to suggest, though, that the Prime Minister was invoking 1970s fears in the service of this more sophisticated argument. No, openly musing about wage-price spirals was meant to win political support for the government’s industrial disputes.

There may be good economic reasons for real pay restraint for rail workers, given technological developments and the collapse in rail demand following the pandemic. Rising inflation is not one of them.

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Gerard Lyons: Sunak should raise the lower tax threshold this autumn to put more money in people’s pockets.

5 Apr

Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.

Higher inflation is inevitable. An economic slowdown is expected. Recession is possible. That is the economic outlook and challenge facing the UK. The question is whether policy makers are doing enough?

This troubling economic climate is not unique to us. All western economies are facing an imminent inflation challenge. And, alongside the war and its consequences, this is starting to weigh on confidence and growth prospects for later this year and next.

It was against this backdrop that the Chancellor delivered the Spring Statement two weeks ago. In many respects, it was a missed opportunity. While he cannot be blamed for higher inflation or fuel prices, and although there were some welcome measures, he has to accept some responsibility for the tax take continuing to rise and failing to increase benefits in line with inflation ahead of the cost-of-living crisis.

As expected, the Official for Budget Responsibility (OBR) projected a slowing economy over coming years and higher inflation before it subsides. After 7.5 per cent growth last year, growth is expected to slow to 3.8 per cent this year and 1.8 per cent next. Inflation, meanwhile, is expected by the OBR to rise from 2.6 per cent last year to an average of 7.4 per cent this, and then be four per cent next and 1.5 per cent in 2024.

Such an outlook – with the cost-of-living squeeze hitting people hard, and an economic slowdown ahead – added to the pressure for the Chancellor to do more to help.

Rishi Sunak stepped up to the plate during the pandemic, and perhaps the challenge from that is that it has created the impression that there is a bottomless pit of money into which he can dip. There isn’t.

Yet, as the Spring Statement showed, while debt is still historically high, the public finances are on an improving trend because of the strong rebound in the economy over the last year. This presented the Chancellor with ample room to act. Public borrowing was £321.9 billion in 2020-21 and is now expected to be £127.8 billion in the last fiscal year, 2021-22, which is £50.9 billion lower than the OBR forecast only last October.

But even last autumn it was clear that the finances were improvingm and at that time this cast doubt on the need to announce the increase in the national insurance. Moreover, the margin of error on these budget forecasts is high, suggesting the Chancellor should not feel bound by them when it comes to fiscal policy – especially for predictions several years into the future.

There is still much uncertainty about how resilient the economy will prove to be, as previous monetary policy stimulus is replaced by tightening, as the post-pandemic rebound loses momentum and as the cost-of-living squeeze bites. Measures of confidence have already started to deteriorate. The GfK measure of consumer confidence fell to its lowest level in sixteen months of -31 in March. This will likely get worse.

The biggest problem has been monetary policy and in this context the Chancellor should – at some stage – call for a fresh look at the Bank of England’s remit, operations and communication.

For more than a decade, the UK has suffered from a cheap money policy. This has had three damning consequences, each with economic and political implications.

First, it has fed rampant asset price inflation, not just in financial markets, but in property prices. This has fed inequality and inter-generational problems.

Second, the combination of low rates and the Bank’s buying of government debt through large-scale quantitative easing has contributed to financial market instability, with markets not pricing properly for risk.

Third, monetary policy has contributed to inflation. Even though the pandemic and supply shortages may have been a catalyst for rising inflation, the Bank’s complacency last year fed the problem. Moreover, it now means too that if the Bank has to tighten monetary policy, it will do so at a time when the economy is less able to cope.

With monetary policy having been too loose for too long, the uncertain economic climate might suggest the need for the Bank to tread carefully. It also added pressure on the Chancellor to do more.

Now, two weeks after the Statement, the dust has still not settled. In part, this is because there is increasing concern about what lies ahead economically, and whether the Government may be forced to act further.

The Treasury’s mindset is on balancing the budget – which they don’t do well – at the expense of economic growth. The prospect of slower future growth means more of the deficit is viewed as structural, not cyclical, necessitating fiscal caution. Furthermore, the fiscal rules which are aimed at making the fiscal numbers appear credible can end up embedding tax increases into future numbers to pay for spending plans.

