Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1-19)

PROFESSOR ANTON MUSCATELLI, PROFESSOR SIMON WREN-LEWIS, MR RAY BARRELL AND PROFESSOR TIM CONGDON CBE

6 MARCH 2007

  Q1 Chairman: Good morning and welcome to our evidence session, the first one on the Monetary Policy Committee of the Bank of England: 10 years on. We are delighted that you have accepted our invitation to kick off this very important inquiry. We have an hour for this session so not everyone need feel obliged to answer every single question, and then maybe we will get through in that time. Could you introduce yourselves for the shorthand writer, please.

  Professor Wren-Lewis: Professor Simon Wren-Lewis from Oxford University.

  Professor Congdon: I am Tim Congdon. I was on the Treasury Panel in the 1990s and I am now associated with the London School of Economics.

  Professor Muscatelli: Anton Muscatelli, Heriot-Watt University.

  Mr Barrell: I am Ray Barrell and I am a member of the National Institute in London.

  Q2  Chairman: Welcome. The MPC appears to have been successful over the last 10 years. However, even the Bank admits that the next 10 years may not be as easy. As the Governor said it will not be perhaps as "nice" a decade. What do you regard as the greatest threat to monetary stability over the next 10 years? Professor Congdon?

  Professor Congdon: At the moment there is a rather high rate of monetary growth and I would say that is a threat over the next few quarters. Then in the longer run there is always the problem of large budget deficits, if they return. On the supply side of the economy I would mention the likelihood—well, the certainty—that oil and gas revenues will be less than they were in the last 10 years and in the 1990s.

  Q3  Chairman: Does anyone else want to add to that?

  Professor Muscatelli: I highlighted in my evidence the last time I met the Committee that I thought global imbalances were still an issue and I think that is something that needs to be watched, especially as we see what happens in Asia in terms of the rate of growth in these economies. The Bank has highlighted the impact from the incorporation of these countries into the world economy on the level of inflation and it has also been the cause of some of the global imbalances we have seen. It will be interesting to see how that unwinds over the next few years and if the rate of growth changes in these countries.

  Mr Barrell: Monetary stability means a number of things. There is almost a continuum of issues here. One can say what are the threats to the short-term stability of inflation and obviously there are things like instability in exchange rates, shocks to expectations, but also there are risks, and we must not forget them, to monetary stability from the occasional dangerous event, like for instance banking crises. The Bank has to keep an eye on issues like the emergence of debt and asset price bubbles partly because large-scale personal debt and large-scale asset bubbles can be harbingers of banking crises. Banking crises are very unlikely but when they do turn up they are very dangerous, so stability is two ends of a continuum: keeping it stable now and avoiding the big dangers in the future. We have not completely removed the risks of banking crises. The fact that nothing has gone wrong partly reflects the fact that nothing has gone wrong, and we still have to keep on eye on those big risks.

  Professor Wren-Lewis: I concur with all those thoughts. I have just one thing to say on the subject of global imbalances, which I agree is a risk. It is not necessarily something that is going to impact very strongly on the UK because I think it is essentially an issue to do with the United States and the Far East, China in particular, and it may be that the problem resolves itself just between those two countries, so there is not necessarily an impact on the UK, but if things do not work out as perhaps they should then there may be some repercussions in Europe and the UK.

  Q4  Chairman: To what extent is the anchoring of inflation expectations around the inflation target important in ensuring that monetary policy is effective?

  Professor Congdon: It is very important because obviously there is, in the short run at least, an effect from inflation expectations to such things as pay bargaining; no-one disputes that. The question is "in the long run what is the cause of inflation". There is not much doubt that in the long run it is the quantity of money rising faster than the quantity of goods and services. What one has is this problem of how relevant is the behaviour of money to inflation. Even if expectations are firmly entrenched at this very low level, will that in the end ensure that the Bank of England can get away with monetary growth in double digits? I doubt it.

