Mervyn King said in a recent speech that inflation was well under control prior to the crunch. See paragraph beginning “Let me start…”. That is pretty much correct. It is true that in the early 2000s inflation was definitely below the 2% target, while just before the crunch it was a bit over the target (3% at most). But certainly, King is more or less right: inflation was under control.
But that raises a dilemma. Had the excessive borrowing taking place prior to the crunch been reined in with higher interest rates, that would arguably have brought an unnecessary dose of deflation.
At least for those not acquainted with the ideas put by the economics Nobel laureate, Jan Tinbergen, there seems to be a dilemma.
The Tinbergen principle comes to the rescue.
The Tinbergen principle states that for each policy objective, at least one policy instrument is needed. Personally I don’t like that formulation. I’d re-phrase the Tinbergen principle thus: for each policy objective, there is a policy instrument best suited to meeting each objective.
Anyway, the obvious way to deal with excessive borrowing is to raise the price of borrowing, i.e. raise interest rates. And assuming that is correct, it follows from the Tinbergen principle that the best way of adjusting demand must be SOMETHING ELSE.
And indeed, there is very simple and different way of adjusting demand: have government create new money and spend it (and/or cut taxes). Or conversely, given a need to rein in demand, government can do the opposite: raise taxes and “unprint” the money collected.
Had interest rates been raised prior to the crunch, at the same time as implementing the right amount of “print and spend”, borrowing would have been reduced, while overall demand would have remained constant. That is, demand would have shifted FROM attempts to purchase more and bigger houses TOWARDS other consumer items (and/or increased public spending).
Indeed, under a full reserve banking system where demand is adjusted JUST BY the above “print/unprint” policy, interest rates would rise AUTOMATICALLY given a surge in attempts by households (or anyone else) to borrow more.
The reaction of some of those who accept the conventional text book description as to how the banking system works will be to claim that the above “print and spend” policy would raise bank reserves, which in turn would reduce interest rates and ENCOURAGE lending.
The answer to that is that the above conventional text book description is wrong (as is now widely accepted). That is, banks and their lending activities are capital constrained, not reserved constrained.
For some literature on the latter point, Google something like “banks capital constrained reserve”.
I listed a good ten or so reasons here as to why using interest rates to control demand is not a brilliant idea here. The above “dilemma” is yet another reason to add to the list.
Another possible objection to the above “raise rates and print” policy is thus. Central banks cut interest rates by buying government debt. That puts cash or monetary base into the hands of the private sector, which in turn reduces rates. However, the above “raise rates and print” policy WOULD ALSO put cash into the hands of the private sector – which would on the face of it reduce rates.
The answer to that is that there is big difference between putting monetary base into the hands of would be lenders (former Gilt holders), and putting monetary base into the hands of the average household. In the latter instance, a smaller proportion of the new money will be lent.
P.S. (same day). Hat tip: I learned about Mervyn King’s speech from Frances Coppola’s blog. She also comments on his speech.