The following is an edited transcript of an interview between the Financial Times and Charlie Bean, deputy governor of the Bank of England, held on 17 December 2008.
FINANCIAL TIMES It was your 100th MPC meeting in December. The last time someone got to 100, Mervyn King did so in August 2005, which was obviously also quite an important meeting when he was outvoted and you voted for a rate cut. Given where we are, do we think that that meeting was the last kick to the boom and unfortunate?
CHARLIE BEAN I think it’s difficult to argue that a 25 basis point move can be of that much significance. Clearly given the recovery of the economy shortly thereafter, it looks like that was an unnecessary cut but I think it’s a mistake to place too much weight on that. The real question should be whether the policy should have been significantly tighter through that period. I have to say I think people who take the view, well, if interest rates have only been 25 or 50 basis points higher, none of this would have happened, are frankly rather unrealistic. You would have needed to have had policy rates very markedly higher to have significantly dampened.
FINANCIAL TIMES When you say very markedly higher, are you talking 1 or 2 percentage points?
CHARLIE BEAN 200, 300 basis points to have significantly impacted on the build-up of credit and the asset prices, particularly house prices, which connects [with the issue that if] there’s more than one thing that worries you, both inflation for goods and services and asset price inflation, well, you really need a second instrument.
FINANCIAL TIMES We’re obviously in a bit of a mess. How bad is it do you think?
CHARLIE BEAN Well, the outlook looks worse now than it did say a year ago or in the spring. The mutation of the international financial markets from a very uncomfortable period of financial turmoil from August of last year through until the beginning of September this year, that was difficult and always had the potential to become worse but you have periods where it looked like conditions were improving punctuated by events like this and so forth. But to me one could at least hope that the deleveraging process might be relatively orderly even if drawn out. The events of the second half of September and early October changed that very markedly and we really were looking at a global systemic financial crisis of the sort that it’s very difficult to think of parallels and that must have impacted on confidence and has also impacted on the way financial institutions are responding at this moment.
They’re much more risk averse, much more focused on being [highly] leveraged. And we’re now basically at what I see as act three of the drama. Act one was from August 2007 through to beginning of September and Act 2 was the mutation into a global systemic financial crisis. Act three is now having to work that through the real economy.
I think the really central question is to what extent banks around the world cut back on their lending to households and particularly businesses. Clearly the more they do that, the faster they try and deleverage, the deeper the downturn may be. I have to say from my perspective my concern is particularly with the need to maintain lending to the business sector. There’s quite a lot of public media discussion about how we have to get the mortgage market going and so forth. That seems to me rather secondary. If you have a cut-off in lending to business, working capital and things like that are affected. Inevitably that leads to job losses, to businesses putting investment plans on hold, shutting down factories, things like that.
FINANCIAL TIMES Presumably you want to avoid viable businesses going under?
CHARLIE BEAN Absolutely. The difficulty of course is that after 15-plus years of steady growth, there will be some businesses that have grown up, which probably aren’t sufficiently robust to survive all those conditions.
That’s probably particularly true in retailing sectors where a long period of relatively firm consumer spending has made it easier for businesses in that sector to survive so there should be some shakeout. But the important thing as you say is that you want to make sure it’s only the marginal businesses that suffer and that you don’t lose businesses, which basically have a healthy future. And one of the trickiness is always judging to what extent you are getting excessive destruction of business capital.
FINANCIAL TIMES We’re seeing in the lending data for private non-financial companies, a very sharp reduction in the growth rate. We haven’t seen a reduction yet although that’s looking like it’s only a matter of time. Do you see existing banks drawing in their lending or are the remaining players still lending as much as ever but there’s just fewer of them now. Where’s the problem?
CHARLIE BEAN Well, it’s certainly true that there’s been the exit of some players and that’s meant that the remaining players have obviously been increasing their market share. You’re quite correct to say that they will claim they are actually still doing plenty of new business. Of course what happens during these sorts of times is that our businesses, which may have had established credit lines but they’ve not drawn on them in the past, are now drawing them down, so the need for credit goes up. There are plenty of stories that one hears, and we hear them through our agents, that the terms on which some of those credit lines are offered have been tightened.
