That same September 2007 report noted ‘the recent rise in asset prices’, one of the ‘factors’ that had been drawn to the MPs’ attention ‘suggesting the possibility that the economic climate over the next ten years may not be as benign as that seen over the last decade’. And it went on:
One possible response by the Monetary Policy Committee would be to target such rising asset prices by ‘leaning against the wind’ – raising interest rates to deflate the bubble in those prices. However, such a move would presuppose the successful identification of such a bubble. On the evidence we have received, this is not possible with certainty. Furthermore, the only instrument available to the MPC is moving the interest rate, and increasing interest rates to counter a rise in certain asset prices could hamper economic growth across the economy, not just in the markets with rising prices. For such a policy to be worthwhile, therefore, the risk to the economy of a rapid fall in asset prices would have to exceed the actual cost of raising interest rates to counter the rising asset prices.
By this time the banking crisis was actually under way, and over the ensuing years the question was naturally raised – inevitably with the wisdom of hindsight – whether indeed the MPC should pre-crisis have curbed credit growth through having higher interest rates. Among those reflecting were Kate Barker (an external member of the MPC from 2001), the Bank’s Charles (Charlie) Bean (chief economist from 2000, before becoming deputy governor for monetary policy in 2008), and King himself. In a valedictory speech shortly before stepping down in 2010, Barker remained broadly unrepentant, but did accept that she had ‘seriously underestimated the scale of the downside risks from a potential financial crisis’; while soon afterwards she identified 2005 – when house prices kept rising, but there was only a single quarter-point move upwards – as the year when with ‘some signalling’, in the form of raising interest rates, ‘you would have sent out through doing that, that things weren’t quite right’, which ‘might have been helpful’. In that same interview, she also pointed to how the MPC’s unrelenting emphasis on medium-term inflation, central to its remit, ‘encouraged too much focus on exactly hitting the target at exactly the two-year horizon and I think that distracted us perhaps from wider strategic issues’. Bean, while not saying he would have done anything differently, likewise accepted there was a lesson to be learned from the pre-crisis experience. ‘Hitting the inflation target is not enough to guarantee economic stability,’ he observed in 2012 on the MPC’s fifteenth anniversary. ‘Long periods of stability encourage households, companies and investors to extrapolate such conditions into the future, to underprice risks, and to increase leverage, so increasing the vulnerabilities in the system.’ As for King, who during the pre-crisis period had more than a dozen times voted in a minority for higher interest rates, he emphasised the inherent difficulty of the policy-making situation. ‘We did talk in the Bank of England about whether we should have had much higher interest rates before the crisis,’ he told BBC radio listeners some six months after leaving office in 2013. ‘If we had done that, we undoubtedly would have had a downturn, probably a recession even, unemployment, and inflation well below the target.’ Moreover, he added, ‘we as one country could not have stopped the financial crisis occurring, so I think we should have been shooting ourselves in the foot, even if you could argue that if every country had done that it may be we would not have been in such a difficult position’. As he also put it, ‘the real problem was a shared intellectual view right across the entire political spectrum, and shared across the financial markets, that things were going pretty well’.
Even so, and as King fully acknowledged in his stimulating, elegantly written 2016 treatise The End of Alchemy (not a history of the crisis, but inevitably touching often on it), there had been pre-crisis a significant debate. Arguably the crucial years were the early 2000s, when overly loose monetary policy contributed significantly to the ensuing asset price bubble of the mid-2000s. ‘In the view of some members,’ recorded the MPC minutes for February 2002, ‘rising debt levels risked increasing the volatility of output and so of inflation,’ whereas ‘other members placed little or no weight on this’. The underlying problem was the two-speed UK economy: high domestic consumer demand, but weak global demand for British exports. ‘In effect we have taken the view that unbalanced growth in our present situation is better than no growth,’ George candidly stated that same year, while in early 2003, shortly before becoming governor, King looked ahead:
The challenge is that by building up the imbalances in order to have some average growth rate close to trend and keep inflation close to the target, you know that at some point a correction will come, and when it comes, it could be very sharp. The difficulty for us is that we simply don’t know how big that correction will be, when it will come, how sharp it will be and whether, in fact, it would be difficult to offset.
