Personal reflections by Dr Andrew Sentance, External Member, Bank of England Monetary Policy Committee(1)
The Financial Crisis and its aftermath have dominated the period of over four years I have spent as a member of the Monetary Policy Committee (MPC) of the Bank of England. When I joined the Committee in October 2006, the economic background was of fairly steady growth and stable inflation, with unemployment around 5% of the labour force. If someone had described the momentous events which lay ahead, I would have found it hard to believe. At that point, my main concern was that the economy was picking up too strongly and inflationary pressures might emerge as a result. I earned my reputation as a “hawk” by arguing for interest rate rises during my first nine months on the Committee.(2)
Indeed, interest rates did rise by one percentage point between October 2006 and July 2007 – from 4.75% to 5.75%.
Over the Summer of 2007, we saw the first tremors of the financial crisis – though it was not initially clear how serious it would turn out to be. Northern Rock failed spectacularly in September 2007, but it appeared that its problems could be contained and the economy continued to grow both at home and abroad. Indeed, as we moved into 2008, the MPC faced conflicting signals – with inflation being pushed up to over 5% by rising energy and commodity prices. The normal response to such a sharp rise in inflation would have been to push up interest rates, but the MPC did not do so, because we were concerned about the impact of the financial crisis on future growth and inflation. Indeed, interest rates were edged downward in late 2007 and early 2008 and held constant at 5% over the summer as it was not clear whether higher inflation or weaker growth would be the dominant influence on the economy over the years ahead.(3)
That dilemma was resolved in the Autumn of 2008 in a spectacular fashion with the failure of Lehman Brothers and severe stresses for many other banks and financial institutions on both sides of the Atlantic. In the US, UK and many other countries, governments directly injected money and provided financial guarantees to stabilise the banking system and financial markets more generally.
These events in turn provided a massive negative shock to business and consumer confidence, which collapsed around the world. The resulting cutbacks in spending plunged the UK economy and most other major economies into recession.
It was too late by then to prevent the recession, but the damage could be limited by cutting interest rates dramatically and by ensuring that government spending and tax policies were also helping to limit the damage. In the UK, the MPC cut the official Bank Rate to 0.5% – the lowest level in the 300-years plus history of the Bank of England. In 2009, this policy of low interest rates was buttressed by direct injections of money into the economy. £200bn of new money created by the Bank of England was used to purchase government bonds. In the short-term, the object of this policy – known as Quantitative Easing – was to reverse negative trends in financial markets which were reinforcing the downturn. Over a longer period, it was hoped that the money injected and a return of financial confidence would support recovery.
Though the UK and many other economies suffered a serious recession, these policies had the desired effect. The world economy has bounced back – supported by strong growth in Asia and emerging markets. And here in the UK, economic activity has recovered relatively strongly. In UK manufacturing industry we are seeing the strongest growth since the mid-1990s and across the economy as a whole, growth has been stronger than we have seen in the early stages of previous recoveries.(4)
Employment performance has also been better than in the aftermath of the two previous major UK downturns, with unemployment rising to less than 8% of the labour force, compared with a peak of over 10% in the 1980s and early 1990s.
As economies recover and confidence returns, economic policies need to be adjusted to changed circumstances. That means gradually reducing the large public sector deficits which have resulted from the recession, as the coalition government in the UK is now planning to do. And monetary policy also needs to be adjusted as the recovery progresses and worries about rising inflation replace concerns about a damaging deflation. There is an active debate on the MPC about how quickly we need to move away from the current exceptionally low level of official interest rates. I have argued in speeches and articles since the summer that the economy would benefit from a gradual transition to a more normal level of interest rates, starting sooner rather than later. This has underpinned my votes on the Committee since last summer to raise the official Bank Rate gradually from the record low level of 0.5%.
The lessons from the crisis
A large amount has been written and said about the conclusions we might draw from the recent financial crisis and the policy response to it. In my view, the framework for monetary policy here in the UK has served us reasonably well through the crisis and the ensuing recession and we do not need to make major changes in the operation of the MPC or the principle of targeting low and stable inflation which underpins its approach.
Previous UK recessions – in the early 1980s and the early 1990s – did highlight failings in our monetary policy framework, but both of these downturns were preceded by a period in which inflation got out of control and the recession was part of the process of restoring monetary discipline. This recession was different – it was not part of an inflationary boom-bust cycle here in the UK, though there were inflationary pressures in the global economy which emerged in the build-up to the crisis which may point to deficiencies in the management of the global economy. (5)
During the recession, monetary policy has played a significant role in mitigating the effects on employment and living standards here in the UK – through the dramatic reduction in interest rates in late 2008 and early 2009 and the policy of Quantitative Easing. As I have already noted, these policy changes helped head off bigger rises in unemployment and other negative economic consequences. Our inflation target framework permitted these unprecedented policy moves because the MPC rightly saw significant deflationary risks when the recession was deepening. Now the economy is recovering from recession, there are good reasons to question whether these policy settings remain appropriate and are compatible with economic stability in the future.
However, even if there is no need to make fundamental changes to our monetary policy framework, there are still important policy lessons we can draw from the financial crisis and the recession which unfolded from it.
