Sunday, November 06, 2011
Shadow MPC votes to hold rates, warns on QE
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its latest quarterly gathering on 17th October, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one that Bank Rate should be held at ½% when the official rate setters make their announcement on Thursday 10th November.

The dissenting SMPC member wanted to raise Bank Rate to 1% with immediate effect. The main reason most SMPC members voted to hold in November was concern over the potential adverse consequences of the turmoil in the Euro-zone for Britain’s exports and UK banks. Several of the holds thought that the UK inflation situation was bad enough to have justified a credibility-preserving rate hike in the absence of the uncertainties on the Continent.

There was also a near universal concern on the shadow committee that the supply side of the British economy was so arthritic that any monetary stimulus would be largely dissipated in higher inflation.

The other major worry was that heavy handed financial regulation and additional capital requirements, at a time when banks could not raise capital in the equity markets, could lead to a retrenchment in UK bank credit and broad money. From this perspective, the additional £75bn Quantitative Easing (QE) announced in October was trying to offset the perversely negative effects of a pro-cyclical regulatory stance with a direct cash injection into the economy.

The same analysis implies that the extra capital requirement imposed on the Continent’s banks by the 26th October Euro-zone Summit would also act as an adverse regulatory shock to the supplies of money and credit. This had the potential to seriously reduce activity in the zone as a whole.

Minutes of the Meeting of 17th October 2011

Attendance: Tim Congdon, Andrew Lilico, Patrick Minford, David Brian Smith
(Chairman), Peter Warburton, Trevor Williams.

Apologies: Philip Booth (IEA-Observer), Roger Bootle, Jamie Dannhauser,
Anthony J Evans, John Greenwood, Ruth Lea, Kent Matthews (Secretary),
Gordon Pepper, David Henry Smith (Sunday Times Observer), Akos Valentinyi,
Mike Wickens.

Chairman’s comments
David B Smith expressed his concern about the revamp of the Office for
National Statistics (ONS) website carried out in late August. He explained that
the ONS had taken a number of cost saving measures including the abrupt
cessation of many of its traditional publications. These titles included Financial
Statistics, the Economic and Labour Market Report and the Monthly Digest of
Statistics. This followed on from the earlier decision by the Bank of England to
cease publishing its monthly Bankstats publication as one coherent report. The
overall outcome of these changes was to reduce the accessibility of economic
and financial statistics and often to destroy the continuity of long runs of time
series data.

On the specific matter of the new ONS website, he was shocked by the radical
changes to format and procedure, including the separation of data tables
from the body of statistical press notices. Another extraordinary change has
resulted in the interspersal of data of different frequencies in downloaded
files. A discussion followed where there was unanimous criticism of the new
ONS site. Tim Congdon suggested that the old website should be reinstated
immediately and the new format reconsidered. Patrick Minford expressed
incredulity that the ONS had spent so much effort on creating a new format
when excellent examples exist elsewhere, such as the sites of the US Bureau of
Economic Analysis and the US Federal Reserve (FRED). (Editorial Note: Some
of these concerns have subsequently been recognised and partly addressed in
a ‘website update’ mounted on the ONS site on 23rd October.)

The chairman then asked Andrew Lilico to give his assessment of the global and
UK monetary background.

The Monetary Situation
The International Situation

Andrew Lilico began by reviewing global indicators for economic growth,
unemployment and broad money growth, observing that there was little evidence
to support the notion of a global economic crisis. While the leading indicators
compiled by the Organisation for Economic Co-operation and Development
(OECD) had weakened since the spring, these also failed to sound the alarm
over global recession. Andrew Lilico then highlighted the context of the Euro-
zone as the potential catalyst for a much weaker global outlook. He asked
the question, can the Euro be saved? In his presentation, he articulated three
different types of crises that afflicted the various countries. He described the
situation of Greece and Cyprus as unsalvageable. In Belgium, Spain and Ireland
he identified a crisis in the banking sector as the defining problem. In contrast,
Italy and Portugal suffer from a crisis of competitiveness, which had been a
significant factor in their weak pace of productivity and economic growth.