Some of that may be entirely rational, in response to the heightened risks that banks take. Nobody wants banks to make loans which are going to be unprofitable. We think there may also be an element of some businesses drawing down credit lines that they don’t necessarily need to draw on yet, but wanting to build up some liquid assets, so they’ve got it in the bank, if you like, even if that’s a bit costly for them to draw on the line and redeposit them. It’s a sensible defensive measure.
FINANCIAL TIMES So that’s why you’re still seeing growth.
CHARLIE BEAN Well, it may also account for why there’s overall quite healthy lending, but simultaneously we are hearing lots of stories from businesses saying that they actually can’t get the credit they need, because there are other businesses who are drawing heavily on it. And getting to the bottom, to know exactly what’s going on in this area is not straightforward. It is one of the things that we’re trying to understand better as part of our input into the Treasury’s bank lending panel.
FINANCIAL TIMES Is there a generalised co-ordination problem in that it’s individually rational for banks not to lend but collectively that’s very destructive.
CHARLIE BEAN There certainly is a collective action issue, if you like, because for an individual bank, particularly if it feels that it’s over-leveraged, it makes plenty of sense to cut back on lending activities, try and de-leverage, to improve its resilience. If an individual bank does that, that’s fine. But if everybody does it together, of course, the consequences are more failures, higher unemployment, lower demand, more defaults on loans, and that worsens the positions of the banks again. So there is a sort of multiplier process that kicks in. What I think, and the legislation says, makes sense, is to try and encourage the banks to realise that it is in their collective best interest to maintain lending to what are essentially healthy, profitable businesses. As I say, nobody wants them to lend to unprofitable businesses.
FINANCIAL TIMES How do you do that, because we see, we hear from the authorities saying we’ve stuffed lots of capital in, we don’t want your capital ratio to be high, we just want to have a buffer for you to make losses, but the markets at the moment are judging banks essentially on the strength of their capital ratios and so they’ve got very conflicting incentives. They’ve got governments telling them to allow ratios to fall with a sort of uncertain future if losses happen to be even bigger than they thought and maybe this amount of capital wasn’t enough, and they have the market forces pushing them in the opposite direction.
CHARLIE BEAN Yes, you make a very fair comment about the capital buffers, because we’ve always seen the injection of the extra capital as not about raising capital requirements, but about, if you like, aping where we would have been if we had had pro-cyclical capital requirements, where you would have forced banks to build up more reserves. They would have entered the downturn with a bigger buffer of capital, which could then absorb the losses that you would expect as the downturn proceeds. Actually, I think there are very good arguments for saying that now is exactly the time that you should reduce minimum capital requirements. That’s what you’d have under a macro prudential model. And then they would be raised as the economy recovers.
FINANCIAL TIMES Do you need the FSA to do that?
CHARLIE BEAN It is the FSA. It’s not our role to do that. The essential point here is that you’re entering the downturn with a bigger margin of capital, which can absorb the losses. It is unfortunate that plenty of the banking analysts haven’t really got that point and actually have interpreted the authority’s action as representing an increasing in required or target capital ratios. Of course, with the economy slowing, I think it’s fair to say that the news on the outlook over the past few months has been to the downside. It may well turn out that further capital injections are required. I certainly wouldn’t rule that out. It may well be necessary if the banks feel they’re going to feel comfortable about continuing to lend. The other part of the story, of course, is the funding element. It’s fine for them to have the extra capital, but if they can’t get the funds to lend, they also can’t do the lending. I think the changes to the credit guarantee scheme that the Treasury announced two days ago seems to be a perfectly sensible way to go. The pricing of the scheme did look a little on the expensive side, particularly when you compare it to what other countries implemented. And the extension of the term and the extension to other currencies, they all seem entirely sensible modifications, which I hope will ease the funding problem. It’s quite possible that further measures will be required, though.
FINANCIAL TIMES On funding?
CHARLIE BEAN Well, generically. It includes capital funding.
FINANCIAL TIMES Because we’re not seeing the effects we hoped from the initial capital raising?
CHARLIE BEAN Certainly not yet. You can say measures take time to work through, and maybe once we get into the new year you will see more of the effect from the policy measures that have already been taken working through. Obviously banks are worried about getting through the year end, and so forth. But, as I say, I think it is quite likely that some further action may be required to bolster bank lending.
