The former Governor of the Bank of England, Lord Eddie George gave the keynote speech at our Annual Investment Forum last week. You can read the full text below. In short Lord George argued that there has emerged a political and public consensus in favour of financial and fiscal stability. This means that interest rates and inflation should remain much more stable (and lower) than they might have been in the bad old days of non-independent central banks, and imprudent fiscal policy. He did however warn about the re-emergence of protectionism as a threat to the global supply side and as such the possibility of lower global growth than we might otherwise achieve. Finally he warned that returns from private equity and alternative investments might disappoint – although he added that he didn’t see any systemic threats to the real economy from those asset classes. Click “read more…” below to read Eddie’s speech.
Lord Eddie George’s Speech:
“I plan to talk about the state of the global economy and some of the recent developments in financial markets. But I’d like to begin by reminding you of some of the fundamental changes that occurred – very gradually – in our whole approach to macro-economic management over time in the UK, but also, from different starting points and to varying degrees, in much of the rest of the world. I think those changes help to explain why I believe the outlook for the real economy may be more stable than in the past and less volatile than is often suggested by financial markets and media commentators.
Soon after I joined the Bank in the early 1960s I was sent off to Moscow for a year to study the Soviet economic and financial system – as the extreme example of central planning and control. I don’t know what crime I’d committed to deserve such punishment but it was a seminal experience for me. It wasn’t so much what I saw there, though it was clear that the system was not working very well. What really made an impact on me was on my return to the UK, I noticed for the first time just how centrally controlled we too were in this country. I suppose I’d grown up in that atmosphere and simply took it for granted.
The Bank at that time devoted much of its time and energy to administering direct controls of all kinds over the financial system – you will remember foreign exchange controls; credit controls under which we told banks how much they could lend, what fed markets and in what form; rationing of access to capital markets through the equity queue and so on. But it wasn’t just the financial system that was controlled from the centre in this way. Across the wider economy we had prices and incomes policies; extensive public ownership of major sectors of industry – with powerful trade unions secure in the knowledge that the employer couldn’t go bust; and we had marginal rates of income tax that at one point reached 83% on earned income and an unimaginable 98% on investment income!
Happily all that has now largely gone, though it took 20-30 years to bring it about. Gradually we moved to a much more market based economy. Of course we still have masses of rules and regulations in the place of the direct controls – I’ve never seen a business opinion survey that didn’t have excessive red tape near the top of its list of complaints. And we need regulation if markets are to be reasonably fair as well as reasonably free – as they must be if they are to serve their fundamental purpose of allocating resources, whether human or physical or finance resources, to wherever they can be most productively deployed. If we simply had a free-for-all, resource allocation would be hopelessly distorted – though I recognise we can always have too much of a good thing, or even a necessary, thing! But the difference between what we have today and what went before is that today we’re not told what we can and cannot do: today we’re told the criteria we must meet and the standards we must observe in doing whatever it is we choose to do. And that leaves for more room for both producer and consumer choice through market competition
All of that was on the supply side of the economy, which was critically important because it is the supply side that determines the rate of growth of output and the level of employment and income that we can hope to sustain. But there were equally fundamental to our approach to macroeconomic management on the demand side.
Throughout the first half of my Bank career fiscal and monetary policy was used more or less in tandem to manage overall demand, with the aim of managing what was seen as a trade-off between growth and employment on the one hand and inflation and the balance of payments position on the other. The result, you will remember, was a go-stop policy cycle that contributed to the notorious boom-bust economic cycle. And worse still the situation was becoming explosive with inflation moving higher and higher at each successive peak, reaching 27% in a single year at one point; and unemployment higher and higher at each successive trough, rising well into double digits. We really were looking over a precipice.
But we eventually learned from the experience. We learned that fiscal policy was a cumbersome instrument for managing overall demand in the short term, and recognised the importance of containing the government debt proposition in the medium and longer term. That opened the way to a more distinctive role for monetary policy – now essentially through control over short term interest rates – as the key instrument for shorter term demand management.