He argued that the solution for banking crisis countries was to disentangle the
state from the banking sector and impose debt-equity swaps on distressed
banks. This would involve bringing forward the European Commission ‘bail-
in’ proposals from 2013 to the present. His prescription sought to avoid bank
recapitalisation either by the banks independently or by the state. In the former
case, banks had a vested interest in conserving capital by shrinking their loan
book rather than diluting existing equity shareholders. The by-product would
be a potentially violent contraction in the Euro-zone money stock. Andrew
Lilico rejected as a solution any arrangement whereby Germany, France, etc.
became responsible for current debts in Italy, Spain, etc. This would rule out the
Eurobond proposal, the leveraged European Financial Stability Facility (EFSF)
or substantial purchases of government bonds of the PIIGS countries. He drew
a distinction between collective debt issuance in future and responsibility for
legacy debt.

In the case of countries suffering from a crisis of competitiveness, the solution
was to raise their economic growth rate to allow them to service their own debts.
He advocated the use of ‘Euro-zone only’ structural funds to improve the supply-
side characteristics of these countries. He reminded the gathering that Ireland
had received structural funds equivalent to 0.5% of GDP in the 1990s. Applying
the same rule of thumb to Italy and Portugal would imply structural funds of
€9bn. He considered that there might need to be double this level in the early
years to be credible but that this was not out of the question. The structural and
cohesion funds budget runs at €58bn per year. He reiterated that the key was
to boost investments that would have a lasting effect on the pace of economic
growth. In contrast, the cost of debt pooling for Germany and France could be as
high as €36bn per year on the assumption of a 100 basis points addition to their
borrowing costs.

The UK Economy

Andrew Lilico then focused on the long-term sustainable rate of growth in the
economy. The Bank of England was expecting a return to annual Gross
Domestic Product (GDP) growth of 2.3% in 2012 and the Office for Budget
Responsibility (OBR) had asserted a sustainable growth rate of 2.35%. He was
concerned that these estimates were too high. The UK economy seemed to
have stalled during the preceding nine months and measures of consumer
confidence had slipped back towards the weakest levels of last year. In his
research at Europe Economics, he had derived an estimate of the risk-free real
interest rate of 1.4% and of sustainable economic growth of 1.1% per annum. If
the sustainable growth rate was indeed this low, then the output gap was
negligible or negative and the Coalition’s targets for budget-deficit reduction
would not be met. Also, it would imply a vulnerability to rising inflation that was
inconsistent with an inflation target of 2%. Andrew Lilico observed that the
reported rates of the Consumer Price Index (CPI) and Retail Prices Index (RPI)
measures of inflation had trended steadily higher since 2001. This upward drift
broadly coincided with a slower pace of productivity growth. He also drew
attention to the plunging real yields on index-linked gilts as evidence of a
weakened supply-side potential. Regarding the Bank’s own inflation forecasts,
he recalled that in May 2010 the Monetary Policy Committee (MPC) had
assigned zero probability to an inflation outcome in September 2011 that was
higher than 3.5%. (Editorial Note: The September figures released on 18th
October showed annual CPI inflation at 5.2% and RPI inflation at 5.6%.)

Supply-side uncertainties cramp monetary options

The Chairman thanked Andrew Lilico for his excellent presentation and opened
up the meeting to discussion.

There was a lot of concern expressed about the potential rate of UK economic
growth. David B Smith started the debate by stating that he accepted that the
real rate of interest should equal the rate of economic growth in Solow-style
steady-state growth models, as Andrew Lilico had suggested. However, Britain
had a small open economy and probably took its real bond yield from the world
outside – which theoretically reflected the much higher growth rate in the world
as a whole, including the newly industrialising countries (NICs) – rather than
purely domestically. Patrick Minford also claimed that the UK risk-free real rate
was derived from the global risk-free rate. He considered that the explanation
for poor potential economic growth in the UK was over-regulation in the banking
system and a falling rate of productivity growth. He failed to see how monetary
policy could help to raise the risk-free rate and feared that an expansionary
monetary policy would worsen the inflationary outlook. Peter Warburton argued
that two explanations were needed of the UK’s sluggish economic performance.
Even if one accepted the logic of a slower potential growth rate, there remained
the issue of the failure to recover the output level of 2008. A second explanation,
concerning the obsolescence of the capital stock was required to justify the
inability of the UK economy to make up lost ground.