FINANCIAL TIMES Going back to the economy, we seem to be, more than I can ever remember, in a situation now where Keynes and the paradox of thrift is a good description. This seems to be happening, as far as we hear anecdotally, in lots and lots of employers. But collectively this is going to be quite problematic.
CHARLIE BEAN That’s very fair. I was on an agency visit down near Southampton at the end of last week, and I was struck by the number of businesses that I spoke to, some of whom said their demand had fallen off sharply, in which case it’s not surprising that they’re retrenching. But there were others who were in cyclically insensitive businesses. One example was a contact lens manufacturer, which is not particularly cyclically sensitive, but [it] nevertheless thought that it was rational to look at rationalising their activities, look to cut out any surplus labour they had, look to cut out extra costs.
Of course, when everybody is doing that together, as you quite correctly imply, you get these adverse multiplier effects. Similarly, on the spending side, [it is] perfectly rational for an individual household, looking to increase their saving. Of course, household savings rates are at very low levels, and in the long term we do want those savings rates to rise. That’s part of the necessary rebalancing of the economy. Of course, if everybody does it quickly, today, you make the downturn far worse. What we need is Augustinian consumers who will be economically responsible in the medium term, but don’t rush to become virtuous overnight.
FINANCIAL TIMES So, if things are getting quite bad, there’s a lot of talk about zero interest rates here – we’ve got there in the US; we’re there in Japan, we’re not there in Europe – do you see that as a significant likelihood for the UK?
CHARLIE BEAN We have to recognise that it’s a possibility. I think some of the excited media coverage – not, I hasten to add, the Financial Times – make people think that we’re about to be there in January, but of course interest rates, the bank rate, is still at 2%, so we still have some margin to go yet, but of course we may find ourselves getting them all the way to near zero.
It’s a moot question whether you actually want to go all the way to zero, or stop at a small positive number; it really depends on how the money markets operate. And the problem with going to zero is that effectively you don’t leave the banks very much incentive to manage their own liquidity. As you know, our money market operation’s bank rate is the rate we pay on commercial bank reserves held by us and the banks have a target that they aim to hit over the month as a whole, and if they’ve got excess reserves they deposit them with us at 25 basis points below bank rate, and we can supply them with extra funds if they need it, again, at good collateral at 25 basis points above.
FINANCIAL TIMES So you’d find it difficult to go below 25 unless you’re asking for a penalty for depositing with the Bank?
CHARLIE BEAN What would happen as the bank rate goes down, obviously when the bank rate gets to 25, if we hadn’t narrowed the corridor, then the rates on deposits would be zero, but what then happens if we lowered bank rates further, is the corridor automatically narrows, so that the deposit rate never goes below zero. So there’s a technical question that needs to be addressed there.
But the substantive questions in relation to so-called quantity easing relates to what assets you want to purchase. Some of the public coverage portrays this as though well, it’s just helicopter drops of money. That is true, as one variety of it. But the more normal way [and] how the Japanese conducted it, is if you’re buying outright, assets, either public sector debit or it could be corporate debt or equities, and the essential purpose in those cases is to drive the interest rates on those other assets towards zero and thus affect the level of spending in the economy. In addition, to the extent that you’ve got lots of central bank money piling up at the banks, then that may also encourage them to increase their lending.
FINANCIAL TIMES Do you sterilise?
CHARLIE BEAN The thing is you would be sterilising when you’re above the zero floor. So if, for instance, we conduct a long-term repo where we’re supplying central bank money in exchange for whether it’s solid debt or mortgage bonds security, whatever, like that, that will mean there’s more central bank money in the economy. And if there’s more in aggregate than the banks have said they want to hold, either the excess will end up having to be put in our deposit facility, or else we would need to suck out, to drain, in the terminology, the excess, and typically that’s what we and other central banks would do under normal circumstances: you drain, or as you’ve described it, sterilise the excess. If you don’t do that, it’s putting down the pressure on short-term interest rates, and that’s why in the US we’ve seen the Federal Fund’s rate, the actual Federal Fund’s rate, be so far below their target over the last few weeks, essentially because they haven’t been in a position to drain those extra reserves.