King was speaking to Institutional Investor; and he added that using monetary policy to control asset prices was ‘never likely to be successful, because you’ll never know by how much you need to raise interest rates in order to reduce asset prices’. And: ‘What is the theory that tells you how a small movement in interest rates affects irrational behaviour? There isn’t one.’4
Not everyone agreed. In particular, Andrew Crockett, former Bank man and now general manager of the Bank for International Settlements, warned in February 2003 that if the central bank, exclusively focused on ‘inflation control’, failed to ‘tighten monetary policy sufficiently preemptively to lean against excessive credit expansion and asset price increases’, then the overall consequence would be ‘insufficient protection against the build-up of financial imbalances that lies at the root of much of the financial instability we observe’ – a perspective on monetary policy almost immediately condemned by Bean, in a speech at Basel, as ‘the heterodox view’. That same year, an unidentified ‘senior and influential director’ of the Bank spoke to the journalist Robert Peston, though what he said would not become public until 2012:
My view on asset prices is pretty clear … The reason we care about these evolutions is that they have implications for inflation and activity further down the road. If you build up a bubble in asset prices now, when it implodes that is normally associated with a sharp fall-off in activity, financial distress, all that sort of stuff. You can encompass all those sort of things into what I think inflation targeting is all about. Some people have a narrow conception of what inflation targeting is all about, which is focusing on the target two years out. Now that is not something I would sign up to. Typically these sort of concerns about asset price bubbles leading to financial imbalances that create problems further down the road may require you looking beyond the two-year horizon. Often you know these things are going to unwind but you just don’t know when …
Eventually, in November 2003, after two years of rapidly rising house prices fuelled by low interest rates, monetary policy was somewhat tightened – but by then the horse had bolted.5
Over the next three and a half years, the issue broke cover every now and then. In March 2004 Sir Andrew Large, David Clementi’s successor as deputy governor for financial stability, publicly argued for a longer time-horizon than two years and noted that ‘each month when we on the MPC make our policy decision I am conscious of the debt situation’, in particular ‘the possibility that the potential vulnerabilities stemming from higher debt levels do in fact crystallise at some point and trigger a sharp demand slowdown’; during 2005, it was mainly he and Tucker who voted in vain for higher interest rates, while in August they were joined by Lomax and the governor himself in unsuccessfully voting against a 0.25 per cent reduction; and at the end of that year, Large gave another speech, this time valedictory but again arguing (and again, as far as one can tell, largely ignored in the Bank itself) that ‘there are circumstances which can justify monetary policy being tightened in advance of potential shocks, a form of insurance or risk management if you like’. So too in 2006. May’s Inflation Repo
rt noted that ‘broad money growth is currently well above its equilibrium rate’, but more or less left in the air how much that mattered; in September, nine economists, including Charles Goodhart, Gordon Pepper and Tim Congdon (the initial drafter), wrote a letter to the Financial Times, highlighting the dangers of high money growth; around the same time, John Nugée (a former Bank man, but now of State Street Global Advisors) observed in Central Banking that central banks stood ‘at the pinnacle of their reputation’ following a decade or more of low inflation, but drew on history – not least the Wall Street Crash of 1929 – to argue that ‘price stability is not sufficient to ensure general financial stability’; and in December, delivering the Roy Bridge Memorial Lecture at the Honourable Artillery Company, Tucker explained the rapid growth in UK broad money (up more than 25 per cent since the beginning of 2005), but did not really push through the implications in policy-making terms.6
