Martin Wolf: You’ve decided, haven’t you, to take some real time off before you decide what to do next with your life.
Mervyn King: A “gap half year”, yes. I just do not want any conversation about the future until 2014. This is the whole point.
MW: What is the plan for the gap? Travel?
MK: Some travelling. We’re going to spend a bit of time in New York. July and August is a holiday period. So it’ll be a lot of different things, but we plan to do it in a relaxed way.
MW: Do you think it’s important for someone in your sort of job to disappear from the limelight, to leave your successor a free run?
MK: Yes. I think you just cannot appear to do anything which makes life potentially difficult for your successor, so you just can’t comment on anything related to that. You just don’t want – even just at lunch or dinner in London – to talk about what’s going on, you just don’t want to do it. And from that follows a wish not to think about it. So I want to get away and think about different things altogether.
MW: That makes sense.
MK: But being out of London is, I think, quite an important aspect.
MW: Ben Bernanke wasn’t quite so lucky in that regard, was he, really?
MK: Well, I think Alan Greenspan had a different set of interests and he basically carried on doing what he had been doing since he left the Fed. And I think he was careful not to try and make public statements that would make life difficult.
But from my perspective, what I want to do is to get away from everything for six months, in order then to be able to see everything in a greater perspective, and only then decide what to do. I don’t think I can predict now what I will want to do when I get to 2014, so it makes no sense to commit to anything, and because of that it makes absolutely no sense to agonise about what to do. The thing that I will look forward most to regaining on1st July is my freedom.
MW: Do you feel relief? It’s been a long and hard period.
MK: Well, it’s a mixed set of feelings. I know that I’m going to miss enormously not being at the centre of things. That’s going to be very hard to adjust to. And everyone I know who’s been through this has found it very hard to adjust. You just can’t step away from it and pretend that you’re happy no longer to be at the centre of events. So that is a big change.
MW: It kills some people, actually, if you look at the statistics. Or retirement does.
MK: Indeed. So what you have to do is to find other things that you really want to do, and where you say to yourself, I could never have done this had I still been in the job. So what you have to avoid is doing anything that is the equivalent of having played in the Premier League and then going to play in the 2nd Division. You have to do something different.
MW: But you have been an economist all your professional life.
MW: So stepping away from that will be quite an extraordinary change, wouldn’t it?
MK: It will, and I’m not saying I’ll step away from economics altogether, but I want to just take a complete break now. I do not want to teach in the next six months or have any commitments or obligations. I just want to be free to read, reflect, and try lots of different things.
MW: What are the things that you won’t miss?
MK: The things I won’t miss will be the treadmill aspect of it, sitting in rooms, stuck in meetings for hours on end where nothing terribly interesting happens.
MW: Or is said.
MK: Or is said.
MW: There have been a few exceptions, but I suppose it’s a frequent experience that meetings don’t go anywhere.
MK: Or if they go somewhere, they go somewhere that was predictable a long time earlier. Or they are discussing things that, frankly, it’s hard to believe matter a very great deal.
So I’ve made my contribution to how the bank is shaped and run and the structure of it, and it has changed a lot. I feel proud of what I’ve achieved there, but I can’t contribute much more in thisdirection. Somebody else needs to do that.
MW: When you look at the Bank that you’re leaving behind – well, you started the bank in the early 1990s, is that right?
MW: 1991. So it’s full circle in the sense that the responsibility for regulation of banking has gone back to the Bank, but actually even more so. So it’s an enormously expanded institution even relative to what it was then. And it also, of course, has the monetary policy responsibility. So the bank has become amazingly central to our economic lives, which most people in 1991 would not have imagined.
MK: No, because even supervision was done in a much less high-profile way: it was far less transparent. And the Treasury was always deeply involved in that, as inevitably they’re going to be when public money is involved. On monetary policy, the Bank didn’t have any overt role. It gave private advice to the Treasury, but it was always couched in terms that were not economic but rather concerned the impact on the markets. That has completely changed.
MW: Should we get something to eat?
MK: Yes. Let’s order something. Michael, are we ready to start eating? What I suggest is that we just leave it to them to serve us. Is that all right?
MW: Yes, that’s fine. I love this food. So that’s not going to be a problem.
So the first question, I suppose, is do you think the bank, as it is now, as you leave it, is able to fulfil these tasks?
MK: We’ve got to get out of the crisis and get back to another world for the next thirty or forty years. And it may or may not have been necessary to do it all through one institution. Whether it will be easy to do it, I don’t know.
So if I think what went wrong with regulation in the period running up to the crisis, it’s that there weren’t any problems with the banks in the sense that no one was coming to the central bank for money and no one was failing. So it was very, very hard for anyone to argue that prudential supervision was at the heart of what regulation was about. It wasn’t very exciting. Nothing much was going on. So it drifted into a rather routine responsibility.
It’s a lot easier now to get people to say to banks, “look, your leverage is much too high. This strategy is very risky.” That is because people are very conscious of what can go wrong. So it’s much easier to create a sense of urgency both in the regulatory organisation and in the banks themselves, among their directors and senior management. So, from that point of view, it’s actually easier to persuade people that the regulator has to do a job.
And I must say, I’ve been very impressed since April 1 2013 at the enormous change in the style, and almost culture, of regulation that’s been achieved in the switch from the FSA (Financial Services Authority) to the Bank of England. This has been going on for a couple of years, but only reached its position in terms of actual decision-taking and telling the banks what to do on April 1. So that has changed a great deal.
You see, when I joined the bank in 1991, within a few weeks I found my fax machine commandeered by the supervisors to deal with a bank that, frankly, I’d hardly ever heard of before: BCCI (Bank of Credit and Commerce International). I wondered: what is this all about? This wasn’t what Bank of England was about, as far as I was concerned. It wasn’t what my area was doing. But that led to a period of massive introspection: could the bank have done something else, how should we do supervision, do we want to do supervision?
And I think it was probably impossible to reform the way in which prudential supervision was carried out in the bank without its leaving the bank first and then coming back. That is because the one thing that both [my predecessor as governor] Eddie George and I talked about quite a lot was the importance of not taking responsibility for depositor protection or consumer protection – that nexus of responsibilities that was in the FSA – indeed, was the heart of the FSA for many years, and is now vested in the FCA (Financial Conduct Authority).
That is not a central banking responsibility and it’s not something that anyone there really has any aptitude for. It’s a different culture of regulation. Whereas prudential supervision is much more about having sufficient intellectual confidence to look at the balance sheet and say, this is just too risky and you’d better change it.
MW: I presume the truth is, isn’t it, that nobody, up to, certainly up to the 2000s, thought that a failure of the British banking system of the scale we saw was possible.
We didn’t have a banking crisis in the 1930s, as the Americans did, and I remember very clearly that after BCCI there was a debate about depositor protection. And in a rather naïve way, I argued, well, shouldn’t we have 100 per cent protection up to a certain limit, because otherwise you won’t prevent a bank run.
No one thought this was a remotely sensible argument because what everyone was focusing – perfectly understandably, since there was no prospect of a general bank run – on was the idea that it was very important for depositors, whether they were local authorities or anyone else, to know very clearly that, on their bank account, they would be taking some share of the loss. So they would have every incentive not to put their money into a bank as risky as BCCI was turning out to be.
That argument obviously still holds. But it’s been overwhelmed and dominated by the fact that I don’t see how you can run a monetary economy if households and businesses do not have access to completely riskless bank accounts from which they can carry out their payments. The ring-fencing of retail banking, for which you’re partly responsible [via the Independent Commission on Banking],is, I hope, going to give a much better likelihood that we won’t get into a position again where those ordinary bank accounts would be at risk.
MW: You still have the problem of corporate bank accounts, which could be much bigger and which are essential for them, and it is very easy to imagine the circumstances in which a run by corporatedepositors or other uninsured depositorscould cause tremendous mayhem.
MK: That is why I don’t think we’ve reached a final position yet in terms of deposit insurance, and I think, certainly for SMEs (small and medium enterprises), it will be necessary to have some form of deposit insurance scheme that allows them to have larger insureddeposits, in just the same way as for an ordinary person, there will always be, one day in the year or in their life when they have a much larger sum of money in the account …
MW: They’ve just sold a house, say.
MK: A house purchase, a divorce settlement, a court settlement, an insurance pay-out. And it may only happen for one day in their life, but what that means is that, on any given day, if a big bank, or biggish bank gets into trouble, there will be thousands of people in this position. And I don’t believe any government will let them lose their money. But the ring-fence will help because it will make it much less likely that the bank will fail.
MW: Well, we hope so.
MK: Provided these deposit accounts banks are supported by much higher loss-absorbing capacity.
MW: It has to be said that under government proposals, even ring-fenced banks are not going to have that much equity.
MW: It doesn’t take much for a bank with 3 per cent of its balance sheet financed by equity to be wiped out.
MK: That is why leverage is a very important issue.
MW: Which has not been resolved.
MK: Which hasn’t been resolved.
MW: Well, it hasn’t been resolved here because it hasn’t been resolved globally.
MK: It hasn’t been resolved in Basel [where the global regulatory discussion takes place at the Bank for International Settlements], because the ratio there is still 3 per cent. And it hasn’t been resolved in any other country.
MW: The Swiss went first.
MK: The Swiss have done it and the Swedes are also moving in that direction.
But this is exactly the problem. If governments are willing to bail out their banking system, then they will not force their banks to have lower leverage ratios. And they will not do so because they think this gives a competitive advantage to their banking system. The banks will certainly claim that.
And this nexus between government and banks will mean that you will get some countries at least where they will be willing to support very highly leveraged banking systems. Banks elsewhere will then argue that, on grounds of competition, they too ought to be allowed to have very high leverage. But of course it’s just another way of saying that taxpayers should be required to subsidise us.
MW: So “we should be entitled to run ourselves just because others are determined to ruin themselves.”
MK: And what is interesting, to my mind, is that we abandoned this argument for the car industry, and one of the results of that is that we actually have a much more efficient and successful car industry today. We don’t drive the cars that we produce. The cars that we drive, we import. But we produce a lot of cars, more than ever, and we export them.
MW: So why are the banks so good at achieving this exceptional position? Almost, one might say, shamelessly, given the scale of the mayhem that has occurred. I mean, this crisis in the UK, but also globally, is among the greatest shocks, outside of world wars.
MW: And yet nothing has changed. Or not much has changed.
MK: Not much has changed.
MW: It’s better than it was.
MK: It’s better than it was, and we’re going in the right direction. And if we get to 2018 and everything that’s promised is implemented, it will look different then.
In some ways, you could say the crisis is bigger than anything except war and the Black Death. I mean, it is very big. And it’s been very difficult to persuade people of that because the effects have been slower coming through. The effects on unemployment in the industrialised world have been much slower to come through because of the policy response in 2008.
MW: The big countries, by and large, have got through this, surprisingly, unscathed, given that GDP, say, in the UK’s case, is about 16 per cent below trend. And in the US it’s not much different.
MK: Yes. And that is still an enormous gap between where we should be and where we are. And I suppose, because it’s a hypothetical counterfactual, it doesn’t quite have the same impact. But there have been big squeezes on living standards. I have been generally surprised by how much of this has been tolerated, even in peripheral European countries. Greece has had the same fate as countries caught in the Great Depression.
MK: And I thought, when I was a student, I thought it could never happen again.
MK: And it has.
MW: Real private domestic demand in Greece has fallen 30 per cent.
MK: Yes. And what’s so astonishing, in a way, is that everyone thinks this is a sensible outcome. It’s not that people are saying: this is so bad, we’ve got to change everything. They are simply saying we’ve got to just keep muddling through.
MW: Let’s go back to the question I was going to ask you before. What do you wish you had known, as an economist and as a policymaker, say ten years ago? What would you have told yourself if you could have done so, that you do know now, about how economies work, about how the financial system interacts with monetary policy, and how policymakers should approach it? What do we know now? What do you know now that you didn’t know then?
Restaurant owner: Anything to drink?
MW: I wouldn’t mind a little glass perhaps of white wine.
MK: Yes, some white wine. I’ll just have half a glass perhaps.
RO: Your usual?
I don’t think I appreciated the scale of the shocks that could occur. We drew great comfort from the fact that we had a framework that meant that interest rates wouldn’t have to rise to 15 per cent, 20 per cent. But we never imagined we’d get down to zero and be stuck there. And I don’t think we really appreciated how much a big shock to the banking system could affect the economy.
The big issue that comes out of this, for me, is something that I think you’ve referred to already, but I think it’s of fundamental importance. Money is a social institution. It’s a very important one. We’ve seen that. Consider the importance of the payment system. That’s why the ring-fence for retail banking is so important. But money is the only social institution that we’ve delegated to the private sector – and a private sector that is regulated in such a way that doesn’t seem to take account of the damage that can be done when it goes wrong. So the massive expansion of the monetary base that we see, some people still seem to think is massively inflationary, but it obviously isn’t, at present, and it can’t be until it feeds through to the broader money supply, which won’t happen until the banking system gets back to a more normal state.