First, we need to buttress monetary policy in the UK (and globally) with much closer supervision and scrutiny of the financial sector and its impact on the activities of households and businesses.With hindsight, we should have paid more attention to the behaviour of the financial sector in the mid-2000s, and a number of individuals did warn about imbalances and vulnerabilities which were emerging.(6)
There is now a recognition that banks need to hold stronger reserves of capital to protect themselves against difficult times, which would reduce or eliminate the need for the dramatic government interventions we have seen in the recent crisis. In addition, we may need to develop new tools of economic policy which would exert more discipline on the growth of bank credit as economic upswings develop. These ideas underpin the approach to “macroprudential regulation” which will be operated in the UK by a new Financial Policy Committee operating in parallel with the MPC in the Bank of England.
Second, we need to recognise the increasing integration of the global economy, with the consequence that an economy very open to international trade like the UK is much more vulnerable to global economic shocks than it was in earlier decades. When I joined the MPC in 2006, it was already clear that most of the shocks that the Committee had had to deal with in its first decade of activity were driven by the global economy: the Asian crisis in the late 1990s; the US “dotcom” boom and bust in the late 1990s and early 2000s; the political and economic turbulence which followed from 9/11 and war in Afghanistan and Iraq; and the upward pressure on oil and other commodity prices in the mid-2000s. We might have seen these events as tremors in the global economy preceding the big earthquake of the financial crisis. But all that is much clearer with hindsight than it was at the time.
The obvious conclusion which we might draw about these global instabilities is the need for more effective international co-operation to address these potential problems. And we had some success in the crisis in developing the G20 as a forum for international policy co-ordination encompassing both developed and developing economies. But it is proving hard to sustain this co-operative approach to policy into the economic upturn. In a recession, the notion that we are all trying to work together to prevent the global economic boat from sinking acts as a powerful galvanising force for action. As economic conditions improve, the tensions between different players in the global economy re-emerge, as we have seen recently.
The third lesson I would highlight is one of humility for monetary policy-makers like myself. A view developed in the 1990s and the 2000s prior to the crisis that monetary policy – the setting of interest rates and the control of the money supply – could successfully stabilise economies in the face of a wide range of shocks. This led many in the financial community and some in the more general public to believe in a “brave new world” of steady growth and price stability which could be sustained into the future.
The views and statements of Alan Greenspan, who was the Chairman of the US Federal Reserve for two decades (1987 – 2006) and other central bankers helped reinforce this belief in a “Great Stability” or “Great Moderation” which could be maintained by the actions of well-intentioned and well-informed central bankers.
This has now been shown to be an illusion. That is not because monetary policy cannot play an important part in stabilising economies. We have seen through the recent crisis and recession that it can. But there are limits to the effectiveness of monetary policy. Central bankers are not all-seeing and all-knowing. And not all economic shocks can be smoothed out successfully with interest rate changes or other tools of monetary policy.
We have seen in the last few years two types of shocks which pose particular challenges to monetary policy-makers: movements in global energy and commodity prices; and disturbances to the financial system. If we look back in history, we can identify a previous period when these types of shocks were very significant – the late 19th and early 20th century. That period is described by economic historians as “the first era of globalisation”, when the gold standard and free flows of trade and capital supported the growth of the world economy in general and the emergence of the United States as an economic power.
With an increasingly globalised world economy and the emergence of new economic powers like China and India we should expect these energy/commodity and financial shocks to continue to be a significant feature of our economic environment looking ahead. And national monetary policy authorities like the MPC will have to develop strategies to deal with them. We have started to do this in terms of the regulation and control of the financial system. But I am not sure we have yet come to terms with the potential inflationary impact and volatility created by movements in global energy and commodity prices, which have been particularly noticeable over the past five years and which are closely linked to the strong pressure of demand created by growth of Asia and other emerging market economies.
A Christian perspective on the financial crisis
There are many insights which can be drawn from Christian thinking which relate to the unfolding financial crisis and the way in which policy-makers have responded to it. Let me highlight three which strike me particularly from a personal perspective.
The first is that there is a moral dimension to the stability of monetary and financial relationships which underpin our society, and when this morality begins to be undermined or questioned, the consequences can be very severe. In the financial crisis, the trustworthiness of banks came into question. Governments and regulators stepped in to reinforce the credibility and trustworthiness of financial institutions, and those interventions appear to have been effective. But this episode highlights the potential fragility of the financial system and the importance of the trust relationships which underpin it.
Monetary stability also has a moral dimension too. It seeks to ensure that the value of money – which underpins our economic relationships in society – is not eroded by stealth through persistent inflation. In the past, we have seen this happen in the UK – with inflation reaching double-digit levels in the 1970s and1980s. Such high rates of inflation are a serious threat to people on fixed incomes and those who have trusted in the stability of prices to underpin their financial planning.
We have taken risks with these principles of monetary stability in the current crisis, reducing interest rates to unprecedentedly low levels and creating large amounts of new money to stave off recession. While these policies were justified at the time they were pursued, they are not sustainable in the longer term. And if they are sustained for too long, these policies will undermine the confidence in monetary stability in our economy by generating high inflation or threatening to do so. We need to be vigilant to signs that this is happening, just as we might have been more vigilant about the threats to the stability of banks and the financial system from excessive risk-taking in the mid-2000s.
