Merryn Somerset Webb talks to Mervyn King, ex-governor of the Bank of England, about the EU referendum, monetary policy, and the role of the IMF.
• If you missed any of Merryn’s past interviews, you can see them all here.
What’s wrong with the eurozone
Lord King: They’ve ended up in a situation where some countries have very large trade surpluses like, Germany and others in southern Europe large trade deficits. And there’s no mechanism now for correcting the changing competitiveness which happened in the first decade of the monetary union.
Merryn: Well, there is a mechanism. They could break up.
Lord King: Well, one mechanism would, indeed, be to break up. There are others which is carrying on with the misery of high unemployment in the south and maybe eventually they would see their wages and prices fall by enough to restore competitiveness.
Merryn: Yes. There’s an idea that you can internally devalue enough to make it work.
Lord King: Yes. Exactly.
Merryn: But this always seems to us… and I think you’re a fan of Bernard Connolly as well, aren’t you? I see you thank him in your book.
Lord King: I think he’s one of the people who had tremendous insight right through the period before the crisis, as well as afterwards.
Merryn: Yes. We had an interview with him the other day where we talked about this at length and we talked about the, you know, the misery and the impossibility, really, of the periphery countries being able to internally devalue enough to get to the right place without there being massive political unrest along the way.
Lord King: Yes. And we tried it in this country in the 1920s when we went back to the gold standard, at too high a rate and that was where you can argue that we needed to adjust our wages and prices by 10%. I think the periphery countries need to do it by more than that now but even 10%, we in Britain could not manage in the 1920s and we left the gold standard and it was only after countries left the gold standard that they were able to recover following the Great Depression.
The dishonesty of EU governments and why monetary union can’t survive
Merryn: One of the things that you say in the book is that you think government have been very dishonest with their electorates about the way the Eurozone has to work. They haven’t told the electorates that the only way for the monetary union to work is for there to be a proper fiscal union and a supranational organisation above democracies?
Lord King: Yes, and, of course, as soon as they get close to saying something similar to that they realise that there is popular discontent with that proposition. And, indeed, it comes both from the countries that would be required to pay for those in difficulty, like Germany, where taxpayers show no enthusiasm for paying what would be a large proportion of their GDP to countries in the south.
But, interestingly, the opposition also comes from the potential recipient countries because they have no wish to have the conditionality that would be required to persuade Germany to make these payments. They have to have some control over the size of the transfers if they’re to be made and there is no legitimacy in any framework in Europe for making those decisions.
And it’s very surprising that the five presidents in Europe in their reports or more recently, the German and French Central Bank governors keep floating the idea of a finance minister for the euro area, who would have the power to set spending and tax decisions for each country within the euro area. The idea that people in Spain are going to accept that someone in Brussels or Frankfurt is going to set their taxes and spending, why on earth are they bothering to vote for a government in Spain if they can’t decide on what are the most important issues facing their country?
So I think that we’re a long, long, way from having a political union which people accept where there’s legitimacy and decisions to make transfers from some parts of the monetary union to others and that’s going to be required if they’re going to keep it together.
Merryn: But if you can’t have that, which, as you say, seems incredibly unlikely, it seems impossible that the monetary union can hold?
Lord King: I think that that is a reasonable conclusion. Now, it doesn’t mean to say it will fall apart quickly. I think governments are struggling to keep it together. At present it keeps going because there is very high unemployment in the south which means those countries have much smaller trade deficits than they would do if they were to get back to full employment and, as a result, they don’t need to borrow very money from the rest of the world.
But if they were to have a significant financing requirement from the rest of the world, then I think they would be in trouble because I don’t think people would voluntarily finance that without the belief that Germany would underwrite those loans, eventually. And that’s the thing which Germany has always been resistant to doing in any formal sense.
On what’s wrong with the eurozone (and Brexit…)
Merryn: Yes. You’re really not making it sound very attractive, the Europe Union, I must say.
Lord King: Well, I mean, I think the prime minister, if he were here, would say that he, himself, finds nothing attractive about the monetary union but that isn’t the issue we’re been asked in the referendum. The referendum is about the European Union not about whether we would be in the monetary union.
Merryn: No, but we’d still be attached to an area that is in some political trouble?