  Q5  Chairman: Did you want to come in, Professor Wren-Lewis?

  Professor Wren-Lewis: I do not think I would quite put it the way Tim does. I think that anchoring expectations does not so much make monetary policy more effective; I think it makes it easier, in the sense that if the economy is hit by shocks then the Bank has to do less to counteract those shocks than if expectations are much more volatile. I think it certainly makes the Bank's job easier and less painful, but it does not mean that if those expectations are not anchored the Monetary Policy Committee could not do its job; it could. I do not share the view that the source of all evil is in monetary aggregates.

  Chairman: Thankfully we have a difference of opinion early on in this inquiry and that is good! Peter?

  Q6  Peter Viggers: How successful do you think the Monetary Policy Committee has been over the last 10 years and is its success more due to luck than judgment? Just to frame the question, the Bank of England in writing to us quotes Ben Bernanke, the Chairman of the Federal Reserve, in saying that if anyone does say it is luck they under-estimate the extent to which the imposition of better policy frameworks has reduced the impact of shocks, so how successful do you think the MPC has been?

  Professor Wren-Lewis: I think the MPC has been very successful. There is no doubt that it has been lucky in the sense that it has not been a very turbulent period, so in that sense it has not been severely tested, but there have been problems that it has had to deal with. It has had to vary interest rates and it seems to me that it has varied them in a very intelligent and prudent way, so I think the MPC has been successful, in my view.

  Professor Congdon: I think it has been massively successful and that has been the result of good policy and, in particular, the adoption of a sensible framework. If one goes back to the period up to the Second World War, a period of about 150 years or so, the economy was basically managed on Bank rates and the economy was sensitive to movements in interest rates. That Bank rate system worked. The focus on interest rates was then very much diluted in the 1940s and 1950s because of Keynesian economics. We had all sorts of, in my view, mistaken approaches, in particular things like incomes policies and over-reliance on fiscal policies. What has happened in the last 20 years is a return, in effect, to the Bank rate tradition. But instead of it being focused on the exchange rate, it is focused on controlling the growth of domestic demand to keep output at trend, and it has been very successful. In my view, it is as if there are different ways of dealing with illness; some of them are bad therapies, some are good therapies, and they have chosen the right therapy.

  Q7  Peter Viggers: We do not need everyone to answer every question unless you particularly wish to add something.

  Professor Muscatelli: The only thing I would highlight—and I certainly would agree with what has been said so far—is the fact that when you try and measure success in an attempt by the Bank, as well as other commentators in the written evidence, just by volatility over the period then it seems as if the UK has done pretty well, just as well as some of the other economies. However, we have to remember just how much poorer UK macro policy was in the preceding two decades and really the UK lagged behind. Also rather than looking at volatility, if you look in terms of a sustained period of growth, the UK has actually fared very well compared to the other European economies which have been subject to very similar shocks, so I think it has been very successful.

  Mr Barrell: Although I would agree largely with what my colleagues have said, I would use only the word "successful". You can only be "very" successful if you avoid an accident when an accident is looming and there has been no accident looming, therefore it has not really been tested. The Bank has been lucky, as Ben Bernanke says, in that the world has changed to a better monetary policy environment and that has allowed it to change to a better monetary policy environment and improve  massively on the UK's monetary policy performance. The Bank of England system since 1992-93 has been much more successful than any previous regime we have had in the UK in the post-War period: so successful, yes; very successful, we cannot know that yet.

  Q8  Peter Viggers: Okay because there may be problems coming. For instance, house prices are about two-thirds above where you would expect in terms of the average historical ratio of house prices to income. Do you think the Monetary Policy Committee has been successful in integrating house prices into its equations? Is there more it should do?

