By Frances Coppola, Proprietor, Coppola Comment
“Inflation”, said Milton Friedman, “is always and everywhere a monetary phenomenon”. Upon this statement has been built three decades of faith in the omnipotence of central banks. It does not matter what government does: it does not matter what markets do: it does not matter what shocks there are to the economy. As long as central banks get the money supply right, there will be no inflation. Or deflation. Growth will simply proceed smoothly along a pre-determined path.
Leaving aside the question of whether central banks really control the money supply at all in an endogenous fiat money system, it is clear to me that the control of inflation – in all its forms – is by no means so simple. Despite Friedman’s statement, the forces that create inflation and deflation are in reality poorly understood. The delicate balance between supply and demand in a monetary economy is easily disrupted: shocks to supply or demand reverberate around the economy in a manner similar to a tsunami, overwhelming everything in their path and causing lasting devastation. The means by which shocks propagate themselves are a matter of considerable debate in economic circles. There is no agreement whatsoever on what the transmission mechanisms are, let alone how to manage them. And there can therefore be no basis whatsoever for the blind faith that central banks can at all times control inflation. Or growth, for that matter (I’m looking at you, NGDP-targeters).
To be sure, central banks can limit the immediate effects of shocks. I am no fan of QE, but even I have to admit that its use by central banks around the world to prevent catastrophic debt deflation after the fall of Lehman was successful. But I would regard this as firefighting. Central banks were able to put out the bush fire caused by the fall of Lehman. But they were then expected to restore the forest to its previous green and growing state using exactly the same tools that they used to put out the fire. Flooding the place douses the flames, but it doesn’t help new life to grow. On the contrary, it may actually drown it. Too much liquidity is as dangerous as too little.
What was needed after the Lehman bush fire was careful nurturing of a very damaged private sector by governments. And to start with, that is what happened. The ground healed, the plants started to grow again, and the animals began to return.
But then governments got scared. They didn’t do the serious pruning of overgrown banks that was really needed to reduce the likelihood of another bush fire: instead, they encouraged central banks to flood the fire-damaged banks with liquidity in the hopes of getting them to flower again before they were really healed. But even worse, they decided that pouring water and fertilizer on the areas where fire had scorched the earth and life was slow to return was too expensive. So they stopped nurturing the scorched areas, and instead imposed a drought: the green shoots died and the animals left. They blamed the fire-damaged banks for this: if only they would flower, the plants would grow in the devastated areas even though there was no water, and the animals would return even though there was nothing for them to eat…..
And it worked, sort of. The fire-damaged banks did flower again, eventually. But the flowers they produced were not the life-giving variety that give nectar to the bees and food to the animals. They were toxic. All they fed was asset prices.
But the UK government thought this was wonderful. If asset prices rise, then that’s new life in the economy, isn’t it? Never mind that millions of people are unemployed or under-employed, real wages are stagnant and productivity is on the floor. The stock market is at an all-time high and London house prices are rising at over 10% a year. House prices elsewhere are rising too, because in addition to the liquidity with which the central bank flooded the banks, the starry-eyed government is adding fertilizer to the housing market.
There are now growing calls for the central bank to intervene to calm down the housing market. Central banks that have macroprudential responsibility, as the Bank of England does, have a wide range of tools that they can use to influence specific sectors: monetary policy is a blunt instrument that should be used only as a last resort. But that’s not what the hawks think. A sledgehammer is the only tool they know. Therefore, because London house prices are reaching for the skies, interest rates must rise.
This is perverse. Firstly, as we have seen with the Eurozone, when monetary policy in a currency union is dictated by the needs of one particular area, the rest of the union suffers. The ECB has been under pressure to raise interest rates because of house price inflation in Germany: to its credit, so far it has resisted this. It would be a tragedy if the Bank of England gave in to equivalent pressure to raise interest rates because of house price inflation in London, and squashed the UK’s fragile recovery.