Lord King: There’s no doubt that the major problems facing the European Union are the euro area, for one, and, secondly, mass immigration from outside the European Union itself. These are the two existential challenges facing the European Union. And there is a debate about what is our long-term relationship with the continent of Europe. Unfortunately, the debate so far, in the referendum, has not really focused on that.
Merryn: Yes. I was concerned when I saw you saying the other day that you weren’t sure which way you were going to vote yet because you were waiting to get all the information. And I thought, good God, if the ex-governor of the Bank of England doesn’t have enough information to decide how to vote on something like this, what will become of the rest of us?
Lord King: Well, what we want are not PR statements about, you know, exaggerated claims about either the cost of leaving or the benefits from leaving. What we really want, I think, is to hear politicians say what their vision is of the role of the United Kingdom in Europe and that could be a vision inside the European Union or outside it. But what it does require is someone to say, what’s the long-term future of the United Kingdom and our relationship with other European countries?
But, these issues are not being discussed in that way. What we’ve been told is, whether it’s statements from the government or other people involved in the debate or all these letters being signed by various people telling us what to do, they’re all assertions. They don’t contain any…
Merryn: And these bonkers numbers. It’ll cost you this or gain you this, things like that.
Lord King: Absolutely. We have no idea. I mean, one of the interesting things is to look back to 1975, the referendum, which I remember then, about whether Britain should stay in the European Union. And what is so striking about it is that the claims made at the time, turned out to be exaggerated. It’s very hard, looking at what’s happened since, to argue that either staying in the European Union led to our economic renaissance of Britain or that if we had left, it would’ve been a disaster. It didn’t make an enormous difference.
Now, that isn’t to say there aren’t big issues about membership of the European Union. There are. But I think the idea that somehow it’s either going to be bliss if we leave or a complete disaster if we leave is a gross exaggeration.
Merryn: So it might not make much difference one way or the other in the in the medium term?
Lord King: Well, there are important questions. I think they are about the relationship between this country and countries in Europe. After all, we went to war – two world wars – because of what was happening on the continent of Europe. These questions are very important.
But I think that the exaggeration of the economic costs and benefits is not helping people because they can see through this. People are saying things because they want somehow to persuade people to vote for their side and what we want… I would like to see people on both sides acknowledge that the other side have good arguments because there are good arguments on both sides and that’s not a surprising position. This isn’t a straightforward decision. If it were, surely we wouldn’t have had a referendum in the first place or we would have left many years ago.
How to make things better – with the IMF
Lord King: It’s very hard to know how it will end. What I do know is that monetary policy and monetary easing is not going to be the answer to get us back to a sustainable recovery. So I think one of two things are likely to happen. One, is that we will see over the next few years, decade, significant debt defaults as we’ve failed to adjust the big disequilibrium in the world economy and in our own individual economies, or politicians will come to realise that monetary policy has done all it can do, it’s bought time which they haven’t yet used but they will now start to use it.
Merryn: Do you think they haven’t realised that? I mean, I think, surely, politicians and central bankers have realised that they’ve gone, pretty much, as far as they can with monetary policy. It’s just that they don’t know what to do next?
Lord King: Well, there’s no shortage of things that they’re being advised to do but there isn’t the political will to do it. I do think that one of the problems coming out of the post-war type of economics, where economists wanted to be like physicists with very precise models that explained how the world worked, is the belief that if we just wait long enough and have enough monetary stimulus then the head winds in the phrase which is holding back recovery in the world, will go away and then everything will be fine.
Merryn: Everything will be fine. It will be unblocked, somehow.
Lord King: Yes. Exactly. And I think this is a serious intellectual mistake.
Merryn: OK. And why is that?
Lord King: Because we are in a disequilibrium in terms of the real economy. Some economies have saved too much and spent too little. Germany and China are the obvious, biggest examples of the countries like that.
Merryn: Yes. So these are the countries whose exchange rates have been fixed at too low a rate, effectively?
Lord King: Yes. And, one, because the strategy was to rely on export-led growth which was not a crazy thing to do when they started on this path but because China became such a big economy so quickly, then this was having major implications, not just for the world but for them too.
Merryn: And this was just an ordinary mercantilist attempt to follow in the footsteps of Japan and Korea, etc.
Lord King: Absolutely.
