British House of Lords inquiry into the Bank of England’s performance is a confusing array of contrary notions

On November 27, 2023, the Economic Affairs Committee of the British House of Lords completed their inquiry into the question – Bank of England: how is independence working? – by releasing their 1st Report after taking evidence for several months – Making an independent Bank of England work better. The report is interesting because it contains a confusing array of contrary notions. On the one hand, the witnesses to the Inquiry claimed it was “Groupthink” in operation that prevented the Bank from raising rates earlier and that it was obvious the inflationary pressures were traditional excess spending driven by excessive monetary supply growth (classic Monetarism). That assessment is contested by the alternative, which I adhere to, that the inflationary pressures were supply driven and not amenable to interest rate shifts. And the Groupthink arises because these economists consider interest rate changes would solve the inflation irrespective of the contributing factors. While the Report is sympathetic to the mainstream view as above, it then launches into a critique of the mainstream forecasting approaches. A confusing array of notions.

The House of Lords have published a range of inputs to the inquiry including evidence from a past US Federal Reserve Board member, a private bank economist, the secretary of the UK Treasury, the Bank itself, and some academic input (mainstream).

The Report was critical of the way the Bank of England operates.

Of particular interest for me, in my work on documenting the way economic organisations become prey for destructive Groupthink, was the analysis presented in ‘Chapter 4 Diversity of thought and culture’.

The Report concluded that:

… errors in monetary policy reflected a lack of diversity of view in the Bank of England and wider central bank community.

But it is not what you might think.

The next paragraph tells the (sorry) story.

The ‘errors’ according to the Report was that the lack of diversity arose because:

When inflation rose, central bankers focused on supply-side shocks as the cause, and the higher inflation rate was seen as transitory. Some witnesses therefore considered that the inflationary potential of elevated rates of money supply growth were given insufficient attention by the Bank.

So we are back to debating whether this inflationary episode has been ‘transitory’ (supply-side driven) or whether it has been a demand-pull event – that is, whether it is reflects excessive spending (fostered by excessively expansionary fiscal and monetary policy).

I remain in the transitory camp.

When I first started writing about that assessment I was careful to not equate ‘transitory’ (or ephemeral) with some time notion of short-run or immediacy.

I was wanting to differentiate this episode with that of the 1970s, were the initial cost shock – the OPEC oil price hikes – triggered a drawn out distributional struggle where trade unions would push nominal wage demands to protect the real purchasing power of wages and price setting corporations would respond with price rises to protect their real profit margins.

Which of those protective mechanisms came first is a separate question – that is, was the 1970s a wage-price spiral or a price-wage spiral?

There is evidence to support both notions.

But the point was that the initial cost shock coming from the imported raw material price rise (oil) propagated into an extended ‘battle of mark-ups’ between labour and capital which then drove the inflation long after the raw material shock had been absorbed.

In other words, the inflation becomes a self-fulfilling process and reflected the structural power that workers and corporations had in the institutions of wage and price determination.

That institutional structure has changed dramatically in the period since due to an array of factors, not the least being, the attack on trade union power by successive neoliberal governments around the world.

It was that change that led me to predict that there would be no similar wage-price/price-wage struggle this time and once the supply-side factors that initiated (and have extended) this inflationary episode abated, then the inflation would quickly fall.

What I didn’t know when I made that prediction was that Putin would invade Ukraine and OPEC+ would use its cartel to further extract profits by manipulating supply.

Those events that followed the pandemic supply shock have extended the inflation but they still fit, in my view, within the transitory framework.

Why?

Already, the world has adapted to the global food and timber supply impediments that the Ukraine situation initiated.

Also Europe has adapted to the shifts in energy supply away from Russian sources.

And the OPEC+ oil price gouging has not continued despite a renewed peak in October 2023.

Oil prices are largely back to where they were in late 2021.

The House of Lords Report though considered the Groupthink element to arise from “overlooking the quantity of money as an explanation for monetary behaviour, or for the behaviour of the economy or inflation”.

In other words, ignoring traditional Monetarist explanations, which I found rather interesting.

One mainstream economist told the inquiry that there:

… is a divergence in macroeconomics between those who want to interpret inflation entirely by looking at the labour market and to explain what happens to national income and national output by the income expenditure mode … and those like me who would defend the quantity theory of money.

The Quantity Theory of Money is the basic mainstream proposition that if the nominal money supply expands, there will be price level acceleration.

In crude terms ‘too much money chasing too few goods’.

It arrives at that causality because it assumes institutional characteristics like velocity (turnover of the money stock) to be constant and that the economy is operating at all times at full capacity.

Its application to the pandemic is questionable because clearly economies were operating at well below capacity with all the restrictions and sickness.

However, the QTM advocates would claim that given the supply restrictions, any expansion of nominal demand (spending) would push the economy into an inflationary space.

I agree with the latter assessment and wrote about it extensively in 2021.

But there is a difference between supply constraints that one knows will ease quickly – like factories closed because of temporary health policies, opening immediately when the health policy shifts – and an absolute lack of extra productive capacity arising because the existing capital stock is working flat out and investment (and long time lags) are needed to expand that capacity.

The former resolves quickly, while the latter takes time.

And there is a world of difference in the policies that one might take in either case.

The conventional demand pull approach (excessive spending relative to a fully employed supply-side) – that is the latter situation – attempts to resolve that spending excess by creating unemployment which brings nominal spending back in line with the existing productive capacity and allows the economy to grow again once investment in new capacity is forthcoming and the new capacity is installed.