Concern about the rise in debt service payments in the coming fiscal year also appeared to weigh on the Spring Statement’s plans. Perhaps this was overdone, with this rise explained by the increased cost of the principle of index-linked debt. This future liability counts as borrowing in the year in which it accrues, hence the spike in the next fiscal year which should not divert attention from the improving trend in the budget finances.

The Chancellor did unveil some significant and welcome targeted measures to cushion the pain. Most notably, increasing the National Insurance threshold, bringing it in line from July with income taxes at £12,570. This helped many people.

The other was the immediately fuel duty cut by five pence per litre until next spring – although this has not been fully passed on. This followed on from help announced before his Statement on council tax, fuel bills and changes to the universal credit taper rate. He also pre-announced a cut in income tax.

The alignment of national insurance and income tax allowances was a big deal. It not only helps simplify the tax system, but may be a stepping stone to abolishing national insurance completely. This is something many Chancellors have talked of, but none have done. This moves that closer.

Despite this, more should have been done and more help is now likely. This leads onto whether the Government is seen to be on the front foot, or are forced into acting. For instance, benefits could have been increased in line with the latest, higher inflation numbers. Also, recently announced changes to student loan repayments were unnecessary, and expensive for students, but bring in the Treasury sizeable revenues.

Looking ahead, there is still scope for the Government to cut taxes such as VAT on fuel, and shift green taxes from fuel bills onto general taxation (else they might be seen as a green poll tax, not linked to peoples’ ability to pay).

I would suggest raising the lower tax threshold this autumn, if not sooner, to put more money back into peoples’ pockets and to start to reduce the overall tax burden. Raising the upper tax threshold may be too expensive, or not politically acceptable.

Overall, the OBR reported that living standards are expected to fall by 2.2 per cent this coming year – the largest fall on record. And, despite the statement’s measures, previously announced policy measures and the more tax-rich composition of economic activity, the tax burden is set to rise to its highest since the late 1940’s, from 33 per cent of GDP in 2019/20 to 36.3 per cent in 2026/27.

Alleviating the cost-of-living crisis, keeping inflation in check and delivering stronger growth is the aim. This should be supported by smarter regulations and sensible taxes that lower the overall tax burden.

Gerard Lyons: How to tackle the cost of living crisis

11 Jan

Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.

Crisis? What crisis? The good news is that the economic rebound continues, and the jobs market has returned to broad health. We may also be over the worst of the pandemic, although possible new variants mean that learning to live with Covid and avoiding further restrictions may be a key priority this year.

Yet it is not this recovery but two other economic matters that look set to dominate policy this year: the immediate cost of living crisis and, less talked about, where growth will settle post-pandemic. Views on the latter may influence how policy responds to the former.

While the consensus expects growth around 4.5 per cent this year, after seven per cent last, there is still much pessimism about the future trend rate of growth.

It decelerated following the 2008 global financial crisis. If future growth is low, more of the budget deficit is structural, not cyclical, and needs to be addressed through fiscal restraint – a squeeze on spending or higher taxes. That thinking, which seems to dominate at the Treasury, will be resistant to reversing planned tax hikes for this spring.

Moreover, the economic consensus is that Brexit will exacerbate this challenge. However, despite this common refrain, tax rises are not inevitable. It is not leaving the EU but what you choose to do after you have left that helps determine future growth. In this respect, the Government still needs to articulate a market-friendly pro-growth economic strategy.

It also has bearings for now. There is no easy way to stop a cost-of-living crisis, but the first thing you should do is not implement policies that will make it worse.

The present crisis has multiple components. Inflation that is set to peak at over seven per cent in the spring. Higher energy prices though global in origin, are exacerbated here by decades of poor energy policies, including price caps that are now being lifted.

Furthermore, there have been two separate decisions taken to raise taxes this spring: higher national insurance, and a stealth tax in the form of a freeze on income tax allowances. And then there is a postponement of the triple lock on pensions, which means that they will rise by less than the increase in inflation this year.

Often at times of economic shocks, the search is for a timely, targeted and temporary response – that is, one that addresses the immediate problem but does not change longer-term policy.

