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Sancho Panza

Douglas Carswell-Mending Monetary Economics.

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Some good stuff in this paper by Carswell I was sent by a colleague.It's definitely worth half an hour if you're interested in a pretty thorough analysis of how we got here.

Politeia 16/1/14

'In recent decades, monetary policy, it was often said, has been more lax than it should have been because of politics. First in 1980, then just before the 1983 election, and again in 1987-88, interest rates were supposedly eased because of political considerations.

To prevent this, it was said, those who set interest rates needed to be independent. And so initially under the then chancellor Kenneth Clarke, the Bank of England was given greater freedom to set rates independently of the Treasury. Gordon Brown formalised these arrangements in 1997 when he granted the Bank of England independence. 'Now' wrote Mervyn King about independence 'we really did have a chance to show what the Bank of England and price stability could do for this country'.13 And they did.

Unaccountable central bankers presided over an even greater monetary policy disaster than the ERM debacle. Given independence in order to ensure that they could set a sufficiently tight monetary policy when needed, the Bank of England has in fact done the opposite. Once independent, the central bank's monetary policy has been consistently loose.

To be sure, the Bank seemed to achieve price stability initially, meeting its target consistently in the first ten years after 1997. Inflation, which had averaged 12 per cent in the 1970s and 6 per cent in the 1980s, has averaged 2.1 per cent in the twenty years since inflation targeting began. Movements in interest rates by the Bank's Monetary Policy Committee seemed to anticipate perfectly future changes in output, moderating the ups and downs. Interest rate targeting produced the longest period of sustained GDP growth in our history. The technocrats seemed to have found the perfect solution to the monetary policy question. And yet all was not well. Inflation did not turn out to be the ideal target after all.

Unfortunately, real life, unlike economic theory, turns out to be more complicated than that. Despite the conceit of central bankers, they simply were not able to assemble in one spot all the data they needed to be able to know how to set interest rates. The late 1990s saw a massive expansion in the industrial output of China and other countries. By 1999 – two years after the Bank of England was made independent – this was starting to have a significant effect on the UK economy. China's industrialisation meant a flood of cheap imports into the UK. While this might have been great news for consumers, it had the effect of pushing down the price of imports and meant that inflation was considerably lower than it might otherwise have been. Because inflation was lower than it might otherwise have been, the central banker targeting inflation kept interest rates lower than they might otherwise have done.

Worse, although the extended inflation measures, RPIX and CPI, accounted for increases in the price of household items, it did not properly factor in the price of houses. Nor indeed various other assets, the price of which was rising on the back of an asset bubble caused by low interest rates.

In other words, inflation was not telling the central bankers all that they subsequently discovered they needed to know in order to make the judgements about monetary policy that they were making. Indeed, they ignored evidence that suggested they might have got it wrong. While the MPC could see house prices rising relative to incomes, they chose to see this not as evidence of loose monetary policy creating an asset bubble, but as evidence that long term interest rates would, in future, be low. Mervyn King has since tried to suggest that the housing bubble formed because householders mistakenly extrapolated past increases in house prices into the future. If that was partly the problem, perhaps it was because technocrats in Threadneedle Street had sent misleading signals to millions of homeowners. However successfully RPIX and CPI were targeted before 2007, it did not prevent the building up of a lending and property bubble.

An excessively loose monetary policy produced the Brown bubble. Between 2001 and 2008, asset prices soared. Output rose. Debt expanded. Convinced that the additional tax revenue pouring in was a permanent addition to the tax base, Gordon Brown went on a spending spree. Fiscal incontinence, combined with monetary madness produced a period of unsustainable growth and the Brown bubble. 'But there was nothing wrong with inflation targeting', I was once told by a Treasury expert. 'It worked fine until 1999, and only started to go wrong because the CPI target was too narrow'. Too narrow?

