Monetary Policy
Robert Skidelsky
Hansard | Thursday, July 12, 2001

My Lords,
May I add my name to those who have already congratulated Lord Peston and his colleagues on the Select Committee on the MPC for the admirable Report we are discussing this afternoon. It is an intellectual treat, a store of practical wisdom, and a notable contribution to economic education. It is also an example of the sort of thing your lordships house does superbly well.
We are constitutionally debarred from voting Supply. We do though have an opportunity to influence the principles of economic policy. I hope the two reports produced by Lord Peston and his committee will embolden us to seize this opportunity more confidently than we have in the past.
We are now almost at the point of having a critical mass of economists in this House. While economic debate should not be monopolised by economists –economists, as is well known, are not much in favour of monopoly - it does at least help to have these issues discussed by people who know what they are talking about.
I welcome the decision the decision turn the Select Committee on the MPC into a standing Committee on Economic Affairs. As the Report notes, the new committee will have a wider remit than the previous one, though happily the same chairman and much of the same membership. It will be able to look dispassionately at such questions as the balance between monetary and fiscal policy, the problems of forecasting, what account policy should take of regional variations in the economy, the causes of low inflation, globalisation, debt-management, and such like.
May I suggest a further topic? At present, the relationship between the level of taxation and economic growth-or more generally, between economic growth and the size of the state-is a matter of intense political, even ideological division. I would like some progress made towards de-politicising it. An enquiry into this relationship by the Select Committee on Economic Affairs would help give the public debate a much firmer underpinning in economic theory and evidence.
Reading through the Report and the fascinating Minutes of Evidence accompanying it, I was driven to reflect on the differences, but also the similarities, in the way these sort of issues are discussed today and and in the period I know best from my historical work – that is the time of Keynes and the Keynesian ascendancy. I just want to pick out two themes.
It is often claimed that Keynes is dead, that governments have given up the attempt to manage economies. This is nonsense. What is the Bank of England’s MPC doing? Let me quote Sir Eddie George: ‘What we are trying to do all the time is to balance the aggregate demand with the aggregate underlying supply in the economy’. (Q.16.HL Paper 5) And this is true of all central banks, whatever their explicit mandate. Take Donald Brash, Governor of the Reserve Bank of New Zealand: ‘Monetary policy should be aimed at regulating the level of demand….it is trying to keep demand in line with the economy’s sustainable capacity….to minimise the booms and minimise the busts. So…we are fine-tuning’. (Q.424,439.HL Paper 34-II)
This is not what Montagu Norman, Governor of the Bank of England before the 2nd World War, thought he was trying to do. He did not think in these conceptual categories –aggregate demand, aggregate supply. That we owe to the Keynesian Revolution, and the associated development of national income accounts. No Central Bank would now dream of pursuing a monetary, or a Finance Minister a fiscal, policy which would allow aggregate demand to get seriously out of line with what Sir Eddie George called ‘underlying supply’. The fact that they now pay as much attention to excess demand as to deficient demand is in fact a return to original Keynesian virtue, for a time neglected by his followers.
Of course, there has been a change in theory. This is indicated by the two Governors’ careful choice of the adjectives ‘underlying’ and ‘sustainable’ before the word ‘supply’. Today we measure the balance between aggregate demand and aggregate supply not by the unemployment rate but by the inflation rate. The economy is said to be in balance, with unemployment at its equilibrium rate, when there is no tendency in the price level to move up or down. This reflects the influence of Milton Friedman, and particularly his theory of the ‘natural rate of unemployment’. But this theory was put forward in the late 1960s as a critique of existing methods of demand-management, not against the principle of demand-management per se.
The question was frequently raised during the hearings whether the Bank’s mandate should include a specific requirement to pay attention to the level and growth of economic activity. To this, it seems to me that the Chancellor gave a convincing reply in his evidence, when he stressed the symmetrical nature of the 2.5 per cent inflation target.(Q 1188, HL Paper 34-II). Undershooting –indicating the development of demand deficiency –would be as of much concern to the Bank as overshooting, an indication of the opposite. In endorsing the symmetrical target, the Report rightly noted that ‘the symmetry is in order to avoid a too conservative monetary policy’.(Report,para.42, HL Paper 34-II)
Another change from the old demand-management technique is that short-run stabilisation –what Donald Brash called ‘fine-tuning’ –is now done by monetary, not fiscal, policy. This is partly because monetary policy-changing interest rates-is supposed to act more quickly than fiscal policy –changing the level of taxes or spending –though as far as I could judge there is pretty little evidence for this, since the full effect of a change of interest rates now is not expected to work through to prices for two years or more.
But the main reason for the switch from fiscal to monetary policy is surely different. It is that governments could no longer be trusted not to ‘fine tune’ fiscal policy for political advantage, but fiscal policy could not be entrusted to an outside agency in the way that monetary policy could. So fiscal policy is now ‘essentially a medium term tool’, as Gus O’Donnell of the Treasury put it, ‘subject to meeting the golden rule and the sustainable investment rule’. (Report, para.20. HL Paper 34-I) This does not mean that the budget plays no part in stabilization policy. A budget which aims for balance over the cycle will tend to go into deficit automatically in a recession, and a sustainable investment rule will also allow for increased public investment during a downturn.
Let me, more briefly, point to a second big difference between then and now. In Keynes’s day and for many years after his death, stabilisation policy was discussed in the context of fixed exchange rates, whereas today it is discussed in the context of floating rates. This not only alters the nature of the target, but the dynamics of the adjustment process. Today, a policy of higher interest rates works in part by forcing up the exchange rate. So the policy of monetary restriction inflicts what one might call a double whammy – it reduces domestic demand and export demand at the same time, whereas under a fixed exchange rate system only the first effect was felt.
In a globalised economy the loss of export markets, particularly in manufactures, caused by an appreciating pound, may well be permanent, although the effect is intended to be temporary. As Lords Taverne and Paul frequently pointed out in the hearings of evidence, you cannot nowadays switch manufacturing capacity on and off like a tap. Firms can switch inputs from British to foreign suppliers, or relocate abroad. So to my mind, the fact that the transmission from money to prices works partly through movements in the exchange rate is a major problem for current policy.
But this is not the only drawback of floating rates. As Donald Brash, Governor of the New Zealand Reserve Bank, pointed out, floating rates are subject to big cyclical swings which are not correlated with changes in yields and are in fact very poorly understood.
Keynes pointed out many years ago that it is not socially tolerable for domestic output and employment to be the plaything of arbitrary changes in the value of money, which is why he tried at Bretton Woods to set up a system which tried to combine domestic price stability with stability in exchange-rates.
We have to get back to that as an aim, whatever the immediate obstacles, and I hope that the matter might be further considered by the Select Committee on Economic Affairs.
I hope too that this House will be given an early opportunity to debate the Single Currency, and the implications of uncertainty about whether or when we join on the conduct of monetary policy today.
In conclusion, may I simply repeat my thanks to Lord Peston and members of the Select Committee for giving us a challenging opening for discussing matters of vital importance in the House this afternoon.