  Professor Congdon: There is this general problem about asset prices. In my view, in the end there is a relationship between the growth of money, the behaviour of asset prices and movements in national income and expenditure. In the long run these are all related. At the moment you have got an anomaly really, because house prices are out of line with incomes. What has happened in two previous cycles—a cycle in early 1970s and again in the late 1980s—was that we had this very high house price:earnings ratio and then a bust. The ratio came back in the first case with a lot of general inflation and in the second case with house prices falling quite sharply in nominal terms. I think there is a medium-term problem out there and the question is whether there will be a bust or a gradual what is called "rust", in other words a long period in which house prices go sideways. My guess is that it is more likely they will go sideways for a period than collapse. Logically, history says there should be a problem of adjustment in the next few years with house prices.

  Q9  Peter Viggers: So looking at what Professor Wren-Lewis rather endearingly calls "bubbles"—that is, as it were, irrational exuberance in prices—do you think that it possible or wise for the Bank of England to try to identify these bubbles? Can I bring in here the comments of the International Monetary Fund which has said that Mr Brown, the Chancellor, should be building in cushions needed to respond to adverse shocks and that should be a priority. What they have indicated really is that in following his predecessor Ken Clarke's policies for a couple of years the present Chancellor was cautious. He then let the brakes off and we are now, as it were, at scene VI of Hogarth's A Rake's Progress where he is needing to slam on the overall controls. Can you comment on that?

  Professor Wren-Lewis: There are a number of parts to that question. On the issue of house prices and whether the Bank should try and identify bubbles, certainly it should be on the lookout for bubbles, that is periods in which asset prices in particular seem to depart from fundamentals, because potentially those bubbles can impact seriously on the economy. However, although in principle it should look out for those things and in principle could act to try and counteract them, in practice actually identifying when bubbles occur is incredibly difficult. Let us take the issue of house prices. It is far from clear whether the current level of house prices represents in any sense a bubble. For example, some of my colleagues at Oxford have suggested that if you go beyond rather simple price:income ratios and look at other factors that would influence house prices, then the current house prices might well be at a sensible level and not represent a bubble. So I think the problem with trying to pick bubbles is that it is very difficult to actually identify a bubble at the time. These things are only clear 10 years after the event. That is why I think it is dangerous to expect the Bank to do too much in this area.

  Q10  Peter Viggers: Because the thrust of the IMF comment says that "the public spending surge of 2001-2004 led to a sharp deterioration in the fiscal balance and rising net public debt, leaving little room for manoeuvre in the face of a global downturn." Would you regard this as a problem?

  Mr Barrell: I agree strongly with that and I have said similar things myself. I do not think the MPC can do very much about the Chancellor's spending and tax decisions. The MPC's remit is to deal with the consequences of that increase in public spending. On house prices, I think there is something one can add to that which is the same thing about public spending. When there a risk, like too much public spending for stability or too high house prices, then the Bank of England can hold interest rates slightly higher than it otherwise would have done, and I think that is wise. We have to remember though that the Monetary Policy Committee may actually be part of the cause of the rise in house prices and that could be a good thing. Volatility has come down massively in the UK; therefore the risks of owning a house have come down massively in the UK, therefore the demand for housing is shooting up. Exactly the same thing has happened in Ireland and in Spain. Suddenly interest rates are much more stable and the world is more stable and people demand more houses and house prices have come up, so it may not be a bubble; it may be the result of the Monetary Policy Committee's actions being so successful rather than the Chancellor's actions of pouring in rather more money than he perhaps should.

  Q11  Mr Love: Can I turn to household debt: do any of you think that the Bank of England should have been more proactive in dealing with the issue of household debt?