I suppose the thing which I hadn’t appreciated was a key part of Keynes, which I think was never fully integrated into conventional banking economics: the idea that the future is completely unknowable, but the extent to which it’s unknowable doesn’t seem to disturb us very often. We just cope with it quite well. But there are occasions when you get dramatic changes in people’s assessments about their future and then you get enormous demand for liquidity.
The uncertainty is something that they can’t calculate. So you can’t just argue that, oh, something’s changed, so therefore we know what the probabilities of various future events are, so we re-price an asset. We used to think the price was P. Now it’s P1. But we can still price it as competently as we could before because, even if risk has changed, there’s a price for risk. Everything can be priced. And I think the point of Keynesian economics is that there are some things that simply can’t be priced, and people just go into cash and become highly liquid. And that can just lead to a collapse of the banking system.
MW: Cash is what you hold when you don’t know what to do. That defines, in a way, what cash is about.
MK: Yes. Cash is fundamental to the day-to-day running of the economy. But at the same time, it’s the asset that you move into when you have no idea what to do, which is why our monetary economy is so unstable.
MW: Some people would argue – and indeed not would argue, do argue – that inflation targeting was at fault.
The argument would go something like this. The world had a disinflationary shock. You can describe it, although it’s a bit too simple, as the “China shock”, which ran until the early 2000s. That was a sort of one-off price effect that had the purpose of lowering inflation in the developed world. You all had inflation targets that you were actually beginning to be worried about in the early 2000s. Then of course that was reinforced by the stock market crash. So actually inflation was going to be too low. And even in the UK, we undershot the inflation target for quite a long time.
So you then, to meet your target, all pursued really quite expansionary policies that created the conditions for this enormous credit boom. Once that got going, it got into asset prices, into housing. Then the financial sector created derivatives of all sorts and kinds, based on that underlying security. You know all that very well. And so the central bankers, with the target they were adopting, actually made things unstable when they thought they were making it stable. How would you respond?
MK: I think I’d ask a question, so what should we all have done.
MW: I suppose the argument, some would say quite explicitly, is you should have allowed deflation.
MK: But if we’d raised interest rates, yes, that would have led to deflation, and we could have allowed that, but more than that it would have led to slower growth of aggregate demand and output growth below a perfectly sustainable long run average.
So I do think that it is very important to recognise that none of the major economies were growing, in terms of output growth, at above their long run average in the period running up to the crisis. The average growth rate in the five or 10 years before the crisis seemed perfectly sustainable. So it wasn’t that the economy was running against capacity limits, as we were in the ‘60s and ‘70s, that was creating a problem.
The problem was something rather different. It was a problem that most of the macroeconomic models, which central banks, and others, were using, did not look at enough, which was the whole pattern of demand. And we debated this pretty actively in the MPC. And here I come back to an issue that I banged on about. I don’t have a simple answer to it, but it’s that if the UK on its own had tried to say, okay, so we’ll have deflation. We’ll have higher interest rates. We’ll have deflation. We’ll try to prevent credit growing quite as rapidly. We would have had a higher exchange rate, slower growth of output, weaker economy, higher unemployment, and we wouldn’t have prevented a global financial crisis.
It might have been a little bit less severe, because we weren’t the cause of it, but we’d still have been part of it. And it certainly wouldn’t have prevented the banking crisis because the banks were all global. So I would say that the right answer in that period would have been not to have had a necessarily different monetary policy, but for bank supervision policy to have been explicitly based on the need to prevent leverage and credit expanding as fast as it did.
No, it’s an arguable proposition. I’ve talked about it in my LSE lecture last year and I said yes, you can argue that we’d have been better if we’d had slightly higher interest rates. And I voted for them 14 times, in a minority. And we had a very open debate. In 2000 I talked about it in a speech in Plymouth, and the committee was divided in terms of saying, well, some people wanted even lower rates because inflation was below target, and some wanted higher rates in an attempt toslow the growth rate of domestic demand in order to try and jolt the economy to a different equilibrium.
Whether it would have worked, I don’t know. I certainly can’t claim it would have worked, but the hope would have been, in the UK’s case, that by having higher interest rates we might have jolted the exchange rate back down to where it was before it rose in the late ‘90s. And if that had happened …
MW: Having lower interest rates?
MK: No, no.
MK: Normally, you can argue you want to bring the exchange rate down, so you lower interest rates. And some people did argue that on the MPC. However, if that had happened, I don’t think it would have lowered the exchange rate by very much because it would have stimulated even faster growth of aggregate demand. And, at that point, everyone was making:“oh, the new theory of the exchange rate is that the exchange rates are strong when growth is strong”.
So the other view, which some of us put forward, was that, if we could demonstrate that we’re prepared to run with a lower level of domestic demand for a while. In other words, we’re essentially targeting the growth rate of nominal domestic demand, maybe markets would realise that it was unsustainable to run with this exchange rate, and they would bring the exchange rate down. We never got to find out whether that would have worked or not.
MW: I remember the arguments very well. There was a strong view that, with such a high exchange rate, which we couldn’t fully explain and had good reason to believe was temporary, you should expect and accept lower-than-target inflation for a long period.
Wouldn’t you have been violating your target? And the politicians would have said the Bank of England is taking upon itself to make the economy grow more slowly than it could, and violating its target because it has a theory that, in the long run, not doing so might create some sort of financial excesses. That’s ridiculous. We can’t allow that to happen.
MW: But maybe the problem was the inflation target was too restrictive. You need more flexibility, some would argue.
MK: But you’d still have the problem that the Central Bank would have been arguing that the right monetary policy was indeed to accept low growth, lower than we could achieve, with rising unemployment and inflation below the Central Bank’s own definition of price stability. And it would be arguing it should do that because, in the long run, something awful might happen. And whether or not we’d describe this as violating an inflation target, or merely the Central Bank using its own unstated flexibility to pursue this policy, either justification would have generated a major political issue.
MW: There are two aspects of this that have always interested me. Let me get them both because it’s sort of a counter-factual. Let’s suppose you’d had a “macro-prudential” framework. You’d tightened up on credit. Then you would have found that this would have worked by slowing economic growth. It’s a quasi-monetary policy, in a sense. It affects the credit mechanism directly. You slow the growth, but you yourself say that if you’d done that, inflation would probably have fallen below target. The economy would not have grown as fast as its long run potential appeared to be. Then you would have had to offset it. And the obvious thing to have done in that situationwould have been to cut interest rates in the hope that, with a lower interest rate and a tighter credit system, the structure of demand would in some way have been more sustainable. We don’t actually know that.
MK: We don’t.
MW: But the big point – sorry, I’m not regarding this as a purely historical exercise – is that if you have part of the Central Bank trying to keep the financial sector from going crazy; and another part trying to keep the inflation target going, you’re going to get into some pretty big conflicts. And, in the situation that we were in, in the early 2000s, that’s not theoretical. That’s very real.
MK: But the conflict that’s thrown up by the economy, and I think the question is ...
MW: Indeed, they’re not artificial. They’re fundamental.
MK: They’re fundamental. Absolutely. And this is why the question of the committee structure, in a way, is a bit secondary to it. And how you deal with it, I don’t know.
MW: I don’t wish to focus on a question of whether we should have one committee or two. I have my own views. No, the fundamental question is, what should the aggregate do, faced with that dilemma.
MK: Yes. And I think you can’t answer this satisfactorily without looking at the world as a whole, or at least the industrialised world as a whole. I do feel very strongly that all the things I’ve seen in the last 20 years have demonstrated that if countries have made mistakes, they’ve made them because they didn’t feel that they could move the global equilibrium in any way. So they took what the rest of the world was doing as given. So if it had been possible, in some extraordinary way, to think about a different pattern demand for the surplus countries, so we wouldn’t have had the …
MW: The developed world become a huge net exporter of capital. If this was the late 19th century and the emerging world had been net importers and we didn’t have to juice our credit markets in the way we’ve done, to achieve domestic equilibrium. I’m just trying to make it concrete.
MK: Yes, or even just … No large net flows.
MW: But people don’t want to think this way.
MK: They don’t want to think this way.
MW: Even the people in central banks who, after all, are much closer to setting the global equilibrium than the Bank of England.
MK: Yes, but the attitude, I think, of most large countries, is they feel nervous about appearing to engage in anything that could be described as formal policy co-ordination, and the reason they feel nervous is because they find it difficult to defend, domestically, to the politicians and congress and all that, the proposition that we are doing something which was not done solely in the purely domestic interest. The fact that, if everyone behaved in the same way we’d all be better off, is not a winning argument when it comes to the central bank saying, I’ve taken these measures solely from the purely domestic point of view. If you do that, you’re trapped into the prisoner’s dilemma.
MW: When you went to all those meetings, and this issue was raised in different ways, and of course in the G7 and so on, do you feel that there was ever even a collective recognition of the dilemmas that they were facing as policymakers? Or was the assumption that everything was fine. The legislature knew what it was doing. It was all going to unwind perfectly satisfactorily, even though one could see some excesses, which every central bank noted.
MW: Nobody was unaware that something was going on.
MK: Everyone thought this position was unsustainable but no one could think of a way through. Indeed, we had seminars at the IMF where people were brought in to speculate on how it would end. And most people guessed on a large and sudden collapse of the US dollar. Not collapse of the banking system.
MW: Yes, that was certainly my big mistake.
MK: So the one moment where there was a genuine sense thatwe’ve got to find a way out of it together was autumn 2008.
MW: Which was, in some sense, necessary but too late.
MW: Too late. You were dealing with a crisis.
MK: But what was depressing was that, actually, that sense, we have to deal with it together didn’t last beyond January 2010. It had gone by then. And now everyone was slowly gradually coming out, and we’ll do our own domestic thing and we’ll get out of it. And I think this was profoundly mistaken because I think the challenges that we face are … I genuinely think that all of the things we’ve done in the last three years would have gone pretty well had the rest of the world merely grown at its long run, had the industrialised world grown at its long run average rate.
MW: What about the argument that we were fooling ourselves in thinking that the long-run trend growth of the developed countries was unchanged by the emergence of the emerging countries; that a very large shift, in an open economy, was occurring in the equilibrium location of global capital; and global investment opportunities. And that, while this might be positive-sum for the world, it could well be negative-sum for us.
So, really and truly, properly understood, the global capital system would have wanted to put all its new capital into China and such like places; shrunk investment in our countries; capital stock ought to have grown more slowly. And if we’d recognised that, we would have seen that what was normal growth was actually artificially created credit driven growth. And we now, after the crisis are actually, in some sense, in the world we should have been in, if we’d understood it, before this thing went all crazy.
And therefore our assessment – this is not something that I thought at the time – our assessment of what was normal was wrong. Our response to the shock associated with China was wrong. And we ended up creating more trouble for ourselves by keeping the developed countries going than not.
What do you think about that sort of argument?
MK: Well, I certainly think we didn’t analyse correctly or fully or deeply enough the consequence of this enormous change that basically started with the fall of the Berlin Wall.
MW: Yes: a new economic and political world.
MK: It was sort of the reverse of the Black Death times 10, or times 1,000. And this enormous injection of people into a market economy, prepared to live by the rules of a market economy. People have ideas; produce goods; sell them. And this was going to have a dramatic effect. And we did not take that seriously enough. I still don’t see why it should change our ability to grow output at the same rate. That ought to reflect both population growth, which is largely unaffected.
MW: This is wonderful food. Thank you.
RO: Thank you. This is what we call Singapore laksa – Singapore soup.
MK: So this is one of the gems of London. And I come here to escape. And I just now have learned that you’ve just to ask Michael to feed us, and he feeds us.
RO: Soup okay?
And I don’t think that our ability to generate new ideas and productivity improvements has diminished and, you could argue, created competition, and certainly trade opportunities, as a spur to it. And I’m struck that certainly since the fall of the exchange rate four years ago the companies I see as I go round the UK are full of ideas which they’re selling in a niche way: what makes our country successful in trade is not producing on a mass scale,but it is actually saying to people, including in China and elsewhere, when you have a problem with your product, come to us. We’ll solve it for you and we’ll produce a new component or a new product.
So you get this growing long-term relationship between British companies and their customers abroad, where they are doing something special. And you don’t notice it because any one company here has only maybe 500 or 1,500 people, but they’re growing and they are very successful overseas. So I don’t really, deep down, see why our long run growth rate of output should change.
However, the growth rate of income almost certainly did change. So the real wages and real profits would change. What we should have realised was the need to adjust levels of real spending and real income. And we didn’t do that. And I think what the financial crisis did was to bring home to people that, actually, our future path of real spending and income is going to look very different from what we had hoped.
MW: My view increasingly is that, actually, the shift went the opposite direction because of the surprising effect of the emergence of the emerging countries, particularly after the Asian crisis. As we’ve already discussed, they became capital exporters. And global real interest rates fell. And they fell quite a lot. You can see it clearly from UK index-linked gilts. And it’s not a coincidence, in my view, that if you start looking, very far from it, if you start looking at house prices, they all started rising about this time. Exactly what you’d expect.