Merryn: It’s just that on this scale it causes imbalances on a different scale.
Lord King: Exactly. And I think people in China completely understand that but now they’ve got this terrible problem of knowing how they are going to shift resources from the export sector to the domestic demand. Can they do it in a timescale that makes sense given what the rest of the world is doing?
So far, they’ve shifted very few resources from the export sector to the domestic demand sector. They know they have to do it but, just like Western politicians, they’re naturally very conscious of where the jobs would be lost but they can’t see where the jobs would be created.
Merryn: Yes. And it’s very difficult to say. I mean, Japan never really did it successfully, did they? I mean, there was a lot of talk back in the 70s about Japan shifting from an export-orientated model to a services model and they never really quite got there.
Lord King: No, they didn’t. And it requires the willingness to make big structural reforms and to give up this pretence that fixed exchange rates are a good thing. And I think one of the challenges we face now it that, because the world economy as a whole is pretty weak, almost every economy could say, you know, if only the rest of the world was growing normally, we’d be fine.
Merryn: Yes, but it isn’t.
Lord King: But it isn’t and so we aren’t so what should we do instead? Why don’t we just temporarily – not permanently, of course – but temporarily push our exchange rate down? And so you see economies from Australasia to Japan through Asia to now, very much, the euro area, relying on trying to push down the exchange rate in one form or another.
Merryn: Everyone is just trying to steal little bits of everyone else’s growth, right?
Lord King: Yes. And the country that lost a bit from this is the United States, which has held back their recovery hence they now are concerned about the strong dollar.
But this is a zero-sum game and what we need to recognise is that cooperation should take the form not of going back but to, sort of, target zones for exchange rates, which would be a serious mistake but should take the form of accepting movements in exchange rates brought about by markets but cooperating in terms of a, sort of, plausible timescale over which we would take the measures which would vary from one country to another to correct the this disequilibrium between spending and saving in our economies.
Merryn: Just to clarify what I meant for readers earlier when I said they’re simultaneously too high and too low, rates are too low for there to be a proper balance between spending and saving and too high to stimulate investment in any way.
Lord King: Yes. Absolutely, and we got stuck in this position and one of the reasons it grew as a problem before the crisis and is still a problem today, is that it’s quite hard for any one country to know how to get out of it on its own because if you were to take measures that would, you know, as we tried to in 2010, would slow the growth of domestic demand, unless the rest of the world is growing normally, exports don’t take up sufficient slack to enable you to get back to full employment and have growth on the scale that we ought to be expecting after such a big downturn in 2008/09.
And so countries are reluctant to take that risk because they don’t know what the rest of the world is going to do. Somehow, we need to create a type of cooperation that reassures countries that we’ll all do our bit, even though that’s going to vary from one country to another.
Merryn: And this, you suggest, is led by the IMF, right?
Lord King: Well, it’s the one body that ought to be able to do it. Unfortunately, I think the IMF has become associated far too much with the political projects of monetary union in Europe and that has damaged its credibility in the rest of the world and I think some of the hangover from what happened in the Asian financial crisis.
The fact that the Europeans were deeply sceptical about the scale of lending by the IMF to Latin America and Asian economies and then when it became their turn to need IMF money, when the euro area got into trouble, there was no compunction on borrowing from the IMF on a much bigger scale.
Merryn: A much bigger scale.
Lord King: A much bigger scale. And I think this has created a certain degree of cynicism in the rest of the world about how the IMF behaves. And I think this is deeply unfortunate because I don’t think we’ll be able to create another institution.
Merryn: Yes, because if not the IMF, who?
Lord King: Well, I think there will not be global cooperation absent the IMF playing a stronger leadership role and it needs, probably, to change so many of its policies in order to be able to do that. I think there are certainly developments of cooperation within continents.
I mean, I think many of the new institutions created in Asia mean that the IMF will have much less of a role to play in Asia. But since many of those economies do need to make the same adjustment from exports to domestic demand, that isn’t going to help us very much.
Merryn: OK. So using the IMF to recreate flexible exchange rates is going to be tricky. The other thing – well, there’s several other things you suggest. One is working harder to improve productivity.