The cheap money delusion

Having bought into the mistaken view that central bankers and low interest rates could conjure up prosperity, the Conservatives failed to offer any alternative as the Brown bubble ballooned. Few of them seemed even to recognise what was happening.14 In the 2001 and 2005 manifestos, the party leadership made clear that they supported both an independent Bank of England and low interest rates.

Cheap money and an excess of cheap credit caused a number of problems to build up between 2000 and 2007.

Malinvestment: Holding interest rates down in the early noughties made it much harder for businesses and householders to assess risk. Removing the moderating influence of higher interest rates meant that everything started to look like a safe bet. As a consequence, a lot of bad investment decisions were made. Credit and other resources were misallocated.  Low savings: Low interest rates also discouraged people from saving. With less interest paid on money sitting in a bank balance there is less reason to keep it there. So savings rates declined.  Over consumption: Easy money encourages consumption. Excessively low interest rates meant excessive consumption relative to production.

Balance of payments: With Britain over consuming and under producing, Britain's balance of payments in the noughties deteriorated. Low interest rates, just as they had done when Nigel Lawson was chancellor, had started to suck in imports faster that Britain was managing to export.

Asset bubble: With the cost of borrowing so low, people had an incentive to take out loans and invest the money in assets, which they hoped would appreciate in value. And this is what started to happen with everything from houses to shares.

Zombie firms: Malinvestment should be thought of as economic cholesterol. It builds up in the arteries, a diet of cheap credit laying down one layer upon another.

This meant that there are now an awful lot of zombie firms – businesses with large debts that they are able to service – thanks to low interest rates – but cannot hope to pay off. A period of prolonged low interest rates traps these firms. They cannot prosper, and are doomed. Yet low rates prevent these 'undead' firms from folding, and the reallocation of resources that would follow from happening.

Thanks to the malinvestment, almost one in ten UK firms is now a zombie firm. According to a recent survey, 9 per cent of UK businesses are only able to service the interest on their debts, but not the debt itself.15 That is 160,000 companies – able to keep out new competitors, but not grow.

The Osborne boom?

But not all is quite as healthy as it might at first appear. Private consumption has risen, but so too has private debt. Meanwhile, investment has fallen. The rise in output thus far has been largely driven by consumer spending. Household spending rose by 0.8 per cent in the three months to the end of September 2013, according to the Office of National Statistics. Household spending was 2.4 per cent higher at the end of 2013 than it had been a year before. UK household debt has increased to a record £1.43 Trillion. That is higher that it was in 2008 when Lehman Brothers collapsed. Car sales have grown for nineteen months in a row, according to recent reports. Yet three out of four of them were bought with borrowed money.

The nascent Osborne boom is yet another credit induced bubble. It will end the way all bubbles end. 'Wrong, Carswell!' the government's defenders will say 'The money measures are falling now. How can this possibly be a credit induced bubble when M420 is contracting?!' Far from having created a credit induced boom, they say, the government has got it spot on. For the first time in a generation we finally have a monetary policy that works.

Although the traditional broad money aggregates such as M4 are growing steadily, other measures tell a different story. What is happening to M4 today no more gives us a complete picture by which to direct monetary policy than M3, or exchange rates or CPI once did. Divisia Index measures money more widely since it gauges not only broad money, M4, but factors in how useful-or easily accessible- money is to spend. For this reason, Divisia is considered a better indicator of likely future spending, than just M4.

Far from stabilising the money supply the way that the monetary authorities imagine they are doing, they have been presiding over a rapid increase. Other measures of broad money 'reveal that the money supply in October 2013 jumped to a growth rate of 12.99 per cent compared to October 2012' according to Dr Anthony Evans of the ESCP Europe Business School. We are indeed at the start of yet another credit induced boom.

In fact, reserve requirements were removed. Banks today are required by regulators to hold instead a portion of the loans as equity or capital. These capital requirements under the Basel III rules require capital ratios of 9 per cent. If anything, the switch from reserve requirements to capital ratios as the basis for regulation meant even less restraint upon the money multiplier than there was previously.