Patrick Minford expressed the view that the term ‘balance-sheet recession’ was
inappropriate to describe the UK’s predicament. He believes that the negative
pressures on private-sector balance sheet were a symptom of an underlying
potential growth problem. David B Smith queried whether corporate balance
sheets were weak, pointing out the unusually strong cash flows and high liquidity
of large corporations in the UK and elsewhere and suggested that the real
problem was a collapse in entrepreneurial ‘animal spirits’. Animal spirits were
weak because of the uncertainties over future tax burdens associated with large
budget deficits, misguided regulatory shocks in the labour market as well as the
financial sector, and blood-curdling anti-market rhetoric by politicians who should
know better. Patrick Minford introduced the dimension of political risk (now
widely measured in available indices) which suggested a marked rise in the US
under President Obama.

A broader discussion ensued concerning the explanations for disappointing
recent economic performance in the UK and the US. Patrick Minford blamed
populist anti-business sentiment and President Obama’s distrustful attitudes
towards business. Tim Congdon added that policies had targeted the financial
sector and the oil and gas sector for tough regulatory interventions. He said that
these policies had serious consequences for the operations of heavy industries.
In addition, European Union labour market directives were perpetuating labour
market inefficiencies.

The report of the Vickers Commission on UK banking was also criticised for
its potential negative effects on the future supplies of money and credit. David
B Smith then noted that the burden of public spending had barely risen during
the present century in Germany – but had gone up massively in Britain and
the US – and suggested that this might help explain the relatively stronger
performance of the former. Andrew Lilico summarised his justification for
assuming a very low long-term potential growth rate in the UK. First, the large
increase in the proportionate share in government spending implied higher tax
rates in the future. Second, the rise in the government debt to GDP ratio had
reached levels that were deemed by Stephen G Cecchetti, MS Mohanty and
Fabrizio Zampolli as undesirable and probably unsustainable in their 5th August
2011 paper published by the Bank for International Settlements (BIS) The Real
Effects of Debt. Third, high levels of household indebtedness had already been
instrumental in reducing the pace of economic growth since 2002. Fourth, the
UK’s poor record in terms of productivity growth was in part a consequence
of transferring economic activity from the private to the public sector. Finally,
productivity growth in the UK’s public sector has been negative — if it had
matched private sector productivity growth in the decade to 2007, UK GDP
growth could have been 0.5% faster.

Trevor Williams introduced the dimension of slowing growth of the working
age population as a contributing factor to weakening economic growth. He
commented that the UK had consumed the benefits of its North Sea oil and
gas endowment rather than storing up wealth in a sovereign fund as Norway
had done. He also believed that excessive borrowing by the public sector
has crowded out private sector activities. Pro-cyclical economic policies
were responsible for imposing constraints on the banking system that were
aggravating the economic downturn.

Andrew Lilico questioned whether the Bank of England’s recent decision
to extend the Quantitative Easing (QE) programme was designed to offset
disappointing economic outcomes or to pre-empt the effects of a Euro-zone
banking crisis. Tim Congdon defended the decision to undertake an additional
£75bn of asset purchases as wholly justified in the context of very weak money
supply growth. He estimated that the Bank’s action would add about 5% to the
stock of broad money and would boost UK economic growth during the first half
of 2012. Peter Warburton expressed his concern that this latest intervention
would drive down the value of sterling. The Bank was providing an excellent
opportunity for overseas gilts holders to cash out their recent strong gains.
Patrick Minford agreed with the judgement that there was not much spare
capacity in the UK economy and then highlighted the inflation risk associated
with QE. He believed that the Bank model omitted a major channel of inflationary
transmission, namely the inflation expectations channel. A loss of inflation
credibility had allowed inflation expectations to become untethered, clearing the
way to divergent inflationary outturns in the future.

