Within two weeks in March, two publications came from the Bank of England which overturned the conventional wisdom of monetary policy and macroeconomic thinking of the past few decades. Yet the key elements of the contents of these two publications have been common knowledge in the post Keynesian community for many years.
The first came with the publication in the Bank of England Quarterly Bulletin of articles on the nature and endogeneity of money (and a video). The second came with the Mais Lecture delivered by the Governor of the Bank of England Mark Carney in which he argued that the narrow view of central banks as guardians of stable inflation as “fatally flawed,” as he unveiled a “transformative” overhaul of the Bank of England.
The endogeneity of money has been long known to post Keynesian economists and has formed the bedrock of their macroeconomic analyses for at least three decades. The practice of Central Banks has in effect similarly recognized endogeneity and the new consensus in macroeconomics did not mention money—money for this framework is a “residual.” The Bank of England was (not surprisingly) well aware of the endogeneity of money when it was instructed by the monetarist Thatcher government to pursue the task of controlling the money supply, which proved impossible since the money supply is endogenous!
The highlights of the article in the Bank of England Quarterly Bulletin are that “one common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them” but rather that “lending creates deposits”; and “Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money—the so-called ‘money multiplier’ approach” (McLeay, Radia and Thomas, 2014, p. 15). These are propositions, which have dominated much of mainstream macroeconomics and its thinking. At one level, the difference between treating money as exogenous and treating money as endogenous may appear a technical issue, which leads to different monetary policy instruments (control the money supply in the first case, set interest rate in the second). Yet recognizing this endogeneity of money fits with the post Keynesian view that investment, provided it can be financed, generates savings—and not the reverse of savings generating investment. It removes any notion that inflation is “too much money chasing too few goods,” but rather inflationary processes themselves generate rising stock of bank deposits.
Delivering the Mais lecture in London, the Governor of the Bank of England said orthodox inflation targeting regimes had become a “dangerous distraction” in the previous decade, causing policymakers to miss the rapid accumulation of dangerous risk in the financial system. “Those changes reflected the belief that price stability was the best contribution a central bank could make to macroeconomic stability and by extension to the broader public good. This represented a deconstruction of the old model of central banking. In my view, while there were enormous innovations of enduring value during this period, the reductionist vision of a central bank’s role that was adopted around the world was fatally flawed. In particular, it failed to recognise that financial stability is as important an objective of macroeconomic policy as price stability, and it downplayed the interrelationships between the two.”
The Governor proceeds to suggest that “The Bank of England has now been tasked by Parliament with operating these prudential tools. Our broad range of responsibilities now include: supervision and regulation of financial market infrastructures; acting as lender and market maker of last resort; the design and operation of macroprudential tools; recommendations on core elements of financial reform; and the resolution of failing financial institutions. A return to a broad role is welcome.”
Inflation targeting has long been doubted by post Keynesians for a range of reasons—ineffectiveness being one of them. From early on in the inflation targeting era, we expressed doubts on the wisdom of “independent” central banks (they have not been such a major success since inflation level, persistence in inflation, and inflation volatility seem to have very little to do with the independence of central banks), and on the mechanisms which were supposed to lead from varying the interest rate to the control of inflation. We also expressed doubts on the empirical validity of those mechanisms and on the record of inflation targeting reaching low inflation. One of the more serious elements was the portrayal of price stability as implying financial stability, and the idea that asset price inflation could be addressed by tinkering with the measure of inflation to include asset prices as well as those of goods and services.
In the UK, the inflation targeting era in effect ended in the aftermath of the financial crisis. The policy interest rate has been kept at 0.5% for now five years in the face of an inflation rate which has been well above the 2% target for much of that time—on a quarterly basis continuously from four years ending in 2013Q4. The necessary letter from the Governor of the Bank of England to the Chancellor of the Exchequer seeking to explain or excuse the above-target inflation rate was sent each quarter for 4 years. The responsibilities for financial regulation shifted from the Financial Services Authority to the Bank of England; financial stability was included as a key objective of the Bank of England in the June 2010 Act.
The time has now surely come to recognize the end of the inflation targeting era, to establish financial stability as the crucial objective of the Bank of England, and to bring an end to the so-called “independence” of the Bank of England. Similar changes are required for many other central banks, and the European Central Bank is the key example here; but the prospects for that move are rather slim!
Mark Carney, “One Mission. One Bank. Promoting the good of the people of the United Kingdom,” Mais Lecture at Cass Business School, City University, London (available at: http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech715.pdf).
Michael McLeay, Amar Radia and Ryland Thomas, “Money creation in the modern Economy,” Bank of England Quarterly Bulletin, March 2014.
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