What about the fateful year, 2007 itself? In January, after a surprise 0.25 per cent rise (to 5.25 per cent), the Independent’s Jeremy Warner wondered whether the move ‘might signal a generalised “get tough” stance by central bankers keen to stifle excess liquidity and overexuberance’, but was doubtful, noting also that ‘in real terms, British rates are not particularly high by international standards, even after yesterday’s rise’; in early May, in his ‘ten years on’ lecture about the MPC, King devoted a lengthy passage to ‘the practical problem facing all central banks’ of ‘how to distinguish between shocks to the demand for money and shocks to its supply’, but was unable to promise more than that the Bank was ‘trying to develop models’ to help it make that distinction and that ‘we shall be devoting more resources to this task, including our new Credit Conditions Survey’; later that month, when asked at the Inflation Report press conference whether central bankers generally were concerned that ‘they may have contributed to very frothy asset prices around the world through over-lax monetary policy’, the governor did not deny the broad concern, emphasising that ‘asset prices in the UK can be heavily influenced by what is happening overseas, independently of UK monetary policy’; in June he failed to persuade the MPC to vote for a 0.25 per cent rise, before soon afterwards making a Mansion House speech that only marginally addressed the monetary policy aspect of credit growth; in early July the MPC did raise interest rates by 0.25 per cent (to 5.75 per cent, at last making them relatively high in international terms); in early August it unanimously voted for no change; and on 8 August the quarterly Inflation Report press conference was held. Strikingly, in retrospect, only one journalist, Bloomberg’s Jennifer Ryan, focused at all closely on the credit aspect; and in his reply, King insisted that ‘monetary policy is set to meet the inflation target’, that ‘it’s based on a macroeconomic judgement of the outlook for inflation’, and that accordingly ‘developments in credit conditions’ would ‘matter only in so far as they affect the macroeconomic outlook’. Was that now the case? ‘I don’t think there’s any real evidence here,’ he observed after noting continuing signs of bad loans in the US sub-prime mortgage market, ‘of a fundamental challenge to the macroeconomic outlook.’7 The following day, the credit crunch began.
Inevitably, as the crisis played out, attention also turned to the pre-crisis performance of the Bank’s other wing, charged as it was with seeking to uphold financial stability, though of course no longer – since the 1997 tripartite settlement – undertaking banking supervision as such. As a largely negative consensus soon emerged and in due course became orthodoxy, the underlying assumption was that the Bank had been guilty of significant sins of omission. ‘It is now obvious’, declared the economic commentator Will Hutton in 2012 in words that relatively few observers would have disagreed with, ‘that the Bank should have pressed for controls on the amount banks themselves were borrowing, on the proportion of loans that could be lent against property collateral (loan-to-value ratios), and even on the crazy system of pay and bonuses that encouraged such wild risk taking.’ While that same year, giving his much publicised Today lecture (followed next morning by a lengthy interview on the radio programme itself), King for his part made a notable public confession: ‘With the benefit of hindsight, we should have shouted from the rooftops that a system had been built in which banks were too important to fail, that banks had grown too quickly and borrowed too much, and that so-called “light-touch” regulation hadn’t prevented any of this.’
The external explanation for the Bank’s pre-crisis failings has been predominantly threefold. Firstly, there has been the perception that not only were the 1997 tripartite arrangements intrinsically flawed, being embodied in a Memorandum of Understanding (MoU) that fudged crucial matters of objectives and responsibilities, but also that the Bank failed to communicate as much as it should have with the Financial Services Authority (FSA) – a failure that went to the highest level – and in general was unnecessarily nervous about stepping on the FSA’s toes. Adding to the picture of no one ultimately in charge was the 2016 revelation of Ed Balls, with Labour’s former City minister recalling the episode of ‘a dangerous and fast-changing financial war-game scenario’ during the winter of 2006–7, which showed a fundamental divergence of approach between on the one hand himself and the FSA’s head, Sir Callum McCarthy, and on the other hand the governor. The minister and McCarthy, according to Balls, wanted to guarantee the deposits and provide emergency resources to the fictional large British clearing bank that had become over-exposed to a near-bankrupt building society and now risked running out of money overnight; whereas King ‘was clear that bailing out the clearing bank risked what the economists call “moral hazard”’.8 It should be noted, though, that not all participants remember that particular episode the same way; while at least one recalls the governor urging the Treasury to start work on a legal resolution regime to deal with a failing bank (as in the US: arrangements for winding up banks without interfering with their ability to carry on day-to-day business) – work which the Treasury had failed to do by August 2007.