If you wish to control the supply of money you can do one of two things. You can raise the price of credit, to try to price people and businesses out of borrowing. Or you can try to rein in the money multiplier.

Monetarism is dead

Monetarists talk of 'controlling' the money supply. Control, for them, means managing the supply of and demand for money to ensure output expanded in line with trend growth. What the monetary authorities have been doing for the past thirty years has less to do with equilibrium, and more to do with stimulus. What was once a tonic, used intermittently to perk up economy, has become a drug, to which we have become addicted.

Yet from 1997 onwards, the Bank of England was not merely using interest rates to respond to ups and downs. They were trying to pre-empt ups and downs, and doing so with only cursory regard to any money targets. Both in Britain and America, interest rates were lowered at the first sign of economic trouble. Rates were lowered during the first Gulf War; again after the Long Term Capital Management hedge fund collapsed; again after the dot com bubble burst; and again after 9/11. Whatever the problem, low interest rates seemed to be the answer.

In theory, the Bank of England was being asked to set interest rates in order to manage inflation. In practice the Bank was conjuring up cheap credit as a form of economic stimulus. Monetarism has therefore been dead for nearly three decades.'

Edited by Sancho Panza

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Assuming that IRs were the only tool in the box, what would the outcome have been regarding Chinese imports and balance of trade/payments in general if rates had been raised in, say, 2003?* I can see that we would have bought fewer imported goods, but wouldn't they still have been the best deal for the consumer? Would higher IR have made Chinese goods more expensive, thus increasing demand for domestic goods? Sorry, bear of small brain.

* I'm being generous - it should have been fairly obvious in 2002 what was happening

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Assuming that IRs were the only tool in the box, what would the outcome have been regarding Chinese imports and balance of trade/payments in general if rates had been raised in, say, 2003?* I can see that we would have bought fewer imported goods, but wouldn't they still have been the best deal for the consumer? Would higher IR have made Chinese goods more expensive, thus increasing demand for domestic goods? Sorry, bear of small brain.

* I'm being generous - it should have been fairly obvious in 2002 what was happening

I think the more general point is that by focusing solely on inflation targetting,the BoE missed the elephant in the room.

'Britain has experienced four periods of sustained economic contraction since the early 1970s.8 Each time, a downturn was preceded by the same thing: an unsustainable credit-induced boom. The cause and the justification for the credit bubble might have differed, as we shall see. The effect, however, was always the same; a sharp contraction in GDP.

Why is the current chancellor repeating not only the monetary mistakes of his predecessor, making some of the errors made by successive chancellors? Because, fundamentally, free market thinkers have failed to develop an alternative to many of the Treasury orthodoxies that envelop whichever minister sits within it.'

The point he made early on in the paper was that the move to inflation targetting occurred after the ERM debacle when targetting the sterling/DMark rate had usurped targetting the money supply in the Chancellor's affections.

'The then chancellor, Nigel Lawson, did not agree. Lawson felt that setting interest rates to meet money targets was no longer working. The monetary targets were moving. The published money targets had, he felt, lost credibility. He was on the lookout for an alternative benchmark. By early 1987, it seems, Lawson had convinced himself that targeting the exchange rate was a better way of managing the money than focusing on internal measures of money that kept moving. Having stopped targeting M3 as early as 1985, in March 1987 he began surreptitiously to shadow the Deutschmark. This was, he convinced himself, 'exchange rate monetarism'.'

Then that fell apart.

'On 16th September 1992, Britain not only fell out of the ERM. The notion of managing the money through exchange rate targeting fell apart, too.

In politics, more often than is widely understood, politicians take up an idea not because they have pondered long and hard. But because they need a policy, and it is there.