And we learned too that there really is no trade off between growth and inflation except possibly in the short term, but possibly not even then given the pervasive influence that the short term horizon came to have on economic decision making, with employers and employees, investors and consumers, all looking to make hay while the sun shone. We learned in fact that stability – in the sense of keeping demand growing consistently broadly in line with the underlying supply-side capacity to meet that demand, stability in that sense, is a necessary condition for sustainable growth, and that has become the near universal central banker’s mantra. It was that understanding that eventually led to operational independence over monetary policy for the Bank, through the MPC with the mandate from government to achieve and maintain its low, symmetrical, inflation target – in effect reflecting stability in that broader sense – accompanied by public transparency and accountability.
Now the real point about all of this is that none of it could have happened without the gradual emergence of a broad political – and public – consensus; and that consensus supported the combination of changes, on both the supply and demand side: any one of the changes on its own would have been ineffective. Operational independence for the Bank, for example, on its own would in my view have been a poison chalice.
As things turned out the UK economy as a whole has performed very much better over the past 15 years or so. Since 1992 we’ve enjoyed continuous quarter by quarter growth, at an average annual rate of some 2.75%. Employment rose to an all-time high; and unemployment fell to a new 30-year low, though it ticked up a bit last year. Inflation has been consistently within the government’s target range, and interest rates have on average been just about as low as most of us can remember.
And, critically important, the political and public consensus that made all this possible remains robust. It’s on this basis that I am reasonably optimistic – which is strong language for a central banker, even a retired central banker – that we will continue to see reasonably steady growth and continuing low inflation over the next few years which is as far as anyone can realistically look ahead. Now that I’m no longer in my day job, I can tell you with complete confidence that interest rates will remain where they are – unless they either go up or down! But, more seriously, I’m totally confident that any movement in interest rates will be “measured”, with any further rise reflecting the strength rather than the weakness of the economy. I’m bound to say that I find the excitement displayed by many media and financial market commentators about a quarter of a percent this month or next somewhat exaggerated. I can remember the days when they moved by two percentage points at a time and at one point hit 15%!
But let me move on to the state of the global economy, where, as I say, we’ve seen a similar evolution, from different starting points and to varying degrees, in the approach to macro-economic policy. And here, after the sharp slowdown into mild recession after the turn of the century, a fairly solid recovery, particularly in the US. In fact among industrial countries the world became dependent upon US demand growth, which contributed to fears about global imbalance. Europe and Japan argued that the US should address these fears by cutting back on consumer and government demand; whereas the US pointed out that this would mean persistence of global weakness and that the problem of imbalance would be better addressed by stronger consumer demand elsewhere. There was a fairly long period of stalemate. But happily we are now seeing some moderation of consumer demand growth in the US – not the crash that was widely predicted – in the wake of the measured rise, to a more “normal” level in US interest rates, and we are also seeing moderate concurrent recovery of demand in both Europe and Japan, where interest rates remain stimulatory. So the dark clouds of imbalance on the horizon have lifted a little. But the problem – which was never going to be resolved overnight – has not gone away; and we may, as a result, see periodic bouts of nervousness over the dollar exchange rate; but that doesn’t mean a sudden crash.
The other major threat – of a year or so ago – was the threat of accelerating inflation stemming particularly from the sharp rise in oil prices. In fact we survived that remarkably well. Oil prices have declined significantly since then, having a negative effect on inflation more recently. The price of oil remains substantially higher than it was, and it probably needs to remain high to provide a commercial incentive to alternative energy sources, but it is the rate of change which affects the rate of inflation, rather than the level.
A third concern has been the re-emergence of protection pressures in a number of industrial countries. The stalling of the Doha round of trade talks is one example of this, but we’ve also seen protectionist trade measures and resistance to foreign takeovers of so-called “national champions” in some countries, reflecting resistance to globalisation. I find it particularly paradoxical that the US, which for years has preached the gospel that “a strong dollar is good for the United States” should suddenly – with European support – start to bully China into a dramatic revaluation of the Renminbi. China is a country in transition and may well, in the fitness of time, conclude that a stronger Renminbi is good for the welfare of the Chinese people as consumer demand expands, but for the present a major priority is to create employment for those people migrating from the rural areas, which is in the interest of all, not just of China. A sudden, sharp, appreciation of the Chinese currency would have wholly unpredictable consequences for the whole of the global economy. Happily China has not succumbed to the external pressure.
