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Some thoughts on the speech...Sir Mervyn King's speech

    Everyone’s talking about the speech. David Cameron’s speech, that is. But last night the Governor of the Bank of England Sir Mervyn King also made one in Northern Ireland – his final regional speech as Governor of the Bank.  And it was an interesting, if confusing, speech which really did touch upon some of the big issues facing the UK economy and the future of macroeconomic policy more generally. Having hosted a recent event on monetary policy with Andrew Sentence (PwC), Stephen King (HSBC), Pippa Malmgren (Principalis), Chris Giles, Liam Halligan et al, I thought it would be worth highlighting some of the key aspects of the speech in more detail.

    The macroeconomic debate: Demand? Supply? Both?

    The first thing to note about the speech is what Sir Mervyn identified as the things holding back a UK recovery:

    • “the inevitable correction of exuberance on the part of borrowers and lenders…with unsustainable exchange rates, unsustainable paths of consumption, saving and borrowing, and unsustainable low long-term interest rates”
    • “a deep and protracted squeeze on the level of many people’s real take-home pay
    • deleveraging…its counterpart a reduction in the amount of (broad) money in the economy and a reduced willingness on the part of banks to expand lending to finance the recover”
    • “the euro area – where the near term outlook is weak, and the longer term prospects for tackling the evident”

    So: deleveraging, adjustment, inflation/slow nominal wage growth, and the Eurozone crisis. What’s missing? Well, by omission King seems to be implying that fiscal tightening (so far tax rises and capital spending cuts) and an unwillingness to engage in a more expansionary monetary policy aren’t important reasons in why the UK is struggling. Though he suggests that there is ‘spare capacity’ in the economy, he claims that ‘fiscal policy is constrained by the size of government indebtedness’ and that ‘monetary stimulus…is not a panacea’. Thus, he implies that it is primarily supply-side and structural weaknesses which must be resolved. In fact, he went further in advocating structural and supply-side solutions:

    ‘Supply reforms can make that adjustment more palatable, and, by raising expected future incomes, they increase the rate of return on new investment and encourage spending, both investment and consumption, today. It cannot be for a central bank to design a programme of such supply initiatives, but in economic terms there has never been a better time for supply-side reform.’

    This, of course, largely chimes with what the OBR has said has led to slower-than-expected growth. And what, at our most recent monetary policy lunch, Andrew Sentance also suggested. Chris Giles has outlined how significant this apparent shift in Meryvyn King's position could be in relation to the direction macroeconomic policy should take.

    On the efficacy of QE and low rates

    King claimed that the low rates and enormous amount of money being injected into the economy through QE had helped avoid a serious contraction in the money supply and thus helped avoid a depression. But he seemed later in the speech to agree with the view expressed by his namesake Stephen King at a recent CPS lunch that people were now expecting too much of monetary policy, and that continuance of these unconventional measures risked damaging side effects. In particular, the speech identified:

    • How QE can become difficult to escape from (at our lunch Ewen Stewart described it as a treadmill which it was difficult to jump off of). King said ‘Monetary policy works, at least in part, by providing incentives to households and businesses to bring forward spending from the future to the present. But that reduces spending plans tomorrow. And when tomorrow arrives, an even larger stimulus is required’.
    • The potential risks of the effects in keeping bond yields too low for too long ‘With long bond yields at unsustainably low levels, there is a risk to financial stability’
    • How low interest rates can lead to mal-investment ‘a long period of exceptionally low interest rates may also encourage excessive risk-taking, leading to vulnerabilities in important financial institutions’

    Which is all very Hayekian. Yet despite identifying these side-effects, King made clear that ‘low interest rates will not be withdrawn prematurely’ and ‘we are ready to provide more stimulus if it is needed’.  King again failed to outline any potential path of monetary policy normalisation, even though he outlined that other economics conditions were, gradually, returning to normal. In contrast, at our lunch, Andrew Sentance suggested that the outlining of a road map to rate normalisation and QE reversal over the medium term would be desirable.

    On the banking system

    Sir Mervyn King suggested that once the banks had raised more capital and restructured their exposures, ‘there is no reason why the two banks with significant state shareholdings could not largely be back in the private sector within a relatively short period.’ Implicit in this is that returning to the private sector would be desirable.

    Surprisingly, this has received little coverage from the press so far. Labour MP Jim Sheridan reacted by warning against quick re-privatisation and instead said that we should aim to recoup the full amount of the state’s initial investment. But with reports of possible overpayment for the shares initially, coupled with developments since then, it seems unlikely in reality that the state will recoup its initial outlay. The question then becomes: how can the government achieve best value in any re-privatisation?

    It’s difficult to see how this could be achieved in a ‘short period’ given the size of the shareholdings. That is unless of course the Government were willing to consider a scheme such as the policy we outlined in 2011, whereby a distribution mechanism coupled with a floor price helps release banks from state control very quickly. See here for more details. My own view is that I would prefer to see the banks back in the private sector before a possible Labour government or Lib-Lab coalition had the chance to really blunt their decision making through longer or deeper state control.

    On inflation targeting and currency

    This was perhaps the most incoherent aspect of the speech. Sir Mervyn suggested that a review of the inflation targeting monetary policy regime was necessary. But he then argued that the tools of the Financial Policy Committee would be better at preventing rapid financial balance sheet expansion than traditional monetary policy, and that the Bank’s aim should still be price stability in the long run. In which case, he seemed to be arguing against changing the target at all.

    Like Andrew Sentance, he argued that the inflation targeting regime had been successful in anchoring inflation expectations, which risked being lost in a new regime, and that it was not inflation targeting that was hindering growth. This was, of course, all a shot across the bows of those who want to move towards a nominal GDP targeting regime.

    But unlike Andrew Sentance, he justified the long period of above target inflation as being part of the short-term flexibility of the inflation target. Sentance on the other hand as argued that the Bank has already shown too much flexibility over the last few years.

    This brings us to an interesting point about currency. In the speech King warned of the dangers of competitive devaluations or currency wars. He also touched on how imported inflation, accentuated by depreciation, had eaten into people’s living standards. But he himself has recently suggested that a further depreciation of the £ might be desirable.

    Conclusion

    This speech has to be viewed in the context of a departing Governor having to justify some of the decisions taken under his leadership. There were some extremely contradictory messages about currency depreciation and the future monetary policy regime. But, as I’ve outlined above, the speech was significant for three reasons:

    • It set out clearly the limits and some of the dangers of current monetary policy (though then suggested we might need more of the same medicine)
    • It suggested that the UK economy was being held back by structural and supply-side factors
    • It gave an indication that bank re-privatisation could be achieved in a short time frame

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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