Currently, policy is looking at how to support those most in need, which raises questions of how it can be funded.

Temporary financial help as offered during the pandemic would be one approach. It could be paid for by a windfall tax on energy firms. Such a measure would not be ideal, but it has been tried before, for example on North Sea oil producers and banks.

The argument against a windfall tax is the message that it sends. Firms across all sectors may need to factor in that high future profits could be seen as a cash cow by future governments, and this might deter planned investment in the UK by attaching a risk premium to it. Corporate tax rates have already risen, adding to the anti-business perception.

Another option is to cut the five per cent VAT on fuel. The saving, while small, will help those on low incomes. That measure alone, however, would not be enough in itself. And the Prime Minister seems to have ruled the move out as a blunt measure that disproportionately benefits higher earners.

It also appears that the planned tax increases will not be reversed – particularly as the hike in national insurance was effectively presented as a hypothecated tax for health and social care. Reversing this would reopen questions about how to fund the latter.

However, reversing the tax increases makes more economic sense. Not just because it would alleviate the cost-of-living challenge, but because the fiscal numbers, while poor, are improving and mean that such tightening is a choice, not a necessity.

These decisions are not easy. There is no right or wrong answer.  They are about judgement calls – to address the immediate challenge as well as to position for the future.

A current economic debate is about how much fiscal space governments have, despite public debt levels being at an all-time high globally. The debate is less concerned with providing a case for rampant state spending, and more with avoiding being pushed into tightening fiscal policy unnecessarily.

A high level of debt adds to problems, but if the rate of interest is less than the rate of economic growth it creates fiscal space, and improves the chances of debt sustainability. Debt to GDP can be reduced steadily, provided growth is solid and inflation does not let rip. The latter forces rates and yields up, hampering growth.

However, the Bank of England has been asleep at the wheel over the last year. The risk is that the inflation genie is already out of the bottle, as inflation expectations rise and firms increase prices.

In all likelihood, inflation will peak in the second quarter – since some of the initial supply shocks are now over and imported inflation may have peaked already – and, after staying elevated for a short while, will decelerate.

But chances cannot be taken and inflationary risks will force the Bank to raise policy rates this year, and reverse its printing of money by implementing Quantitative Tightening (QT).

We witnessed a short-lived cost-of-living crisis in the wake of 2008, when a weaker pound triggered a temporary rise in inflation. But the last such major crisis was in the mid-1970s.

There is a need not to be taken in too much with current comparisons being made with that decade, since the economy and environment are so different.

While there are not many economic lessons to heed from that period, one springs to mind. In a battle against a rising cost of living, it is vital to have the public on side. Not only so that they can understand the tough policy context, but also in the case of inflation to avoid what are called second-round effects – or put more bluntly, a wage-price spiral.

In June 1975, the annual rate of inflation hit 26 per cent. The then Prime Minister, Harold Wilson, decided that every household needed to receive by post a pamphlet about his policy to fight inflation. I still have a copy.

Entitled Attack on inflation: A Policy for Survival – a Guide to the Government’s programme, its 16 pages made clear why inflation needed to be brought under control. One telling message, in bold capitals was: “the battle (against inflation) cannot be won in one year…but the battle could be lost in one year.”

In the event, the Labour Government lost the battle. Policy focused on a wages and income policy, culminating in the “winter of discontent” in 1978-79. The annual rate of inflation did not fall back into single digits until 1982, after Mrs Thatcher was in power, and also following a deep recession.

I am not advocating such a booklet now, but rather stressing the importance of ensuring that people understand the context of what is happening, especially when here is so much uncertainty and the pain may be severe but short-lived.

The best that can be done is to control the controllables. Provide assistance, ease the pain, reverse the tax hikes, explain why – and focus on a pro-growth strategy.

Tom Spencer: Monetary uncertainty shows the need for GDP targeting

25 Nov

Tom Spencer is a Young Voices Associate, and the Chief Organiser of the London New Liberals.

Predicting what the Bank of England is going to do next is impossible. Despite strong signals that it would tighten at the last meeting, the Monetary Policy Committee (MPC) chose to maintain rates. Such misleadings create uncertainty and chaos in the financial market. The Treasury must change the Bank’s mandate asking that it targets gross domestic product (GDP) to provide certainty, and thus stability, to the economy.

