The satirist Peter Cook had a famous skit in which he played a second world war RAF officer sending a pilot on a suicide mission to Germany.
“I want you to lay down your life, Perkins,” Cook’s character says. “We need a futile gesture at this stage. It will raise the whole tone of the war. Get up in a crate, Perkins, pop over to Bremen, take a shufti, don’t come back.”
There are some among Mark Carney’s critics who think the actions taken by the Bank of England last week fall into the “futile gesture” category. They dispute the governor’s assertion that the package of stimulus measures agreed by the monetary policy committee was “timely, coherent and comprehensive”. On the contrary, they have argued that the Bank is being over-hasty and is over-confident in its ability to make a difference to the economy as it adjusts after the Brexit referendum.
Most of this criticism is unfair. As Carney made clear last week, there are limits to what the Bank can do with the tools at its disposal. It can cut the cost of borrowing marginally, take steps to keep credit flowing from the commercial banks to households and businesses, and it can drive down the level of the pound. But it can’t cut VAT or exploit ultra-low interest rates to invest in long-term public spending projects. These are matters for the Treasury. Nor can the Bank solve the deep structural problems that have held back the economy for decades: an over-reliance on the property market as a source of growth; an undersized productive sector that results in a chronic trade deficit; a lack of skills and investment that manifests itself in a poor productivity record.
The truth is that monetary policy – which is what the Bank does – has been overburdened ever since the financial crisis erupted nigh on a decade ago. It was then assumed by finance ministers that they could leave most of the heavy lifting to central banks. The first line of defence would be cuts in interest rates. The second line of defence would be quantitative easing: measures that would pump money into the economy and drive down long-term interest rates. The third line of defence would be incentives to persuade the banks to lend money. As a result of all this, growth would pick up to its old pre-crisis levels; tax receipts would come rolling in and governments could set about reducing the big budget deficits that had been amassed during the crisis.
There have been times when this approach has worked well. In the aftermath of Britain’s departure from the exchange rate mechanism in 1992, monetary policy was loosened aggressively and rapidly. Official interest rates came down from 10% to 6% in a matter of months, and the pound fell by 15%, boosting exports.
At the same time, the then Conservative government led by John Major, introduced a couple of tough tax-raising budgets that sucked demand out of the economy. The result was a strong and balanced recovery in which consumer spending was held in check by the tax increases but where investment and exports were stimulated by lower interest rates and the weaker pound.
So why did the same recipe not work after the financial crisis? One reason was that the crisis was deeper and more widespread. World trade growth collapsed and has never really recovered to its pre-2007 levels. That has made it harder for countries to generate export-led growth, even when their currencies had fallen in value. Similarly, those firms motivated by lower interest rates to borrow for new investment projects found that banks – badly damaged by the crisis – were unable or unwilling to lend. Finally, the 15 years between Black Wednesday and the start of the financial crisis saw household indebtedness rise sharply, especially in the Anglo-Saxon countries, and there was less appetite for fresh borrowing even at historically low rates.
Monetary policy, in other words, was not nearly as potent as central banks and finance ministries thought it would be. So, when finance ministers such as George Osborne raised taxes and curbed spending, it did not lead to the balanced growth seen in the mid-1990s; it brought the economy to a standstill. The upshot has been that interest rates have remained lower for longer than envisaged back in early 2009, when they were cut to what was considered the emergency level of 0.5%. And the failure of monetary policy to deliver a sustained, balanced recovery has meant deficit-reduction plans have had to be torn up too.
Between them, the Bank of England and the Treasury did manage to generate a pick up in growth from early 2013 onwards, but only by pumping up the housing market with cheap money and government subsidies. By late last year, even before a date for the EU referendum was known, there were signs that the recovery was running out of steam.
The obvious downside of the Brexit vote is that it threatens to turn a slowdown into a recession. The upside is that it provides the opportunity – available when the economy has been hit by a profound shock – to rethink policy.
Criticism of the Bank for adopting the “sledgehammer” approach favoured by its chief economist, Andy Haldane, is wide of the mark. The argument is that households and businesses will think things must be really bad if Threadneedle Street feels the need to act with such force. But it seems more likely that the Bank will have provided reassurance that it is doing its best to limit the fallout from Brexit. It seems wholly appropriate to try to shore up confidence.
At the same time, it needs to be recognised that there are potential side-effects to the Bank’s stimulus package. By signalling so clearly that official interest rates are likely to be cut again before Christmas, the Bank is inviting investors to sell pounds. A lower exchange rate will make imports dearer, pushing up inflation. At present, wages are rising slightly faster than the cost of living, leading to rising real incomes. But living standards could start to fall if inflation picks up at the same time as slower growth leads to less generous pay awards.
In reality, Carney has bought Philip Hammond a bit of time. The Bank can only really generate a more modest version of the muted and unbalanced recovery seen after the great recession of 2008-09. A cut in VAT would do more to boost confidence and demand than a quarter point bank rate cut, and would bear down on inflation. Borrowing for long-term capital projects has never been cheaper. The Treasury could issue infrastructure bonds and get the Bank to buy them. There is little more that Threadneedle Street can do. It is now up to the new chancellor to seize his moment.
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