MW: So a process, which actually was, in some ways, causing us to adjust to a world of, lower real income – this is so often a problem in economics. The short run effect is to raise your perceived wealth.
MW: And this affects everybody. All the signals go in the wrong direction. And the financial sector is not really a creator of this. It’s a follower of all this. And a magnifier of all this.
MW: Surely that’s what we missed.
MK: Absolutely. I mean, we identified mistakes and symptoms in the financial sector, but they were reflecting things that were happening elsewhere. And this global fall in real interest rates was bound to lead to a rise in asset prices. And the mistake was not somehow to get people to understand that this was merely a reflection of low long-term interest rates, and not a reflection of higher future wealth and incomes, out of which they could justifiably spend more. And if we could have somehow managed that transition better …
MW: Of course, if they hadn’t spent more, the world would really have ended up in the sort of Japanese trap ten years earlier.
MK: But with a different pattern of exchange rates to go with it. That might have made a difference. China might have realised that its strength depended on releasing the consumer spending power of its population.
MW: The question, in a way, is whether what happened before the crisis was the normal GDP levels or today’s, or both. Because if you think the way we’ve now been thinking, the financial crisis, though incredibly important, is almost an epiphenomenon of even deeper processes.
MK: Yes, I think that is true. It’s a symptom of what was going on. And this is why, you know, the bankers played their part, but they were actors on a stage in a play written by someone else.
MW: So even if we’d contained them that might only have reduced the worst excesses.
MW: At some point, some adjustments would have had to occur, even if they hadn’t done what they did.
MK: Yes, and that is why, I think, it is proving so difficult to get out of this mess.
MW: The conclusion, or at least your conclusion, is that a financial crisis is a very important event because it tells you a lot about how the financial sector itself behaves. But it is not sufficient explanation of where we are now.
MK: Correct. It was the biggest financial crisis, I think, the world’s ever seen. But to understand what’s happening now, you have to look at macroeconomics. And you can’t just treat the world as a single economy, and you can’t just assume that our country is an island. It isn’t. It’s the interaction between countries, which is proving very difficult at this stage.
MW: The implication of what you’re saying, just to be clear, is that really and truly, even if we look back, it’s not clear that there was another set of policies available, to this country at least that would have avoided some pretty painful adjustments somewhere along the road.
MW: Though not necessarily in the form that occurred.
MK: Absolutely. Absolutely. And that’s I think why people were so reluctant to do anything. There was no possibility for any one country on its own to deal with this.
MW: But do you think then, even if inflation targeting didn’t cause it, I’m not suggesting that, that the complacency around the great moderation encouraged people to believe that everything was more under control, more comprehensible, more predictable than it actually, as we now know, was. We fooled ourselves, collectively, in a rather big way.
MK: No, I think we probably did. I don’t think it’s an argument against inflation targeting. I think the things that happened domestically were two. One is we demonstrated that it was possible to run monetary policy in a way that meant that you could avoid high and variable inflation. That was a doable proposition, and we did it. And secondly, and this is where inflation targeting comes in, the best way to do it wasn’t just to have some great magic guru or some politician just do it once and say oh, it’s been imposed on us. We created a set of institutional arrangements, whichmade this seem a normal, professional common sense outcome. It didn’t require magic. It was just doing it competently.
I think what happened was that people interpreted that to say, oh well, all the problems have been solved. And one of the things I remember vividly from when I joined the bank, was whenever we did anything that seemed to work, even members of parliament would say to us, well, that’s terrific. You’ve done really well. Would you like to tell us how to reform the social security system? As if success in one area would guarantee success in all areas. Once real interest rates started to fall, I think what we should have done was, internationally, we should have said this is not a sustainable. You can’t run a market economy on negative real interest rates. So we’d better find a way out of it. And we didn’t. And then we got into a position where real interest rates ...
MW: They’re more negative.
MK: They’re more negative. They’re negative after 25 years in the UK. If you had said to me ten years ago, could we ever find ourselves in a position where real interest rates on government securities would be negative after 25 years, I’d say you’re mad.
MW: I give lectures on this, and I say: if you want to know how sick we are and how far we are from equilibrium, just look at this. This is not supposed to happen. If we weren’t growing at all and everybody expected that we’d never grow again, it might make sense. But actually we’re growing quite briskly, in aggregate. Now, there are many reasons for that. One of them we’ve discussed. Obviously the fact that China has emerged in the way it has, with the highest savings rate in the history of the world, and also the highest investment rate, and the savings rate is even higher, is not something anybody really imagined.
Can I just turn to how we handled the crisis, and what we did right and what we did wrong?
Most people would feel that, when it became obvious just how dreadful things were, in the autumn of 2008, the crisis was handled pretty well. Do you feel, a sort of general view and I’ll come back to the British story, but one of the things that gets raised in this is: was the Lehman failure decisive or was it actually, as it were, just a trigger, and there was going to be another trigger? Was it a mistake that we got into that sort of mess, or was it actually something that had to happen before we’d actually do anything?
MK: I’d go for the latter. Right through this crisis, I’ve used the phrase privately, the “audacity of pessimism”. Only when things look bleak will people ever get round to doing anything. The only international meeting where people …
MW: It was October 10th, 2008 when you tore up the …
MK: We literally tore up the communiqué. I’ve never been in a meeting when anyone was remotely prepared to do that, before or since.
MW: Because they were so frightened.
MK: They were frightened…
MW: What about? They were terrified of what was going on.
MK: Yes, but they were also very conscious of the fact that everyone was in the same boat. That was the interesting thing. So, after Lehman Brothers, what I found very striking was that my Indian opposite number would ring up and say steel sales are collapsing in India. What’s going on? And my Brazilian counterpart would say, car sales are collapsing in Brazil. Why?
And the only explanation I can give is that, around the world, people thought the one country that really is a successful market economy, that has solved all these problems, has a very successful financial system, is the US. If this can happen in the United States, what on earth is going to happen to us? And so you had a complete collapse of confidence, and world trade fell faster than even in the 1930s.
But what was interesting was, by the time you got another six, nine months through it, the emerging market economies had said, well, hang on a minute. Our financial system isn’t bust in the way that theirs is, so we shouldn’t be going through this. And then there was a recovery of confidence in those countries and they came out of it much faster than we did, because our financial system, at that point, generally, was in a desperate situation.
And it was the very high degree of leverage which then meant that they were vastly undercapitalised. And I think this is a reflection of one of the things that Keynes didn’t write explicitly about, because he never actually experienced a banking crisis in the UK. He saw it from afar, in the US. So if you asked the question, how much capital does a bank need to have in order to retain the confidence of the markets and persuade people to leave money in the bank and lend money to the bank, or buy shares in banks, before the crisis we know, by observation, the answer was, hardly any. Afterwards, we know the answer is, a vast amount.
MW: Whatever it is, it’s not enough.
MK: And banks use that as an argument for not making the adjustment, but actually, unless you do make the adjustment, they are completely zombie banks. And we’re gradually and slowly moving out of it. But you get these big shifts in confidence, and this is one of the things that’s been missing from much modern macroeconomics, that you get sudden and big shifts, which are not well represented by the sort of distribution of outcomes…
MW: Don’t you think that Minsky understood this better than most?
MK: Yes, absolutely.He did. And, in a sense, it’s more than that. I remember in the ‘60s that Joan Robinson and Richard Khan, who were lecturers in Cambridge, would rail against modern neo-classical economics. And they would even rail against Hicksian IS-LM. And I would interpret what they said as saying that Keynes was saying “don’t write down a mathematical model where people have a well-defined distribution of outcomes.”
MW: Because that’s not the way it works.
MK: It’s not the way it works.
MW: But we can deal with risk; we can’t deal with uncertainties.
MW: And mathematically it’s almost impossible.
MK: And I have a lot of sympathy for some of the recent contributions in what’s been called emotional finance. Now, this is only being applied to the financial sector: people talking about how banks and financial people behave. But it’s everybody. It’s everybody. And you can get a point where people say, I don’t care what the interest rate is, I’m just going to hang on to cash. I’m just not prepared to spend. I will pull up the drawbridge. And in that situation it is extraordinarily difficult to do anything to stimulate private sector demand.
You really do have to have a whole series of measures that give people confidence that you genuinely are on a path that’s going to lead to a brighter future, which will justify people investing today and spending today. They won’t invest today if they don’t think there’s going to be a return on the project tomorrow. And they won’t spend today if they think it’s going to depress their future consumption so much that they just don’t want to take that risk.
MW: Doesn’t this mean that, whatever you think about inflation targeting, that the big theoretical enterprises of the last 30 years in macroeconomics – rational expectations, real business cycle theory, and then their articulation in dynamic stochastic general equilibriummodels – were all a mistake?
MK: No, I don’t think they’re all a mistake, but I think that they don’t describe the world. You can argue that the way in which both Keynes wrote and in which people wrote down models about Keynesian economics, in the end because very static. There is today; if we spend more today, output rises today, but there was no effective link with the future. Now, Keynes was right in saying that this rather mechanical world in which you maximise expected utility, hence a known distribution, is not the way to think about it. But he didn’t provide another way in which you can incorporate the future into the present. And I think the great virtue of, say, the rational expectations model, was to point out that if you ignore how people think about the future, then you may introduce a policy, but people will undo the effects of that policy.
MW: That was a subtle point. But the way I saw Keynes – and everybody has their own view of Keynes because of course he was almost deliberately ambiguous – but I mean it is relevant to probably the only real disagreement we’ve ever had – on fiscal policy. I’ve been thinking about why Keynes would think that in certain circumstances fiscal policy was important. People are radically uncertain. They’re not willing to spend. They want to be told that things are all right. They have to believe the governments are able to deal with this problem, because that’s what governments are for.
MW: Government is the ultimate insurance mechanism, in a working democracy, not the enemy. Most of the time you don’t need it. Obviously it has lots and lots of normal day-to-day functions, but I’m thinking about when things go really wrong: wars or big financial crises – governments exist to show us it’s going to be okay.
The central bank is a government organ, of course. And it does that by acting as a lender-of-last-resort. And the government comes along and stabilises the banking system. We have no worry about that. But then there’s the question, well the private sector really doesn’t want to spend. It really doesn’t want to spend. Your banks are bust. But the government can spend because it can borrow at very low real interest rates. Shouldn’t it do that?
MK: It should. But the question is how it should do it and within what context, and I don’t think you can do it just by ignoring the future. So Keynes did actually use the argument once – well, we’ll just pay for them to dig holes.
MW: I wouldn’t be in favour of that.
MK: No. And I think this is what’s wrong with the argument, because that’s just another way of saying, well, we’ll pay some unemployment benefit to people who are unemployed. And since those who were financing that unemployment benefit, either today or in the future, you see, digging the holes and filling them in again doesn’t actually add to GDP – so the people who are going to have to finance that unemployment benefit, either now or in the future, will recognise that there isn’t any extra output out of which to finance it. It will be a burden on them, and therefore they may cut back their own spending. So I don’t think it’s quite as simple, and I think that the way you put …
MW: GDP clearly fell by more than it needed to do. This was the second-round effect – in a really big crisis you end up with losses, which are over and above those that are necessary.
MK: But what happened in the UK was we had a fiscal policy that said, whatever happens, the automatic stabilisers would be allowed to work. And the issue was: do you announce some medium term path for demonstrating that the government actually is in control of this situation? Because the way you put it, that was rather good, which is, in a situation of radical uncertainty, what people want is, if you like, they need something external to themselves. The government – the father figure, whatever – to give them confidence that it’s all going to be all right.
But what that requires in terms of policy measures isn’t, I think, quite so obvious, because it isn’t enough to argue, well, here’s something, but God knows what they’re going to do three years down the road in order to pay for what they’re doing tomorrow. It has to be a framework of policy that people believe is credible and will work. And I think, in some circumstances, that does mean saying you have to think about what the path of debt is in the future.
Look what’s happened in Japan. I think they’ve reached the limits of what fiscal policy can do. When we were there in 2010, the central view in 2010, at that point, before the euro crisis really got into a serious position, was that it looked as if the rest of the world was going to grow at a rate which would mean that, given the depreciation of sterling, that path of a medium term fiscal consolidation was consistent with recovery.
And if you go back, I think those numbers were perfectly reasonable. What went wrong was that the rest of the world, particularly the euro area, did not grow at that rate. And also our financial services exports fell faster than we had expected. Now, whether that’s a real phenomenon or just in the numbers, I don’t know, but at any rate that combination, combined also with the other factor, which was much higher than expected rises in oil and commodity prices in world markets, which acted as an external indirect tax on us. Those things slowed the growth rate.
The question is, what was the right way to respond to it. Well, the right was, clearly, was not to stick to the same level of the deficit or the same path of fiscal consolidation, but to allow the automatic stabilisers to work, which they did. And the deficit hasn’t come down anywhere near as much as had been hoped, and would have come down had the rest of the world grown at a reasonable rate. So that’s the story I would tell.