It is a costly approach because the income loss that is engineered by the restrictive policy impacts disproportionately on low-income families.

There is a debate about what is the most effective way to engineer that income loss, which is one of the differences between the New Keynesian macroeconomics, which assigns the policy imperative to monetary policy, and say, the Modern Monetary Theory (MMT) approach which prioritises fiscal policy.

The MMT economists, in line with many Post Keynesian economists, consider monetary policy to be an ineffective policy tool for moderating aggregate spending and contains the capacity to be inflationary itself when it is aiming to be the opposite (via interest rate rises impacting on borrowing costs and being passed on as higher prices or higher rents).

But that debate is not the issue here.

The issue is whether one wants to compound the (temporary) cost of living pressures with higher unemployment (however achieved) when one knows that the supply impediments are not due to a lack of productive capacity but rather reflect a temporary restriction on the use of the existing capacity.

That difference is at the heart of Report’s findings in my view.

I consider the situation to be best described by the former concept of supply impediment and provides no evidential basis to validate the QTM.

So, I conclude quite the opposite to the evidence given by the mainstream economists to the House of Lords inquiry.

The Groupthink that I observe is in believing, one, that this was an excess demand episode, and two, that interest rate rises would deal with it.

The witnesses appeared to want higher interest rates imposed earlier.

I am in the Bank of Japan’s camp – higher interest rates were not the appropriate tool for dealing with this peculiar conflation of events.

I go further, that higher interest rates are never a particularly effective tool for dealing with inflation of any origin – supply-side or demand-pull.

The House of Lords report though, sides with the Monetarist view that it was excessive monetary supply expansion that was a crucial factor in explaining this inflation and recommended:

… that the Monetary Policy Reports should include discussion of the main monetary aggregates, accompanied by an analysis of their relevance to the Bank’s inflation outlook and the various scenarios the Monetary Policy Committee considers.

I then found it curious that the section on ‘Forecasting’ in Chapter 4, sided with the view that:

… the conventional models used … have been the source of much recent criticism and challenge in the last few years.

The conventional models refer to the DSGE (Dynamic Stochastic General Equilibrium) models which are the hallmark of the mainstream New Keynesian macroeconomics.

One input the Inquiry received said that there are:

…. profound intellectual problems with [DSGE] models … they are likely to give you bad advice.

Remember that these models “rarely have a role for the financial sector or money”, which was highlighted by the failure of the mainstream economists to see the GFC coming.

The Inquiry heard that:

… students are taught this view in universities and schools and they go from there to the research departments of universities before moving to central banks.

Which is where the Groupthink arises.

Young cadets learn that to get employed then enjoy career progression it is best to parrot the orthodoxy and the ‘group’ never really questions that approach.

The dynamic is biased towards proving ad hoc excuses when forecasts fail, as they do regularly.

But, as I have noted previously, it is not that forecasts fail, but that they fail in a systematic way as a result of the built-in biases of the models.

When a forecaster gets it wrong consistently in the same direction, then you know something is amiss in their approach.

We saw that in the extreme during the GFC, when the IMF was making predictions about the impacts of the bailout/austerity packages on Greece.

They predicted things would improve as they became increasingly worse,

The gap between the forecasts and the reality became ever larger with devastating consequences for the Greek people.

It is not an isolated example.

A witness to the Inquiry said:

I used to be at the IMF and we used to run our models there. There was nothing monetary policy could not cure.

The Report noted in this regard that:

He intimated that in the face of economic shocks, such models would routinely forecast a return to ‘normality’ with only minor adjustments to interest rates … Dr Rajan also noted that the assumptions feeding such models go unexplained and yet are unquestioned.

That is where the Groupthink arises.

It is not that the Bank of England thought the inflation was transitory or not, but, rather, that they thought that interest rate changes would solve the problem no matter what the source was.

There was also analysis of the “Appointments” to the Monetary Policy Committee and the Bank staff.

It was interesting that witnesses cited the reality that it was the HM Treasury that essentially made the senior appointments to the Bank and:

… although one thinks of the Bank of England as being independent, it is independent but with the Treasury still casting a shadow over it.

Another, said that there “was a racket going on. Essentially, friends are appointing each other.”

The Inquiry Report concluded that:

It is notable that three of the four current Deputy Governors have a Treasury background. While they are undoubtedly able, this does not strengthen the perception of independence.

My view is that the diversity issue does not arise because the Chancellor has the capacity to appoint senior bank officials upon recommendation of his treasury department.

The problem is that the treasury, itself is lacking in diversity and is full of New Keynesian economists locked into a single model.

A major economic policy making institution in any nation should be fully accountable to the voting public.

I consider that makes it imperative that the central bank is fully accountable to the political process, which over the neoliberal period has not been the case.

The evidence submitted to the Inquiry leaned towards further separating the central bank and its decision-making processes from that process – a move we call depoliticisation.

Depoliticisation allows the politicians to avoid accountability for key macroeconomic decisions that have the capacity to impact significantly on the lives of the people.

My preferred approach is to downgrade the importance of monetary policy – keep interest rates constant – merge the central bank functions into a broader economic policy department (that is, combine central bank with treasury) and ensure that the new department recruits broadly and always has a diversity of viewpoints.

The problem, then, is that the feeding institutions – the higher education sector – are producing graduates that are highly homogeneous as a result of the biases in the teaching and post-graduate programs.

Conclusion

Nothing is going to change quickly until we shift the academy.

Which is my remit.

That is enough for today!

(c) Copyright 2023 William Mitchell. All Rights Reserved.