In the weeks before Britain's ejection from the ERM, the Bank of England's International Division just happened to have been studying the New Zealand model of monetary management using inflation targeting. A study commissioned out of intellectual interest was seized upon and became the new orthodoxy.

According to Mervyn King, speaking in 2012 as Governor of the Bank of England, three weeks after Sterling was forced out of the ERM, 'newspapers reported that for the first time monetary policy in Britain would be based on an explicit target for inflation'.12 And how did this decision come about? Well, Mr King continued, 'After debates within the Treasury and the Bank of England, the answer emerged – the inflation target'. Having jettisoned the idea – or rather been jettisoned by the idea – that we should steer monetary policy so as to manage the external value of the currency, those in government circles effortlessly took up the idea that we might do so by managing the internal value of the currency. From one folly, they lurched to another.'

Edited by Sancho Panza

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Is inflation targeting necessarily inadequate? The problem seems to have been dishonesty/stupidity about what assets and goods were included in the assessments.

To put it another way, credit fuelled booms must lead to inflation in something, so constricting the range of "something"s you monitor is asking for trouble. That said, not sure how you monitor inflation in stocks and shares (or, rather, how you distinguish it from genuine growth).

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Is inflation targeting necessarily inadequate? The problem seems to have been dishonesty/stupidity about what assets and goods were included in the assessments.

It doesn't seem to have done the Germans any harm over the last 70 or so years.

I agree, they were rigidly tracking one measure of inflation without looking at the effects on the rest of the economy. Normally this wouldn't be too much of a problem but unfortunately they started tracking RPI/CPI just as the China effect started to push prices down.

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I remember very well when Gordon removed house prices from the calculation used by the BoE. Inflation targeting is all very well, except Gorgon nobbled that plan for his own electoral calculation.

The thing that really winds me up about modern politics is how both sides would happily let this country burn if they thought it'd win them an election and let them be king of the cinder.

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To be sure, the Bank seemed to achieve price stability initially, meeting its target consistently in the first ten years after 1997.

It's not as straightforward as that as there was a lot of manipulation of the indices constituents as well as changing the target index when inflation in one index started to get out of control. The article seems to have a lot of rewriting of history in it apparently to make the BoE's performance seem a lot better than it actually was - from an inflation and general economy point of view.

It might have been more accurate to say:

To be sure, the Bank seemed to achieve price stability initially, meeting its target consistently in the first ten couple of years after 1997 and only now and then afterwards.

Inflation, which had averaged 12 per cent in the 1970s and 6 per cent in the 1980s, has averaged 2.1 per cent in the twenty years since inflation targeting began.

That'll include the period before 1997 when the BoE was relatively successful in its targeting - before the job was officially handed over so that would bring the average down. I suspect that the average is significantly higher than that after 1997 to date.

The paragraph below describing the reasons for giving the BoE "freedom to set rates independently of the Treasury" seems a reasonable summary of the basic reasons - although they also often used to compare Germany's economic performance (as well as that of the US) with the UK's dismal economic performance to try to justify attempting better inflation control.

'In recent decades, monetary policy, it was often said, has been more lax than it should have been because of politics. First in 1980, then just before the 1983 election, and again in 1987-88, interest rates were supposedly eased because of political considerations.

To prevent this, it was said, those who set interest rates needed to be independent. And so initially under the then chancellor Kenneth Clarke, the Bank of England was given greater freedom to set rates independently of the Treasury. Gordon Brown formalised these arrangements in 1997 when he granted the Bank of England independence. 'Now' wrote Mervyn King about independence 'we really did have a chance to show what the Bank of England and price stability could do for this country'.13 And they did.

Except no they didn't.

Edited by billybong

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Zombie firms: Malinvestment should be thought of as economic cholesterol. It builds up in the arteries, a diet of cheap credit laying down one layer upon another.

That sounds like an optimistic definition of a zombie firm. Zombie firms are more like firms that have already expired but the credit is still being issued to them. There's plenty of them in the UK.