MW: Would you be concerned that the structural deficit, or the potential of the economy is endogenous through all of this, in the obvious sense that, talking about the animal spirits of entrepreneurs …
MK: No, I do. Yes, absolutely.
MW: You know, if you’re an intelligent British businessman, you might have come to the view that this economy is not going to grow any more. And this being so, the sensible thing to do is certainly not invest at all until you’re sure it’s going to grow.
MK: That is clearly the problem we face. But it’s also the problem the US faces.
MW: To a somewhat lesser degree, in the sense that they have actually managed to get back to a modest … Well, we’ve basically stagnated for nearly three years.
MK: Okay. So here’s my argument about the last year and a half, which is that …
RO: Beef and noodles. Aubergine.
MW: I’m certainly not going to need dinner.
MK: Let me ask you, how do you persuade your wife that she doesn’t need a big dinner?
MW: I don’t. I eat too much; that’s why I get too fat.
MK: So, in 2012, if you put to one side North Sea oil and construction, then actually we grew at the same rate as the US economy. So there is some momentum, and that’s why growth is picking up this year. It’s not great, but it’s not good enough. But there is something. But in both our cases investment hasn’t really picked up. And I think this is that the damage that is being done, partly through the euro area, partly through the same problems in the rest of the world as a whole, is acting as a big black cloud of uncertainty, which is meaning that people are deeply reluctant to invest. You can’t lay all of the problems at the door of the banking system because there are a lot of companies with cash that don’t need to borrow from banks. And it’s weak investment …
MW: Their profits are exceptionally high.
MK: Yes. And the big weak component that we worry about is investment.
MW: And they’re lending to the rest of the economy, which is lending to the government.
MW: My view is that they’re lending to the government, at negative real rates, the government might as well borrow and build something.
MK: And the government is now doing more on infrastructure. I’m always struck when I speak not just to ministers, but to people who work in the Treasury, that it is actually quite difficult in practice to produce the investment project. It’s very easy to spend money, but in a way that maybe doesn’t add to real GDP. But when it comes to investment, which is what we want to encourage, it’s not easy for them quickly to turn this on for projects that genuinely produce stuff. You couldn’t do it for the airport now. You couldn’t do it for the high-speed railway. You could probably do it for smaller projects on road repairs. But the government is now doing some of that.
MW: In the UK we could actually probably, unlike everywhere else, build some more houses. And the government is promoting this by encouraging … they’re basically taking equity shares in houses. Do you think that’s a sensible way to proceed?
MK: In the short term, there was clearly … well, a combination of very high house prices because of low real interest rates, and a collapse of the willingness of the banks to lend for mortgages. Finding some alternative source of finance, particularly to help first time buyers in the market, makes sense. I don’t think it makes sense to interfere with the private financing of mortgages in the long run. That’s why the US got into a mess.
MW: We don’t want to have Fannie and Freddie here, do we?
MK: No, we do not want to do that.
MW: Okay, let’s leave aside the fiscal policy issues. Is QE, in the form you’ve adopted it, more or less as you’d have hoped?
MK: Yes, I’ve always myself seen this as a way of increasing the broader money supply. And the thing that’s so extraordinary is that, for the last few years, the banking system, which is normally responsible for creating 95 per cent of it.
MW: Has been contracting it.
MK: Has been contracting it. So our bit of it, and this is why I say that it’s the creation of money, which is so important, is basically carried out by private sector institutions, which are not coordinated with each other. And since we only supply about five per cent of it, the percentage increase in our bit has to be massive in order to offset the contraction of the rest.
MW: And it hasn’t been enough.
MK: Well, the broader point is that monetary policy can and should be expansionary, but there is a limit to how effective monetary policy can be, whether you call it “pushing on a string”, whether you call it a limit to how far people are willing to sacrifice future spending in order to boost current spending. But there just have to be limits on it.
MW: When was funding for lending introduced? About a year ago?
MK: It was announced in June last year.
MW: Yes, almost exactly a year ago. Some people think that we should have done more, quote unquote, credit easing, not just straight purchasing of government bonds but direct lending either by the Bank of England or via some other mechanism of this type much sooner. Would that have made much difference?
MK: It’s hard to know.
MW: Too slow?
MW: Others of course are saying funding for lending has hardly worked, so it wasn’t worth doing.
RO: Your fish.
MW: I don’t know how many people you were intending to serve.
MK: I had rational expectations about what I thought you would eat.
RO: It’s a lovely piece of fish.
MW: It looks unbelievable.
MK: Marvellous. Thanks. Thank you.
No, right from the beginning I said that if other assets should be purchased, and I took no view as to whether they should or should not, then the government should decide on which assets are purchased, and we would finance it. I think that’s the right division of labour between central bank and the finance ministry. If you’re going to buy real assets out there in the economy, then that is putting taxpayers money at risk, and every time I’ve ever suggested putting taxpayers’ money at risk, government sent parliamentarians and the treasury committee who’ve been absolutely adamant that this is a decision for the Chancellor and not the Bank of England.
And indeed there was a suggestion in 2009 that maybe it would be a good idea to finance the issue of bonds by car companies. And I said, well, that’s fine, but it has to be a scheme actually decided by the government. They have to choose which car companies will benefit from it and we can finance it. But the decisions have to be made by the Treasury. And I explained that carefully to Peter Mandelson who was involved, and he said you better go to the Treasury. They have to make the decision. Well, nothing more was heard of the scheme after that.
MW: I can imagine the enthusiasm with which it was greeted!
MK: But I’m not quite sure where it would have worked. I don’t think there’s any virtue in buying equities or … We did, when markets were very illiquid, buy corporate bonds. And the scheme is still open. But once those markets had returned to normality, and the equity market never really deviated from that, there’s no value in buying stuff in a deep liquid market. You might as well buy government bonds. Because all you’re doing is putting money out there, and people reallocate their portfolios. So it really is a question of buying stuff from issuers of instruments who can’t issue them to the private sector.
MW: What about securitised lending? I think Adam Posen recommended it at one stage.
MK: There’s a very good reason for leaving that to the government, which is it’s absolutely clear that the SME lending that you would get in the securitised instruments is the stuff that the people who’ve done the financing are keenest to get rid of. There’s a massive adverse selection problem with that. And indeed it’s precisely because there’s an adverse selection problem that you don’t get the private market being created.
But at no point did we ever stop the government from doing that. My job was to say, well, we’ll print money, which we’ve been doing to the extent we thought was necessary, and one of the killer facts in all of this, if you actually look at the size of the government debt that’s in private sector hands, it’s hardly risen. There’s a big increase in debt to GDP ratio, but it’s very much smaller if you look at debt sold to the non-public sector. We’ve been buying it.
MW: That raises the question, which I’ll come to at the end, on how we exit from all of this. Just one question on where we got to. We had a number of financial events in the year before Lehman’s failure, starting with Northern Rock, then through the other building societies and so on. Is there anything we could have done differently, which would have changed the outcome?
MK: Other than effectively nationalising and recapitalising a wider range of banks sooner, I’m not sure we could. That would have made some difference but it would have cost more.
MW: It would have been difficult to argue for in the absence of a clear crisis.
MK Well. One of the reasons why the government was very naturally reluctant to nationalise Northern Rock was that it could only be done on the floor of the House of Commons, against enormous opposition, and it would be portrayed as a great political defeat. There was no legal resolution mechanism that would have taken the issue of dealing with a failing bank out of politics. Now, we were the only G7 country without such a regime.
MW: Why didn’t we have such a regime? Did you discuss that?
MK: Indeed, we did war games and recommended that it be done. And no one resisted that proposition. It was understood we did need one. But there were so many pressing claims on legislative time that it was understandable that people would say, well, we must do this, but something else has to be done next year. So it got put back.
MW: So we ended up in the crisis without having the means to deal with it.
MK: That was very costly in political terms. I’m not sure whether it made that much difference to the economics in the end, but if we’d been able to deal with Northern Rock over a weekend, it would have altered people’s perception of the fact that there was a terrible problem with the British banking system.
MW: It might have created complacency.
MK: It might well have done. And it was still the problem that Northern Rock was the first of the bigger banks to get into trouble. Once August 2007 had happened, their whole funding model collapsed.
MW: In addition to having inadequate capital, they had been encouraged, mainly by the City, and with the acquiescence of the authorities, to rely on a funding model that turned out to be hopelessly unstable.
MK: Yes, although all funding models can turn out to be hopelessly unstable if they’re based on high leverage.
MW: Well, obviously deposits would have gone too if people had come to the conclusion that the government would let them go.
MW: But I suppose most people didn’t think that the government would dare to let ordinary deposits go. So there wasn’t a general run on deposits. But, as you point out, in Northern Rock there was a run on deposits.
MK: Yes, absolutely. And none of these were particularly difficult issues to know what to do about. They were tried and tested. You end up guaranteeing deposits; you act as a lender of last resort. All of those things were done.
MW: You did have to change your doctrine on that all fairly quickly didn’t you?
MK: No. The memorandum I sent to the Treasury Committee was exactly the same view that the bank had held for many years, and it’s exactly the same we hold now. It’s a traditional central bank – you lend at a penalty rate but you lend freely. You lend freely at a penalty rate against good collateral. And we never deviated from that. What that means in practice has evolved in that what we’ve now got is a much more sophisticated discount window facility, where we get banks to pre-position collateral. So we know what the collateral is before we have to lend against it. But this would have made no difference. Northern Rock could not have got enough funding based on our willingness to lend with haircuts against good collateral.
MW: You would have wiped it out.
MK: We would have wiped it out.
MW: And that was clear. That’s a point I’ve made many times. I agreed that it was clearly bust on any plausible model. With anything like sensible haircuts. And given the scale of funding it needed.
MK: Yes. And the advisers which were brought in from outside to advise on it very quickly came to the conclusion that the only solution to Northern Rock was to nationalise it.
MK: In the absence of a resolution. Anyhow, looking back on it, it, was only, what four months?
MW: This is an interesting comparison, although again I don’t think central, but it’s an important part. We’re now discussing a lot, the price and the sale of RBS at a loss, and there’s a question what should be done, and it’s clear that you – I’ll come to this in a moment – think more needs to be done about the banks. When you look back to what we did in October 2008 and the Americans did in October 2008, Hank Paulson went to all the major banks and said, here is the capital. You’re all going to take it. Which meant that the US got shares in good banks and bad banks, and actually ended up making money. We, as it were, let the bad banks choose us. I’m being a bit provocative. And the good banks got away. They got away with not having government capital. Were we too permissive?
MK: Yes, absolutely. The sad thing was …
MW: After all we did, in effect, rescue them all.
MK: Yes, absolutely.
MW: Some of them like to pretend we haven’t.
MK: Absolutely. And I think…
MW: By we I mean the British taxpayer.
MK: The sad thing is that we were the first country that really took this seriously and put it as our main policy response, and we got to very close to it. And then, in the end, the political processallowed it to be treated as a negotiation, bank by bank, instead of getting them all into a room and saying, you’re all in it. The extent to which they would be in it would vary from bank to bank. But nevertheless, they would all be in it. And as a result, we had to come back and do some more in 2009, and even then that wasn’t enough.
MW: And now we end up with owning shares in banks on which, it is very plausible, the taxpayer will make a loss, even though, essentially, the taxpayer has saved everybody.
It seems unfair.
MK: Well, it is unfair to the taxpayer.
MW: That’s what I mean.
MK: But worse than that, in a way, is that although the amounts of losses may seem large, they are tiny in comparison with the damage that’s been done to the economy. And we’re five years on, and still we’re debating about how we’re going to restructure the banks, which have been receiving so much support. This should have been done a whole lot earlier.
MW: So what should we do now, given the history, given where we are now?
MK: The Prudential Regulatory Authority is implementing, as we speak, the recommendations of the Financial Policy Committee. All major banks have now received a letter – maybe one will get a letter next week – spelling out how much money they’ve got to raise in new capital or requiring them to reduce their assets in a form other than lending to the UK real economy.
So they’ve got to do the equivalent of improving their capital ratios to a 7 per cent figure [against risk-weighted assets]. And, more than that, if their leverage ratio [ratio of equity to unweighted assets] is worrying. And the PRA is doing this for all the major banks, without exception. No one is being let off. That’s one thing we’re doing. Then there are the two banks which are in state hands where I think the important thing is to get them back into the private sector as quickly as we can. The reason is because they don’t function as banks when the government owning 82 per cent and then claiming it’s trying to run it at arm’s length paralyses them. This doesn’t make any sense. It needs the government to restructure the bank into a form that can be sold back to the private sector quickly. And ideally these banks would become ring-fenced banks, serving the UK real economy. Lloyds, I think, is on the path to achieving that.
MW: We should just face up to reality now and do the right thing. If you look at the big universal banks based in the UK …
MK: I think where they’re based isn’t so much the issue. I think there has to be a real question about the viability of banks that are so large that there are questions about their control. So even the banks, which appear to have come through this crisis, well have had major problems in other areas, namely control problems, where massive sums of money have been lost due to the failure of control.
