Monday, October 27, 2008

Should We Blame Bank of England for Recession?

Since the Bank of England was made independent in 1997, there has been a general consensus that they did a good job in preventing boom and bust and promoting the longest period of economic expansion on record. (1992-2008) Gordon Brown rarely missed an opportunity to offer himself self-congratulations on giving the Bank independence and therefore, avoiding the boom and bust, which characterised the post war British economy (See: Lawson Boom) However, the speed at which the UK has entered recession this year have left many re-evaluating the performance of the Bank.

Positive Aspects of the Bank's Record

  • We did have 16 years of positive economic growth. (compared to two recessions in the space of 10 years 1981 and 1991).
  • The Bank did avoid an inflationary boom. Inflation only increased above target this year, and that was due to cost push factors beyond the Bank's control.
  • The recession has been caused not so much by UK monetary policy, but, the subprime mortgage crisis, originating in the US.
Nevertheless, UK policy has arguably failings.

1. Problem of Inflation Targeting. The Bank of England have one target - low inflation.- CPI of 2% +/- 1. The problem with targeting just inflation is that the Bank have a duty to place much less emphasis on:
  • Slowing growth
  • Booming housing markets and assets
For example, 2008, has presented the Bank of England with a dilemma - because of cost push factors (rising oil prices) we had a rise in inflation and lower growth. Because inflation rose above target, the Bank didn't want to cut rates (until this October). As David Blanchflower, a member of the MPC, argued, this meant interest rates were too high for too long. Meaning that the recession will be deeper. If the Bank had a target of low inflation and high growth, they may have had greater confidence to cut rates sooner and help avoid recession.

Should the MPC have prevented Booming house prices?

The other aspect is that maybe the MPC should have used interest rates to reduce the growth in house prices. If a boom in house prices had been avoided, the slump would have been less severe.

However, I am not convinced they should have used interest rates to target house prices. The boom and bust in house prices was due to:
  • Shortage of supply, squeezing prices higher then lower
  • Mortgage lending. Once very generous then completely seized up.
To avoid boom and bust in the housing market, we need policys specifically for housing market, rather than relying on macro instruments.

What Should Happen Now?

There is a good argument the MPC should give greater flexibility in targeting macro economic objectives.
  • Low inflation is important, but, it is obviously not the only macro economic objective. Inflation is above target, but, clearly the prospect of unemployment rising to 3 million should be taken into consideration rather than just worrying over temporary cost push inflation of 5%.
  • The government actually state the Role of the MPC is:
  • The objectives of the Bank of England shall be
    a) to maintain price stability
    b) subject to that, to support the economic policy of Her Majesty’s Government,
    including its objectives for growth and employment.”
  • The MPC could be given flexibility to consider other issues such as house prices / unemployment and balance of payments.

Should Government Take away Independence and control Interest Rates?

I don't think so. I don't believe if the government had been controlling interest rates in the past decade we would be any better off. The government certainly wouldn't have raised interest rates to avoid a boom in house prices. However, the government can change the MPC
s Target - including growth as well as inflation.

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