Secondly, it is by no means clear that raising UK interest rates would have any effect at all on the London housing market. The principal drivers of the London housing bubble are overseas cash buyers, many of them financed at very low interest rates by foreign banks, and UK investors diversifying into property in the search for yield. A rise of a few basis points in interest rates is not going to be enough to make the returns on financial assets more attractive than London property. To have any significant effect, an interest rate rise would have to be several percentage points – which would be an enormous negative demand shock to the UK economy. Using monetary policy to prick the London housing bubble would be likely to knock the economy back into severe recession.
And thirdly, it is not only perverse but morally wrong for an unelected central bank to attempt to override or counteract the intended economic effects of the policies of an elected government. Help to Buy is pushing up house prices outside London: this hurts the people it is primarily designed to help, but it does encourage construction, and the rising house prices create “wealth effects” which act as a much-needed economic stimulus in depressed areas such as the North East. Despite widespread derision at what appears to be blatant buying of homeowner votes, the government has made it clear it has no intention of ending Help to Buy. Therefore we must assume that the government likes the current housing boom. While Help to Buy remains in place, the Bank of England has no business raising rates purely to calm the housing market. If financial stability is threatened, Help to Buy must end.
I doubt if macroprudential tools would have much effect on the London housing market, since it is primarily driven by cash buyers. Fiscal tools would be far more effective, and there are numerous alternatives. Punitive taxation of capital gains on speculative purchases: 100% taxation of notional rents on properties left empty: wealth taxation on very high value properties: a top band on council tax: even a land value tax. Anything to give the clear message that housing is first and foremost shelter, and speculative activity that drives up prices beyond the reach of ordinary people is not acceptable. But this, of course, is the job of government – not the central bank.
And this brings me to the real point of this piece. The myth of central bank omnipotence has been carefully fostered by the academic economics profession, by central banks themselves and by politicians. The first two of these clearly have a vested interest in technocratic management of the economy. But it is perhaps less clear why politicians sell this myth.
Politicians sell the myth of central bank omnipotence because it allows them to pursue all manner of stupid fiscal and quasi-monetary policies while escaping responsibility for the consequences. If Help to Buy causes asset price inflation, it’s the central bank’s responsibility to sort it out – even at the cost of widespread collateral damage. If a front-loaded austerity programme in the teeth of oil price shocks and a sovereign debt crisis in our largest trade partners squashes a fragile recovery, it’s the central bank’s responsibility to get growth going again. If ill-considered and callous changes to the benefits system force a lot of people on to the unemployment register when the jobs market is already depressed, it’s the central bank’s responsibility to stimulate the economy so new jobs magically appear. If the central bank fails to achieve these because of an unhelpful fiscal stance, blame the central bank.
But the truth is that central banks are not omnipotent, and the tools they use are not cost-free. As already noted, interest rate changes can have unpleasant and unintended side effects. The effectiveness of QE when the fiscal stance is contractionary is uncertain, and it is unquestionably regressive, benefiting the very rich far more than any other section of society. Macroprudential tools are of questionable effectiveness too: they are easily evaded or watered down, and they are ineffective if improperly targeted. And the inadequacy of information available to central banks – and poor timing – means that their actions are always likely to be “too little, too late”. For targeted sector interventions, fiscal tools can be both more powerful and more effective: we should be far more willing to use them.
Most importantly of all, central banks simply do not have the power to override a determined government. One of my favourite academic papers, Sargent & Wallace’s “Some Unpleasant Monetarist Arithmetic” reminds us that central banks are powerless to control consumer price inflation generated by reckless government borrowing and spending. The same is true of asset price inflation generated by irresponsible and meretricious government support of housing markets. And in my view the same is also true of deflation caused by inappropriate fiscal contraction.
Whether they like it or not, politicians are accountable to their electorate for managing the economy. It is wrong of them to attempt to pass this hot potato to unelected central banks, and equally wrong of central banks to think they can accept it.