How to cope with the new normal: First, do no harm

Newly-qualified doctors are required to swear the Hippocratic Oath before they can practice.  Should members of the Monetary Policy Committee not do likewise?  Doctors need to have some idea of how the body works, but they know that there is a lot they don’t know, and they need to be wise and humble enough to know the limits of their understanding.

The same applies in economics. Events a decade ago exposed the failings of economists and central bankers mercilessly.  They are having to reconsider a great deal of what they previously regarded as accepted doctrine. That means reconstructing the foundations of the models which underlie the forecasting and thinking of central banks. Some of this work is being done in central banks, but at least as much in universities and research institutes, where the task can be approached with more detachment and less baggage from the past.

It will be many years before macro-economic models can command anything like the degree of confidence that they enjoyed in the early years of this century. In the meantime, central bankers retain their heavy responsibility for managing the currency. The present environment – the new normal if you like – is one where the public’s confidence has been shaken not only in financial institutions, private and public, but also, we fear, in money and financial assets more generally: hence the continuing demand for houses, not just as places to live but as stores of wealth.

How should monetary policy be conducted in this environment? The key, we suggest in our article for the August NIESR Review, should be rebuilding confidence. That implies the following:

1. Retain the inflation target. Whatever else has gone wrong, inflation has remained restrained. A resurgence of inflation would make a bad situation very much worse. Resist suggestions that the inflation target should be increased.
2. Acknowledge that monetary policy can no longer be conducted in isolation from other financial policies, such as macro-prudential, government debt management and fiscal policies, or from financial regulation. But at the same time, make sure that the allocation of responsibilities is clear, so that the system does not succumb to paralysis, as it did in 2007, because everyone has to consult everyone else and no-one is in charge.
3. Reverse some of the emergency measures which were taken in the crisis, which are now creating serious difficulties. Specifically, begin, very gently, the process of raising interest rates. That would have several benefits. It would help reduce the massive pension fund deficits which induce extreme caution among corporate treasurers and retard investment. It would help the banks restore their profitability and reduce the risk that they simply abandon important parts of their businesses. It would, it is true, be a blow to some households’ finances, though it would help others’: but ultra-low interest rates cannot possibly last forever, and it would be less disruptive to start to raise them very gradually now rather than abruptly in response to some unforeseen future setback. And it would, no doubt, expose the poor underlying quality of some bank loans. But again, that will have to happen sooner or later, and bitter experience teaches us that it really does not help to delay dealing with deeply troubled loans.
4. Starting to reverse quantitative easing is also important.  Reversal will take many years. In the immediate future, the gilts that the Bank of England bought in QE should be removed from its balance sheet by being transferred to the Debt Management Office, so that the Bank can use its balance sheet again if it needs to as an auxiliary weapon of monetary policy.
5. The government had no choice but to rescue the banking system after the banking crisis.  But doing so created massive moral hazard. As a result, the rules of banking had to be changed.  There has been an avalanche of new regulation worldwide, all of it drafted in haste. Its full effects are not yet clear, but it will certainly have a great many unintended consequences, some of them counter-productive. The regulatory apparatus should be kept under constant review, so as to ensure that it is doing what it supposed to do, no more and no less.
6. The tax system  – not just in the United Kingdom – allows companies to deduct interest paid on loans from taxable income, but not dividends paid to shareholders.  There is thus a powerful bias in favour of debt financing and against equity. This is a serious menace to financial stability; had it not existed, the banks would probably have had much more equity before the crisis and been much less fragile. Removing the bias would make the world a much safer place.

William Allen (NIESR ) and Peter Sinclair (University of Birmingham) co-authored the article  “Monetary Policy Normals, Future and Past“, which appeared in NIESR’s August Review.