views

Time to reform our monetary policy

Allister Heath
THERE have now been dozens of books and thousands of research papers on the causes of the crisis yet we are no nearer to a consensus. But there is one factor on which virtually all US analysts agree, regardless of ideological differences: the Fed kept interest far too low for too long.
This triggered the lending boom by commercial lenders (and also encouraged a competitive lowering of loan standards). Some believe this was the main cause of the crisis; others that it only played a small part. But the only camp that still seems to completely reject the analysis is the Fed itself.

I, for one, agree with John Taylor, the Stanford University scholar famous for discovering his “Taylor Rule” to work out the “right” level of interest rates. His view that “excessively easy monetary policy by the Federal Reserve in the first part of the decade helped cause a bubble in house prices” is supported by 42 out of 54 business economists surveyed by the Wall Street Journal. Ben Bernanke attempted to defend the Fed in a speech for the American Economic Association using an adjusted version of the Rule; but his claims have been rebutted by Taylor himself as well as others.

Thomas Hoenig of the Kansas City Fed has shown that during the past decade real interest rates were negative 40 per cent of the time. The last time this occurred was during the 1970s, also fuelling chaos. Greenspan’s free money for borrowers was a disaster. It was meant to stave off a Japanese-style deflation after the dot.com crash (itself caused in large part by excessively low interest rates) that was never a real risk.

We need the sort of rational, level-headed debate the Americans are having here in the UK, involving proper research from proper economists willing to scrutinise the Bank of England. Its low interest rates helped fuel the housing bubble; yet British politicians and the media focus almost exclusively on populist banker-bashing.

Had interest rates been 3 per cent higher on average during the past few years, the economy would have grown substantially less quickly but the worst of the crash would have been avoided. The Bank, like the Fed, disagrees; it thinks rates should be reserved for controlling consumer, not asset, prices. It wants to be given untested “macroprudential” powers to control more directly the volume of lending by the private sector and to allow it to vary banks’ capital requirements and other lending rules depending on how well it thinks the economy is doing. This would be a mistake: the authorities will never be able to work out at what stage of the cycle we’re at so the process will appear arbitrary from the start.

It has become almost taboo to criticise UK monetary policy. Yet with talk that John Varley, the CEO of Barclays, is being lined up by the Tories as the Bank’s next governor (Varley would be an excellent choice; others being mentioned include HSBC’s Stephen Green or the Bank’s Paul Tucker) it is of paramount importance that we start thinking about how to reform a system drawn up hastily by Brown’s henchman Ed Balls in 1997.

My preference would be for a new, loosely defined and evolving liquidity target that includes more than just the traditional money supply. If this accelerated (or slowed) too much, rates would be hiked (or cut); the Bank could also engage in some quantitative tightening (or easing) to drain (or add) liquidity to the economy. I’d love to hear your thoughts.

allister.heath@cityam.com