It is now widely acknowledged that central banks acting in isolation do not have the capacity to stabilise the economic system. Larry Summers recently argued that central bankers are facing “black hole monetary economics”, wherein the usual tools of monetary policy have become powerless. At what was effectively his last European Central Bank press conference, Mario Draghi noted that “there was unanimity [among the council members] that fiscal policy should become the main tool”.
Even a few years ago such views would have been seen as heretical: it was assumed that a return to the system of macroeconomic management that prevailed before the financial crisis was just around the corner. Instead, discussion is now dominated by the tools that central banks should turn to next: helicopter money, deficit monetisation or negative interest rates? Demands are also growing for central banks to join the fight against climate change.
The disintegrating conventional view, that a return to pre-crisis orthodoxy is both possible and desirable, mirrors what Henderson and Keynes called “the fashionable view” of the 1920s: the view that all that was necessary to recover the sunny, predictable comforts of Edwardian empires was a return to the monetary arrangements that obtained before the war.
On the 90th Anniversary of Henderson and Keynes’s “Can Lloyd George Do It?“, which argued against this view, and in favour of Lloyd George’s programme of public spending, we have written a report for the Progressive Economy Forum on the effectiveness of the Bank of England’s monetary policy.
The report argues that a reversion to pre-crisis central banking is neither possible nor desirable. Just as the Bank did not have the capacity to stabilise the pre-crisis economic system — stable inflation during this period was, instead, due to factors outside the Bank’s control — it does not have the capacity now to achieve stabilisation using a broader array of tools. Nor does it have the power, acting alone, to achieve productivity targets or a carbon-neutral transition.
The principal reason why pre-crisis central banking is not possible is that the Bank of England now has a substantial balance sheet which cannot be reduced without adverse consequences for capital markets in Britain. The principal reason why pre-crisis central banking is not desirable is that it was precisely that model of central banking, restricting monetary policy to the management of short-term interest rates, that contributed to the crisis that broke out in 2007 and caught the Bank of England by surprise. The Labour Party’s review of policy offers an opportunity to re-examine how central banks can contribute to stabilising economic activity at high rates of employment.
The report reviews various proposals that have been put forward for enhancing the responsibilities of the Bank of England. Targets for productivity would work in a perverse way and may create unemployment, while credit support for greening the economy requires a much greater investment irrespective of Bank support. The report concludes that the Bank has limited instruments for influencing economic activity, and those instruments should be concentrated on what the Bank can do effectively, which is to contribute to economic growth and prosperity by maintaining financial stability. We therefore argue that the Bank should be given an enhanced financial stability mandate in the form of a target to conduct open market operations to keep the yield curve stable. This should be implemented through a policy of open market operations aimed at keeping rates of interest at different maturities stable at levels that support the solvency of financial institutions, and the availability of finance for investment. This is what the Bank of England can do. Stabilisation of the economic system and regulation of employment and investment is a matter of policy for Government, not the central bank.
The full report can be read here. Photo credit: Flickr/Dun.can.