Patrick Minford opined that the Bank of England appeared to be willing to do
anything to stimulate growth. Tim Congdon countered that UK banks were
still not growing their risk assets and that the growth of broad money was
very weak. He supported the use of QE to provide a burst of money growth.
He reminded the committee that the impact of the original £200bn of QE had
been dented due to huge capital raising by the banks. Trevor Williams warned
that the process of capital raising by UK banks might not be over, citing the
implications of the Solvency II directive. He noted that there was a scramble to
secure US$ assets in Europe and that US banks had drastically reduced the
provision of US$ liquidity to European banks. Andrew Lilico wondered whether
the Bank of England should promise some future inflation in order to induce
corporate investment. Trevor Williams thought that it would have been better to
delay the QE decision until the November Monetary Policy Committee (MPC)
meeting. However, David B Smith said that recent major changes to the national
accounts almost certainly meant that the Bank’s forecasting model, like his
own, had been effectively rendered non-operational for the time being, and that
there was nothing to be gained from waiting for the November Inflation Report
projections. Tim Congdon also disagreed with Trevor Williams on the grounds
that it was better to counteract a monetary contraction as soon as possible and
he expected inflation to fall back considerably next year.

Andrew Lilico raised the issue of the fallout from a Euro-zone banking crisis
on UK banks and wondered what policy responses lay beyond QE. Former
MPC member Sushil Wadhaani had advocated a form of QE whereby people
were sent cheques. Another idea was for the banks to fund the government
budget deficit directly rather than through the purchase of gilts. Patrick Minford
suggested that the Bank of England was using a foreign crisis to excuse a
domestic monetary easing. He believed that UK monetary policy had been held
hostage by the Euro-zone crisis and that the Bank had panicked at the prospect
of a worsening demand outlook for UK exports. David B Smith was increasingly
concerned, in the light of QE2, that the overseas sector might judge the UK as
a high sovereign risk situation, provoking a further downwards adjustment of
sterling, higher inflation, and much higher official funding costs in the longer


The Chairman then asked each of the other five SMPC members present to
make a vote on the appropriate monetary policy response. In addition, to the
votes cast at the gathering at the IEA, three votes were subsequently cast in
absentia by John Greenwood, Ruth Lea and Kent Matthews in order to ensure
that exactly nine votes were cast. These votes are included below and all nine
votes are listed alphabetically, in line with the customary SMPC practice.

Comment by Tim Congdon
(International Monetary Research)
Vote: No change in Bank Rate.
Bias: Easing through additional QE, conditional on monetary outcomes.

Tim Congdon stated that he endorsed the additional £75bn of QE that had been
announced and would support an extension of the programme, conditional on
the path of broad money growth being too low to support a proper recovery.
However, he believed that the same effect could have been achieved by
the government borrowing directly from the commercial banks. This would
have avoided the sizable increase in the Bank of England’s balance sheet.
Tim Congdon supported measures to boost the supply-side capability of the
economy as a means of restraining future inflationary pressures.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Expand QE further if M4ex broad money declines.

Economic growth in the UK, Europe and the United States, had disappointed
during the current economic recovery according to John Greenwood’s
submission in absentia. The downward revision to the second quarter UK
GDP growth figure to only plus 0.1% quarter-on-quarter had been just one
manifestation of this persistent weakness in growth in the developed world. The
recent deterioration in demand prospects associated with the sovereign debt
crisis in the Euro-zone, together with the steep falls in financial markets since
July, had prompted the Bank of England to implement a second programme of
asset purchases. This amounted to £75bn of gilt purchases to be conducted
over the four months October to January.

Two broad sets of factors explained the weakness of growth in Britain, according
to John Greenwood’s post-meeting submission. First, the relatively strong
growth of the period 2002 to 2008 had been artificial to a significant degree,
based on the rapid growth of money and credit, accompanied by a rising shares
of government and household consumption in GDP. Consumption was routinely
mistaken for prosperity. In this sense, the current period of slower growth was
largely a reaction to the earlier period of unwarranted consumption growth.
Second, the increase of debt on household and financial sector balance sheets,
and more recently on government balance sheets, had reached levels that
were clearly inhibiting growth. The Bank for International Settlements (BIS)
study by Stephen Cecchetti and others (cited by Andrew Lilico) showed that
over-indebtedness beyond well-defined thresholds in a variety of sectors –
household, non-financial business, or government – typically caused growth
to plunge in the aftermath of crisis. The reason – which was not spelled out
by Cecchetti et al – is that balance sheet repair or debt repayment necessarily
takes several years, and detracts from investment and other spending during
that period. Those who argued during the past two years that the UK recovery
would be strong and vibrant (either using the standard Zarnowitz argument
that deep recessions are followed by stronger than normal recoveries, or the
argument that economic agents would respond positively to abnormally low
interest rates) have therefore proven to be wide of the mark.

