What would you do if you were in Mark Carney’s shoes? Our experts give their views.
Merryn Somerset Webb: Imagine Mark Carney disappears. In desperation the Bank of England rings you. You are now governor. What are you going to do?
Andrew Smithers: Ring up the chancellor and explain that I can’t do anything to cure Britain’s problems. But the fact that I can’t do anything sensible is not an excuse for me to do something stupid. If you want a sustained recovery, you have to avoid having another financial crisis.
You can’t raise interest rates when your banking system still has insufficient equity to take it. Do that and you are building a system for causing a banking crisis.
Merryn: So what’s he actually supposed to do?
Andrew: Absolutely nothing, bar make that call. There is no sensible policy the Bank of England can pursue.
Merryn: Okay, so we leave rates exactly where they are, no quantitative easing (QE), no macroprudential measures, no forward guidance…
Andrew: If there comes a point where Carney has to do something – and if the economy keeps growing at speed, he will have to raise interest rates – he will have to warn the government in advance. There is an asset bubble in UK housing. That’s dangerous. If you deflate it suddenly, you’ve got trouble.
Merryn: Liam, you are now Mark Carney.
Liam Halligan: Inflation is now 2%, but it has been above target for 49 months. I don’t think inflation has been squeezed out of the system at all. If inflation is so low, then why is the whole of British politics cast around the question of a cost of living crisis?
I think the consumer prices index (CPI) measure is an issue and the central bank’s credibility on tackling inflation is an issue too. The Bank may now lower the unemployment threshold for considering rate hikes from 7% (now that unemployment is down to 7.1%) to maybe 6%, but that costs it what credibility it’s got left.
Merryn: What’s your preferred measure of inflation?
Liam: It needs to have housing costs included and some notion of asset prices. A lot of the inflation we’ve seen from QE has gone straight into asset markets.
Merryn: Would you have put rates up by now?
Liam: At least a year ago.
Merryn: Where to?
Liam: 1.5%, and moving back towards some kind of normality. The idea that businesses need rates at this level to invest is ridiculous. They’ve never been lower. Businesses aren’t investing because they are still worried about another Lehman-style disaster.
Andrew: You are right, in that lack of investment isn’t about rates. But if companies were worried about the future, they wouldn’t be buying back shares and gearing up at a rate of 3% of GDP per annum. So it isn’t that either. It is about the major change in management incentives in the last decades.
The priorities of management are simple: in the average four years a CEO is in power, he wants the company to make as much profit as possible, in order that he does the same via options and so on. He does that by not investing, buying back shares with borrowed money, and so on. That isn’t good for the economy as a whole, but it gets profit margins high in the short run. It also explains why productivity is so poor on both sides of the Atlantic.
Liam: But not all companies are quoted and offering options.
Andrew: A new paper suggests that roughly speaking half of corporate America is quoted and half is not. In the last decade the unquoted section has invested twice as much as the quoted. That has been sufficient to depress investment ratios and to push up profit margins on both sides of the Atlantic.
Douglas Carswell: It’s not a view I’ve heard before – I’m interested in the idea that productivity might be related to corporate structures. Switzerland has had better productivity growth than us, but similar corporate structures. I’ve come to the view that perhaps poor productivity performance is about mal-investment – the money going to the wrong place.
Andrew: I’m sympathetic with the idea of mal-investment. But the real problem is just lack of investment. If firms had invested badly but at least invested, there would have been a fall off in the corporate sector’s financial surplus and that would help immediately. This is a very important thing. The cash flows in an economy must sum to zero. You can’t have a fiscal deficit unless you’ve got a cash flow surplus in one of the other sectors of the economy. We have – in the corporate sector.
Dominic Frisby: But a low-interest-rate environment doesn’t reward labour, it rewards capital. It rewards those who hold assets. So while you have this environment, investment is going to the wrong place. Mal-investment.
Sebastian Chambers: There is no shortage of capital in the world. But I’m interested in the idea that quoted companies are not as productive as unquoted firms. One thing hidden from view in the US and UK is a huge movement of money into private firms – private equity. The very largest will flip assets and so forth, but many actually invest for the long term and grow employment. All the small and medium companies that we’ve worked with are growing organically rapidly.
Andrew: Private equity runs the gamut between what you might call the virtuous – those whose activities are fit for public interest – and the other extreme – those who just buy out companies and leverage them as far as possible while extracting as much capital as possible.
Sebastian: We have a massive challenge here – that dividends are paid after tax and interest is paid before corporation tax. It’s a fundamental skew towards too much debt and too little equity. It needs to be changed.
Andrew: I haven’t yet met an economist who doesn’t agree with you on that. We have a world debt problem, so subsidising debt is plain lunacy.