MW: And you also see the problems that have emerged amid the scandals, which might be cultural, but they’re also presumably also managerial.
MK: For a US Attorney General to go to Congress and basically say this bank was “too big to jail” – those are his words, not mine – is an extraordinary statement. And I don’t think that’s a statement that attorney generals in the future will ever want to be in a position of having to make. So something has to give.
MW: So we really just haven’t reached a consensus. There’s only been a consensus that they need more capital. I think there’s a debate on how much more, and you and I will probably feel it hasn’t gone nearly as far as it should …
MK: No, I don’t think there’s a …
MW: But the consensus on what the banking industry should look like just isn’t there.
MW: So this is a disappointing failure, isn’t it, because it would suggest this may be the first great financial crisis we’ve had, but it could well not be the last.
MK: I think that’s absolutely true. And I think there are similarities to the debates in the US in the early 20th century about the structure of industry.
MK: Trusts. Trusts were the great institutions that brought the modern world to the American economy. What a disaster to take them on. Now, antitrust is seen as a key building block in an efficient and competitive market economy. And it took many years before that change in thinking took place. I’m sure it will in the financial sector, too.
MW: But this crisis hasn’t been big enough to achieve it.
MK: The costs of the crisis so far have not been big enough. We don’t yet know what they will be.
MW: Because we’ve managed it too well.
MK: Well, we’ve dealt with the short term problem, the immediate short term problem, except in the euro area which is in a way the embodiment of the problems that we think ultimately lay behind the emergence of this crisis and which have the hallmarks of an old fashioned balance of payments crisis.
And the astonishing thing, in many ways, is: you’ve talked about the political world not taking sufficiently seriously the problems in the financial sector. But what’s going on in the euro area is not a question of highly sophisticated or complex economics. This is basic economics. And that isn’t to say that economics can tell you what the answer is, but it can tell you what are the solutions from which you can choose. And what I find astonishing is that the people there are not willing to face up to the fact.
MW: What are the solutions from which, in your view, they can choose?
MK: I think there are four of them. One is to continue with mass unemployment in the South in order to depress wages and prices until they’ve become competitive again. The task facing those countries is bigger than the task we faced in the 1920s when we look back on the Gold Standard.
MW: And we didn’t stay on it. We came off it.
MK: And I don’t think many people think that the attempt to go back to the Gold Standard on the pre-war parities was a terribly sensible approach. That’s one.
The second one is to say, well, we have to get rid of this imbalance in competitiveness, so we need inflation in Germany. A, you’ve got to generate the inflation and, B, keep it going for long enough. And then stop it quickly, without causing costs there. That seems unattractive. It seems difficult, economically, and unattractive politically, certainly for the Germans.
The third is to give up on this question of restoring competitiveness quickly and just accept that there is an indefinite transfer union. That requires two things. One is for people in the North to give money to people in the South, and people in the South to accept that in return for this they’ll have to accept the conditions imposed on them, which will limit the size of the transfer. That’s the third one. There doesn’t seem any support for that anywhere, even though there’s an element of that going on, clearly.
And the fourth one is to change the composition of the membership.
Now, I don’t know what the right answer is, and it will depend on their political objectives, but economics tells you that you have to have one, or some combination of these.
MW: There is a fifth, I suppose. I don’t know whether you see it as a variant, which would be to crash the euro so dramatically against other currencies that you seek an export-led solution for the entire eurozone.
MK: I regard that as a subset of the second one; namely, how can you get higher inflation in Germany.
MK: You choose the depreciation to be sufficiently large that it generates the appropriate inflation in Germany, and it gets you to, say, price stability in the South. You get rid of deflation and price stability. And you get restoration of competitiveness. But how you manage to achieve that without disrupting the rest of the world is not clear to me.
MW: I suppose the truth is they’re doing a bit of all these things together.
MK: Yes, that’s right. Well, apart from the last one.
MW: I think they’ve concluded, probably rightfully, that unravelling the euro in a manageable way is actually a very, very difficult project. To take apart bits of it is quite a tricky proposition. It’s not impossible, but it’s quite a tricky proposition. When you discuss this with your colleagues, would they agree with the analysis?
MK: I think they fundamentally agree that these are the sort of choices, but they would probably regard the cost of these as being lower than might otherwise be assumed. So I think the costs of the first one are being underplayed, so you often get good news stories.
MW: Well, there has been quite a lot of external adjustment.
MK: But not full at employment levels.
MW: No, exactly. My view is that that largely reflects the depression level of collapse is in demand.
MW: If real domestic demand collapses on this scale, and most of it of course in the private sector, they’ve simply got to sell into foreign markets. And in short run variable costs, it doesn’t mean that they are actually profitable in the long run, which is, I think, unlikely. But we don’t know.
MK: This is obviously proving extremely costly.
MW: Well, to generate very large productivity increases and that’s just the mirror image of the huge rise in unemployment.
MK: Yes. What is true, I think, is that there has never been a better time for every country in the world to try to improve its supply performance, either, in some countries, as a means of improving its competitiveness; or, in others, as a means of persuading its domestic consumers to spend more. It’s a way of trying to raise future income.
MW: Do you understand why our productivity performance has been so poor?
MK: Well, in one form or another, I think there is a very large amount of labour hoarding. Certainly what our agents would say and what I see as I go round the country is that most businesses, if you ask them: is there a capacity constraint on your ability to expand output? And they say no. So they could expand output.
MW: Does this mean that the Office for Budgetary Responsibility is being too pessimistic about the supply potential of the economy? But in fact, if there were a real pick-up in demand, supply would turn out to be more buoyant that we now fear.
MK: Well, that would be my judgement. But I think what is tricky is to know over what time horizon that statement is true. I think if you very slowly expanded demand over 20 years, you could well get back to the same path of output as we would have been on. We’d be caught up again. Albeit with a different pattern of output, where we have a big switch to net exports and a slower growth of consumer spending.
But it’s very hard to make sense of what’s being going on. It’s very striking that in the US they are really worried about fall in the participation rate as representing a concealment of unemployment. In our case, participation hasn’t fallen at all.
MW: No. The difference between the labour market behaviour in the US and the UK since the crisis is very, very remarkable.
MK: It is, and I don’t have a simple explanation as to why that’s happened.
MW: You don’t think it suggests that the British economy has basically lost the ability to grow?
MK: No. And I certainly don’t think, when I actually go and visit companies, that they are less capable than they were before. I can certainly see that the data on the financial sector may have exaggerated real output before.
MW: That doesn’t explain the 16 per cent shortfall in output, relative to trend.
MK: No, it doesn’t explain it. It’s obviously not big enough to explain the numbers.
I don’t find it easy to understand, not at all, but I somehow, you know, my big judgement would be that if we could find a way to encourage people to spend more in a way that was sustainable, a sustainable path of spending, and in particular if the rest of the world would buy more from us, then we would certainly be able to meet that without leading to a massive pick up in inflationary pressures.
MW: Do you think our inflation overshoots, obviously going on for a long time, is worrying?
MK: Well, because I voted for more stimulus, I think the inference is that I don’t. I don’t want to be complacent about it, but we haven’t seen any dislodging of medium term inflation expectations. We’ve seen extraordinarily low wage growth. If you were to say to me where would I expect to see signs of trouble if we’d lost control of inflation expectations it would be in nominal wage growth. It’s weaker than it’s ever been in our lifetime.
MW: Labour has accepted real wage income cuts, which does suggest that the economy, in some deep sense, is more flexible than it used to be.
MK: It certainly is.
RO: Can I clear this away?
MK: Absolutely. It was wonderful. Thank you so much.
MW: Thank you.
MK: Absolutely marvellous.
RO: Thank you.
MK: Yes, and I think in some ways this is why the crisis was such a tragedy, because, if you go back to the recessions of the ‘70s and ‘80s, I think you can plausibly argue that something had to be done to shut down industries that were generally unprofitable, or companies that were unprofitable. And part of the impact of the recession was to concentrate that process of closing down unprofitable activities, and creating conditions for a gradual recovery, where resources could slowly move into profitable activities. But I think we’ve achieved all that.
There wasn’t, on the eve of the crisis, a series of nationalised industries that we ought to have been putting into the private sector, or the equivalent of shipbuilding, or the old car industry that needed to be run down significantly in size. We had a much more flexible, and actually rather impressive economy. So the tragedy is that we’ve lost out precisely at a time when there was no need to. So if you looked at the structure of the real economy, you wouldn’t look at it and say oh, we’ve got some very big readjustments to make here, and maybe we can’t do it without having, inevitably, a period of weak output while the adjustment is going on. That wasn’t the case.
But somehow we found ourselves in a position where, not just us, but other economies, had to make big changes in their pattern of spending. And the only way that could come about was by somehow a recognition that the values of assets in the financial sector were at levels that people simply had no idea whether it was right or not.
So when the crisis began, I remember talking to Stanley Fischer [governor of the Bank of Israel] about it, and all the supervisors were asked by the central bank governors: is the scale of subprime assets out there big enough to bring down the banking system? And the answer was: no, clearly not. We know how big the assets are.
But what no one really took on board was – and the supervisors certainly didn’t know, maybe this was the problem with having derivative instruments – that, although the derivative instruments were a zero-sum game, so they netted out, they were capable of bringing down the banking system. They were big enough. They dominated the scale of the direct subprime assets. Unless you knew exactly which bank had which assets, knew what their value was, every bank became suspect. So the banking system collapsed.
MW: Yes – counterparty risk.
MK: Yes. But then you get big downturn in money, money creation and a big downturn in demand and real activity. So clearly the primary transmission mechanism of all this unravelling of the false expectations about the sustainability of patterns of demand, that transmission mechanism was the banking system. But it wasn’t the original source of the shock.
MW: But you did have a very large expansion in leverage throughout the entire economy, not just the private sector. Not just the financial sector.
MK: You did.
MW: It was difficult to imagine that continuing.
MK: But we talked about it explicitly on the MPC in terms of housing and mortgages, and basically the difficult judgement we had to make was do you think that long-term real interest rates are low for a considerable period. If they are, actually house prices weren’t obviously overvalued.
And if people were buying houses, what we saw was a continuation of what we had seen for almost a decade, which was a transfer of the housing stock from the old to the young, where the young had to borrow more than the previous generation had. But it was being offset, because the older generation, who had sold the houses to the young, were accumulating financial assets. So essentially the old were lending to the young to enable them to buy their houses. So in a net sense, this didn’t seem necessarily problematic, unless you thought real interest rates were going to fall back quickly.
MW: Or asset prices were going to collapse.
MK: Yes. And we’re still in that position.
MW: Well, in the US the asset prices did collapse. And in Spain too.
MK: Yes, but largely there and in Ireland and Spain because they actually compounded it by having a massive construction expansion, which is what we didn’t do. We didn’t build any houses. That saved us. Our planning system saved us.
MW: I know: the most inefficient housing construction system in the world!
MK: Yes. But then what do you do now, faced with market long-term interest rates that are so low? Should we set policy to the assumption that they’re going to have to rise in the next two or three years? Or six years. Or do we say that they’ll stay low as long as the market currently believes? Clearly, it points to the risks associated with high leverage. And it means that certainly you don’t want to have the banking system so highly leveraged.
MW: Well, you have a sort of macroeconomic-process problem, because you have been sustaining demand in your economy via very strong credit-creation, which is linked to house prices as collateral, which allows a large class of people to spend consistently above their incomes, as long as leverage expansion occurs. So, in aggregate, household savings just disappear.
MW: Now, once that credit creation process is disrupted, all that has to stop. So savings start getting positive and it is rather difficult to see what can change that. Going back to the old leverage process would seem very unfortunate – and unlikely.
In our case, households don’t seem to have behaved quite like that. Essentially, it was leveraging up the housing stock in the way you describe. Of course, as long as house prices remain high, that’s okay. Then the economy doesn’t need to collapse, for that reason. You do have a problem if at some point house prices fall. And that, in our case – because we’re not building lots of stuff – is going to occur because of the real interest rate moving up. I think that’s pretty clear.
The puzzle is that if this is true, essentially, the disequilibrium in our economy was not as big as in other countries: we didn’t waste as much of our GDP in expanding the construction industry, for example. And it therefore didn’t have to contract so much. It makes the extraordinary weakness of output even more puzzling.
Some people argue – Ben Broadbent’s been arguing at the MPC – that it’s explained by the banking sector itself, and I think you have a similar view.
MW: But I find it very difficult to understand, how the banking sector can inflict such massive cumulative reductions in output. It’s there. Yes, it’s shrinking, but is it shrinking because it’s, as it were, turning its back on perfectly good investment opportunities? Or is it shrinking because it doesn’t see them?
MK: Of course, there’s a chicken and egg problem here. If all the banks together are behaving in a way that means they don’t extend lending and the business economy is flat, then that justifies the decision not to lend. So that is one of the issues. But I do sense that the banking system has just said: we have to contract our balance sheets; we have to deleverage; we have no choice. They want to do that outside government control. But they are going very rapidly in that direction.