In this situation, there remained limited scope for either fiscal or monetary
stimulus. However, asset purchases by the central bank were justified to prevent
a monetary contraction. As demonstrated by the experience of Japan in 2001 to
2006, there was no link between QE and CPI inflation when the private sector
was deleveraging. On the contrary, deleveraging was inherently disinflationary
in John Greenwood’s view. The Bank of England needed, therefore, to have
no concern that QE would add to inflation unless and until broad money growth
accelerated, and there had been absolutely no sign of that so far this year.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate; no change to new £75bn QE package.

In her vote in absentia, Ruth Lea stated that the MPC’s decision to authorise
a further £75bn of QE at the October meeting was something of a surprise in
terms of timing and magnitude. Even though the September MPC minutes had
indicated that more QE could be in the offing, market expectations had focussed
on November rather than October for action. Furthermore, the amount had been
more than expected. Expectations had been more in line with an extra £50bn.
Following the announcement, Sir Mervyn King had been in apocalyptic mood.
“This is the most serious financial crisis we have seen, at least since the 1930s,
if not ever” he had said. Given the deepening crisis in the Euro-zone which
could only be ‘solved’ by break-up or full fiscal union, neither of which appeared
likely in the foreseeable future, the Governor could not be accused of idle
scaremongering, in Ruth Lea’s view. More QE was probably the right decision.
The economy needed all the support it could get and, whilst the Chancellor
stuck to his fiscal retrenchment package – and rightly so, in her view - monetary
easing was an obvious alternative.

The Bank remained especially concerned about the state of the banking sector.
The October minutes had said “stresses had been particularly acute in bank
funding markets….while banks in the UK had made significant progress in
meeting their debt issuance targets for the year as a whole, there were limits
to how long they would be able to withstand elevated funding costs or closure
in the markets before lending to the domestic economy would be affected.”
Furthermore, and even though the objective of further QE had not been stated
explicitly in terms of supporting the banking system, it was reasonable to
conclude that one of the main reasons for the action, if not the main reason, was
to do just that. However, given the 2% inflation target, the Bank had probably
felt obliged to justify its actions in terms of ensuring the 2% CPI target was not

The ONS had revised GDP growth for 2011 Q2 down to 0.1% in early October.
Household consumption had fallen by 0.8% and there had been a disappointing
deterioration in the net trade balance. Buoyant ‘export-led’ growth, which had
been a key part of the OBR’s March forecast, had not happened. Furthermore,
and given that the Euro-zone and the US, which were our major export markets,
were stuttering it was not likely to happen for some time. The economy had
almost flat-lined since autumn last year.

There was not much ONS evidence for real activity for 2011 Q3 available yet.
However, what there was, failed to inspire. Retail sales slipped in the quarter
and industrial production was disappointing in both July and August. Surveys
had been mixed. The most recent Markit/Chartered Institute of Purchasing and
Supply (CIPS) Purchasing Managers Index (PMI) surveys, for example, painted
a patchy picture. The manufacturing PMI was only 51.5 in September, the
services PMI picked up to 52.9, but the construction PMI fell to 50.1, suggesting
stagnation in the sector. The first estimate of 2011 Q3 GDP, which was due on
1st November, may only show an increase of around 0.2%.

Moreover, the labour market was clearly deteriorating. The International Labour
Office (ILO) measure of unemployment had increased by 114 thousand in the
three months to August, to reach a seventeen-year high. Inflation continued
to run well ahead of the Bank’s 2% target. September’s CPI inflation picked
up to 5.2% and RPI inflation, at 5.6%, was the highest since June 1991.
Nevertheless, it was reasonable to suppose that inflation would fall rapidly
next year. Earnings annual growth remained a very subdued 2.8% in the three
months to August, on the measure including bonuses, implying a major squeeze
on households’ incomes. This meant that there should be no change in interest
rates in November, with a bias to keeping interest rates at their present level,
and no change to the current programme of a further £75bn of QE agreed at the
October MPC meeting.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate.
Bias: Neutral.