Rules do exist governing the actions of the Bank. For example, its mandate holds that it’s required to maintain price stability and help meet the Government’s economic policy objectives — namely, strong, sustainable and balanced growth. Though maintaining price stability and economic growth sounds simple, it’s a job that brings much controversy. For example, we’re seeing rising inflation at the moment, but growth remains lower than what was projected pre-pandemic. It’s unclear based on the current mandate how the bank should respond to such a turbulent period.

The recent actions of the MPC symbolise these problems very well. Before the meeting, members such as Huw Pill backed limits on quantitative easing and warned about the risk of inflation exceeding five per cent. This signalled one thing: that they were going to tighten monetary policy. As a result investors purchased sterling, hoping to take advantage of the higher return on savings as the value of the pound increased. Thus, when the Bank surprised them by maintaining rates and purchases, it caused the pounds’ value to plunge by more than one per cent.

Instability like this is extremely damaging to investor expectations and consumer confidence. According to Nobel prize-winning economist James Buchanan, the ability to predict the value of a currency allows for greater economic coordination lending itself to better economic outcomes. Buchanan’s theoretical observation is consistent with more recent empirical analyses. For example, a 2014 paper in the Journal of Economic Dynamics and Control found that rules-based eras of central banking are associated with higher levels of economic performance.

The best idea of how to bring about this rules-based system is one popularised by American economist Scott Sumner. He argues that rather than the Bank having discretion to do what it likes based on its idea of what stable prices and strong growth means, it should have a simple target: to ensure that GDP rises at a given percentage annually.

The main benefit of this is that it is a much more accurate measure of the business cycle. When we’re in danger of overheating, GDP will rise, leading to the Bank tempering the market by raising rates; meanwhile, if the economy needs stimulus, then the Bank will provide it. Under the current regime we simply don’t have this level of protection. Currently, if growth is low and inflation is high, then we always have uncertainty and debate over whether we care more about growth or employment.

GDP targeting would resolve the need for those debates and provide more certainty to all. This would lead to better outcomes in the long-run. According to an article in The Quarterly Review of Economics and Finance, this mandate could reduce volatility by as much as 25 per cent relative to the current approach.

This will be particularly important during times of economic crises. Leading up to the Great Recession monetary policy was rather tight despite a massive fall in GDP, due to fears of inflation. This resulted in a crash in asset prices causing highly leveraged companies like Lehman Brothers to fail. It wasn’t until this failure that the real economy was impacted — resulting in a financial crisis becoming a Great Recession. Had the Federal Reserve intervened by loosening money supply earlier, then we likely wouldn’t have seen the global crisis that we did.

Even if the recession does hit, then GDP targeting is better placed to help resist it. In 2011 when the Great Recession was peaking an oil shock, similar to what we’re seeing now, resulted in temporarily higher levels of inflation globally. Despite GDP indicating that there was no risk of overheating, the Bank responded by raising interest rates. Naturally global oil prices fell again, and overheating didn’t occur anywhere. But the nations who accepted the temporarily higher prices continued to recover from the crisis, whilst the Eurozone plunged into a debt crisis.

The current uncertainty manufactured by confusing signals and actions by the Bank is hurting consumers and businesses alike. It is no wonder consumer confidence is at its lowest point since January when we simply can’t make long-run spending plans without knowing how expensive our debts will be in the near future. GDP targeting would take away this uncertainty and provide more stability during turbulent periods. If the Government wants to protect our long-term macroeconomic future, then its best off doing this by changing the mandate to a GDP targeting regime.

Howard Flight: It’s time for the Bank of England to take its foot off the accelerator

2 Aug

Lord Flight is Chairman of Flight & Partners Recovery Fund, and is a former Shadow Chief Secretary to the Treasury.

The Bank of England and Treasury were correct to adopt Keynesian stimulant measures when the Covid bombshell hit. The economy was kept afloat, where otherwise there would likely have been an economic collapse.

As Andy Haldane has argued, it is now pretty clear that the time has come to start to phase out these stimulatory measures, as not to do so poses a dangerous risk of rising inflation that could force the Bank of England to execute an economic ‘handbrake turn’ in sharply reigning in the loose monetary policy.