Douglas: I’ve just published a paper called “After Osbrown”, the clue being in the title. In it, I argue that artificially low interest rates – and the consequent debt – have caused huge problems. Once the stimulus is removed, as it must be, we will go through something akin to the 1970s and the 1980s.
In January 1973, the deficit would have been falling as a percentage of GDP, inflation would have been stable, unemployment would have been falling. It would have looked good. Rather like today. It looked very different 24 months later.
I think we’re heading into another credit-induced boom like the ones under Nigel Lawson and Gordon Brown. The Divisia index (a weighted index of money supply) – my favoured measure of credit – is the canary in the monetary mineshaft. The index is rising.
Steve: And once an inflationary expectations cycle takes off the only way to stop it is with a shock.
If the Bank of England can’t predict unemployment five months ahead, why do we let it decide what the interest rate is?
Sebastian: On the matter of investment there is one positive. We are seeing a lot of companies investing in IT. Services are going through the same process that manufacturing went through in the 20th century – automating. Transforming the productivity in a service industry is less visible and less expensive than transforming productivity in a manufacturing industry. The world has been transformed in terms of fibre optics, for example. The productivity gains will work their way through.
Liam: But business investment is the lowest as a percentage of GDP that it’s been since 1953.
Andrew: The evidence is that businesses on both sides of the Atlantic are running large cash surpluses. Unless they invest it in ways that reduce the cash surplus, that is going to be a structural problem. To say that they are spending vast amounts on IT isn’t enough. That kind of spending could even be considered as running costs, rather than investment.
Dominic: Back to Merryn’s original question. I am happy to agree with Liam’s scenario that the Bank will change its unemployment target to 6.5% or 6%.
Andrew: It seems we think that the Bank of England is going to end up behind the curve.
Douglas: If the Bank of England can’t predict unemployment five months ahead, why do we let it decide what the interest rate is?
Liam: Douglas, do you believe in independent central banking, or would you have some kind of metallic-based system?
Douglas: I wouldn’t expend political capital on that. What I think we ought to do is rein in the worst excesses of fractional reserve banking. Politicians are fixated with using interest rates to control people’s appetite for debt, but that doesn’t control the money supply.
Actually, over the four boom/busts we’ve had since 1971 we’ve been spectacularly bad at preventing the build-up of excess credit. The way to do it is to constrain the ability of banks to conjure up credit out of nothing. That, I think, requires some far-reaching bank reform. Until you do that you’re going to have disruptive credit boom/busts.
Liam: I agree with all that. But the problem now is that independent central bankers don’t exist.
Douglas: The Bank of England was made independent in order to prevent politicians giving people low interest rates. But the minute the technocrats got control, they did what the politicians wouldn’t have even dared to do – cheap candyfloss credit for everyone. Not a good idea.
Look at output and look at credit. You will see that every fall in output since 1971 has been preceded and caused by growth in credit. The growth in credit bit is happening again.
Steve: There has been huge credit easing – think of the government’s Funding for Lending and Help to Buy schemes. The authorities can’t use rates any more, so they find other ways to restart the credit expansion process.
My preferred measure of the money supply – money you can spend – is increasing by 12% a year at the moment. I reckon we’re going to see some inflation sometime in 2014 – although it all depends on expectations and sentiment.
Liam: On expectations – we are in the month of tapering, from $85bn to $75bn a month in the US. That means US-based money will still expand this year by $900bn, having expanded by just $800bn from 1913 to 2007. But will the tapering really happen?
Steve: I think unemployment will rise at some point during the tapering process and the Fed will cancel it. Then people will realise that it will never stop.
Liam: So then they just let the bonds expire? When do they cross that Rubicon?
Steve: Different people set their Rubicon at a different level. Is it when the central bank starts buying government bonds? Is it when they start sending the coupon payment back to Treasury? Or is it when they actually write the bonds off?
Merryn: Let’s go back to interest rates, deficits and how the state causes inflation. Is inflation an inevitable result of democracy, in that people only ever vote for more spending?
Douglas: In the past 36 years the government has run a surplus only six times. To make up the difference it persistently debauches the currency. That’s not an inevitable consequence of democracy.
America from 1820 until today has basically been a democracy. It’s only really since 1971 that the dollar has been systematically debauched by government in order to pay for overspending. Progressive taxation was only allowed in America in 1911 – that’s what has allowed the advance of a redistributive state. It’s not democracy that’s the problem – it’s human frailty.
Merryn: But is progressive taxation an automatic result of democracy?
Steve: Look at inflation back to 1750 and you’ll see that for 40 years we’ve lived in an unprecedented inflationary age. After the Second World War, Richard Nixon closed the gold window (decoupling the US dollar from gold) and that was that. Since then there has been a bizarre intellectual consensus to justify this collapse in the value of money.