But at zero, it’s precisely the thing that you don’t want to do. You want to increase the amount of central bank money in the economy, so you wouldn’t be aiming in general to drain the excess. I mean, it may be that you decide you want to drain some of it, but the whole purpose is to actually increase the amount of money in circulation.
FINANCIAL TIMES And how does the MPC work in a circumstance like that?
CHARLIE BEAN It will partly depend on the answer to the prior question that I posed, namely what assets are you going to conduct this in? Because it’s not a uni-dimensional policy, it’s multi-dimensional, you need to decide which assets you’re going to buy, and inevitably there would have to be a degree of co-ordination with the debt management office and the Treasury if you’re going to buy public debt, you don’t want a debt management office undoing our action, so there has to be some co-ordination there.
If we were to get into the business of buying private assets, we would probably be taking more credit risk onto our balance sheet, and clearly the Treasury would have an interest in that. You know, they may need to re-capitalise us at some stage if we took on too much risk which turned bad. So there has to be some co-ordination. And what one would expect is that the parameters within which the MPC was then free to operate would then be determined by what assets we were acting in, what the Treasury and the DMO would accept was acceptable to them.
FINANCIAL TIMES So you would expect to see, just like we have our 2% inflation target, then you have freedom to set interest rates, you would be given certain parameters to work within and you’d have freedom within those parameters?
CHARLIE BEAN We would be given parameters to work within, yes.
FINANCIAL TIMES That would require a change in the MPC remit, at least for a period.
CHARLIE BEAN It doesn’t require a change in the remit, because the remit’s about our target, and that would presumably remain 2%: CPI inflation in the medium term. But what you could see the MPC doing was deciding on the total expansion in central bank reserves, for instance. But that would be one way. There might be other ways that you choose to implement it. So there’s a bundle of practical issues that the committee would have to decide on before going down this particular route.
FINANCIAL TIMES In Japan there was a lot of talk about the need to change the inflation target at the time from a pinpoint target to a price level target, so that if you were in a position where you’re having persistent deflation…
CHARLIE BEAN Well, the Japanese didn’t even have in inflation target, and the BOJ were actually loathe to adopt on while they were actually in deflation, because they felt they couldn’t guarantee to achieve it: didn’t have the capability. Now, I actually think that having a positive inflation target is a positive virtue if you do get into a situation of deflation. Because, of course, the thing that is problematic in deflation is not if you have a quarter or two of falling prices; it’s when expectations become firmly anchored, as people expect in falling prices, and that goes on for some years: there’s a redistribution away from debtors to creditors as a result of falling prices; households hold off spending because they expect prices to fall further and so forth, and having a positive inflation target helps to anchor those expectations in positive territory. And given I think that we have a reasonable track record of having achieved the inflation target since 1997, or indeed back to 1992 if you include the first years of inflation target, one would hope that that might help. Now, there is a question beyond that of actually saying would it even be desirable if you actually had a price level target.
FINANCIAL TIMES So that you made back whatever price falls had occurred?
CHARLIE BEAN Yes. There is some discussion of this, particularly in Canada. At the moment they’re reviewing whether they should switch to a price level target from an inflation target. I have to say there’s pros and cons of it, and I think where I am at the moment it’s given that I think the inflation target has by and large worked pretty well, I would be wary about going to a price level target unless I was pretty convinced that there were significant positive gains from doing so. But this is an open area where, as I say, the Canadians are doing work on it: they’ve committed to produce something for public consumption, I think in the course of next year, and it’ll be interesting to see what comes out of that.
FINANCIAL TIMES Let’s move on, assuming that we get through this.
CHARLIE BEAN We will get through this. The one thing that I can confidently assert about downturns and recessions is they do come to an end, eventually.
FINANCIAL TIMES So when it comes to an end, eventually, we’re going to want to think hard about how we avoid getting into this sort of mess again.
CHARLIE BEAN Yes. And it is important that when we get through that we don’t relax. I think one of the problems in the past has sometimes been that when a crisis hits, like the Asia crisis, we say … we must make sure that this never happens again and we must do X, Y and Z, and then once you’re through the crisis, the will to actually undertake major changes gradually subsides and in the end that you don’t end up making the system more resilient. I think that’s less likely this time round, simply because the scale and the global nature of the financial crisis will mean that the political will to do something to reduce the likelihood of a recurrence will remain for far longer. But it is important that we will follow it up.
