Mervyn King, Governor of the Bank of England between 2003 and 2013, discusses monetary policy since the financial crisis and what comes next with Cesar Perez Ruiz, Chief Investment Officer of Pictet Wealth Management.
You once said that central banks need to be ‘as boring as possible’. Is that still the case today?
Central banks should respond to developments in the economy as predictably as possible, so the news should not be about debates within a policy committee, who is going to vote for a rise or for a cut, but about the implications for the future of recent data on the economy. And that predictable response of central banks to the data is what I meant by central banks being boring. I think that it is still important.
Do you think Quantitative Easing (QE) worked? Inflation still hasn’t really picked up and growth is still slow.
QE easing is simply a way of boosting the money supply. That is a traditional tool of monetary policy. What was unusual this time was the sheer scale of it, and that was because, after the banking crisis in 2008 when the contraction of bank balance sheets threatened to lead to a substantial drop in the amount of money in the economy, we might have gone back to a 1930s-type depression. We didn’t, and QE was very successful in preventing that. But the time for further QE has run its course.
The reason for the current stagnation in the world economy is different. It’s not just because total demand is inadequate, it’s because of a very distorted pattern of spending. Germany has an unsustainable current account surplus; the UK and US still have large current account deficits. This reflects the fact that we have not allowed exchange rates to move sufficiently far for spending to rebalance. So China has not actually switched demand from exports to the consumer. Germany has a very undervalued exchange rate – it is relying heavily on exports but ought to rely more on domestic demand. Growth in the US and the UK is being boosted by consumer spending, but that is not sustainable because the associated debt levels keep rising. These structural facts explain why growth is still below where it ought to be, and are also holding back inflation. That’s not a failure of monetary policy, it’s merely that monetary policy cannot solve all the problems of the world economy. It is possible that at some point inflation will pick up sharply but we are certainly not there yet.
What could be done differently in order to solve these imbalances and make growth more sustainable?
It is quite difficult for any one country to embark on a path of rebalancing if you don’t believe the rest of the world is going to do the same at the same time. Some kind of agreement between the major economies in the world, particularly China and the euro area on one side as the surplus countries, and the US and UK on the other, as the main deficit countries, will be needed. How far the EU can contribute is doubtful, given the very divergent real exchange rates within it.
Looking at the need to unwind QE, should interest rates be raised, or should central banks run down their balance sheets first?
The Bank of England (BoE) has made clear – and I think other central banks will do the same – that when they want to tighten monetary policy and withdraw stimulus they will start by raising interest rates. My own view is that they should focus pretty much exclusively on raising interest rates, because QE makes the banking system hold larger liquid deposits with the central bank; it’s a form of liquidity regulation, and makes the banking system much safer. So, I would focus entirely on raising interest rates. The difficulty is judging the appropriate time to do it.
Are central banks responsible at all for the rise of populism?
Populism is a division between ruling elites and a large number of ordinary voters. It reflects a failure by the elites to understand the concerns of ordinary people: static or falling living standards, the impact of high levels of immigration, greater political correctness. None of these are the responsibility of central banks or the outcome of their actions. But it is important that central banks are not seen as taking sides in this political debate. If they are seen as siding with cosmopolitan elites, then support for independent central banks will start to be undermined.
What do you think the BoE can do around brexit, and what is your view on how brexit will play out?
The UK has to have a fall-back position if we can’t reach an agreement with our European partners, which is to leave and trade under World Trade Organisation rules. That’s manageable, it’s what the US and China do, but it requires a good deal of practical preparation, and it’s a great shame that not much has been done so far. There is no clarity in the UK, even within the government, as to what kind of Brexit we want. This is a fundamental problem. However, none of these things are the responsibility of the BoE. In the long run, the honest answer about the impact of Brexit is that we don’t know, but I don’t think it will be particularly large. It’s in the interests of both sides to agree continued free trade in goods, so manufacturers should not be particularly perturbed. Even if tariffs were applied, they would be so small as to make very little difference in comparison with, for example, changes in exchange rates.
What is the biggest risk to financial markets that you see currently?
I think the biggest risk concerns the amount of debt. The leverage of the banking system is less a concern than before, but in all other sectors of the economy, debt has gone up. My concern would be that many asset values will ultimately have to be written down. For example, a lot of the capital equipment in the German export industry will never be as profitable as hoped, because we cannot continue having a German current account surplus of 8 or 9 per cent of GDP, so there will have to be changes in the value of capital assets in different sectors. As asset values start to adjust, particularly if interest rates are slowly rising, then balance sheets will start to reflect weaker asset values. If assets have to be written down to some extent, so do liabilities, and then leverage. So there could be defaults. Rather like the last financial crisis, you get a few apparently unconnected defaults, then suddenly people realise that the potential scale of defaults is a lot larger than they had realised and there is another financial crisis.
Lord King was Governor of the Bank of England between 2003 and 2013. His book, The End of Alchemy: Money, Banking and the Future of the Global Economy, was published in 2016.
Cesar Perez Ruiz is Chief Investment Officer of Pictet Wealth Management.