Andrew Lilico believed that the Bank of England had jumped the gun in its
QE announcement. He would have liked to hear more details of the ‘credit
easing’ proposed by Chancellor Osborne. He was concerned that such policies
contained a veiled signal that the UK banking system was under threat. He
would like the Bank of England to explore other forms of unconventional
monetary policy besides QE.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To raise Bank Rate; QE should be held in reserve.

The argument that the rise in inflation was temporary and would drop next
year was wearing thin, in the post-meeting view of Kent Matthews submitted in
absentia. Kent Matthews added that people were told that temporary factors,
which the Bank could not control, had been the main reason for inflation
reaching its three-year peak. Inflation would slow in the coming months, once
factors such as the January 2011 VAT increase fell out of the system, in the
official view. However, it was hard to accept the claim that inflation had nothing
to do with the Bank’s policy given the near 25% depreciation of sterling since
2007. The monetary authorities’ argument that inflation was driven by external
factors and that the domestic drivers, such as wage inflation, pointed to its
transient nature hinged strongly on what has happened to productive capacity.
If we were in a world of Keynesian excess capacity, the argument went that
demand deficiency would place downward pressure on inflation. Evidence for
the Keynesian scenario was ample. Firms were hoarding cash while interest
rates were near zero (i.e. the liquidity trap); investment intentions were weak
(i.e. low animal spirits); and conventional monetary policy was ineffective (i.e.
pushing on a string). The conclusion was that extraordinary direct measures
- such as QE and possibly fiscal policy - were the only escape from the
deteriorating economic situation and weakening world demand.

An alternative view was that excess capacity was much lower than the Bank
thought. The world economy had seen major capacity destruction from the
realisation of low marginal returns from excess investment, principally by
the Far-Eastern economies, and prospects for capacity building by the small
business sector in the Western economies had been stifled by the credit crunch
and credit rationing by the banks. In the UK, the growth in the government
sector, business unfriendly regulation and increased taxation had compounded
negative world shocks that had resulted in a contraction in productive capacity
and a weakening of underlying productivity. In this scenario, real wages needed
to fall, which was happening through the rise in prices in a world of nominal
wage frictions, and competitiveness to improve through a depreciation of the real
exchange rate. Consumer spending would remain muted with the realisation of
the decline in permanent income. Business investment would stay pessimistic
as long as the world economy remained sluggish and with no sign of positive
supply-side policies from the government. In this latter scenario, there was
little that monetary policy could do. QE could be deployed if the Euro-crisis
turned particularly nasty. However, this should be used to stop an asset-price
deflation from turning into a financial market melt-down not to stimulate domestic

If the first view was correct, inflation would indeed begin to fall by the middle
of next year and the credibility of the Bank could be restored with a smug ‘I
told you so’ response to the doubters. If the latter was proved correct, inflation
expectations would feed into domestic costs as firms began to hit capacity
constraints and the anti-inflation reputation of the Bank would be shot to
smithereens. Rebuilding reputation would then be long and painful. Quite clearly,
there was currently little the Bank could do in the face of the continuing Euro-
crisis and the uncertainty it was causing in the financial markets. Raising interest
rates now would do little to restore the Bank’s anti-inflation credibility and could
zap an already fragile financial market. There was nothing for it, but to do
nothing to Bank Rate and keep QE in reserve.

Comment by Patrick Minford
(Cardiff Business School)
Vote: Raise Bank Rate to 1%.
Bias: Raise Bank Rate; no further QE.

Patrick Minford stressed that the UK economy was hamstrung by fundamental
problems that could not be solved by a progressively easier monetary policy. He
remained worried that the recent addition to QE will have further adverse effects
on inflation. He believed that there had been a huge over-reaction by regulators
to the financial crisis to the detriment of the supply capability of the economy.
The diminished growth potential of the economy left the UK open to a worsening
inflationary scenario. He believed that tighter monetary policy was justified as
a response to inflationary concerns and that the structurally weak growth rate
should be addressed through deregulation and other means.