So, here we are, great fountains of new money coming in to the economy and we wonder why there’s wealth inequality and a division between north and south. If you triple the money supply, as they did between 1997 and 2010, you shouldn’t be surprised if you end up with a redistribution of wealth. It’s madness that people can’t see this.
Sebastian: Most of us who understand it benefit from it. That’s why we let it continue.
Steve: That rather brings us back to the question of what money is and how a state should organise money. I’ve been ignoring bitcoin on the basis that gold is all I need. But I’ve now bought some bitcoins. Their value fluctuates too much at the moment, but in terms of showing what people want to use as money, it’s amazing. Only 21 million will ever be produced and no one can change that.
Merryn: How do you know?
Steve: The amazing thing about open source software is that thousands of software engineers can just go and look at it. If it was a lie, they’d just tell us.
Liam: There will be many different alternative currencies to come. But the notion of using software to create scarcity is a massive leap forward in technology. It’s got to be better than linking scarcity to a naturally occurring substance of unknown quantity. Let’s not think this is marginal.
I mean the value of bitcoin transactions is now bigger than the value of PayPal transactions. They’re closing in on Western Union. Even the Chicago Fed has brought out a little two page note on bitcoin (last October). It says bitcoin showed promise – it may be that in the future governments use bitcoin. Already in Germany you can pop bitcoin transactions on your tax return.
Dominic: bitcoin also has incredible first-mover advantage. Nobody talks about cryptocurrency or altcoins, it’s bitcoin, bitcoin, bitcoin.
Steve: So tell me, you love gold?
Dominic: I do.
Steve: But how do you think gold compares to bitcoins? It strikes me that bitcoin is easy to audit in a way that gold isn’t. I’ve never inspected my small physical holding of gold in a vault. I can’t be sure of it. It might be the case that bitcoin’s better base money than gold.
Dominic: It may just be more practical…
Sebastian: I think the big change in money will be when banking is done by non-banks. When banking services can be provided by Google, PayPal, O2… or you get M-Pesa type currencies (where the currency is a unit transferable on a mobile phone). A third of Kenyans use M-Pesa already. And that is where the innovation will be – banking without the architecture of retail banking.
Liam: Both. You can now use M-Pesa for bitcoin transactions.
Sebastian: But you know bitcoins are almost certainly going to fold. Think tulips.
Liam: Tulips aren’t divisible, tulips can’t be used in transactions, tulips can’t be transferred across the world in a tenth of a second.
Sebastian: There was a belief system that got excited about tulips and there’s a belief system that’s excited about bitcoins.
Steve: I don’t doubt it – there are libertarians thrilled by the way this non-state body has been enabled by the internet. But we also live in a technological age where people are coming to question the validity of the banking system.
Merryn: I’m getting the general idea that you would all like to see the state get out of the business of creating and controlling money.
Douglas: One way that states have been able to grow so big and so invasive is by running up deficits – which their ability to debase money allows. But as more and more people start using alternative currencies that will force good practice onto the government.
The tax base is also becoming more mobile – so it is getting harder to raise money that way too. I was interested in the points that Andrew made about investment in intellectual property. If you wanted to raise money in the 19th and 20th century you taxed factories or the workforce who worked in them.
In 1980, Bethlehem Steel was, I think, the 20th largest company in the US. Now the 20th largest company in America has a fraction of the workforce and Bethlehem Steel doesn’t exist. How do you extract tax from Google when you can’t really say in which jurisdiction intellectual property is being exploited?
Merryn: So the state has to shrink because it can’t finance itself anymore?
Douglas: Yes. There is the mobile tax base, the innovations in money, and the fact that we can’t defer the debt down many more generations. I’m often told that the state won’t shrink because no one in Westminster wants the state to shrink. But it isn’t about want. It’s a question of mathematics.
Sebastian: Very few people really think the state should be as big as it is now – not far off 50%. The extreme libertarians would go for 20%. Somewhere between 30% and 40% seems better.
Douglas: 30%-33% is about right. Technology will help here too. If, for example, you’re chancellor and you find you have to spend less on education, digital technology allows you to say to people: “We will give you control of your budget – allow you to self-commission.”
A generation that grew up listening to remote DJs selecting music is not going to have the same relationship with choice as the generation that grows up with a Spotify playlist. So while it is essential to reduce the size of the state, it is much easier to do politically than you think.
You can already do this with nursery care – you take your state voucher where you like. But it can happen for non-nursery education and for primary healthcare.
Sebastian: I don’t have a problem with whatever people vote for in a liberal society with a free press. I have a problem with a system that deliberately obfuscates the numbers.