As for the second strand of explanation, it was crisply summarised as early as 2008 by the financial journalist Alex Brummer in his reading of why the Bank ‘fell short’: ‘Under Mervyn King the Bank became so wedded to its role of controlling inflation that ensuring financial stability assumed a secondary function, inadequately staffed and without real decision-making powers.’ The following year, a review of tripartism by Sir James Sassoon similarly found that during the mid-2000s the Bank ‘significantly downsized the resources devoted to monitoring and analysing changes in the structure of the financial system and assessing their implications for its stability, efficiency and effectiveness’; that it ‘lost and did not replace critical financial market expertise among its senior executive team’; and that it ‘narrowed the focus of its Financial Stability Reviews’, which in turn ‘meant that the Bank was actually, and mistakenly, lessening its engagement with the markets in the run-up to the financial crisis’. In November 2010, the FSA’s Hector Sants stated to the Treasury Committee that ‘the level of communication, and the level of interest, from the central bank in financial stability issues was recognised by all to have been very low, to say the least, in the pre-2007 period’; while in 2012 a close examination by the Daily Telegraph’s Philip Aldrick of the Bank’s annual reports revealed that whereas in 2003–4 the budget for financial stability was £30.6 million, two years later it was £1.5 million smaller (compared to the monetary policy budget’s £2.4 million increase) – and that even when in 2006–7 financial stability received a £6 million budget hike, it was only half that for monetary policy.
The final strand of explanation focused even more specifically on King: in essence, that his relations with the City – above all the leading bankers – became remote; and that almost irrespective of what the banks were or were not doing, his attitude towards them was somewhere on a spectrum between detached and unsympathetic. Tellingly, subsequent analysis by Goldman Sachs demonstrated that in the course of thirty-four speeches betw
een 2000 and 2006, whether as deputy governor or governor, King spoke the words ‘banks’ or ‘banking’ a mere twenty-four times.9 Whatever the rights or wrongs of the matter – and King as governor consciously sought to distance the Bank from its traditional role as spokesman-cum-special-pleader for the City – this was an approach that most of his twentieth-century predecessors would have found almost wholly baffling.
King himself led the case for the defence. As early as April 2008, appearing before the Treasury Committee in the context of his re-appointment by the Labour government for a second term, he explained that ‘the big concern that I had before the events of last August, which led to the rewriting [in 2006] of the Memorandum of Understanding, was that the Bank was assumed to have responsibilities which it could not deliver because it had no powers or instruments to do so’ (with the new MoU saying no more than that the Bank sought to ‘contribute’ to financial stability); justified the reduction of staff numbers on the financial stability side, from 180 to 120 during his first term, by noting that ‘the only powers we had really were to make speeches, write reports and draw attention to the risks, so we re-organised the work in order to focus very much on how we would identify the main risks’; stated that ‘what we did in the Bank was in a generalised way to ask questions about what has happened to the banking sector as a whole and what were the characteristics of some of those developments that we thought most risky’; added that ‘we did write a number of reports and spelled out in our financial stability reports and our speeches that we did think excessive reliance on wholesale funding, for example, relying very much for funding on selling into markets for instruments that could become illiquid, was a risky strategy, and we made that clear on a number of occasions’, but at the same time emphasised that having raised such questions ‘it then requires the regulator [the FSA] to go into an institution and obtain much greater detail in order to find out how risky that institution actually is’; and finally, pointed to how ‘on day one when I was Governor, I said to Paul Tucker, “I want you to create a new market intelligence function”’, and added that Tucker had done this, creating a function that ‘is highly respected in the markets and has a lot of information that it makes available and feeds into all our decisions on this’.
Till Time's Last Sand Page 89