Comment by David B Smith
University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: Tighten, conditional on developments in the Euro-zone.

David B Smith was appalled by the explosion of public sector spending during
the present century in Britain and the US. This had provoked supply withdrawals
in both countries and was an unacknowledged cause of the Global Financial
Crash. The reason was that a supply contraction reduced the net present value
of assets, such as equities and property, where the current price reflected
the discounted stream of future returns - because these returns themselves
depended on the prospective growth rate. He added that the ‘big picture’
was that the size of the state had reached the point in the UK and US where
governments encountered the problems traditionally associated with financing
a major war. David B Smith added that the share of UK GDP absorbed by
government now substantially exceeded the peak costs of fighting World War I.
In the US under President Obama, government expenditures narrowly exceeded
the peak cost of World War II. In both cases, there had been a massive
diversion of resources from the private to the public sector and seriously
deleterious effects on the supply side. He viewed proposed regulations to oblige
private banks to hold more public debt as a form of ‘forced funding’ on wartime
lines and QE as being worryingly close to ‘resorting to the printing presses’.

Large Budget deficits crowded out private activity not only for the well
understood ‘Ricardian-equivalence’ reasons but also because private agents
faced uncertainty about their future tax liabilities. He advocated as a response
that the UK government should pre-announce that there would be no more tax
hikes for the duration of the parliament and that any future borrowing overshoots
would be tackled solely through spending cuts. His perspective on the recent
addition to QE was that the policy was unlikely to create any ‘added value’ with
bond yields already so low. However, he also believed that an active funding
policy was a valid tool to control monetary growth, provided that it was used
symmetrically in both directions. On a more optimistic note, he noted that there
had been a sharp drop in world non-oil commodity prices recently and reckoned
that there was some scope for the UK economy to recover next year. However,
there was now a powerful stagflationary bias in both the UK and US economies.
Traditional Keynesian demand measures would not be effective in the absence
of the supply-side improvements that could only be achieved through lower and
more predictable tax levies on the private sector and a bonfire of unnecessary
regulations. Unfortunately, he had serious doubts as to whether the present UK
coalition had either the desire or the will required to implement the necessary

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate.
Bias: Raise Bank Rate once economic outcomes improve.

Acknowledging the disappointment over recent UK economic performance,
Peter Warburton had dropped his longstanding call for a higher Bank Rate.
The failure of the Bank of England to raise the rate last year had undermined
the credibility of the inflation target regime and damaged perceptions of the
Bank’s independence from the political process. The ritual exchange of letters
between the Governor and the Chancellor was proof that this mechanism fell
short of proper accountability. The average cost of notice deposits at banks
and building societies rose from a low of 0.2% in 2009 to 1.4% in the autumn
of last year. It has since fallen back to 1%. This rate gave a better indication
of UK interest rates than Bank Rate, which remained largely irrelevant in the
post-crisis world. Bank Rate still had a residual totemic significance, however,
through its psychological impact on public attitudes. In today’s febrile economic
climate, it would be a mistake to inflict a Bank Rate rise. For the record, Peter
Warburton stated that he disapproved of the recent QE addition, believing that
this could give rise to a perverse response with regard to the policy imperative of
budget deficit reduction. Should further asset purchases be judged necessary,
he advocated the purchase of land and property assets which would support the
collateral of the banking system.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate.
Bias: Neutral; no more QE.

Trevor Williams echoed earlier comments regarding the impact of supply-side
constraints on inflation. He was concerned that the recent QE addition could
backfire and would have preferred it if the Bank had delayed the move. He
acknowledged that more UK bank recapitalisation could be required if the Euro-
zone system suffered an irrevocable breakdown. He also favoured measures
to support the supply-side capability of the economy, such as Research and
Development and capital investment tax credits for businesses.

