Mervyn King. Getty Images
Mervyn King’s speech on UK economic policy on Tuesday has received relatively little attention, perhaps because he is in his last few months in the governor’s seat at the Bank of England. However, it is extremely interesting , both in its analysis of the UK’s current predicament and in its recommendations for future policy action.
It lays out a distinctive course of action, which is different from the Plan A adopted by the government and the Bank in 2010, and also different from the Keynesian alternative that Olivier Blanchard of the IMF seems to have recommended at Davos.
The King plan, tinged with both pessimism and realism, argues for a long-term fix, rather than a short-term dash for salvation. But while the fix will take a long time to work, it does have some important implications for the banks, and the exchange rate, in the near term.
Let us start with the diagnosis. The governor says the disappointing recovery in the economy has been due to three factors: the squeeze in real take home pay, the deleveraging of the banks, and the crisis in the eurozone. Note that there is no mention here of the UK’s fiscal tightening, or the size of the multiplier, which others would want to emphasise.
This is all familiar territory, but the governor has been developing a new strain of thought in recent months, and this has come to fruition in this speech. It is that quantitative easing is becoming less effective, because it has worked by bringing forward economic activity from future periods, rather than by boosting the underlying level of activity over the long term.
This is no different from how monetary policy usually works, but the problem becomes more intractable in a very long recession, because policy has to work harder and harder just to keep output at a constant level. Here are the governor’s words:
Monetary policy works… 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 to bring forward yet more spending from the future. As time passes, larger and larger doses of stimulus are required. We are not in a typical post-war business cycle recession.
This is an important argument, which has not been widely recognised in other central banks. If valid, it suggests that QE will become less and less effective as time goes on. The governor hedges his bets by saying that “we are ready to provide more stimulus if it is needed”, but overall there is a clear sense that his enthusiasm for QE has waned.
So the governor is not recommending either a fiscal easing (as far as we can tell), or an extra dose of QE. Furthermore, he does not seem to have any sympathy for a nominal GDP target, implying that it is the work of “dreamers”, and he defends the inflation targeting framework even more strongly than usual. Yet he says “we should do more to revive the patient”. He adds: “We must not be inactive, but we must be selective in order to be effective.” What does he have in mind?
First, he clearly has an aggressive view of what needs to be done to restore confidence in the banks. He does not think that this is a matter of providing more liquidity from the central bank. Instead, he sees the banks’ problem as being one of insufficient capital, which has led to a lack of confidence in the markets. He points out that bank regulation will be the Bank of England’s responsibility after April 1, and says “it is likely that banks will be required either to raise more capital or to restructure their businesses and the Financial Policy Committee will review the position in March”.
It is hard to avoid the suspicion that Sir Mervyn would like to get something meaningful done on bank capital raising before he leaves office in July. Investors in UK bank shares seem remarkably sanguine about this possibility, presumably because they believe the Treasury will not be willing to provide any extra capital for the state owned banks, and will not want to face dilution either. But there could be a real battle over this. Sir Mervyn points out that there is no reason why the state-owned banks should not be largely back in the private sector within a relatively short period.
Second, the governor gives an extremely broad hint that he would like sterling to be much lower against other currencies. In his view, the drop of 25 per cent in sterling, which happened between late 2007 and the beginning of 2009, was “certainly necessary” for a full rebalancing of the UK economy. The words “certainly necessary” imply it might not have been sufficient.
This is very bearish for sterling, since the pound has actually lost much of the competitiveness it gained in 2007-2009, especially if we allow for the relatively high rate of UK inflation since then:
In order to return to the levels reached in early 2009, which the governor suggests may be the minimum adjustment needed, sterling’s nominal effective exchange rate would need to fall by 7.4 per cent from its December levels, and the real effective exchange rate would need to drop by 12.7 per cent. No wonder sterling has been falling sharply in recent days.
In the conclusion to his speech, the governor calls for “patience and realism”, and appears to accept that the supply-side recovery he recommends will be “inevitably slow and protracted”. Apart from action on the banks and the exchange rate, and some unspecified “supply side reforms”, the outgoing Sir Mervyn clearly believes the UK authorities have little room for manoeuvre. Patience, the governor says regretfully, “is not a quality associated with our political debate”. It will be fascinating to see whether Mark Carney, and indeed the chancellor of the Exchequer, agree with his farewell prescription.