Carswell does recognize that elsewhere in the report so why it's not in the definition is anyone's guess.

Edited by billybong

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'blah blah blah...what the Bank of England and price stability could do for this country'.

Soon after seizing control of the printing presses they created the Boskin commission. The stated objective of the Boskin commission was to fudge the CPI data, as central banks were being made to look incompetent. Since then the doubling of prices in five years is recorded as 3% inflation. Having completed this fraud they began to pump out self congratulatory propaganda. Worse still, they began to believe their own ********. The ongoing great depression is the result.

The real question is when the charlatans, fraudsters and useful idiots will be replaced with competent people. When that happens the depression will end quickly.

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The thing that really winds me up about modern politics is how both sides would happily let this country burn if they thought it'd win them an election and let them be king of the cinder.

"It is better to reign in hell than to serve in heaven" - this quote comes to my mind quite often of late and does more or less sum up the mindset of the political class- they don't give a sh*t about any one or any thing except their own power and delusions of grandeur.

Osborne and Cameron see themselves as radical game changers who will create a new paradigm for Britain- that's the fantasy- the reality is a credit fueled 'recovery' that will spawn a new economic meltdown as soon as it runs out of steam- they think they are Margaret Thatcher but in reality are Gordon Brown! :lol:

Let's at least enjoy the irony- there's precious little else to enjoy as these two buffoons run through new labors playbook of boom and bust.

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Is inflation targeting necessarily inadequate? The problem seems to have been dishonesty/stupidity about what assets and goods were included in the assessments.

To put it another way, credit fuelled booms must lead to inflation in something, so constricting the range of "something"s you monitor is asking for trouble. That said, not sure how you monitor inflation in stocks and shares (or, rather, how you distinguish it from genuine growth).

Inflation targetting is one tool of many in managing an economy.As you point out,it's easily manipulated and hasn't a great record in preventing asset bubbles or maintining price stability if you spend 50% of your income on food and not sofas.Other mechanisms(not an exhaustive list by any stretch)-fiscal/banking regulation/currency management etc etc.

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Inflation targetting is one tool of many in managing an economy.As you point out,it's easily manipulated and hasn't a great record in preventing asset bubbles or maintining price stability if you spend 50% of your income on food and not sofas.Other mechanisms(not an exhaustive list by any stretch)-fiscal/banking regulation/currency management etc etc.

Inflation targeting = central planners tinkering stuff which they don't and cannot possibly understand.

The systems they are attempting to monitor are far too vast, complex and varied that the idea of adjusting an interest rate can make things better is pure fantasy.

Inflation targeting was completely blind sided by cheap goods coming from elsewhere, leading to a huge trade deficit and a local credit bubble. The whole appearance of stability was an illusion - it was short term gain, for long term pain. Like most central planning, in fact.

Edited by Traktion

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The other thing that is only touched on late in the report is the role the banks themselves played in the economic collapse with all the fraud and dodgy lending etc. Seeming to imply earlier in the report that the banks were victims of the collapse (rather than one of the main reasons) needing bailouts etc

One of the prime reasons for the economic collapse (apart from the BoE failures and the political failures) seems to have been reduced to:

Break up the banks

Banking in Britain is a cartel. It needs to be broken up.We cannot be certain if being part of a cartel makes banks more likely to extend credit recklessly, but the cartel has undoubtedly behaved recklessly.

It's only just better than saying nothing about it. The banking cartel has long been recognised.

The success that the Bank of England has had in reducing repeated failure of the BoE to control inflation seems to have come at a terrible price; booms and busts in the banking system and credit markets.

Corrected.

Britain is already ensnared in the trap.

Should it struggle on, tangling itself even further into a web of malinvestment, or look for a way out?

‘Sooner or later foreign [traders] will work out that the only thing we can do with our debt is inflate it away’ Moulton continues. ‘The day they realise that, rates will start to rise’.