  Mr Barrell: It is very hard for the Bank to do that because one of the things that happened when the Bank was given independence was that certain parts of financial stability were separated from the Bank's remit into the FSA, and to the extent that we might be seeing too much debt rising, the most effective instrument for dealing with that would be constraints on lenders and the Bank of England cannot do that, so the Monetary Policy Committee cannot do that. Again, it should be keeping a careful eye on the rise of household debt because the rise of debt raises the risks of bankruptcy and raises the risks of problems in the banking sector and therefore it is one of those long-distance threats, it is not an immediate threat—and if the banking system begins to have problems that scale of debt will cause it severe problems, so the Bank of England should again perhaps be cautious on interest rates and holding interest rates higher than they would otherwise have been. That is not always popular with this Committee and we have discussed this before. Holding interest rates higher than they otherwise would have been in order to deal with debt and to deal with asset prices and those risks means holding them higher than they really need to be to hit full employment immediately, so there is a choice, a trade-off.

  Q12  Mr Love: Can I just ask you whether you think that the Bank should have signalled action to the FSA or the Treasury?

  Mr Barrell: I personally think they should have done. I do not know exactly what channels of communication they have between each other. I would hope that the Bank is aware of the risks from excessive debt of banking crises because it is relatively well known in the academic literature. I think they should have been signalling perhaps more worry about the scale of debt than they have.

  Q13  Mr Love: Do you agree Professor Congdon?

  Professor Congdon: The Bank cannot try simultaneously to control house prices and the Consumer Price Index; that is not possible, so when you have (as we have had in the last few years) a large rise, an apparently anomalous rise in house prices to some extent, there is not much the MPC can do. Of course it can give warnings and it has been doing that. Can I just say, as I said in my evidence, that the striking feature of the behaviour of the British people is how sensible they are? The ratios of wealth to income have been fairly stable in the long run. Wealth is much larger than debt. At the moment net wealth to income is at an all-time high. The debt is dominated by secured debt, it is secured against houses, and the unsecured debt is always small—it is very small at the moment—relative to total wealth. On the whole people behave sensibly. I am not saying there are not exceptions, which is unfortunate, but on the whole people are very sensible.

  Q14  Mr Love: Those who think there is a problem point out the fact that those who hold the wealth are not the same as those who hold the unsecured debt. Is there a problem for those people who hold the unsecured debt and is that an issue that the Bank should be concerned about?

  Professor Congdon: This probably sounds slightly heartless but I think this is a problem really for individuals and social security; it is not a problem of monetary policy. This probably does sound a bit harsh but one cannot get round it; this is not the Bank's job. It is not their job to deal with those people who have got excessive debts and so on. I am sorry for them, but that is not the point. It is not the Bank's job to deal with those individuals. Its job is to keep the overall inflation rate stable.

  Professor Wren-Lewis: I would agree with that in the sense that the Bank can express concern but it cannot act to deal with that problem. The one point I would like to add is that the big increase in secured debt does pose direct problems for the MPC because it probably means that the economy is going to be more sensitive to interest rate changes than it has been in the past. I think that makes the Bank's job when it has to raise interest rates, for example to cool the economy, that much more difficult because it really needs to tread a little bit more cautiously than it might have done in the past because there is this amount of debt out there, and as a result consumers might react much more to interest rates than they have in the past.

  Q15  Mr Love: I want to come on to that issue of sensitivity to rising interest rates but before I do, do any of you think, along with Mr Barrell, that there is a role here in terms of this unsecured household debt for the FSA and the Treasury? Do you think action should be taken by someone if not the Bank of England?

  Professor Muscatelli: First of all, on the issue of leverage, I think this is the biggest risk. The thing is we have not had a recession over the last period. If we had a recession similar to that in the early 1990s, given the high leverage situation, it would pose significant problems for the Bank. In terms of what can be done, I think it is certainly a role for the FSA to look at the way in which lenders behave, but I would agree with Professor Congdon this is not a matter for monetary policy and it is certainly not a matter for the Bank of England. It is a matter for the Government and it is a matter for the FSA to keep an eye on to see whether the sector is behaving responsibly.

  Professor Congdon: I am not denying that, if there were two years of 10% falls in house prices that would be very relevant to monetary policy because there would be effects on consumer spending and there would be effects on the banks and the building societies. In the early 1990s negative equity did impose heavy losses on the banks and building societies. But the situation now is not like the early 1990s when we were trying to get inflation down from double digits, and so in that sense I am not expecting a repetition of that.