Lord King: I think in the end this is going to have to be – I know it sounds like motherhood and apple pie – but a sustained programme over ten years to improve the efficiency of our economy, would have the effect of leading people to believe that they genuinely would be better off in the future. Not immediately.
Merryn: Yes. But there’s a lot of talk about the productivity puzzle. They’re endlessly talking about it as a puzzle?
Lord King: Yes.
Merryn: Do you think it’s a puzzle or do you have a sense of why productivity is so low?
Lord King: Well, I think it’s hard to… Well, I think the question is what, sort of, computer models do you use to make these judgments? I think two things have happened. One is that in the immediate aftermath of the crisis, the banking system, understandably, was deeply reluctant to lend and that hit, particularly hard, new businesses so that innovation coming into the economy was probably held up for a while.
I think since then what’s happened is that one of the consequences of very low interest rates is that it persuades people to spend today rather than tomorrow. And, of course, what happens is, as time goes by, the tomorrow becomes today and you have to do even more.
What you’re doing as you engage in that process of continually easing monetary policy, is to create more and more concern that future demand will be weak and that lowers investment. And I think what we’ve done and what we’ve seen in the post-crisis period is very weak investment and what people have done is to say, well, rather than invest in capital equipment, we’ll hire more labour because we know that if there is a downturn coming towards us we can get rid of the labour quickly whereas we don’t want to be encumbered with a lot of capital equipment that turns out to be not very valuable.
Merryn: Yes. Do you think there is also an interplay, particularly in the UK, between productivity and the welfare system in the way that, particularly, our tax credit system encourages people to work part-time?
You know, I was very, very struck earlier this week when McDonald’s, which, as you know, is always criticised for its zero-hours contracts, announced that because everyone had their knickers in such a twist about the zero-hours contracts, they would introduce fixed-hour contracts. And the fixed hours that they offered people were 16 hours or 30 hours and, as you know, those are the number of hours that open the gateways to tax credits, depending on whether you’re in a couple or not in a couple.
And I looked at that and I thought, well, there it is laid bare, the interaction of the low-wage economy and the welfare system. And that has got to have an impact on productivity because you can argue about it endlessly but I think instinctively we know that a nation of part-time workers is probably less productive than a nation of fulltime workers.
Lord King: Yes. And it’s putting in artificial constraints on people’s choices about hours to work and hence the occupations that they may go to. And there’s no doubt that this interaction is important and, in fact, when tax credit systems have been introduced around the world, one of the concerns has always been that employers would work out how to make the taxpayer pay for a good deal of the effective wage.
Merryn: Which they clearly do.
Lord King: And the employers are sensible and they are smart and they can work out what kind of…
Merryn: And employees are sensible.
Lord King: Absolutely.
Merryn: I mean, this is not irrational.
Lord King: No.
Merryn: It’s entirely rational for McDonald’s and its employees to work together to define the hours that work for people to have the best possible incomes and lifestyles. So it’s not a criticism of their rational choices but it’s certainly a criticism of the system.
Lord King: Yes, and one the reactions of governments has been to keep pushing up the minimum wage to prevent employers offering wages and hours contracts that, you know, exploit the system of benefits with which they’re confronted and the difficulty there is that if you have that at too high a level, again, you are restricting the likely supply of jobs to people who would want to come in.
Merryn: Yes. So we’re ending up with bad policy on bad policy on bad policy which is pretty much the way policy normally works.
Lord King: No, indeed. Well, not always. I mean, I think that, you know, here’s a policy suggestion that I think ought to be manageable and would have real benefits which is that the Trade Round – known as the Doha Trade Round – which really got completely stuck in a rut because the major emerging market countries didn’t want to make further progress on agriculture, I think what the advanced industrialised economy should do, since they were the part of the world that had the financial crisis, is to say, well, we’ll now have conversations among ourselves with the industrialised world and sign new trade agreements focused on services.
And, indeed, the United States has proposed this, both with Asia and with Europe, and we need to make much faster progress on this because one of the things we learnt after the Second World War was that the expansion of trade is a real boost to productivity growth. People discover new products, new ideas, new processes. It stimulates thinking about how to improve what they’re doing.
Merryn: Gets competition going.