I’ve got here the NHS Pension Scheme accounts for last year. In this there is a deficit of £250bn. That’s a third of GDP and more than twice the size of the NHS annual budget – and that’s the pension deficit. The deficit went up by £37bn last year. In one year! But this is all off balance sheet. It’s a disgrace.
Steve: It is incredibly hard for MPs to do anything about all this. There’s a chapter in Hayek’s The Road to Serfdom on the future of democracy under socialism. We are where Hayek said we would be – parliament has become a pressure release valve, a place where general grievances are aired but little detail dealt with.
Every day we’re hit with a tidal wave of complaints about the failures of the state – so we never really get to the important detail, like what the pension liabilities are.
Dominic: How can we get proper accounting?
Sebastian: Move the UK government to using Generally Accepted Accounting Practice (GAAP). As a director of a company I have properly to take into account future liabilities that the business will incur.
In the same way that if I want a pension I have to save up for it now. The state doesn’t have to do these things, so its finances aren’t clear. All the things we vote for or against are on the basis of fudged numbers.
How can we call it austerity when we’re doubling the national debt in seven years?
Liam: There is a clear problem here. As Sebastian establishes, MPs are scarcely appraised of the fiscal facts, never mind the public. But there are huge vested interests in keeping it this way. In 2005, I made a documentary about the public-sector pension deficit, pointing out that some 26% of the council tax that ordinary pensioners pay was going on public-sector pensions.
If you want to know why you’re only getting your rubbish collected twice a month, there’s the answer. There was fury at this being aired, and one by one the accounting and pensions firms that had helped get the numbers together backed away from them – helping wasn’t a great career move. Note that all the people who decide pension policy in this country have public sector pensions.
Merryn: Sebastian, what’s the first big change you’d make to make things better?
Sebastian: Only the GAAP. That would make it clear. If people voted to spend 40% of GDP, the state would have to do that – not spend 50%.
Liam: I would submit that it’s not only in the fiscal undergrowth where this obfuscation takes place – it’s absolutely in the headline debate and that has to change. Let’s just consider the facts in the last few years in this country.
In 2010, the national debt was about £790bn. By 2016 it is going to be upward of £1.5trn. Yet we call that austerity. Why? Because politicians and journalists continuously conflate deficits – the annual increase in the national debt – with the absolute level of debt. How can we call it austerity when we’re doubling the national debt in seven years?
Sebastian: It’s like describing a diet as a process of getting fat a bit more slowly.
Merryn: Dominic, if you could do just one thing to improve the state, what would it be?
Dominic: Simplify taxation. I still don’t understand why individuals pay one rate of income tax and corporations pay another. I would have a flat rate of tax – corporations and individuals both paying 15%-20%. I would also look at introducing some kind of land value tax. Then I would repeal the 1948 Planning Act in its entirety.
Steve: With some covenants to protect some greenbelt, I hope. The other things I would do are included in four bills that Douglas and I have co-sponsored. UK GAAP accounting for banks.
Increased liability for directors, using the bonus pool as capital in order to get people in the banking system to behave responsibly. Douglas’s competing currencies, plus moderating the fractional reserve system. Tax simplification and then getting the state to live within that base.
Dominic: Everyone knows taxes must be simplified. I just don’t get why it doesn’t happen.
Steve: There’s too many vested interests. I was on the Finance Bill committee this year. You stand up and say it’s wrong to give special tax breaks to video games and posh high-end drama production. And even liberals stand up to defend special privileges for these sectors.
That’s what’s wrong with a complicated tax system: it creates special privileges. People obsess that MPs having lunch with somebody might influence policy, but the horrible truth is that special interest privileges are embodied in the Finance Bill and nobody notices. With flat rates, there are no special privileges.
Douglas: I do think that rates should go up. We need a tighter monetary policy and real bank reform. We need to rein in the ability of banks to create credit on the basis of their appetite to lend, the borrower’s appetite to borrow, and the regulators’ requirements for capital reserve ratios.
Liam: I would focus on the banks, we need to impose an absolute separation between investment banking and commercial banking in this country. The removal of that barrier has done more than anything else to land us in the mess that we’re in. I think too big to fail is worse now than it was before the crash.
Our banking sector is five times the size of our GDP and we don’t have a reserve currency. America’s banking sector is one time its GDP and it does have a reserve currency. The Americans can afford another bail out and maybe another after that – we can’t.
Dominic: Could a simple way of implementing all this be simply to stop guaranteeing bank deposits?
Liam: You should guarantee deposits – but only at certain institutions. You stipulate whether it’s an A bank or a B bank, then people vote with their feet. If you want a low rate of interest but 100% capital safety, you go with the guaranteed bank.
Steve: If that were brought into effect, it wouldbe profoundly transformative to the banking system.