Strategy & economics

They're forever blowing bubbles

17/04/2014

Richard Jeffrey

Richard Jeffrey

Chief Economist

Given the nature of the financial crisis and the depth of the accompanying recession, the recovery process was always going to be a hard grind. Indeed, it is partly the pain caused by the destructive nature of the downturn and the difficulty in engineering the subsequent recovery that we hope results in less profligate behaviour in the future. There were a number of aspects to bad behaviour in the economy that we might hope will not be repeated for another few cycles. An obvious focus of attention has been the role played by the banks, which over-extended their balance sheets through a mixture of poor quality lending, extreme financial engineering and ill-judged corporate transactions.

Because the banks play such a crucial role in a modern capitalist economy, they are bound to come under heavy scrutiny – and deservedly so. Very often, they are cast as the bad guys, with the authorities forever trying to curb (with varying degrees of success) their all-too-animal spirits. However, banks perform their role within a policy and regulatory framework established by the authorities. In fact, the banks play a crucial part in the monetary policy transmission mechanism, because it is largely through the banks that monetary policy impacts the real economy.

Nonetheless, whenever we look for the gun-slinging bad guy we tend to look towards a bank. Equally, there is a tendency to see the authorities generally (and central banks in particular) as constantly striving to establish economic equilibrium in an environment that without them would descend very quickly into economic anarchy. But this is far from being the case. While we cannot absolve banks from all responsibility, it is not unreasonable to suggest that they behaved badly in their lending behaviour prior to the recession in large part because they were encouraged to do so by inappropriately constructed regulatory and monetary policy.

By definition, changes in monetary and fiscal policy are brought about to achieve a desired effect. So, an increase in interest rates may be designed to depress domestic demand, so as to reduce inflationary pressure; or, an increase in capital allowances would be designed to encourage a higher level of capital spending. Of course, such policy changes do not take place within a vacuum. Not a day goes by without one lobby group or another calling for a change that will be of specific benefit to its members or supporters. But all this begs the question: how effective are policy changes designed to influence economic behaviour?

It seems reasonable to suggest that, through the operation of monetary policy, the primary role of a central bank should be to dampen potentially damaging swings in the economic cycle. Equally, we hope that help provided by the Treasury to one sector or another might lead to better balanced growth within the economy. But what if, rather than achieving these objectives, the authorities actually exacerbate the problems they are trying to address?

I would argue very strongly that in the five to ten years prior to the recession, both the Treasury and the Bank of England took policy decisions that instead of reducing the risk of a boom and bust cycle, actually made it inevitable. This was due partly to inadequate understanding of how the cycle was developing and partly bad policies.

So, what are the risks now? It seems clear that the economy is gathering momentum, and that, on the analysis of both the Bank of England and the Office for Budget Responsibility, the amount of spare capacity in the economy is limited. Nonetheless, monetary policy remains as loose as it has ever been, and the Treasury continues to support policies that are encouraging a growing bubble in the housing market.

The obvious problem is that neither the Treasury nor the Monetary Policy Committee is willing to be sufficiently forward looking in their policies. When setting interest rates today, for instance, the MPC should be thinking about the economic environment in one and two years’ time. But, for all the rhetoric regarding future developments, it is evident that policy is still being influenced more by what has happened than what is likely to happen. If the MPC believes its own forecasts – that if interest rates remain unchanged, the UK will grow by 3.8% this year and 3.2% in 2015 and 2016, it should now be raising interest rates. As for the Treasury, it should steer clear of narrowly targeted policies that are more likely to encourage disparities and bubbles than a well-balanced and sustainable recovery.

This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

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