MW: Then what we could have done is simply said to them, for the next ten years you can’t pay any dividends. I understand the difficulties of getting that implemented. But it would have been a rational response. It’s a very quick way of leveraging.
MK: Or simply forcing a much more rapid write-down of asset values to the point where new investors would come in.
MW: That would have been an alternative.
MK: Yes, but I think that would have been a better way of doing it. Anyway, we are where we are.
MW: Do you think they have a lot of zombie assets?
MK: Well, the FPC looked at it and that’s why it made some adjustments to the asset values stated by the banks themselves in terms of expected losses, in terms of the provisions for regulatory redress, certainly in terms of the optimism used in their computation of risk weights. There is a massive difference in the risk weights on what look like similar assets across banks.
MW: Risk weights are usually endogenous in the sense that they are used to justify the capital they have. It’s what I would have done if I were them.
MK: You might think that. I couldn’t possibly comment.
But what I do know is that the people in Basel, when they looked at this, were shocked by the scale of the discrepancy in risk-weights across banks. The exercise was carried out, interestingly, because some banks complained that other banks were not using the same risk weights. So the exercise was carried out and the results were much worse than people had imagined, which is a very strong reason for looking at leverage and not risk-weighted capital ratios
MW: You could apply the risk weights of the most conservative bank, as a matter of principle.
MK: You could. Some banks would obviously say that their portfolios are better managed than others, and obviously there’s some truth in that. But the trouble is, banks can choose their risk weights. The system’s got so complex that it’s hard to have an enormous confidence, in my view, in the numbers that come out, which is why, in the end, if you want to start looking at a bank, you don’t start by looking at its published risk-adjusted Basel capital ratio. You start with the leverage ratio.
I’m not saying you stop there, but certainly that gives you quite a good idea of the scale of the issue that you’re looking at. And the leverage ratio is the relevant number to look at if you’re asking the question: by what percentage would the average value of these assets have to fall in order to make the bank bankrupt?
MW: Do you think that – we’ve discussed this before – that basically the banking system, as we have it, is just a fundamentally bust and unsustainable model? We cannot do better, as it were, than have as the transmission belt for everything, a set of institutions that are in some sense, designed to fail.
I’m putting it rather provocatively.
MK: Well, I think it’s the right question to pose and I don’t think there’s any simple answer to it. And we clearly failed to answer it, because if we had been able to answer it, we wouldn’t have had, for 300 years, market economies with continuing banking crises.
MW: So you can see why university of Chicago economists came up with the Chicago plan in the 1930s: 100 per cent reserve banking, basically used to fund governments. And all the rest of the financial sector is on a mark-to-market basis, on both sides of the balance sheet.
MK: And the principle behind that is similar to the ideas of Larry Kotlikoff [of Boston University].
And many well-known economists are advocates of this.
MW: Indeed. Interestingly, both the left and right.
MK: Yes. There’s nothing left or right about thinking that a banking system that is so prone to crises is not the best way to manage a monetary economy. But it’s a deep and difficult question, and no one’s come up with a simple way of making this work – one that doesn’t involve a significant extension of state power into the way in which credit and money are operated.
MW: But since we have realised that the state stands behind the banking system and has had to construct a whole range of institutions to support it, and second-guess it, you can’t say that state power is exactly absent.
MW: And if we look at America, which is, after all, the bastion of capitalism, the housing finance system is essentially nationalised. The financial system is concentrated, overwhelmingly, in a very small number of megabanks, which, as you have said, have been described by the attorney generalas essentially above the law.
So they have incorporated the state, as it were, because the state stands behind them, but the state doesn’t control them. It seems to be worse than the exercise of state power you were concerned about.
MK: Suppose you look at China where you have, if you like, the opposite extreme, then certainly the taxpayers haven’t been immune from having to recapitalise their banks there.
MW: No, and will do so again. And soon, is my guess.
MK: And the process of allocating credit is highly politicised there, which is a very undesirable position to be in. So I think the big challenge is to work out how you can have private sector allocation of credit in a way which doesn’t mean that you’re forced to accept that the operation of money as a means of payment is subject to these swings – enormous volatile movements – which then require the state to come in and bail out these private sector institutions, which, as a result, then receive large subsidies, for which there are no conditions imposed. There may be no answer to that. I don’t know.
MW: One of the things I am specifically worried about, thinking about a book I’m writing at the moment, and a number of intelligent people have commented on this: if this system is so intimately intertwined with nation states, and the fiscal capacities of nation states, well, that means that if they’re going to have a eurozone banking system, they have to “eurozone-ise” the whole thing. Yes?
MW: Wow, the coup de grâce.
MK: I won’t, actually.
RO: Coffee, tea?
MW: Coffee, I will, actually.
MK: I’ll have a green tea, please.
RO: Green tea. And you, sir?
MW: I would like a coffee, actually. Double espresso.
MW: One of the questions is, is the globalisation of finance either desirable or feasible in this sort of world? Shouldn’t we just accept it’s just something we can’t do, because in the end banking is too national? How can you have the British economy blown up by the foreign adventures of a bunch of entrepreneurial thrill-seekers? How can you explain this to the British public? It’s just not reasonable, is it?
MK: If you step back and say: what are the things we like about having an open economy? We like having trade.
MW: We like the trade.
MK: Trade is excellent.
MW: We like the FDI. That’s fine.
MK: Okay, fine. So we have to have the FDI. We have to have the trade.
MW: We need enough finance to support these.
MK: And there’s a question of the means of payment you need, to finance both the trade and FDI. Since you can’t suddenly withdraw it.
MW: True.That’s a small part of international banking.
MK: Well, certainly, well before the crisis, when we were talking about the Asian crisis, one of the standard recommendations was these countries should rely far less on international capital flows through banks, and far more on FDI and equity investment.
MW: Which was perfectly right.And they took that advice.
MK: Of course, if you like, that is the international equivalent of the proposition that, domestically, you should not want to run your financial system with such a high degree of deposit finance, or leveraged investments. All the allocation of credit, essentially, should be financed, in one way, or another, by something akin to equity. And, ultimately that has to be something towards which we should want to go.
So I think one of the consequences of the crisis should be quite radical thinking about the structure of finance, both domestically and internationally. But I don’t think it will happen until we get through the immediate problems. And then what I rather feel will happen is that the people who will still worry about these longer term questions will be you and I over a nice meal …
MW: And a few academics.
MK: And a few academics. And that the “audacity of pessimism” will turn into the complacency of steady growth.
MW: It’s quite clear, perfectly, I don’t criticise it at all: the policymakers want this crisis over and they want the economy to recover. And then that’s exactly what they should want. Many tens if not hundreds of millions of ordinary people have suffered as a result, and one wants them to have a decent life. And so they’re right. But, unfortunately, it means we leave this shadow hanging over us.
MK: And the hope has to be that people’s concern and anger won’t disappear; that they won’t forget that this happened. And although they will be glad to get back to a more normal position, they will want to know that these problems have not been ignored. But it’s not a recent problem. It’s been true of a capitalist economy forever.
MW: I agreed completely, from my reading, that the last financial crisis looks like being the biggest ever.Take the medical system: the extension of life expectancy. Take the way we manage many sorts of disaster. Take the complexity of the systems we have and that we rely on in IT. These are robust systems, and we expect our standards to be better, don’t we? We don’t expect the most important part of the economy to be worse, to be capable of a bigger meltdown than at the time of our 19th century forbears. So it sort of looks like negative progress. More sophistication and more fragility, which is, of course, Andy Haldane’s big point in many of his brilliant papers. This is absolutely scary.
MK: It is. So, again, one of the things that people are reluctant to do in finance is to ask what they can learn from other industries. And one of the big lessons I think about regulation in other industries is: keep it simple. If it gets too complex, then the firms will just run rings around the regulators. I don’t blame them for that; they have every incentive to do so.
But if the regulators insist on accepting the system is so complex, they will have to accept that the people in it will run rings around them and therefore they will lose their ability to regulate. So keep it simple and ask for big things. The big thing that we should be thinking about is leverage. That’s the one that should matter above all others. But of course it’s precisely for that reason that the banks will resist most strongly regulation of leverage. And the politicians will compromise on precisely that.
MW: The banks themselves don’t benefit from lower leverage. The people who benefit from lower leverage are everybody else: creditors, taxpayers and everybody in the economy. But as far as the banks are concerned, it’s all downside. The lower the return on equity, the less they can pay themselves. Why should they be interested? They’re completely rational. What is puzzling is that people take seriously that their interest is our interest.
MK: Well, there’s always been a willingness to be overly impressed by people who appear to be extraordinarily successful financially. That was true with the great entrepreneurs of the past in the real economy. And they achieved tremendous prominence in society, and political clout. And politicians wanted to be befriended by them and be supported by them. So they had influence beyond what we’d think of as rational.
MW: And, of course, money itself has power. But I don’t think that’s the core of it. I think it’s actually intellectual prestige as well.
MW: It’s surprising how much of this has survived, to me. It’s very interesting. It’s the proponents of reform and not the opponents who have had to defend their position at every moment. And I had thought, when the crisis happened, that no one would take seriously anything a banker said for at least a decade, and I was completely wrong.
MK: Michael Lewis, the author, said that. He said at a meeting in London, why would anyone listen to these people? “They’ve presided over a disaster, so why are we listening. I’m not even prepared to engage in the debate. These people should be off the stage.”
Clearly, the opposite is the case. And we ought to consider a rational debate, but what we’ve found is that the structure of the system has been something which led – as it has before: it’s not the first time; it’s happened many times before – to a highly unstable outcome, which has been damaging not just to a small number of people as say an aeroplane crash, but to millions of people. So it’s very, very costly. And it requires deep thought about how we can try and prevent it again. But tinkering won’t prevent it happening again.
MW: Can I ask you about one other area. There’s a lot discussion now about, in the UK particularly about forward guidance and nominal GDP targeting. Does any of this make any real difference? Some people feel, clearly, that the Fed, with its guidance programme on the conditions for continuing with QE, has been very successful in shifting expectations. What’s your view of this? Have we been too cautious in this? Or have we been hamstrung by our institutional structure?
MK: I don’t think we’ve been hamstrung by the institutional structure, and indeed, obviously the monetary policy committee will reply in August about forward guidance.
But to make a general comment on this first, inflation targeting, as perceived when it was introduced, was never meant to be a new theory of monetary policy or a theory of how the economy behaves. So all the issues we’ve been talking about have essentially been substantive; namely, how does the economy behave. Inflation targeting is not relevant to that.
What inflation targeting was about was saying how do we make decisions about interest rates and monetary policy. Can we not do them in a more sensible, systematic way? So when I joined the bank in 1991, literally you could get a telephone call before lunch saying the Chancellor wants to hold a meeting at 2:30 to discuss interest rates. So the market had no idea. Interest rates could change at any point on any day.
MW: For any reason. I remember it well: we joined the exchange rate mechanism and we immediately cut rates.
MK: Yes. So we’re in a completely different world, and I think all of that is “plus plus”. It’s much more systematic.
And that world has put at the heart of it the rational discussion about, you know: What can we say that’s useful to people in the market and households about what the future might hold, and what we might have to do? And I think, at the centre of that, has always been the recognition that we shouldn’t pretend that we know what the future will be. We can’t do that.
So from that point of view, giving guidance about what interest rates will be, unconditionally, is not sensible. And, indeed, it hasn’t worked, which is why the Fed, although it introduced it for a short period, rapidly moved on to where they are now, which is conditional guidance.
I think, in some ways, you could think of that as simply the logical extension of what we’ve been doing all along, which is, I’ve always said in press conferences, look, I can’t tell you where interest rates will be. But I can tell you what will determine where they will be. Then you explain the factors that will lead us to decide whether to put rates up or down.
I see conditional guidance, if you like, as a somewhat more sophisticated and quantitative version of that. So it’s a natural, logical extension of where we are. And how far you go down the road will depend upon your confidence about the precision with which you can make statements today, about the numbers that will guide you tomorrow. And that’s a judgement.
Now, so I think you can say it will help to reduce uncertainty. How important that is depends on the circumstances and where you are. And I think before the crisis hit, between ‘92 and 2007, I don’t think conditional guidance would have added very much. I think people knew what we were doing, knew what the factors were; there was a pretty stable reaction function. I think in the immediate aftermath of the crisis, it was obvious what we had to do – cut rates to zero. So we did. And it was obvious rates were going to stay at a zero rate.
Somehow I think it’s only become more relevant in the last year or so where the question has arisen – so for how long are the rates going to stay where they are? And of course no one knows that. So unconditional guidance won’t work. But it may well be sensible to say to people, well, I can’t tell you how long we’re going to keep rates where they are, but I can tell you what will determine when we will start to put them up.
Now, whether that will lead to a change in expectations or the precision with which expectations are held, I think is an empirical judgement: it is hard to tell. But that’s what the MPC will decide and report on in August. And most discussions are well underway, and I’ve deliberately stood back from them because I won’t be there in August.