Lord King: Competition. And it enhances productivity growth. And I think that one of the things that would be completely manageable now would be to say, well, we really want to do this. This is something we have to do, and start to have serious discussions to free up trade and services and if we could do that then that would boost, you know, the supply side of the economy. And that would, in turn, lead people to believe, yes, maybe I will be better off in the future than I previously thought.
And if that’s the case they’ll be less concerned about repaying debt too quickly, more likely to spend today, and that will help bring about the sort of recovery that we want and with higher productivity growth, that recovery will then be sustainable.
The lack of real investments for ordinary people
Merryn: Do you think that there are any safe investments at the moment? I’m having an argument with another FT columnist at the moment who tells me that I’ve been complaining about low interest rates and the distortionary effects of them on saving and spending behaviour, etc, and he sent me an email saying that, my problem was the belief that people are entitled to a return on their savings, and they’re not. I take his academic point but I think that it’s very harsh.
Lord King: Well, I think that’s far too harsh because I don’t think that a market economy that’s in any healthy state shouldn’t… There must be opportunities to invest at positive, real interest rates. Now, they don’t have to be, you know, particularly high, 3% or 4% after inflation.
Merryn: That would work for me, I can tell you.
Lord King: No, well, I mean, that used to be the norm for 150 years, probably very much longer and, on that basis, it is possible to say, there is an incentive to save for retirement and also, interest rates at that level plus once you start to think about risk, the required rates of return on investment projects, it then becomes an effective discriminator between good projects and bad projects.
Merryn: Yes. But where is that place for the ordinary investor? You know there was, in one of your Bank of England quarterlies back in 2011, there was a terrifying chart that has always stuck with me about the Bank of England, the expectations for Quantitative Easing and it showed how nominal asset prices would soar above real GDP growth and then as QE was sterilised, reversed, whatever, nominal asset prices would, sort of, collapse right back down again, pretty much to run along with the GDP.
And so, you know, I keep thinking about that chart and, of course, that day, one way or another, will come to when the great asset boom caused by phenomenally loose monetary policy, will come to an end and that, presumably, will be before I retire as a double whammy. So what is safe for a saver today?
Lord King: Well, there are safe assets in the sense that you could invest in index-linked gilts or government assets. They will repay what they claim to be offering you. The trouble is they’re not offering very much and it doesn’t give you a high return and one of the difficulties of very low interest rates is that people are tempted to take risks that they wouldn’t otherwise have taken because of the promise that they might get a higher rate of return.
But it’s risky and if the risks materialise then you lose more than the lost opportunity of a higher return, you lose much of the capital as well.
Merryn: So all your money is in index-linked gilts?
Lord King: So I’m very fortunate to have a pension scheme from the Bank of England. And this is not a moment to, you know, to believe that there are easy investment opportunities out there.
Merryn: So you’re not planning on switching your final salary into a defined contribution and then going out and doing a buy-to-let portfolio?
Lord King: I’m certainly not. I have a defined benefit pension which I receive and I shall carry on receiving that so I’m not going to take risks with that.
Merryn: We often hear from readers who are keen to take out their pension money to start buy-to-let portfolios but we suspect that’s not a rational response to the environment?
Lord King: Well, it is very unfortunate that people think that there is some opportunity out there. They don’t really understand that someone has told them that they can make a lot of money by investing in a different opportunity and, of course, when you’re faced with, effectively, zero interest rates, the temptation… you want to believe that there is something out there.
Merryn: But there should be.
Lord King: But in a healthy economy there would be.
Should rates have been cut before the crisis?
Merryn: Rates? Would you set rates differently?
Lord King: Well, I discussed this in the book and I think the problem is to know what the counterfactual would have been and we did, in fact, discuss quite a lot on the Monetary Policy Committee, whether it was sensible to have low rates in order to maintain adequate demand in the economy because, you know, we did debate the idea of raising interest rates to try and shock people into spending less at home with the hope that this will bring down the exchange rate and replace the lower consumer spending with higher exports.
But if we were the only country to do that, the chances are that by putting up interest rates rather than the exchange rate being shocked to a lower level, it might actually have risen, exacerbating the problem. I think only if countries could have cooperated together, could we have been sure that they would have worked.
And that failure to cooperate, I think, was part of the reason why countries kept on cutting rates to boost their own demand and, in fact, when everyone did that, it just made the whole problem worse.
