Alex Morton is Director of Policy at the Centre for Policy Studies, and was a member of David Cameron’s Downing Street Policy Unit.
We need to focus more on monetary policy
Last week, the Bank of England announced something rather extraordinary buried in one of its working papers: it increased house prices by 22 per cent between 2008 and 2014. The story wasn’t front-page news – it was in fact barely noticed.
Recently, a debate has been raging within the Conservative Party about whether tax rises or spending increases will see off Jeremy Corbyn. (Though neither seems as likely with politicians running a small near-permanent deficit.) But even as the debate over fiscal policy gets more heated, we ignore the other side of the equation: monetary policy.
I’ve been thinking about this recently as I’ve just joined the Centre for Policy Studies as Director of Policy, to oversee its new programmes on housing, tax, enterprise and welfare. (I’ll still be writing here regularly about politics and policy in general rather than just what the CPS is up to.) The CPS and ultimately Margaret Thatcher believed that fixing monetary policy was as critical as dealing with Government spending.
Today, by contrast, we outsource the issue to the Bank of England – even though it is one of the most important questions in public policy with huge knock on effects. For example, as long as interest rates are practically zero, there will be little desire or reason to see borrowing reduced – making the financial debate nearly irrelevant. But zero interest rates, by and of themselves, are deeply unhealthy, existing only to sustain the gigantic imbalances created by a rigged capital market.
Under Thatcher, the last leader to truly grasp the importance of an economic philosophy, Conservatives at least theoretically believed levels of monetary growth and debt should not grow too rapidly ahead of savings, or this would fundamentally destabilise the economy. Nigel Lawson abandoned this during the mid-1980s, and replaced it with exchange rate targeting that created an unstable boom and bust that helped to bring Thatcher down. The next successful Tory leader to emerge, David Cameron, ignored monetary policy, initially because he was more interested in updating Burke’s little platoon theories for the modern age, and was then simply overwhelmed by the crash.
Thatcher’s view built on a thesis developed by a group of economists termed the Austrian school, including Friedrich Hayek and Knut Wicksell. They argued that you could not magically create growth by creating new debt and money. To sustain a greater increase in investment and borrowing, you either had to create a more productive economy or increase savings. Rapid growth in debt and money supply well ahead of economic growth and savings would, Austrian economists argued, always end in a serious problem. It was this, as much as Milton Friedman’s view monetary growth just led to inflation, that fed Conservative thinking during the 1970s and 80s.
To achieve stability, Austrians argued that interest rates should be set at a rate where savings being made matched the level of new debt and investment created. This was the ‘market’ rate of interest and created little monetary growth and limited growth in debt ahead of the economy’s growth rate (since any higher debt would eventually have to be repaid, debt growth could not outrun wider growth rates). The correct interest rate balanced capital’s supply (savings) with demand (new debt) – just as supply matches demand in any other market. If you ignored this, the sectors based on debt and asset prices would outgrow their sustainable size and eventually destabilise the entire economy via a financial crisis.
Explosive growth in the money supply under New Labour, which rose (measured most broadly) from £564 billion in January 1995 to £1,934,070 billion at the end of 2008, allied to soaring private sector debt, which rose from 200 per cent of GDP in the mid-90s to a staggering 450 per cent of GDP in 2009 culminated in the 2008-9 financial crisis, just as Austrian economists predicted.
Interest rates should have been much higher throughout the New Labour bubble – because market signals in terms of a sharply rising debt-to-GDP ratio and rapid growth in the money supply were frantically signalling that the economy was becoming destabilised. The Bank of England’s failure reflected a belief as long as consumer price inflation was low the economy was on a stable keel (a point well made in the CPS pamphlet The Myth of Inflation Targeting).
You cannot beat Corbyn with rigged markets
I remember a meeting in Number Ten where two very senior aides argued about Corbyn, with one saying ‘he’s mad – he just wants to print lots of money and give it to people’ and another commenting ‘didn’t we just print lots of money and give it to the banks?’
This might seem simplified, but there is a fair amount of truth in it. We cannot defeat Corbyn if we are simply defending a different way to rig markets. And there’s no doubt that the capital markets are rigged in ways that most people do not fully grasp.
Yes, individuals are subject to market disciplines in terms of lending – in that you are compared with similar applicants applying for similar loans. But the scale of lending to overall sectors is largely determined by a bureaucratic apparatus. The Bank of England broadly sets out the ‘risk’ that different classes of lending fall under – and prioritises borrowing based on property and (unsurprisingly) Government debt. There is no real market mechanism.
One side-effect is the spiralling debt referred to above has largely bypassed the productive economy, with the share of total lending to the non-property, government and financial sectors falling from just under half in 1986 to just over 10 per cent now. This is before you get into quantitative easing or the thousands of pages micro-managing the financial markets. Deregulated capitalism it is not.
The Bank of England accepts that its monetary interference has fairly large impacts. The study referred to above stated that monetary policy since the crash had boosted house prices by 22 per cent, and equities by a similar amount – as well as claiming to have increased GDP by eight per cent. But it has also had many other effects, for example the collapse in annuity rates, where each £100,000 in a pension pot would have bought annuities worth £7,500 a year in 2007 but just £5,500 a year a few years later (despite inflation).
Lower interest rates and monetary manipulation have been presented as the solution to our economic woes. But increasingly they create them. After all, if interest rates are always low, we should simply borrow more forever. And if government can set the rate of interest without concerning itself about the market rate, why not direct other sectors of the economy?
The Conservatives, unlike the Labour Party, still do not have an argument that explains the financial crash and its aftermath – other than blaming it on Gordon Brown’s spending, which exacerbated the problems, but most certainly did not cause them. If we are going to defend capitalism and stop Corbyn, Conservatives must surely focus more attention on the manipulated capital markets at capitalism’s heart. For the greatest irony of Corbyn’s success is that much of the frustration he preys upon – from the crash itself, to a sluggish economy, falling home ownership, and poor pensions – is a direct result not of too much market failure, but of the failures of too much government.