It is, however, always difficult ‘getting off the opium’. The danger is that the Bank goes on expanding money supply/QE, with negative interest rates and rising inflation. It certainly looks as if Haldane has got it right and Andrew Bailey and the Bank of England have it wrong.

It is now time to start tightening monetary conditions (albeit not aggressively) and scaling back the emergency stimulus so as to keep inflation under control.

It looks as if the Monetary Policy Committee (MPC) is gearing up to scale back the emergency stimulus. The House of Lords Economic Affairs Committee Report – “Quantitve easing – a dangerous addiction” – has had significant impact on the MPC and the market. It is reasonable for the Bank not to want to see the economy retracting, but inflation is the result of too much money chasing too few goods, which looks as if this is where we are.

The Bank of England argues that the current nudging up of interest rates towards three per cent expected next year is caused by transient factors, especially the global increase in oil prices – albeit that rises in oil prices have been a major cause of inflation over several cycles of the last 30 years. The Bank of England Report made no mention of the recent surge in UK monetary growth. CPI inflation has already jumped to 2.5 per cent in June and will rise further in the coming months; and prices are now going up e.g. the review of railway charges.

The Bank of England Report made no mention of the recent surge in monetary growth or of the measures of money supply conditions in the MPC policy statement. The MPC is still planning more stimuli by completing the purchase of the £150bn of gilts under QE policy.

Economic recovery and the pickup in inflation have been stronger than the MPC or the Bank of England expected. With conditions having changed, policy should also change, and it is apparent that injecting more stimulus now may be unwise. It is time to end QE next month and to scale back gilt purchases. A managed and relatively modest tightening should not derail economic recovery. In fact, it should deliver a more sustainable recovery. As Haldane has made so clear, now is the time for a gentle change of direction.

The Bank’s response has been that it has been important not to overreact; the British economy is not yet fully recovered and the jump in prices has been caused by bottlenecks and Covid distortions; which are not permanent.

Bailey has made it very clear that he does not want the Bank to react to what he identifies as temporary strong growth and inflation, in order to ensure the recovery is not undermined by premature tightening. He expects the rise in inflation to over three per cent next year to be temporary. But it is not good enough to hope that inflation will return to two per cent in two years, if it hits five per cent first. The fact is that the economic recovery and the pickup in inflation have both been stronger than the MPC expected when it made the decision to expand QE last year.

Bailey expects the rise in inflation to be temporary and claims his reasons are strong and well founded. Haldane believes the economy has already regained its pre-Covid size and so is increasingly at risk of overheating.

The danger is that inflation rises to over three per cent later this year, where Bailey’s claims that this is only temporary and that the Bank should not react by tightening, cutting back QE, or raising interest rates and that it should keep stimulating the economy are likely to be met with widespread scepticism in the markets. His recent “good news” was that the economy is only some five per cent smaller than it was 18 months ago, and that the gap is closing quite rapidly. If so, it is a good reason to phase out the expansionary measures.

My money is on Haldane and starting gentle tightening now. With the extent of gilt interest rate servicing required, it will be crucial to keep interest rates as low as possible.

Steve Baker: Ministers should reject a second lockdown and prepare for Plan B

19 Oct

Steve Baker is MP for Wycombe, and served as a Minister in the former Department for Exiting the European Union.

“We have not overthrown the divine right of kings to fall down for the divine right of experts” – Harold Macmillan

The public are rightly concerned. Daily, they are warned of disaster. “Coronavirus is deadly and it is now spreading exponentially in the UK,” said Matt Hancock last week.  No wonder poll after poll shows consistent public support for stricter measures, even as the economy tanks and mental health sinks.

The omniscient SAGE has spoken. The Government drags along. The language of fear cows the public. Cases soar. Truly, we have fallen down for the divine right of experts.

But this is not working. We need experts and expertise, but we must beware of experts with counterproductive incentives, and of the structural problem of the division of expertise among fields and individuals.

Ministers and experts have worked hard in good faith, but the pandemic has asked the impossible of them. We must not blindly follow whatever strategy is put forward by scientists with a monopoly on advice. We now know that SAGE has suggested another national lockdown, but calling it a “circuit breaker” cannot make it costless. The immense economic, social and non-Coronavirus health damage that the first lockdown caused means that we cannot allow another.

