Osborne’s monetary policy errors won’t manage to stimulate growth

Patrick Minford
GEORGE Osborne looks poised to announce a new era of looser monetary policy by changing the Bank of England’s mandate of targetting inflation. His aim is to prime the monetary pump to create growth. But when did we last hear such a mantra? It was in the early 1970s, when Prime Minister Edward Heath abandoned fixed exchange rates and threw everything he had at driving down unemployment. That last time, the money supply took off at over 20 per cent per annum and UK inflation hit 25 per cent by 1975.

This convinced the Labour government of James Callaghan that inflation had to be stopped by discipline over monetary policy. Callaghan failed, but in 1979 Margaret Thatcher introduced “monetarist” policies to bring inflation down. In 1992, after an experiment tying the pound to the deutschemark, the inflation target was brought in, with the Treasury and Bank of England committed to making it the dominant criterion for monetary policy. In 1997, the Bank was made independent with the single role of conducting monetary policy to hit this inflation target.

That policy has been broadly successful in keeping inflation down, with some recent hiccups. But what is most worrying about the chancellor’s latest idea, echoed in a recent speech by the incoming governor Mark Carney, is that he doesn’t seem to understand why the inflation target was made binding. The problem it sought to solve is that there is always a temptation for politicians to stimulate the economy in politically “painless” ways.

Yet we know that the economy cannot be stimulated by monetary means except in the short run when it is largely a surprise. The effort to stimulate by money, and worse the anticipation by everyone of that effort, causes inflation to take off. It was precisely to stop this political pressure for higher inflation that the Bank was put in charge of monetary policy with a low inflation remit.

The argument Osborne uses is that “this time it’s different”: economic growth is being held back by a lack of money supply growth, so we should print more of it by carrying on with quantitative easing (QE). But consider why money supply growth is low, and with it the growth of credit – for small businesses credit is falling. It is due to the government’s own actions in drastically regulating bank behaviour. The chancellor’s left hand wants banks to lend and raise the money supply; his right hand has made the same thing prohibitively expensive. The chancellor and his friends are still proposing an endless litany of new capital requirements, ring-fences, and so on.

So ironically, if the chancellor wants money supply and credit growth to improve, thus stimulating growth in business activity, the first thing he should do is stop this drive for more and more bank regulation. He should instead deregulate, enforce competition by breaking up large government-held banks, and restore a proper credit market. This would boost growth healthily, with no inflation effect.

If he refuses, we can at least comfort ourselves that whatever he forces the Bank to do by way of QE and printing money will have little or no effect on money and credit growth. Therefore, it will not actually trigger any inflation either.

The problem is, however, that yet more QE will force down or keep down yields on government debt and wreck returns for savers, as it has done so far. QE has also subsidised the banks by allowing them to park at the Bank of England the extra money printed, and then deposited with them at zero interest rates, for the 0.5 per cent Bank Rate. This again helps the Treasury, as it fattens the banks up for resale. The banks are getting fatter, while doing nothing of use to society – failing to lend to small businesses and propping up some zombie companies that should be wound up.

What this adds up to is that the chancellor is making two big mistakes over monetary policy. First, he is excessively regulating the banks so that the credit channel is blocked. Second, he is urging monetary policies to boost growth which, if they worked, would only raise inflation. He is being saved from more inflation by the fact that the first mistake cancels out the second. Unfortunately, the first is blocking growth and the second is ruining savers.

These problems may be beginning to dawn on the Bank of England at last. But it is time the chancellor also understood these monetary problems, instead of worsening them.

Patrick Minford is professor of applied economics at Cardiff Business School.