FINANCIAL TIMES In Turkey you explained that interest rates alone were not a good tool to stop a house price boom. But it seems very interesting how you actually operationalise your suggestion of having an additional regulatory tool.
CHARLIE BEAN I mean there’s a clutch of significant analytical issues that have to be worked through. In my Istanbul speech I mean I was mainly concerned to signal that we just actually need to create the second instrument.
But at this stage I don’t have fixed ideas about exactly how it should be done. I mean, firstly, in terms of the sort of mechanism that you choose, this could be running off capital requirements; it could be dynamic provisioning of the Spanish form; there’s the capital insurance idea that, run under Anil Kashyap, Jeremy Stein, and Raguhuran Rajan. So, first of all, [there are] a range of things that you might be actually working on. Then there’s the question about what things they respond to: what are the keys against which they move. And are they entirely macroeconomic, in which case is it GDP that you’re looking at? Is it bank credit? Or do you also want to have a role for individual firm level measures in there as well, so leverage ratios and so forth might come in? There’s the question about to what extent any macro prudential regulatory system is automatic, so it’s hard wired in, or do you have an element of discretion in there? And if there is an element of discretion, who operates it. Is it the FSA? Is it the Bank of England, or is it somebody else? And I think one might argue that since this is in large part a macroeconomic dimension, it’s not obviously where the FSA’s comparative advantage lies, but that’s not to say it can’t build up a capability, but that’s clearly an issue that would have to be faced.
FINANCIAL TIMES So could you imagine – I mean, I’m not trying to say you’re trying to take the FSA’s role away from it – but a situation where there MPC, if it had two levers, or a series of levers, it would decide the interest rate and perhaps if it wasn’t entirely automatic, some other policies
CHARLIE BEAN That might be one way of operating it.
FINANCIAL TIMES So you could keep a 2% inflation target.
CHARLIE BEAN Yes.
FINANCIAL TIMES And have a series of tools…
CHARLIE BEAN Yes. And essentially what one would be doing from a macroeconomic perspective then, is not only using Bank Rate to hit the inflation rate for goods and services over the medium term horizon or round two years that we look at at the present, but also using the macro prudential weapon to enhance your likelihood of hitting the inflation target in the medium term. So I mean that’s the way I would think of it.
But clearly there would need to be appropriate co-ordination with other bodies, particularly if that macro prudential weapon were wielded by somebody other than the Monetary Policy Committee. And I guess the final one to throw into the pot here that is very relevant, is that this is an issue that needs to be thought about in an international setting: can banks operate across borders, and that there’s scope for banks to relocate across borders or to shift their state of location, their business? So there needs to be international agreement on some of the principals here. The FSF, it is one of the areas that they’re working on, so I suspect that further down the road we will see some convergence on models here. There’s an awful lot of work to be done.
FINANCIAL TIMES How do you think it needs to be done? This presumably needs, actually both at the international level and then presumably at the government level, because they have to give you a slightly different powers and tools to use them.
CHARLIE BEAN Yes. I mean, depending on exactly what the tool is, but it is quite likely that there may need to be some appropriate legislation, some amendment. [But] this is a long, long way down the road, and it depends. I mean, it’s quite possible if it was decided this all goes to the FSA, that it’s probably within the discretionary elements that they already have at their disposal.
Because I mean they have quite a lot of room for movement there. And then the MPC would need to co-ordinate in some way with the FSA. Maybe under those circumstances we might make a recommendation or something that the FSA should consider whether in view of the overall macroeconomic evolution of debt
FINANCIAL TIMES A comply or explain type of operation?
CHARLIE BEAN Something like that. So I mean there’s lot of different models that you could contemplate pursuing here. But the one thing we are actively doing – in fact I put it in my Istanbul speech – John Gieve had a speech the week before when there was actually rather more on the possibly ways of doing it, and I think Mervyn mentioned it at the Treasury Committee – So I mean the one thing that the Bank wants to do is make sure that this issue is on the agenda, and doesn’t get forgotten.
But other than wanting something done along these general lines, we don’t have a particular view about how we think it should be implemented. We obviously have to think about what the issues are.