The next crisis – and how to really create inflation
Merryn: Second question. Second important one is, it seems to me inevitable, even more inevitable now we’ve had this conversation, that there is another crisis coming. It seems unavoidable because your suggestions as to how we should avoid another crisis, while they would clearly work, I can’t see it really happening. Again, you saw it. I feel another crisis coming. What starts it? What do we watch for?
Lord King: I think the first signs of it will be the inability of borrowers to repay their debts. We’ve seen it recently in China with state-owned enterprises. We’ve seen it already in many cases in the Euro area, Greece being a good example but there are other potential sovereign borrowers who might find it difficult to repay and there are many banks that might find it difficult to repay.
So, if you add to that the problem of quite a lot of smaller emerging market economies that have borrowed, again, in US Dollars and have a currency mismatch between their borrowing and their lending and then you look again at the BRICS where this acronym which ten years ago represented the major emerging market economies Brazil…
Merryn: So dynamic and exciting back then, wasn’t it?
Lord King: Dynamic, exciting, the future will guarantee global growth. With the possible exception of India, they are all in bad shape, politically and economically. So the world is not in the sort of place that when we sat round the table in Washington in October 2008 and said, we will do what we have to do in monetary and fiscal policy and to ensure the financial system doesn’t fail, no one round that table thought that eight years later we would still be in a position of desperately having, you know, zero interest rates, negative in many countries, large amounts of quantitative easing, money creation.
And we did not believe that eight years on we would have failed to generate a world recovery. But that’s been the case and I think a non-economist would react to that by saying, well, I don’t really understand economics but surely monetary policy can’t therefore be the answer. And it’s only economists that seem to think it is.
Merryn: It is. Interesting. I know I said there were two more questions. There’s one tiny one. I also know you have to go but what about a big wave of debt forgiveness and I am sure you’ve read Adair Turner’s book and, for him, it’s so simple: one stroke of the pen, all the debt with the Bank of England is gone, the debt to GDP ratio collapses and we spend our way out of trouble.
Lord King: I don’t really understand how this can work. The money creation, whether it is in the conventional form of the central bank buying government bonds or whether it’s in the form of governments printing money and handing the money over to citizens…
Merryn: That’s the bit I’m hoping for. Vouchers.
Lord King: So the question is, is this really going to make you any better off? You will know the economy is no better off. I mean, there’s no productivity gained by just printing pieces of paper.
Merryn: And you will know that it’s not real money.
Lord King: And it’s not real money. And it’s actually identical to the idea of the government, today, cutting people’s taxes and selling bonds to finance that but selling it to the central bank which creates money. So we are already doing this. The real difference, I think, would be if people believe that the objective of printing money was something that was not being undertaken by the central bank – an independent central bank committee, to broad stability, but was being done deliberately recklessly, irrespective of the consequences for inflation.
Now, if that’s the idea which is to create people’s fear about future inflation, there’s a much simpler way of achieving this objective which is to abandon and abolish independent central banks and give politicians the power to set interest rates because I absolutely guarantee that the best way to raise inflation expectations would be to say that from tomorrow morning all decisions on interest rates will be taken by elected politicians and not independent central banks.
The best way for central banks to destroy their reputations
Merryn: I worry that’s a risk though, now we’ve been through of all this, you know, you could say, that central banks have lost an awful lot of credibility. People no longer believe in central banks and central bankers in the way that they used to. So they wouldn’t kick up at a change of policy like that in the same way they would have even three, four or five years ago, right?
Lord King: Well, certainly there is a concern in the United States that the Federal Reserve went beyond its mandate in the crisis. But I think, I mean, we, very carefully in the Bank of England, refused to go beyond our mandate. Politicians were often deeply unhappy about that. But we did not do things that we thought were equivalent to fiscal policy because they ought to be undertaken by the elected government.
Merryn: Quite right. Yes.
Lord King: And, I think that the risk to central banks is not that people will lose faith in them because of what they’ve done so far but if central banks were now to go further and do things which are, in effect, fiscal policy so some of the suggestions that the European Central Bank would buy private sector assets, for example, they would only do that because governments seem incapable of working together in the euro area to make a success of it.
But once the central bank inserts itself as a player like that, it’s moving away from a technical independent central bank, into a political actor and that is the way to lose your reputation.