Wikinvest Wire

Bootle on bubbles and banks

Monday, July 06, 2009

Roger Bootle writes in today's Telegraph on the near certainty that conventional wisdom at the Bank of England is quite wrong, but he may as well be talking about the Federal Reserve here in the U.S. as the two banks are cut from the same cloth.

After we left the Exchange Rate Mechanism (ERM) in September 1992, the era of inflation-targeting was born. Its current format, with an independent Bank of England, was the result of one of Labour's first acts upon gaining power in 1997.

Under this system, the MPC sets interest rates in order to ensure that inflation is kept on target all the time, but the forecast horizon is two years ahead. Asset prices are only taken into account in so far as they affect the outlook for inflation.

For a time, this approach seemed to work very well. In fact, though, all along it had major problems. Most importantly, it seemed to assume that as long as the inflation rate was OK then the whole monetary system would be OK. But, as we have seen, while inflation can stay relatively close to the target for several years, an asset bubble may be inflating.
What is still surprising to me after what we've been through over the last couple years is that this conventional wisdom has not already been universally discredited and that those promoting this errant thinking have not already been taken around back to the woodshed.

According to Roger, the first part of the above process is the much easier of the two, the reason for no economists suffering the paddle thus far having much to do with the fact that there are no better ideas currently gaining favor.

Mr. Bootle has some ideas...
An alternative approach would be to introduce some other macro-instruments designed specifically to control lending and asset prices – what Mervyn King has called a "macro-prudential toolkit". The favoured option is variable capital ratios – whereby banks would be forced to hold more capital during the "good times" in order to create a bigger buffer for the inevitable "bad times". Again, if we could rely on such a system then interest rate policy could be left to get on with inflation targeting in the way we have grown used to.

Yet I find this idea unappealing on its own. Who knows what the shape of the next bubble will be? Perhaps it will not involve banks lending large multiples of their capital. Every bubble is different.

Even though such variable capital ratios will help, I suspect that the only way forward is to give the Bank of England a wider brief in the way it sets interest rates. The objective could still be to hit an inflation objective, say 2pc per annum on the CPI, but the Bank would be charged with achieving this only over the medium–term.

In such a regime it would have the power to raise interest rates in the midst of a housing boom even if CPI inflation was modest, on the grounds that in the long run, housing booms are not compatible with monetary stability.

I know that the objection to such a regime is that it gives too much discretion to central bankers.
Just as in the U.S., the default solution appears to be giving even more power to the central bank, the group that many feel is most responsible for the current mess.

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