Economic Viewpoint

Brendan Brown

Tuesday, June 7, 2011

British lessons in monetary failure

Key messages:
DEVALUATION AND QE PRODUCE STARKLY NEGATIVE RESULTS

 The IMF in its latest In many respects the UK is a basket case as to what is wrong with Bernanke-
report gives thumbs up ism. All the elements – inflation targeting, repudiation of automatic monetary
for further doses of QE control mechanisms which would have the central bank targeting monetary base
should the economic whilst leaving interest rates market-determined, non-comprehension of wider
aspects of monetary stability than just goods and services inflation, deflation
recovery weaken further.
phobia, principle of central bank infallibility, and legitimization of currency war
Yet they (IMF) offer no (competitive devaluations) - had all come together in the conduct of UK monetary
critical assessment of how affairs even before President Bush invited Professor Bernanke to pack up his bags
the UK version of and move from the Princeton Economics Department to the Federal Reserve.
Bernanke-ism – QE plus And what is the visible consequence of Bernanke-ism as applied in the UK?
aggressive currency Well, first there was the bubble economy of the last decade, featuring a gigantic
depreciation – has credit bubble alongside a consumer boom and commercial/residential real estate
actually fared. market boom and bust (except for the special case of London prime residential).
And so deep was the mal-investment during the bubble years that even now the
 In fact the experience of level of output in the UK economy remains some 3% below its 2007 peak. That
UK monetary and shortfall is all the more remarkable given the aggressive policies of QE and
economic outcomes currency devaluation (the two are opposite sides of the same coin) which were
during the past decade meant to powerfully stimulate a UK recovery.
provides a basket case of Instead, the main recovery story in the UK has been the return of inflation,
what is wrong with expected to peak this year at above 5%, and then sink back towards 2% p.a. by
Bernanke-ism! late 2012 or into 2013. At least, you might think, if there were going to be such a
gigantesque bubble and bust the UK could at least extract the benefit of long-run
price level stability from its woes. But no, the QE policies and aggressive
devaluation (under-written by the QE) have left the UK economy with an inbuilt
inflation momentum significantly higher than in other medium-sized advanced
economies around the globe.
And yet despite this fairly self-evident catalogue of failure the UK monetary
policy makers can take pride in the fact they are still getting good marks from the
IMF! In its latest survey of the UK economy (published yesterday) the IMF lauds
the conduct of policy by the UK monetary authorities and – wait for it! – exhorts
them to turn to a further dose of QE should the present recovery continue to
stutter. Well, the UK may be a bigger case of what University of Chicago
Professor Robert Aliber recently observed in connection with Iceland. He raises
the question “How did the IMF and OECD completely miss the implications of the
massive imbalances in Iceland (even as late as early 2008): staff from both
institutions visited Iceland once or twice a year”. And Professor Aliber continues,
This publication should not be “one of my economist banker friends commented – Darwin had to visit the
viewed as a ‘personal Galapagos to see phenomena that he might have observed in his backyard in
recommendation’ as defined by the England if they had not been obscured by a lot of clutter. And you had to go to
rules of The Financial Services
Authority.
Iceland in your hunt for a bubble and to identify its origin”.
The IMF scores such big misses in part because it purveys the same monetary
Contact: Brendan Brown doctrines as the flawed ones practised in the countries it visits. A journalist
Tel: +44 20 7577 2712 recently questioned whether Adam Smith or von Hayek would get a job today in a
Economic Research
US university given the dominance of econometrics and mathematics (tools which
Mitsubishi UFJ Securities they did not espouse). Well in similar vein, it is certain that a leading economist
International plc preaching a story of monetary stability and the role of monetary disequilibrium in

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creating cycles of asset inflation and deflation would not want to join the IMF and would not
be offered a job there. Indeed if somehow he or she got into that institution and then started
deriding “deflation phobia” and “inflation targeting”, the experience would not last very long!

And so returning to the IMF establishment as it is, let’s look at its contention that
Sterling depreciation as promoted by UK monetary policy (at least they call a spade a spade
here as against UK monetary officials who deny there is any connection between QE and
Sterling’s cheapness – and QE has not ended, all the vast purchases of gilts and the base
money created in the process are still out there) has helped to “re-balance” the UK economy.

It seems the IMF’s UK team have in mind here the transfer of resources from the once
bubble sectors to new sectors of the economy. Does it not occur to these IMF officials (let
alone the UK monetary officials) that “re-balancing” is a process best accomplished by private
market forces and depends on Schumpeterian “creative destruction”.

If the UK officials were serious about promoting the inevitably slow process of new
investment opportunities emerging and entrepreneurs/equity stake-holders becoming ready to
assume the risks, by far the most important consideration is the promise of long-run monetary
stability and low taxation and lack of regulatory interference? Short-term brilliance of tactics
in a Bernanke-ite currency war cannot produce meaningful medium-term results. And indeed
according the record so far the upturn of business investment – crucial to the re-building of an
economy after the disaster of credit bubble and bust – has been particularly feeble in the UK
relative to elsewhere in the OECD area.

Let’s turn finally to the trump card sometimes put on the table by UK monetary officials
and wider economic policy makers when all else is failing – “well, at least we kept outside
EMU”. In closer examination, this is no trump card, but at least it has been a stroke of luck
that the UK economy, borne down by such monetary woes of its own policy establishment’s
making, does not face the same scale of bills related to the insolvency of the periphery zone
countries as EMU members.

The trump card is no such thing. The really poignant question is how did the UK outside
EMU with none of the additional problems of building a framework for stability in a new
monetary union suffer even worse monetary instability?

And as a matter of historical record, the UK policy-makers did contribute to the flaws in
the EMU framework. So long as the UK kept the door open to EMU membership it negotiated
as a full partner in the run-up to EMU’s start. It has been well documented how the UK’s
insistence of low reserve requirements (in contradiction of Bundesbank practice) was a
decisive factor in the eschewing of monetary base control founded on high reserve
requirements in the new union. Under such a system, the extent of monetary instability
(reflected in credit bubble and real estate bubbles) during the first decade of EMU might have
been notably less than what in fact occurred.

Finally from the viewpoint of the EMU countries, there can be no luckier fact than the
UK not having joined. Just imagine the fall-out from a UK bubble and bust within the context
of EMU. Commentators now debate whether a run on Spain will eventually bring broad EMU to
an end. A run on a bubble-bursting UK inside EMU would certainly have done so and at a cost
to French, German and Dutch taxpayers which would transcend the giant bills they already
face over the long-run for the “rescue of the periphery” in its fullest sense (to include the re-
capitalization of their own failing banks).

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