  Q16  Mr Love: Can I come on to this issue about sensitivity to changes in interest rates. Is there any way in which the Bank should be able to measure this more effectively and accurately than it does? Professor Wren-Lewis, you have an ironic look on your face so I thought I would start with you.

  Professor Wren-Lewis: In a sense I am sure it is doing everything it can. The problem with macroeconomics is that you can never nail things down precisely, there is always a huge amount of uncertainty. However, I am sure with the kind of calculations where you look at the proportion of debt and you look at microeconomic studies of how individuals react to interest rate changes with particular levels of debt that the Bank has pored all over that evidence. I am not sure that there is anything obvious more that it could do.

  Q17  Mr Love: Let me ask you all and maybe somebody could give a comment about whether or not there is a linear relationship here between increases in the interest rate and decreases in consumption or whether there is mythical problem that once you reach a certain level, consumption will change very, very rapidly. Does anyone have a view on that?

  Professor Muscatelli: I think the problem is exactly what we were discussing a moment ago which is the relationship may be linear within certain bands, within a certain situation if that persists, but all you need is a major discontinuity because borrowers are constrained for that to change. If you have a situation where unemployment rises very suddenly or you have a big recession, then non-linearities do kick in and people do find it very difficult to smooth their consumption over time and at that point it becomes much more difficult for the Bank to do something about it because it is not only necessarily about reducing interest rates and reducing the debt burden but also about the impact that has on employment prospects because it is a combination of a variety of things. It is the interest payments on the debt but it is also the extent to which people are in employment or not. If you look again back to the 1990s, in some cases the problems of negative equity and people defaulting on their mortgage payments were to do as much with their employment prospects as with the actual interest payments per se. These sudden major changes can cause discontinuities and at that point the uncertainty which Professor Wren-Lewis referred to kicks in because you are almost in a different regime at that point.

  Q18  Mr Love: The other question I was going to ask arises from Professor Congdon's comments earlier. The Bank seems to have been paying much more attention to money supply figures than it has in the past and of course they have been rising very quickly. I think we know Professor Congdon's view in relation to that. I wondered whether anyone else wanted to comment on whether this was a sensible way for the Bank to respond.

  Professor Wren-Lewis: It certainly is something that the Bank should be concerned about in that very rapid increases in monetary policy have, on occasion, signalled a more serous problem to come. However, as an indicator it is very unreliable and rapid increases in monetary aggregates have also happened with virtually no consequence to the real economy. In a sense it is something the Bank should keep an eye on, but if nothing else happens to worry the Bank and there is no supporting evidence that demand is building up, then I think it is just one of these problems that will turn out not to be a problem in the long run and that is how it looks to me at the moment. It is certainly right that the Bank should keep an eye on it.

  Q19  Ms Keeble: To what extent do you think that the Consumer Price Index remains a credible target for inflation in the UK? Perhaps Professor Congdon if you could answer and Mr Barrell could you respond on that point.

  Professor Congdon: There has obviously been a problem in the last few months with the Retail Price Index being so far ahead of the Consumer Price Index. There have been periods in the past when the two indices have diverged very markedly. I have not got any very strong thing to say about it. Obviously insofar as the Retail Price Index affects pay bargaining then that is, in a way, the one that really matters. By the way, I do not deny wage costs are very important to the inflationary process. There is obviously at the moment this whole question of monetary policy affecting largely the private sector. In the public sector it is much more a matter of bargaining and in a way just brute force, frankly, who wins between the Treasury and the Chancellor, and the public sector unions. I think that is something to watch out for because there has been a long history in Britain of trouble on inflation after the public sector unions force big pay rises through strike action. We seem to be facing something like that, on a lot smaller scale than in the past but it is there.


 
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