Following the monumental Conservative election victory, now is the time for the economics to work through. The chancellor, Sajid Javid, has unveiled Andrew Bailey as the new governor of the Bank of England. He will take over after Mark Carney steps down in March following nearly seven years in post.
Bailey is the current head of City regulator the Financial Conduct Authority, and a former deputy governor at the central bank. He bested two other existing deputy governors, Jon Cunliffe and Ben Broadbent, as well as leading contenders Minouche Shafik, director of London School of Economics; Kevin Warsh, a former top official at the US Federal Reserve.
This is a pivotal decision for the chancellor – no doubt in close consultation with Boris Johnson and his advisers – and certainly Bailey should not expect a honeymoon period. He will be arriving against the backdrop of Brexit, widening regional inequality and the prospect of a downturn in the global economy.
Bailey is seen as a safe pair of hands and the appointment was broadly welcomed within the City, but time will tell if he is the sort of governor best suited to the times ahead. There is a strong case at present for someone willing to think differently about central bank management. With interest rates still very low in the UK and most other developed economies, there are widespread concerns that central banks will be unable to fight another downturn using the classic response of cutting rates.
Beyond this, there are arguments for revising the entire model of central banking. In recent years, the trend has been for them to manage rates without any political interference and to concentrate purely on keeping inflation low. Indeed, it is almost 30 years to the day since the Reserve Bank of New Zealand became the first central bank to make inflation the sole priority.
In times of inflation, this system made sense. But since the 2007-08 financial crisis, the world has found itself in a situation where economic growth is much weaker and deflation is more of a risk than inflation.
The Bernanke exception
As former Federal Reserve chair Ben Bernanke said in a speech in Tokyo in 2003, “in the face of inflation … the virtue of an independent central bank is its ability to say ‘no’ to the government”, but with protracted deflation of the kind that has continually dogged Japan, “a more cooperative stance” by central banks towards the government is required.
His argument was essentially that it’s hard to sustain inflation by manipulating interest rates, and that you’re more likely to be successful using the fiscal levers of government spending and tax cutting. The same approach is arguably required in the UK today and across the developed world.
Having lost the ability to properly stimulate the economy using interest rates, the Bank of England and other central banks have taken it in turns to resort to quantitative easing – essentially creating money with which to buy mainly government bonds from banks and other financial institutions. This was supposed to drive extra liquidity into the economy, but mainly it has just been used to bid up prices in the likes of the bond market and stock market and exacerbate the wealth gap.
As an alternative, some commentators are now touting “helicopter money”: this would involve central banks creating money that would be handed straight to the public via government tax cuts or public spending – thus requiring them to coordinate their policies in a way that does not happen at present.
This could be pursued in conjunction with a novel concept called “modern monetary theory”, which envisages government targets to boost demand and inflation financed by a disciplined central bank that keeps interest rates at zero. We are already seeing signs of the government moving in the same direction by shifting away from austerity towards more generous spending.
As for the Bank of England’s own targets, greater policy cooperation with the government would provide wiggle room for focusing beyond inflation. In particular, the Bank could play a role in addressing regional inequality. The UK already has the one of the worst rates of regional inequality in the developed world, with areas like the north of England and West Midlands bringing up the rear. This will be heightened by leaving the EU, since these same areas are key to international supply chains and expected to be the worst hit.
The answer is for the government to pursue an industrial policy that aims to improve productivity in regions where it is weakest, through the likes of targeted tax breaks and economic development zones, with an accommodating Bank of England providing the funding to facilitate.
More productive areas attract more capital, which is the reason behind the north-south divide in the first place. Such an industrial policy would encourage more investment in these areas, produce real-wage increases, boost local demand and stimulate regional development. In short, it would help counteract the impact of Brexit.
Long-term thinking
If Bailey is to succeed in his return to Threadneedle Street, two central criteria stand out. First, he must understand the deeper economic and social circumstances that have led to Brexit and the UK’s shift to the right. He must act as governor for the whole country and not just for London plc: a move away from focusing on smoothing short-term fluctuations towards prioritising long-term growth.
Second, the job specification for the next governor said that the candidate should have “acute political sensitivity and awareness”. This might suggest that the government does not want the new governor to have such outspoken views as his predecessor on say, the economic risks from Brexit. Be that as it may, policy coordination needs to be a priority. I don’t rule out the possibility of Andrew Bailey being able to work like this, but I worry he may be too orthodox for the challenge. My hope is that he will recognise the shifting sands in central bank policy and be willing to lead from the front.