MW: What about nominal GDP targeting as an alternative?
MK: I don’t think there’s much merit in that. I don’t think there’s anything wrong with it, but I don’t think it adds anything to inflation targeting. We didn’t do that in ‘92 for the very good reason that we thought that inflation targeting had two enormous benefits over nominal GDP targeting. One was that it helped to make clear that what we were trying to achieve was stable inflation. And why on earth would anyone aim at four per cent nominal GDP? In order to get that, you have to get it from some view about an inflation target and the underlying growth of the economy. And secondly, rather mundane but not irrelevant point, the data for nominal GDP get revised by quite a bit. Then what are you supposed to do? Say you’ve revised the number; do you suddenly change the policies? It just is not a very sensible basis to do it.
MW: What about price level targeting?This is a really different sort of approach, isn’t it?
MK: Well, we discussed it a lot. I gave a paper at Jackson Hall in 1999 where the whole conference was about this kind of issue, because it was taking place in the context of the “lost decade” in Japan. So we did discuss it quite a bit. I think you can make quite a good argument for saying that price level targeting is what you would like to have in the very long run. But you don’t want to have to correct the deviations of the price level from the desired level over one or two years, but over say ten to 15 years. In practice what you’d have to do is every five years you say okay, what was inflation over the last five years. And you say oh, it was 1.7 per cent. So you say okay, well, for the next five years the inflation target won’t be two but 2.3.
Well, I think that’s perfectly reasonable, and it’s doable, and you only revise the target by a small amount every now and then. And it’s a very long moving average. Whether that really has enormous advantages, I don’t know.
People’s concern about inflation targeting is that the variance of the price level moves off towards infinity. That simply hasn’t happened. The average inflation rate has been almost bang on 2 per cent. The CPI inflation rate has been bang on 2 per cent for 20 years. Even the last five years, the GDP inflation rate in the last five years has been 2.1 per cent. So the deviations in the short run have been the factors that you would want to deviate from the target for: namely, oil and commodity prices, taxes, and so on. So the underlying thing, I think, has worked extraordinarily well, but what it shows is that that is certainly not sufficient to give you what you really care about.
MW: Should we have a target for domestically generated inflation of some kind?
MK: I think it is better to say the target we’re using is the target for the inflation that people believe corresponds to what they’re paying. Then one can explain to them why we’re not trying to bring that measure of inflation back to 2 per cent quickly, because it’s above or below for reasons, whether it’s oil and commodity prices, whether it’s student fees, that we think justify deviating from it. This is better than claiming credit for hitting a target that is not one people think corresponds to what they actually face. But you can argue either way. It’s not a big issue. But I think you need to have a pretty good reason for changing from where we are.
MW: When you did quantitative easing, did you think about having a target for the long-term interest rate? And explaining what it was?
MK: No, because we thought that, in a world of open capital movements, we were not controlling the long-term interest rate.
MW: But QE clearly has some influence on it.
MK: It clearly influences it, but we thought: suppose there were to be a correction in the world economy of the very low level of long-term rates, we’d be powerless to prevent that. So we could try to influence what was going on but we would not be able to deviate indefinitely from that level. So the idea that somehow we could choose it as an independent domestic target, I thought, would be very difficult. No, you can argue that you can separate your domestic real interest rate provided you are willing to see big swings in the exchange rate, but that has costs.
MW: If you look at the exit issue, is it important that the QE, in the end, will all be unwound? Would it worry you if, 15, 20 years from now, the reserves of the banking system ended up being permanently higher?
MK: Not necessarily. And it depends on what consequence that would have for their ability to expand credit and broad money. So one way is just to raise the reserve requirements, force them to hold that. But in the long run it shouldn’t make very much difference.
MW: It’s an indirect way of taxing the banks.
MK: Except we remunerate reserves.
MW: Yes, you do. But if you raise the requirements, you could stop remunerating them. I’m not recommending it. It’s just a possibility.
MK: And then you start to distort the process how interest rates are set. We remunerate reserves so that we can control the interest rate, which really matters.
MW: Of course.
MK: It does relate, though, to an interesting point, going right back to 2007, which is, one of the reasons why the European Central Bank managed to convince people they were supplying lots of liquidity and we weren’t was that, on day one, they said they were going to lend over €100bn. What no one seemed to appreciate was this was for 24 hours, and on day two they lent €97bn, and on day three €92bn. After one month, the amount of extra liquidity they were putting into the system was zero, absolutely zero.
We had introduced a system not long before, a new system, which we were very reluctant to meddle with, and our system said: you the banks can choose how big your reserves are. The first thing I did when I became governor was to ask Paul Tucker to go away with the economists and create a new system that would eliminate the volatility of overnight interest rates. Italy had done the same thing, and I thought, well, if Italy can reduce the volatility, surely we can, too. And we did it. And it was a very successful switch.
But we didn’t tell the banks how big their reserves should be. It was quite deliberate. We wanted them to be able to choose. But with the benefit of hindsight, I wish we had actually set the level, because since they could choose the level of their reserves, we took the judgement, when the crisis began, we were only ten days away from the date when they were going to be telling us how much reserves they wanted. And were committed to supplying whatever they wanted. So we assumed they’d want more. And they didn’t ask for more. And I think this was the first example we had of what you might call the “stigma problem”; that everyone was rather reluctant to ask for more reserves.
So the sad thing was that the crisis hit exact at the point where we’d successfully introduced a new regime for supplying liquidity to the banking system, for monetary policy purposes, which had the property that the banks themselves could say we’d like to hold higher reserves. And we’d guarantee to increase the supply of reserves accordingly. But if they didn’t ask for it, we didn’t supply it. And what we should have done was just compel them to hold lots more. But you couldn’t have just suddenly overnight changed it.
And that was why people think we were slow off the mark, because we had a system that didn’t require us to do anything. But the banks took the initiative. That was how we saw it. As soon as we realised that there was a collective action problem, then we did start to supply more.
And of course, you know, the IMF has this very interesting chart where they show it. And if you look at the increase in the Central Bank balance sheet over GDP, and ask the question, which central bank balance sheet expands soonest and fastest after the crisis hit in ‘07, it shows the Bank of England.
Now, we were doing it partly because Northern Rock was there and we were pumping money into Northern Rock. That went to the banking system. But nevertheless, there was no need to do anymore because we were supplying vast amounts. But the ECB were supplying it in a form that attracted good headlines, and we were doing it in a form that attracted bad headlines. Yet the fact was that we were putting more liquidity into the banking system than the other two central banks. The fact is, we’ve expanded our balance sheet in terms of QE by far more than the others. Now, this may be a good or a bad thing, but what it isn’t is inaction.
MW: Yes. You might have to say that the results have been a little disappointing, all things considered, but that suggests it’s only partly a monetary problem.
MK: Well, the scale of the banking system is such that we have had to do this in order to prevent a significant contraction of broad money. With a banking sector that’s over five times GDP, compared with the US, less than one times GDP, this is a very different position.
MW: Do you think that we would be better off if we had something more like their shadow banking system?
MK: No, I certainly don’t think we want the money market fund system. Nor do they. The Fed would love to change the regulation on money market funds.
MW: And go back to a bank based system?
MK: What you don’t want is the ability to have runs on a bank outside the banking system. At least they can manage what goes on in the banking system.
MW: Can you imagine what the world would be like if the existing four or five major banks in the United States expanded to the scale which would give the US an aggregate balance sheet of five times US GDP? The balance sheetsof each would be about 10 or 12 trillion dollars.
MK: It would be scary. It would be scary for every country in the world. That’s the whole point. The spill over effect would be enormous.
I think this is one of the things that, if you look back to Bretton Woods in 1944, the great figures took very seriously: the question of interactions between economies, even though trade was low. They didn’t want to have free capital mobility. But they thought the international dimension was very important.
And I think what’s so interesting about the period running up to the crisis was how everyone thought how unimportant the international dimension was, in the sense that it might have an interesting impact on what was going on in the world, but it had no relevance to policy. Policy was set purely domestically. There was no serious impetus to doing anything in terms of international co-ordination.
MW: Wasn’t that the floating rate delusion? If you go back to the economics we learned, certainly that I learned, and I imagine you did similar sorts of things in international macroeconomics - the idea was that if we have a floating exchange rate, you can do whatever you like, to put it crudely, and the currency will cope with the adjustments. And surely one of the biggest lessons we’ve learned is that this just isn’t true.
MK: The question is: why it isn’t true. And I think the answer to why it isn’t true is that it doesn’t stop there being big mistakes in terms of flows of capital that create debts and credits between countries, about which people suddenly realise one day: “Gosh, why did we borrow all this money? We can’t repay it.” But it’s not solved by having fixed exchange rates.
MW: We can see that in the euro.
MW: That just makes all the adjustments quantity adjustments instead of price adjustments.
MW: And that’s real hell.
MK: It’s worse. It’s real hell. Instead of mere hell, it’s real hell. And that’s where they are. And I think, therefore, I mean that’s the similarity to the 1930s, I think, which is what’s going on in the euro area is that …
MW: It’s the Gold Standard.
MK: It’s the Gold Standard, and people aren’t willing to recognise that you can’t expect these countries to repay debt, internationally, unless you allow them to earn a trade surplus, out of which they can finance the repayments. And where they are now in terms of competitiveness, they can’t do that.
MW: They certainly can’t do it as long as Germany is itself structured, to be a very large net exporter. That way, if they even try, you just get into a downward GDP spiral.
MK: Yes, a downward GDP spiral and, you know, you’d think that Germany would think it more reasonable to enjoy the benefits of spending their surplus on buying stuff from other people, or investing it abroad in genuinely real assets. But if you ask them, well, wouldn’t you rather buy it than give it away, they’d say they can’t give it away? That’s a transfer union and it’s impossible. And the answer is they don’t make stuff we want to buy. And I said well, have you thought of changing the price. And they think about it and then work out what that means, and then they say no, they can’t do that.
But if they end up buying assets in the form of giving loans to banks in the south that the latter can’t repay, they are basically giving it away. Then eventually these debts will be restructured.
MW: They’re giving most of it away via the ECB, or a large chunk of it. And it’s taking the form of credits of the Bundesbank within the European System of Central Banks, which of course my friend Hans-Werner Sinn is complaining about. But it’s really nicely concealed. There really aren’t many people in Germany who are aware that this is the mechanism.
MK: There are also loans to banks, from banks in particularly France and Germany, to southern Europe.
MW: Yes, of course.
MK: And the question is: can those loans be repaid? And this is exactly analogous to the problem that Europe got into in the inter-war period. So in the end I think it’s going to be very hard to get out of this without some further big adjustment in terms of debts and credits.
And all this is why the international monetary system isn’t simply a question of do you have floating, do you have fixed exchange rates. It’s how do you manage the build-up of debts and credits across countries in a situation – and this is where Keynes comes in – in a situation where the factors that determine the scale of those debts and credits were not rational decisions based on complete knowledge, but were based on beliefs and judgements that may suddenly get reversed.
MW: I think there are two interrelated problems. They’re not quite the same, though they are very closely connected. The first is that people make serious mistakes and they are particularly prone to make serious mistakes where the purchase and sale of assets abroad are concerned, for the fairly obvious reasons that they know less about what’s going on abroad. And they have to take more on trust. They do take more on trust, and such trust can change more quickly.
So foreign finance has always been more unstable than domestic finance, at least among more sophisticated countries. Probably in Argentina it’s the other way round. But in most countries there is this high likelihood that you will make mistakes. The Chinese thought when they were buying US bonds that they were buying something absolutely safe. In terms of renminbi, as I pointed out to them, this is not the case.
And the second problem is that the adjustment process that is required to repay at the macroeconomic level if a whole number of creditors decides simultaneously they want their money back, is inherently very painful and complicated. It’s not a matter of individual market adjustments. It’s about a whole chain of macroeconomic adjustments.
And it is very plausible, indeed almost certain, that a situation in which quite a few people want their money back will be a situation in which almost everybody wants their money backat the same time. And so the two problems coming together more or less guarantee that the international system guarantees international crises. That basically has been the history, forever.
Now, I suppose that if you are in 1880 and you have agold standard world, it is really credible that whatever macroeconomic adjustment you throw at a society, it will adjust because there is no alternative. Nobody is going to challenge the gold standard. Nobody is going to challenge balanced budgets and all the rest of it. Contracts will be honoured. You can manage such a system. And one by-product of that is the quantity of international lending is contained, at least in the banking form. But it’s not the world we live in.
MW: And the point surely with the eurozone is they tried to create a Gold Standard type of mechanism in societies that I would have thought are about as far from the political economy underpinnings of the Gold Standard as any sophisticated society can be. None of them were set up to make that sort of adjustment possible. Far from it. They are all set up to avoid such adjustments.
