The City and British financial establishment are worried. Recently 20 senior economists, including some who know the Treasury and Bank well, wrote a letter to the Sunday Times saying that the Uk needed to curb its deficit. The authorities were defended by more than 60 in a subsequent letter to the FT. This morning a couple of City heavyweights have questioned the Bank's anti inflation record of the last decade, pointing out that there has been a bias to underestimate the UK inflation rate when forecasting and to end up with higher inflation rates than the target dictates.
The City and the British economics establishment is usually a consensual club. Its members are normally at one on the big issues of how the establishment architecture should be constructed and what judgement calls the main players should make. Consensus thinking can lead to complacency, to similar forecasts from all the main players, and at times has led to disaster.
In the 1980s the establishment wanted the UK to join the Exchange Rate Mechanism. It took some time, as there were a few of us mounting a long rearguard action to prevent such a move, as we thought it would be destabilising and ultimately self defeating. Even Margaret Thatcher, a natural ERM sceptic, gave in to the pressure eventually. The ERM gave us boom and bust. It first required us to set interest rates that were too low, and to print pounds, to try to keep the value of the pound down. This gave us an inflationary boom. Then it forced us to hike interest rates too high and to buy in pounds, squeezing credit too much and giving us a bust. Establishment figures argued that if we had gone in at a different rate it might have worked better. In the end most prudently walked away from the traffic accident they had helped cause, sensibly forgetting their passionate support for this independent auto pilot system which was meant to give us stability.
In the late 1990s the Establishment invented a new version of the independent ERM. They gave us the so called independent Bank of England. In fairness to the advocates, they did not recommend stripping the Bank of so many powers in the way the new government decided to do. However, instead of having a row at the beginning and warning that a Central Bank stripped of banking regulation and government debt issue would struggle to understand all the forces in the money markets it had to supervise, they went along with the idea that we were in a new era of independent central banking which would create stability.
We now know that this system also gave us boom and bust. Indeed, it gave us a more violent cycle than the ERM. Why did the independent Bank fail to control inflation, and how did it end up presiding over such a violent ride? Why did the politicians override the ERM sooner than they dared publically override the independent Bank? The speed of the eventual disaster in the ERM forced politicians hands to abandon the experiment. In 2008 the Chancellor effectively overrode the independent system with the international agreement to cut rates, but was keen to present it as business as usual. The MPC met to settle the rates as if nothing had happened.
It is true that the US did something similar to the UK this cycle, but it is not a satisfactory explanation to say we were swamped by the US influence. Other trading partners of the USA followed very different courses on output and inflation. The US downturn was less severe than the UK's.
The UK policy errors that did most damage were the interest rates set by the Bank based on their theory of the output gap, and the attitude taken to banking cash and capital by the banking regulators. The Bank of England held interest rates too low for too long, reassured by cheap imports temporarily keeping the inflation rate down and by its calculations of how much spare capacity there was in the economy. The Treasury egged this on by claiming that the UK's trend rate of growth rose to a sustainable 2.75% a year by 2007. Subsequently they held rates too high for too long.
It is difficult judging how big an output gap there is at any given time. Capacity can be easily destroyed. Once a firm has made the staff redundant the capacity has gone. It takes an act of confidence to rehire staff and set the factory to work again. If a business has been so starved of bank finance it has squeezed its stocks dramatically, its immediate ability to produce more is constrained by lack of raw materials and parts. In this cycle pricing behaviour has changed from some of the text book analysis. Some businesses have said that as demand has fallen so much it costs them more per unit to supply, so prices have to go up. The falling pound and rising import prices gives them more cover to do this.
Meanwhile the banking regulators are squeezing bank balance sheets and therefore private sector bank finance hard. These strange conditions have given us lively inflation against the backdrop of recession and poor final demand. The squeeze on people's living standards is now intense, with practically no overall wage growth in the private sector allied to sharp price rises. This is now spreading to the public sector.
Yesterday I was asked to make some predictions about investment in the UK for a group of Charity investors. I had to say that there are better prospects elsewhere at the moment. The UK has large imbalances in its economy to correct. It is spending and borrowing too much and saving, exporting and investing too little. Its public sector deficit is unsustainable, and its banks being squeezed by regulatory pressures. When the UK establishment is as worried as it is currently is, you too should be worried.