Many of the problems we are experiencing boil down to fundamental issues in how we use experts to inform social policy. We need a better system of expert influence on social policy without tearing down the edifice, but we must avoid the monopoly rule of experts. Thankfully, there is a literature of expert failure showing how government can more safely and effectively take advice.

Scientists respond to incentives like everyone one. Pressures bear on even the most sober, scientific and impartial person. Knowledge in a pandemic is incomplete and uncertain. Suppose an epidemiologist provides the Prime Minister with a low estimate of the number of deaths, and there is no lockdown. Perhaps there are many more deaths than predicted. The epidemiologist will be blamed as a bad scientist. Shame and guilt will follow: a bad outcome.

Suppose our expert provides a high number and there is lockdown. However many people die, it can always be said it would have been worse without lockdown. A high estimate therefore implies credit for saving lives. Praise, pride and innocence follow: a good outcome.

Expert failure also arises when incentives create uniformity of opinion. Professionals earn livings from the official recognition of their profession’s knowledge, enforcing orthodoxy. We think experts do not disagree over “the science” so we are quick to follow their advice.

Moreover, all experts only give a partial perspective. We must recognise that epidemiologists are not economists, GPs, mental health practitioners, cancer specialists or social workers. Their narrow expertise must be complemented, and not at the ministerial level.

Furthermore, since the start of the outbreak, scientists, politicians and the media have treated untested and uncertain theories as certain. When scientists speak of the risks of coronavirus, they do not speak of certain knowledge. Risk is not certainty – as Professor Neil Ferguson’s now infamous record of predictions illustrates. Confusing the two is damaging.

Government expert advice requires four important reforms.

First, we must simulate a market for expert advice using competing expert groups in the same field.

Second, ministers should require three independent expert opinions on critical policy.

Third, the partial perspective of experts should be exposed by bringing together complementary fields.

Finally, employing “red teams” (advocati diaboli) is a good way to challenge and test prevailing expert opinion.

Meanwhile, a Department of Health and Social Care report has shown the lockdown leading to more cancer deaths, deteriorating mental health and many other social harms that can make the cure worse than the disease.

Breast Cancer Now has estimated that around 986,000 women have missed mammograms in the UK after screening services were paused because of coronavirus. The charity has also estimated that around 8,600 women could be living with undetected breast cancer.

Earlier this month, 66 GPs wrote to the Health Secretary to urge him to consider non-Coronavirus harms and deaths with equal standing beside coronavirus deaths. This complex optimisation problem of saving the most lives deserves more public debate.

Dr Raghib Ali, an epidemiologist and consultant in acute medicine, recently highlighted on this site that lockdowns can need to be repeated until a vaccine or fully effective treatment is found. They postpone rather than prevent infection, and a vaccine may not come.

Even if it does, it may not be as effective as people hope. A vaccine may take longer to be rolled out than people wish. No wonder in response to my question last week on when the vulnerable may be vaccinated, the Prime Minister stated that he cannot say by when he expects a vaccine to be produced. He admitted that a vaccine may never come.

But the Government’s strategy remains to supress the virus until vaccination. That has petrified sections of our economy, propped up by £745 billion of quantitative easing and ultra-cheap credit. In evidence to the Treasury Select Committee, the Bank of England has made it clear that such extraordinary monetary policy is only possible because of the independence of the Monetary Policy Committee, and that it is not its job to fund government.

The implication is clear: if inflation were to rise above target, then the Bank would have to act under its mandate. With QE at about the level of Government borrowing today, that could have the effect of pulling the plug on public spending.

The Government’s finances and our broader economy are in a precarious position. Even without an inflation, such extraordinary monetary policy is bound to create misallocation of resources: the longer we prop up our economy like this, the deeper the distortions and the longer and harder our economic recovery will be.

The economy is, of course, closely related to the health of the nation: poverty shortens lives. That’s why Ministers must move now to reform the structure of expert advice, publish serious analysis of the costs of the options they face and prepare for plan B. It is time for Conservatives to relieve experts of unreasonable burdens and reject a second national lockdown.