Policy response

1. Eight out of the nine SMPC members concerned felt that Bank Rate should
be held on 6th November.

2. One Member of the shadow committee believed that an immediate 50 basis
points hike to 1% was more appropriate.

3. There was a widespread view on the SMPC that the supply side had been so
damaged by excessive government spending and regulation and high and
uncertain taxes that there was unlikely to be an elastic supply response to
any stimulatory measures taken by the authorities.

Date of next meeting

Monday 16th January, 2012.

Appendix: ‘E-Mail from America’

Editorial Note: The SMPC member Anthony J Evans is currently on an academic
sabbatical as the Fulbright Scholar in Residence at San Jose State University,
California. He will not be contributing to the SMPC UK Bank Rate polls while he
is away. However, it was thought that his occasional views on the US economic
scene would be of general interest. This section has been named ‘E-mail
from America’ with appropriate acknowledgements to the BBC’s late Alistair
Cooke, and his ‘Letter from America’. Anthony Evans’s first occasional e-mail
correspondence appears below.

The author recently attended a Monetary Policy workshop at the San Francisco
Federal Reserve, with panellists including the well-known US economists Glenn
Rudebusch, Eric Swanson, and Carl Walsh. It was focused on how the US
Federal Reserve’s response to the financial crisis has impacted on the way in
which we teach. However, three more general themes seemed to emerge.

Firstly, traditional forecasting techniques struggle with economic uncertainty.
The Bank of England’s ‘fan charts’ are an attempt to factor uncertainty into its
forecasts, but they rest on an assumption that the underlying distribution is
reasonably normal. When the person responsible for the San Francisco Federal
Reserve’s forecasts was asked to add a confidence interval his response was
that the distribution was probably ‘bi-modal’. In other words, we were not dealing
with probability theory but scenario analysis – we might expect an EU implosion
and minus 2% growth or a gradual recovery of plus 2% to 3% in national output.
However, these were two alternative futures and not merely gradations around a
most likely one.

A second insight was that unconventional monetary policy tools were having
negative unintended consequences. Consider ‘Operation Twist’ – the US
Federal Reserve’s attempt to change the composition of its bond holdings
in order to target long-term interest rates. This sort of decision should
be the province of a Debt Management Office, and severely blurred the
distinction between monetary and fiscal policy. It was yet another example of
unprecedented powers being granted to central banks without any exit strategy.
In addition, we lost an important signalling device by deliberately manipulating
the yield curve. The increase in discretionary powers and the loss of market
signals should not be neglected costs of policy.

Finally, US central bankers do not pay close attention to events in Europe. When
pressed on whether the US Federal Reserve would be assisting the European
Union sovereign debt crisis the response was along the lines of “Tim Geitner
offered some advice but it was not well received”. Those conducting stress
tests of US banks were happy to leave EU regulators to deal with their own
companies. The Federal Reserve believed that Europe needed to resolve its
own problems independent of any assistance other than dollar liquidity. One
might view this as an acknowledgment that they have their own problems to deal
with. However, the assumption that Europe could get its own house in order
might be viewed as heroic.

Either way, the use of new monetary tools at the zero lower bound made
this a compelling time to learn and teach economics. Whether or not it was a
good time to be a citizen of the countries that are employing these techniques
remained a more open question, however.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent
economists drawn from academia, the City and elsewhere, which meets
physically for two hours once a quarter at the Institute for Economic Affairs
(IEA) in Westminster, to discuss the state of the international and British
economies, monitor the Bank of England’s interest rate decisions, and to make
rate recommendations of its own. The inaugural meeting of the SMPC was held
in July 1997, and the Committee has met regularly since then. The present note
summarises the results of the latest monthly poll, conducted by the SMPC in
conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff
University, and its Chairman is David B Smith (University of Derby and Beacon
Economic Forecasting). Other members of the Committee include: Roger Bootle
(Deloitte and Capital Economics Ltd), Tim Congdon (International Monetary
Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J
Evans (ESCP Europe), John Greenwood (Invesco Asset Management), Ruth
Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick
Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard
Street Research and Cass Business School), Akos Valentinyi (Cardiff Business
School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike
Wickens (University of York and Cardiff Business School) and Trevor Williams
(Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA)
is technically a non-voting IEA observer but is awarded a vote on occasion to
ensure that exactly nine votes are always cast.