The second point I would make from a Christian perspective is that the teachings of Jesus continually emphasised that the easy way is not necessarily the right way. As we read in Matthew Chapter 7 (verses 13 and 14)
“Enter through the narrow gate. For wide is the gate and broad is the road that leads to destruction, and many enter through it. But small is the gate and narrow the road that leads to life, and only a few find it.”
Easy money and broad access to the financial system were at the root of the crisis – particularly in terms of the operation of the US housing market and the generation of sub-prime and self-certificated mortgage loans. We have created easy money to forestall the worst scenarios as the crisis has unwound. But we need to be mindful of the dangers of this policy of continually easing conditions to solve economic problems. Very low interest rates can distort business behaviour and decisions to save and invest, just as very high interest rates and high inflation can also create economic distortions.
The only way we have discovered to avoid both these extremes is to follow the “narrow way” of monetary discipline, which is not always popular. The job of good monetary policy is to take away the punch-bowl before the party has got out of control. Judging when and how to do this is very challenging, and those who judge correctly risk being criticised and derided, just as Jesus warned his disciples to expect criticism and decision for sticking to their beliefs.
Third, we have been reminded continually through this crisis of the limitations of human nature and the fact that we live in a fallen world. The capitalist system which underpins the development of our economic and financial relationships is an inherent contradiction. It is based on self-interest, which can be a highly negative and destructive force. And yet within the market system, self-interest generally delivers good outcomes for society as a whole. As Adam Smith expressed it in his seminal work on the evolution of the market economy and the capitalist system, The Wealth of Nations, in 1776:
“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”
This property of a capitalist market system, which generally works well in benign circumstances, is also a source of instability. Self-interest may be pursued in a way which starts to undermine the benign operation of the economic system. This creates an argument for government or regulatory interventions of various kinds. These interventions have their own problems – government failure (eg bureaucracy, excessive regulation, political influence on business) can be as bad or worse than market failure. And so we are continually managing a “second-best” world in which we are trying to find the right combination of market processes and regulatory interventions which will deliver the best outcome for society.
In some areas of economic life, this tension is more difficult to manage than others – and financial markets and relationships seem to be one such area. The reasons for this can be spelled out in detailed economic logic which explains why markets may not work perfectly, such as the concepts of asymmetric information (you don’t know as much as I know) or moral hazard (if you get away too easily, you will repeat bad behaviours). But for a Christian these market imperfections and the inability to correct for them perfectly should not come as a surprise. All our human endeavours will be flawed to some degree. We should view with suspicion notions that human activity can deliver continual stability and progress and that we can always successfully tame the instabilities of an economic system based on self-interest.
If the financial crisis has taught us one thing, it is a salutary lesson that the world economic system is a potentially unstable place. And while long periods of relative stability can be achieved, they cannot be sustained indefinitely. A long expansion in economic activity comes to an end eventually, as we saw in the mid-1970s following the sustained growth of the 1950s and 1960s. And we have been reminded once again of the unsustainability of long expansions as the growth period of the 1990s and 2000s came to an end in the last few years.
The instabilities in the economic system have potentially increased through the process of globalisation, which limits the extent to which any one nation can totally control its economic destiny. We are still learning to live in this new world of global economic integration and there will be many new challenges which it will throw up. We will need to develop better mechanisms of economic co-operation to deal with these challenges. And we will also be better placed to deal with these economic instabilities if we also recognise the limitations of monetary policy and other economic policies to keep us in a world of continued steady economic growth and stability. We should be prepared to deal with economic volatility – though hopefully not too often on the same scale as the recent crisis. And the experience of the past few years should give us some encouragement that we have the tools of economic policy to do so.
Dr Andrew Sentance
(1 ) Based on comments made at the Bishopthorpe Symposium convened by the Archbishop of York on Thursday 21st October 2010
(2) In popular discussion of monetary policy, individuals who favour tighter policy and higher interest rates are described as “hawks” and those favouring a more relaxed policy stance with lower interest rates are labelled as “doves”.
(3) See the Bank of England website for speeches I and other MPCmembers made over this period which reflected this dilemma. Two good examples are my speeches: “A tale of two shocks: Global challenges for UK monetary policy” delivered in November 2007 and “Global inflation: How big a threat?” delivered in July 2008.
(4) See my recent speeches on the Bank of England website for more details – in particular “Getting back to business”, delivered in Belfast in November 2010.
(5) See my speech “The current downturn – a bust without a boom?” delivered in December 2008, available on the Bank of England website.
(6) Bill White at the Bank of International Settlements and Raghuram Rajan, Chief Economist at the IMF in the mid-2000s, were two notable individuals involved in policy-making who issued warnings. For a detailed analysis of the global credit boom in the mid-2000s see Michael Hume and Andrew Sentance “The global credit boom: challenges for macroeconomics and policy” Bank of England External MPC Unit Discussion Paper no.27, available on the Bank of England website.