That seems to be an almost incredible thing to say. For sure "foreign traders" will have worked out that already and the question is why aren't rates rising already. Has nobody asked foreign traders? Didn't he ask them?

At least Carswell has tried to address some of the UK's economic problems in the report and makes many useful and important observations. On the other hand there have been similar reports over the decades saying more or less the same stuff but to date they've all resulted in no basic policy change to kicking the can. It would also have been interesting to hear his opinion in the report why the current political system fails time and time again to persist with any economic policy because of election expediency and how to overcome that massive flaw in the system.

Giving the BoE "independence" was supposed to cure that and that has transparently and openly failed YET AGAIN and indeed the problem is worse than ever with Carney blatantly right under the political thumb.

Edited by billybong

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If the Conservative party had any sense, they would make this guy their leader. ....... But they don't have any sense.

That guy actually seems pretty damn sensible, clearly he'll never be allowed to get anywhere near real power. dry.gif

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That guy actually seems pretty damn sensible, clearly he'll never be allowed to get anywhere near real power. dry.gif

He sets out his stall as a Thatcherite. When pressed three times to recognise that Thatcherism is the root of the credit problem, he reverts to "Gordon Brown did it".

Plus he looks like Lawrence Dallaglio:

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He sets out his stall as a Thatcherite. When pressed three times to recognise that Thatcherism is the root of the credit problem, he reverts to "Gordon Brown did it".

Plus he looks like Lawrence Dallaglio:

So not perfect then (didn't think so anyway because according to the vid he apparently thinks we currently have a free market rather than a series of vested interest cartels) but still seems better than the current shower.

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He mentions housing and housing bubbles several times in the report but doesn't get to grips with the true impact housing bubbles and crazy house prices have on the economy. He implies that the housing bubbles are a consequence of the daft policies rather than a core reason for the poor performance of the UK economy over decades. He really doesn't go into the impact of housing at all - it's mainly skirted around.

The report highlights quite a few problems but really says nothing that has not already been highlighted time and time and time again in various reports about the UK economy for decades now.

No - it's matterless if he was leader of whatever party as he really hasn't dealt with the banking, political and economic etc fundamental problems any more than similar reports in the past. Of course give him leadership of the Conservatives but in that event for sure little or nothing will change. It will be revert to the same old same old election expediency. It's endemic with all of them.

The UK does need real change and that won't ever be forthcoming from anywhere within the ConLabLib party.

Edited by billybong

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He mentions housing and housing bubbles several times in the report but doesn't get to grips with the true impact housing bubbles and crazy house prices have on the economy. He implies that the housing bubbles are a consequence of the daft policies rather than a core reason for the poor performance of the UK economy over decades. He really doesn't go into the impact of housing at all - it's mainly skirted around.

The report highlights quite a few problems but really says nothing that has not already been highlighted time and time and time again in various reports about the UK economy for decades now.

No - it's matterless if he was leader of whatever party as he really hasn't dealt with the banking, political and economic etc fundamental problems any more than similar reports in the past. Of course give him leadership of the Conservatives but in that event for sure little or nothing will change. It will be revert to the same old same old election expediency. It's endemic with all of them.

The UK does need real change and that won't ever be forthcoming from anywhere within the ConLabLib party.

I wouldn't trust any career politician to admit to or follow through all of the underlying issues that need sorting out. Direct democracy to bypass the lot of them is the only way to real change IMO. Still, if you have to vote for a lizard, may as well be the most sensible lizard going ;)

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He sets out his stall as a Thatcherite. When pressed three times to recognise that Thatcherism is the root of the credit problem, he reverts to "Gordon Brown did it".

+1

The myth of Thatcher as a free marketer never dies. Thatcher was the banksters ally for untrammelled usury and bankers risk transferred to the taxpayers via the Big Bang. We are where we are now largely because of Thatcher and her disciples, including Nulab.

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