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Problems of Monetary Policy: Theory and Evidence

A talk by Lord Robert Skidelsky, Emeritus Professor of Political Economy at the University of Warwick

Published April 2012

How could economists get it so wrong in the lead up to the 2008 financial crisis? How successful was quantitative easing and where is all that elusive growth going to come from? Lord Robert Skidelsky gave his own enlightening view in the second of his two lectures at Warwick.


The UK and other countries are still reeling from the impact of the banking collapse in the first decade of this century. Although an upturn has in some quarters been expected, “the much-promised recovery has been elusive to put mildly,” says Lord Skidelsky. Initially hopes were pinned on the confidence-boosting effects of fiscal consolidation; “now we’re told that recovery will come from ever-more aggressive monetary policy... but with the Bank of England rate at 0.5 per cent and 325 billion pounds having been injected into the economy over the last three years... GDP growth is barely managing to stay positive, it seems we have a problem.”

The historical background to the problem is clear. “Monetary policy in the three decades leading up to the financial crisis was supported by a set of ideas which were almost universally accepted. The foremost important ones were that there’s no long-run trade-off between output, employment and inflation. Inflation has high costs and is to be avoided at all costs; expectations are critical to monetary policy outcomes; and a strong nominal anchor is the key to producing good monetary policy outcomes.”

There were arguments by economists in this new world that optimum monetary policy on a day-to-day basis would not deliver the best long-term results. “This time-inconsistency problem suggested the need to replace the money aggregate target by a stronger nominal anchor and that became an inflation target.”

bank_note.jpgFrom the late 1970s some countries did just that. They gave their central bank independence “so that it wouldn’t be subject to these political temptations to monkey around with the money supply for political purposes”. The creation of the independent European Central Bank was said to be the epitome of this seemingly triumphant theory. Before the adoption of inflation targeting in the UK the average annual rate of inflation was 8.25 per cent. Afterwards it was 2.69 per cent.

What exactly went wrong? “That correlation is not a cause escaped those who contributed low inflation to inflation targeting and claimed that inflation targeting had abolished boom and bust,” explains Lord Skidelsky. They thought that “not only was there no need for more than marginal fiscal interventions by the government but there was very little need for regulation of financial markets”. In their theory, lowering interest rates would offset any downturn and increasing them could prick any bubble.

In reality of course “the first seven years of the 2000s saw a debt-fuelled speculative spree of historic proportions, which in 2007/08 was followed by an equally spectacular collapse... Rather than abolishing boom and bust, Gordon Brown’s government found itself in the midst of the greatest boom and bust in 80 years”. Labour’s November 2008 pre-budget report brought forward capital spending and temporarily reduced the rate of income tax from 17.5 to 15 per cent to stimulate the economy. This fiscal stimulus was rather small, says Lord Skidelsky, and the majority of efforts to boost the economy were initiated by the Bank of England. It slashed interest rates and began provided emergency liquidity to the banking system.

“There was some additional fiscal activity because 50 billion pounds of taxpayers’ money went to recapitalise Northern Rock, RBS and Lloyds. Even this small fiscal stimulus became increasingly controversial as attention switched in the Autumn of 2009 to fiscal consolidation.” In the Spring of 2009, however, the Bank of England started its programme of quantitative easing (QE).

QE produced winners and losers. Lower interest rates and higher asset prices made mortgage and asset holders winners along with exporters who benefited from the depreciation of the pound and banks who ended up with a lot more cash. On the losing side were savers and pensioners who were worse off due to historically low interest rates. Increased commodity prices also reduced the spending power of consumers.

Both before and after the boom and bust, Lord Skidelsky says, “the central bank was not doing its job of maintaining a steady growth in the money supply”. Credit banks in the Western World had made credit too cheap and plentiful in the years leading up to the crash of 2008, which led to an asset boom based on houses, commercial property and debt-fuelled consumption. “This didn’t spill over into general inflation because the supply of cheap, imported goods from East Asia more than kept pace with the increased demand.” The inflation theory had bitten back – instead of regulating the market it had caused an asset price bubble which threatened the banking system with insolvency when it popped.

QE itself has made little difference. The 325 billion created is about 20 per cent of GDP. If it had worked on a one-to-one basis “we would be in the middle of an inflationary boom. But we’re not.” Why not? According to Lord Skidelsky the Bank of England hadn’t a clue what was going to happen. “There’s no accepted theory of how this extra money gets fed into the real economy.” Banks remain unwilling to lend and borrowers unwilling to borrow. “The expansion in reserves has not translated into a proportionate expansion in broad money and credit; in both the US and UK bank lending has in fact been contracting since late 2008.”

What will the outcome be? It’s too early to say, says Lord Skidelsky, but his hunch is that QE did prevent a slide all the way down to the depths of the great depression. Without QE, “estimates suggest that you would have had no broad money growth at all, the velocity of broad money would have been ten per cent lower and asset prices would not have improved so you wouldn’t have had the wealth effect.” He points out, however, that the effect of QE was “very, very weak... the injection of money caused a stock market boom but failed to make any big inroads into the real economy”.

So where will that all-elusive upturn in the economy come from? Leaving it to the banks and telling them to lend more doesn’t work, Lord Skidelsky told his audience. He suggests bypassing the existing banking system and setting up a national investment bank to mobilise private savings, pension funds in particular. Money then could be invested in infrastructure, housing, transport, green technology... “all the things that aren’t being done because of lack of supply of credit in the private sector”.

As he said, it’s an interesting time to be an economist. Principles of macroeconomic policy, public finance and financial regulation are going to have to be rewritten for the 21st century.

Professor Lord Robert SkidelskyLord Robert Skidelsky is Emeritus Professor of Political Economy at the University of Warwick's Economics Department. His three-volume biography of the economist John Maynard Keynes (1983, 1992, 2000) received numerous prizes, including the Lionel Gelber Prize for International Relations and the Council on Foreign Relations Prize for International Relations. He is the author of the The World After Communism (1995) (American edition called The Road from Serfdom). He was made a life peer in 1991, and was elected Fellow of the British Academy in 1994.

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