Preparing for the next crisis – it’s best to ask questions now so we can shoot later

In the decade leading up to the financial crisis not one speech by the then Chancellor of the Exchequer Gordon Brown mentioned quantitative easing. Between boom, bust, and prudence, unconventional monetary policy did not get a look in. The then Governor of the Bank of England managed one mention, albeit in the context of Japan not the UK. Many (many) more of his speeches mentioned cricket.

Then, on 19 January 2009, the Bank of England announced that quantitative easing (QE) was indeed Britain’s answer to what you do when you cannot cut short term nominal interest rates because they are effectively already zero – when you are at the so called zero lower bound (ZLB). It may not have been debated much in advance outside of academic journals, but the Treasury had agreed that the Bank should issue extra reserves (‘printing money’) to purchase extremely safe assets (initially government bonds). This was intended to encourage cash to flow into longer term and riskier assets.

Two months later, as interest rates were cut to 0.5 per cent, that programme was put into action. An initial £75 billion of assets was purchased. Over time that would become £375 billion.

These purchases were the right thing to do and probably played a part in reducing the chances of even worse outcomes during the financial crisis. Indeed QE remains the most likely to be used unconventional policy in another downturn. But the size of its impact is something we will never know with certainty, while the respective impact of QE and credit easing via the Funding for Lending scheme is also worthy of attention.

Reasonable people may forgive the fact that this took place without public debate given the need for fairly swift action. Those of us in the Treasury at the time have a vested interest ‎in that being the case. But there is no excuse for that to happen again in the face of a future downturn. We should be debating, and deciding on, the policy levers we favour to address the limits of traditional monetary policy now for three reasons.

First, because we may need them sooner than we would like. Seven years on interest rates remain at 0.5 per cent, and are only expected to rise to 1.6 per cent by 2021. If there was another downturn while rates remained that low we would likely find ourselves answering the ZLB question again. Indeed a simple probability exercise based on the chance of the economy shrinking in a given year (based on the UK experience since 1974) implies that there is a 67 per cent chance of the UK experiencing a downturn by 2021. Were that to happen not only would we be facing the ZLB again, we’d come crashing into it much more quickly than we did in 2009.

Second because, assuming we’re able to avoid a recession in the years before interest rates return to normal, there are good reasons for thinking that ‘normal’ means something different – lower – than it used to. Rates have been on a downward trend globally since the 1980s. The result is that we should expect to need to answer the ZLB question more often into the medium term, even if not in the near future.

Third, and crucially, the choice of policy options is itself dependent on whether decisions are taken in advance of actually being at the ZLB. For example, Adair Turner’s suggestion of printing money to openly fund fiscal deficits brings with it significant credibility challenges. Would you trust the Bank, and more importantly the government, to only print money for inflation targeting purposes? Those challenges may not be surmountable, but to have any chance of doing so would require a new institutional framework to be in place well ahead of it actually being used.

Similarly some advocate a more central role for fiscal policy, and in particular infrastructure spending. The experience of 2008-10 is that, while infrastructure spending is a better stimulus than tax cuts, unless a ready pipeline of projects is already planned and developed it proves literally impossible to spend what you might like on them.

Others argue that interest rate cuts will always be a superior option, so the priority is to reduce the chance of facing the ZLB in the first place. Increasing the inflation target, possibly from its existing 2% level to 4%, could help achieve this by raising equilibrium nominal interest rates. In the short term giving a central bank that is struggling to meet a 2 per cent target a new 4 per cent one may stretch credibility. But if this preventative approach was favoured you certainly cannot wait and adopt a higher inflation target during a crisis when deflationary pressure is precisely the problem you face.

The issue of having the space to cut rates also relates directly to the question of the fiscal/monetary policy mix. The Treasury understandably wants to create fiscal space ahead of a future downturn. But the risk is that comes at the cost of reduced monetary space as fiscal consolidation’s drag on growth limits the ability of the Bank to raise rates. That runs counter to their stated view that monetary policy remains the primary active means of supporting the economy in a downturn. Either the Treasury has changed its mind, or they believe that inflation is so low that rate rises are unattainable anyway. Neither matches public statements. Leaving aside questions of effectiveness, the monetary/fiscal mix has very real distributional implications too that we should discuss. Lower interest rates since 2008 have benefited mortgage holders and penalised savers; QE has supported asset prices; while fiscal consolidation has favoured pensioners over working-age households.

All of this is by way of saying there are no easy answers, but also no excuse for a repeat of the experience of policy innovation taking place during a crisis rather than ahead of it. New tools will be, by definition, unconventional – so on this if on nothing else in life, it’s better to ask questions now and shoot later.