Sunday, 28 June 2009

Keep on doing what you are doing

There were many reasons why we got into this crisis; poor financial sector regulation, distorted incentives, bonuses, speculation, excessive risk-taking. However, there is one reason that doesn't get enough attention; the policy remit of the Bank of England.

When the BoE became fully independent, the government gave it an inflation target. It said to the bank "go chase down the consumer price index. Make sure it doesn't increase by more than 2 percent a year". Ominously, the government didn't say keep asset prices under control and avoid speculative bubbles.

The BoE happily went along with this new target. Keeping inflation under control would be easy. Moreover, the Bank added an air of modesty to their objection about preventing speculation. It echoed the claim by Greenspan that it could not properly identify bubbles. Speculation was something that could only be ascertained once the crash had actually happened, and then it would be too late.

For about eight years, the BoE claimed that it had beaten inflation. It met the target and told the rest of us that everything was under control. House prices, it occasionally acknowledged, were increasing at double digit rates. So too was the money supply, but this didn't matter because the CPI was nailed down. Furthermore, the BoE managed to do this with historically low interest rates. In short, they implicitly told us "sit back, relax and if you feel like it, take out a loan."

However, the truth was that the CPI was declining because of the extraordinary increase in the world supply of cheap manufactured goods, mainly coming out of China and other emerging market economies.

During these years, the CPI should have been negative; a fact that the BoE were happy to ignore. Domestically determined prices were increasing sharply. (If you want proof, just take a look at the price of UK rail tickets or the council tax.) Putting a cap on this hidden inflation would have required higher interest rates, which would have put an end to the housing bubble.

The rest of the story we know. Throughout the decade, Banks were taking on too much risk, households were borrowing silly amounts of money and the housing market was out of control. This sorry mess hit the wall in August 2007. So far, the UK taxpayer has been forced to pump in 90 percent of GDP into the financial sector, just to prevent it from collapsing.

Have policy maker learnt anything from this dreadful experience? It seems not. Later this month, the Treasury will publish a White Paper on financial services. In principle, this offers an opportunity to extend the BoE's target to stabilising asset prices and preventing bubbles.

However, for the New Labour radicals that manage the Treasury, this idea is too extreme. They want to keep things pretty much as they are. The BoE will continue to target the CPI and asset prices can do what they want. In principle there is nothing to prevent a recurrence of the current crisis.

It is very much a case of "keep on doing what you are doing". So, is everyone ready? We have a one way ticket back to Bubbleville.


Anonymous said...

Labour will be out next year. That is the only ray of hope.

Im not so certain the Conservatives would have done a better job these past 4 years. The money dazzled many people. The really difficult bit is that the measures required to fix this mess will take a long time and will be very politically unacceptable to huge swathes of our population.

We are going to have to be realistic now about taxes, welfare, pensions, foreign aid, defence spending, University provision and our relationship with the EU. Given the bias of the BBC its going to be a really hard act.

Including the PFI's, the unfunded pensions and the bank bailouts, we are pretty much bankrupt. The oil money which was transforming our economy at the end of last century has been squandered. Gordon Brown should be in the Tower of London for what he's done.

Oh for a man as good as Margaret Thatcher in our hour of need.

QG said...

"a one way ticket back to Bubbleville."

Do you mean another property bubble or just bubbles in general? I do not believe that we will see another property bubble for a decade at least but another bubble in, say, precious metals or low carbon energy technologies seems possible.

Mitch said...

Well I for one wont be boarding that train.I saw this one early enough not to get burned,not by listening to the government or the news it was blogs.I kept reading these warnings did some research and wow!! there is a shit storm commin.
I battened down the hatches and Even on one wage we can get by OK.

Anonymous said...

Mmm. I think worrying about another bubble is a bit premature. The effects of this will be with most people for a large chunk of their working life.
The overhang will still be visible in a decade.

Patrick Crozier said...

A couple of points.

Last time I looked (which was a few years ago) rail fares had kept pace with inflation. For every
hugely expensive First Class Open there are a gazillion cheap ones. And for years commuter fare rises were kept to below inflation.

CPI. Are you sure? I thought it was the RPI which was changed to the CPI in about 2003.

Anonymous said...

I don’t believe that the government was being incompetent in instructing the Bank of England to chase after the CPI and ignore asset price inflation. On the contrary, the use of the perceived wealth effect of high inflation in asset prices, particularly houses, has been at the foundation of keeping the New Labour regime in power.

Clinton wanted to expand access to debt to low income households as part of his misguided social policy that was inevitably to become the so-called sub-prime crisis. However in the UK, New Labour chose to use inflation in asset prices partly balanced with deflation in imported consumer goods and workers.

Would the Conservatives have done the same thing? Absolutely.

DBC Reed said...

If an attempt is made to include the price of houses in the MPC's remit,the result could be disastrous.
As soon as house prices rise they will whack up interest rates which willimpact on non-real estate production and consumption.Better to separate real estate from other prices: deal with real estate by the tax system (LVT); leave everything else to interest rates.

French Hedge Fund said...


As far as I know a few people in the upper echelons of business and government have been fretting,'how is it all going to be paid for?'

They repeat.

It will be paid for in exactly the same way as it has always been paid for. The debasement of the vehicle of monetary exchange.

Recently the US has been extending currency swaps with trading partners, everyone except the UK. One might wonder why?

It would be wise to consider that never in history has a previous boom sector, led the economy back out of recession.

Life's a beach when you have your head stuck in the sand. :)

AntiCitizenOne said...

AS DBC R says an LVT would allow income taxes to fall (and thus cause the economy to grow) and the citizens dividend this would create would allow welfare reform (as there would be no means testing of the CD).

The citizens dividend would also be useful in holding back he size of the state.

Also Alice misses out the biggest cause of the bubble, the lack of currency regulation caused by BASEL2 which led to the massive credit bubble

mike said...

The problem with labour is that it's a case of a billion here, a billion there, with no strategy for re-paying the money. Effectively they are stealing from the next generation.

One example is the department for transport. Billion pound contracts are being exchanged regularly and with hardly any drive to cut costs.