What such protectionist instincts represent is a desire to hold on to what we’ve had. But I think we’ve learned, in this country certainly, that the approach is ultimately a blind alley. The answer surely is to encourage supply-side flexibility and new business activities, and the creation of new jobs through education and training, in areas where we can hope to establish and maintain a comparative advantage. I have every sympathy with people who lose their jobs – but surely their position is much more bearable if they have a reasonable chance to find new jobs; and the contrast between the labour market data in this country compared to some of our European partners is significant in the context.
I don’t suggest that the protectionist pressures we have seen will cause economic growth to stall – even in China and India, which are contributing so substantially to it. I see the danger more as a lost opportunity to increase global supply side capacity and the rate of growth that we can, collectively, sustain.
So, all in all, I anticipate relatively steady growth in the world economy as a whole over the next few years, with perhaps some mild slowdown in the US, somewhat faster growth in Europe and Japan, and continuing very strong growth in China, India, Russia and some other emerging and transition economies that, together with continuing relatively low inflation, reflecting reasonably disciplined demand management policies, certainly appears to be the expectation of most of the official forecasters.
Of course, nothing is certain in economic life, but this prospect does not suggest major shocks to the financial system emanating from the macroeconomic side. But what about the other way round? Macro-economic and financial stability are like love and marriage – they go together like a horse and carriage! So let me conclude with a few remarks on recent developments in financial markets.
Since the end of the dotcom bubble and the recession in much of the industrialised world that we saw at the beginning of the present decade, and the dramatic reduction in interest rates and expansion of liquidity designed to promote recovery, we’ve seen some fairly radical changes in financial markets internationally – driven by a desperate search for yield. I confess I’ve found it hard to keep up with it all since I left my day job. My rule of thumb – and no more than that – used to be that “normal” interest rates – whatever that meant exactly – would be close to 5%, reflecting 2-2.5% real and 2-2.5% inflation. I’d add a bit – not much – for low grade sovereign debt, and rather more for commercial risk – somewhat less on property than on major equities. But I couldn’t get to a “normal” average return on mainstream equities above about 8%.
Since I retired we’ve seen a considerable increase in the sophistication of debt markets, with more different tiers of risk, and an expansion of derivatives trading, allowing risks to be hedged – or acquired – much more easily. And we’ve seen a continuing increase in the numbers and variety of hedge funds and a massive surge of money going into private equity investment, which is often very highly geared. Now, in principle I see these developments as positive – as you will have gathered from my earlier remarks – I’m basically in favour of free markets. They should – again in principle – improve the pricing of financial risk and the efficiency of financial resource allocation. But I suppose I have two main concerns in the present situation. The first is that given the pace of many of these developments and their technical complexity many end-investors have little experience of them and perhaps an imperfect understanding of the nature of the risks. I gather that it is also time that confirmation and settlement arrangements need to be improved. But I’m sure I don’t need to tell this audience that you have to know what you’re getting into.
My second concern is that the rush into “alternative investments” may result in too much money chasing too few opportunities so that they become over-priced. End-investors are putting a lot of trust in the ability of the alternative investment intermediaries to make the right choices – and there have been some notable calamities, as well no doubt as others that have attracted less public attention: performance data is not universally well-advertised, especially when the performance is not so good! But, of course, if investors are only cautious they may well miss out on substantial returns, which is no doubt why we are seeing the rush into alternative investment. Most end-investors I’m familiar with are in fact fairly cautious about the amount they include within their asset allocation – and of course they are typically paid to asses the risk.
Perhaps because I’m retired I am less concerned than perhaps I should be that the risk to individual investors is likely to translate itself into a risk to the stability of the financial system as a whole. Of course anything is possible! But my sense is that in a context of a reasonably stable real economy – particular private equity values may disappoint some investors and some providers of the leverage that accompanies private equity investment may even lose money, the spread of risk is sufficiently widely dispersed for there not to be a sudden loss of confidence in those investors and lenders that could be imperilled which would result in a rush for the exit by those who have reasonable claims upon them. So I don’t see a systematic crisis looming that would undermine the real economy either. But, of course, I may be completely wrong!”