MK: I’m sure that what people talked about when they asked whether another small country should be allowed to join was, while this is a small country, it can’t have much influence on the optimal interest rate which we set, which is true. So it doesn’t matter if we let it in. And the fact that these were still sovereign nations was fundamental because you had capital flows from one entity to another, and it mattered that these were different nations. And the precedent set by how you treat a debtor matters if you’ve got lots and lots of other debtors. And I don’t think this was ever really thought through at the beginning.
MW: In the end, the problem is, and they are trying to solve it in a strange way, multinational money combined with sovereign states is not a stable system. We have discussed that many, many times over the past two decades. It’s not all clear they’re going to create a genuinely multinational political system. What they’re trying to do instead is run this with a set of rules imposed upon governments, which are, in all respects, still sovereign and, above all, accountable. Which constrains them in everything they can do. I don’t see how that can be sustained.
MW: It can’t be a political equilibrium in democracies, I would have thought. So here we are.
MK: Hence the pressure to keep pretending that what they’ve just done is the right thing and will solve it, and all we have to do is just wait a few more months. At least that means that the political pressure is off for a few more months. But the underlying problem hasn’t been resolved.
MW: Yes. It’s what the British, I suppose, would describe as muddling through – a very British approach.
What haven’t we discussed? Almost nothing.
MK: We’ve discussed everything.
MW: Do you think this story has a happy ending?
MK: Well, that we don’t know.
MW: When we sit down in 2020, which I hope we will, and look back, you will see, leave aside the euro for the moment, that in the UK the exit has occurred, interest rates are back to a sort of more normal level, we haven’t had an explosive bout of inflation, the debt has proved manageable and growth is resumed? Do you find that a plausible scenario?
MK: It’s certainly plausible. I think it still leaves you then with the worry that nothing has been done to prevent this happening again. And if we were to get to a point in 2020 when we sat down, or 2030 maybe, and sat down and said, well, we didn’t realise in 2013 that we were only at exactly the halfway point. Maybe we did. Or that we were a third of a way through. What we don’t know is how long this will take.
MW: I would have thought we were …
MW: If things go well, I’m a pessimist, we’re halfway through.
MK: Yes, halfway through is perhaps not a bad way of putting it.
MW: The alternative would be to feel that we’ve lost 16 per cent of GDP forever.
MK: Yes. I know.
MW: And I find that really too depressing for words. So I want us to fix this and have a period of really rapid growth.
MK: And I do think that the prospect of another NICE decade is genuine, because there is no reason, from the capacity constraint side, that we can’t have pretty solid growth, providing it’s not so quick that you strain the capacity in that situation.
MW: But we can’t rely on another huge explosion of debt.
MK: Yes. But we would get a much more sustained basis, as we did for quite a long while from the early 1990s. We gradually brought unemployment down far further than anyone thought we’d be able to do. I see no reason why we can’t go back to that level again and have low inflation and steady growth for quite a long period. The question is whether we can do it in a way which means we don’t sit here in 2030 and say, you know, these imbalances, they are still there and real interest rates are still low, because then we will be in a position where the world economy will be fragile still.
MW: And the banking assets are eight times GDP. That wouldn’t be too good, would it?
MK: No. It wouldn’t. No, it wouldn’t. That would be really terrible.
MW: Good. It’s been a wonderful discussion. I should pay the bill. I have to pay the bill.
MK: So you do. Can we have the bill?
MW: It would be incredibly helpful, I know it might take a while, if you could list what you served us. Can you do that for me?
RO: Sorry, sir?
MW: Can you list the dishes you served us?
RO: I can, yes.
MW: Because I think our readers will be very excited by this meal. I think the interesting thing is – and this is the elephant in the room thing – this effort that we have made as economists, which I sort of understand, to analyse the aggregate economy without bank money and without uncertainty has turned out to be an unworkable abstraction.
MK: Yes, and I think what’s so interesting about it is that – I mean this to my mind is the fundamental intellectual challenge in economics – which is the attempt to turn economics, as it was after the second world war, into a rigorous scientific discipline. It was a laudable ambition.
MK: And much of the work that has been done has been outstanding, and there’s been real progress. But in terms of macroeconomics, it’s created a framework for thinking about the world, which happens to have omitted the two or three things that are most important to understanding the big shocks as opposed to what you might just call the normal business cycle fluctuations, movements of inventories and all that, accelerator model. All that kind of stuff we’ve got quite a decent empirical handle on.
But why do you get big crises and big shocks? Well, you cannot do anything to the standard models and learn anything about them. And the idea that you model some detailed financial friction and insert it into the current models is, in my view, doomed to failure.
MK: And the essence of all this is actually the kind of issues Keynes was talking about. But when neither he, nor anyone subsequently, has been able to make the arguments as rigorous as the rest of economics, and, in the search for rigor, we have managed to sort of, well, it’s the classic case of looking under the lamplight. We’ve used rigor in areas where, in order to use rigor, we’ve thrown away the key observations that were fundamental to understanding the problem.
Now, the trouble is, recognising that what Keynes was talking about was fundamental, and that the interaction between money and banking and uncertainty is at the heart of all of this, is the first step in the right direction. However, we haven’t got very far down the path.
MW: I suppose there are two problems here.
The first is the genuine intellectual problem, which I think almost certainly leads us into different sorts of models, which obviously people are struggling with. You can see little bits of this. But the intuition, which I think we share, that a modern monetary economy is not just a barter economy.
MW: There’s something else going on here. It describes an intellectual programme which is presumably as profound as the shifts from classical mechanics to quantum and relativity. And that took 40 years and 50 years of some of the greatest minds in world history. So that’s the sort of thing we’re doing, and it involves human psychology, so it’s presumably even more complicated.
And the second problem …
MK: That’s what makes it so interesting.
MW: In the meantime, we have to run the world. Not knowing all this. No, I think to me the thing I’ve learned from this is, at least the first requirement of running the world …
RO: I have listed the food ...
MW: Wonderful. That’s fantastic.
RO: Thank you.
MW: That’s absolutely fantastic.
In the meantime, I suppose the starting point in our policy discussions has to be, we know roughly what we’re trying to do and where we’re going, we have some heuristics, but we have to be pretty humble.
MK: Yes, and keep the argument simple. Not pretend to be too clever on this.
MW: The way I put it when I have these debates on banking, which I do quite frequently. I just had one a couple of days ago. We don’t really know now what will come along that might knock a banking system down. But we do know how to make it less fragile. And therefore it is rational to make it less fragile, whatever comes along. After all, that’s what engineers do with bridges. They over-design them, and they over-design them for a good reason. The world turns out to create shocks you hadn’t expected.
MK: The same argument for speed limits, which is yes, you can make cars safer. You can try and train drivers. You can make cars more responsive. But in the end you know that with human reactions to speeds being finite and positive, the more slowly you drive, the less the accident rate. And there are other issues involved in setting the speed limit. A simple robust solution.
And there’s no point the regulator or society saying to the bankers, look, we know the details of your business better than you do. We don’t. What we’re saying is, you create costs on the rest of society, and the only way to put those costs into any sort of reasonable perspective is just to say, look, do whatever you want, but you can’t have a leverage ratio greater than whatever.
To my mind, that will be a simple, robust way of approaching it. And all the arguments against it, the banks, as you say, have every personal incentive to argue against it. And they will do it by coming up with reasons. They’ll say, well, if you have this loan, here’s another loan that’s riskier, you’re giving me an incentive to take a risky loan rather than a safer loan. They’ve still got themselves to judge whether they want to make the risky or the safe loan, but from the society’s point of view, just knowing that there’s that limit on leverage would mean that we weren’t walking on the edge all the time knowing that, if we get something slightly wrong, we’ll fall off. We’re walking sufficiently far from the edge that we know that if we make a few mistakes we won’t fall off. And that seems to me a big lesson for policy.
MW: I was thinking about this, it’s a good parallel, that we do know that when we insisted that cars become safer and people had safety belts, that there is a certain tendency to drive more dangerously.
MW: But, in aggregate, deaths on the road have fallen.
MK: They’ve gone down, yes.
MW: And that’s really all you can hope for.
MW: I don’t think it’ll be easy to look oneself in the mirror, 20 years from now, if we have another disaster like this. Because it would be sort of unforgivable. And in the case of the UK, as I frequently remark, less true perhaps in the US, we can’t afford another one.
MW: I mean, we will be living with the fiscal costs of this for a generation. And we have other fiscal costs coming down the road. We just can’t do this again.
The other thing is I think the way we structure money and banking, it’s not something that we understand well. But we don’t understand why it is that societies evolve in that way. And the intellectual programme is necessary in order to understand how such an economy works, but also to understand why we evolved that way. And until we understand that, it’s not obvious to me that we can easily come up with a programme of reform that will get us from where we are to what is obviously a better system.
So one of the difficulties with the arguments for the Chicago plan or the ideas that Larry Kotlikoff put forward is that, given our current intellectual framework, you can see the attractions of ending up there, but would it be the case that, in one way or another, people would behave in such a way as to create things that would undermine that system or would create an alternative to it?
MW: We know there’s an incentive to do that.
MK: Well, there’s an incentive, but what I’m worried about and what is a deeper issue, which is the arguments we’re using to justify something like that are arguments based on the same kinds of assumptions about rational behaviour that economists always use. And if those assumptions are wrong, maybe we need to think about how people behave differently before we can actually design what the right framework is.
MW: Surely we can accept – I think this is the Minsky point – that human beings will create the fragility.
MW: Partly because they underestimate the risks and uncertainties. I mean, I was very influenced by what happened in the quote unquote shadow banking system. As Paul McCulley has pointed out, they created a fully-fledged banking system, with all the problems of a banking system, without any official support. There was nobody saying we’re going to guarantee this; there was no lender of last resort. There wasn’t any obvious thing like that. People said to themselves:“I like the idea of this money market fund. It looks very safe. They invest in prime bonds. They’ve got really first-rate securities, like Lehman. It can’t go wrong, can it? And they pay me a little bit more than my bank, so it’s okay. And in good times that’s what happens.
MK: Yes, and I think the…
MW: The returns offered by systems like this in good times do seduce people, and there is disaster myopia among us. This is the sort of thing we have to look into.
MK: Well, it can be rationally seduced, because one of the odd things, you know, I talked earlier about the problems with uninsured deposits, but you could turn it around and say these people aren’t going to worry. Can you tell me how many times uninsured depositors have been made to lose? And the answer is it’s very hard. So it doesn’t matter what it says on the paper, or it doesn’t matter when the Chancellor stands up and says no, we’re going to limit compensation to £25,000. Until actually people genuinely are made to lose, if they have deposits bigger than that, people won’t believe it. And they’re right not to believe it because, when push comes to shove, we do bail them out.
MW: I am a perfect example of this, in two directions, which I don’t know if I can put in the lunch. But I probably won’t. But I did have money in Northern Rock, which I put in for the family, and I pulled it out at the first whiff of trouble. So I was a part of the run.
MW: I thought, in the case of Northern Rock, they might conceivably let the uninsured depositors lose money. I was not sure, but I thought it was a possibility. I kept my main bank account, which exceeded the deposit limit, in NatWest, and I kept it there very comfortably throughout the entire crisis, because I could not imagine a state of the world in which the British government would allow NatWest to default on its deposits. And I was sure the British government could create the necessary quantity of pounds.
MK: Well, if I had known, when I was writing a cheque out for £36bn, I was helping to keep your bank account going, it would have given me that warmer feeling.
MW: Well, I’m just pointing out that it was a rational, completely rational view. So, in that sense, as I point out, banks’ liabilities are near substitutes, and we found in the Euro case often better substitutes, for government bonds, which is absolutely unbelievable.
MK: Yes, indeed.
MW: So if you’re running a business which has risky assets on one side, and better than government bonds on the other side, this is a wonderful business.
MK: It is. This is the state where we are, and that’s why, somehow, the idea that all that will happen in the next 20 years is a sort of gradual emergence and recovery from where we are with things not being too bad, it doesn’t seem to be the only thing that can happen. In order for that to be feasible, there has to be some major restructuring of debt one way or another. And people will have to confront that. Of course they don’t want to, but they’ll have no choice. It took a long time in the inter-war period for people to recognise that the debts would not be paid.
MW: Some of it was actually only really resolved after the war.
MW: Will we have to have inflation?
MK: I don’t know. I’m not sure that people would benefit much from that because in the post-war world in Britain, we didn’t have an historical record of high inflation. So it was possible to allow this process of allowing the inflation rate to creep up, to erode the real value of debt in a way that didn’t make government interest rates rise as quickly as I’m sure they would do now. I think we’ve got much more sophisticated financial markets; I think if people thought inflation was likely to rise, for whatever reason, then the cost of new debt, new borrowing would go up very quickly.
MW: You’d need very long term debt. You’d need to get rid of your fiscal deficit pretty sharply, and Britain, fortunately has quite long term debt.
MK: We have long-term debt but we’re still a long way from reducing our deficit. Other countries, their debt is so short term that I don’t think it’s a terribly attractive strategy for them. I don’t think it’s a commitment to low inflation as such that will prevent it. It’s just not an easy solution.
MW: Good. Thanks very much.
MK: Thank you, Martin.