Inflation targeting, or what Arsene Wenger and Mark Carney have in common


Matthew Robertson 1.36pm

  • May 2004: Arsène Wenger hailed as Arsenal go entire season undefeated to win the Premier League
  • December 2012: Arsène Wenger under increasing pressure as Arsenal lose to League Two side Bradford City in the Capital One Cup
  • October 1992: for the first time monetary policy in Britain would be based on an explicit target for inflation
  • December 2012: Mark Carney, the incoming Governor of the Bank of England, has suggested abandoning inflation targeting

"When the facts change, I change my mind". A quote that has long been attributed to the father of modern economics, John Maynard Keynes. It is a belief that policy should be implemented to tackle the world as it is today, not as it was yesterday.  

The position of an English football team and the comments of the Governor of the Bank of Canada may not seem interlinked but they do shed light on whether it is beneficial to adapt to changing circumstances or to maintain the current strategy in total belief that it is the correct way.

One of the great success stories of modern economics is the taming of inflation. As Mervyn King, the departing Governor of the Bank of England, stated in a speech in October:

"Over the previous twenty years (1972-1992) inflation had been the single biggest problem facing the UK economy, peaking at 27 per cent a year in 1975. Over the subsequent twenty years (1992-2012), inflation, as I mentioned earlier, would average only 2.1 per cent."

The key to this success was controlling inflationary expectations and the key to that was inflation targeting underpinned by an independent central bank. Exiting the European Exchange Rate Mechanism freed Britain to set their own monetary policy, which culminated in Bank of England independence in 1997.

A target would be set and it would be free of political interference. As long as the target over the long term was met, the expectation was anchored as any deviation would be expected to return to the anchor. This was the case for most of the past twenty years.

This policy was a reaction to the economic difficulties of the time and has been reproduced in many countries over the world. Inflation is well above expectation at the moment but inflation between 2.5 per cent and 5 per cent is low by historical standards and the reason is that the inflationary expectation is still around the 2 per cent mark.

The footballing philosophy of Arsène Wenger when he first arrived in England was equally as successful. His devotion to ‘pass and move’ football led to five trophies in six seasons as well as the first team in 116 years to go a league season unbeaten.

However, times have changed both for the economy and for English professional football. The financial crisis of 2007-2008 precipitated a new thinking in central banking theory. The Bank of England ignored concerns about inflation and reduced interest rates to almost zero per cent in an effort to enhance liquidity and reduce borrowing costs. The greater concern for the Bank at the time was economic output and preventing the economy stagnating into a long term liquidity trap. There were numerous inflationary concerns regarding world food prices at the time but the Bank, quite rightly, decided that the crisis needed urgent, unorthodox central banking. This was further reinforced by a period of quantitative easing where the Bank of England purchased financial assets from commercial banks to inject money into the economy.

In a speech on 23rd January, Mervyn King argued that pursuing a two per cent inflation rate target throughout the financial crisis, would have worsened the recession:

"To bring inflation down ‘would have meant driving down wages by creating a deeper recession, even higher unemployment and lasting damage to the job prospects of many young people."

The question now is whether inflation targeting should be abandoned for nominal GDP targets, something the new incoming Governor, Mark Carney, has suggested. A deeper question is whether the economic circumstances of the economy have altered significantly to warrant a change in approach.  Are the economic conditions so benign that there will be insufficient demand to produce growth without active interference from a central bank?

Central bankers will need to factor in these conditions along with inflationary expectations to assess which approach to take. The history of the 1970s suggests that active GDP targets don’t work but that might have been for a different time with contrasting conditions.

Whatever route is taken it raises the question of whether to change one’s mid when the facts change. The arrival of Roman Abramovich and latterly Sheikh Mansour altered the nature of English football completely. Chelsea and Manchester City have the ability to outbid and outspend any club to attract the best talent from around the globe. There is growing doubt as to whether Mr Wenger’s prudent approach of developing youngsters and buying affordable players can be successful in today’s Premier League. Despite constant criticism, Arsenal’s manager has remained dogmatic about what he considers the correct method.

Is this appropriate when the facts change? We shall see when Mark Carney takes over the helm in the summer.

By that time there may even be a trophy in that Arsenal cabinet.

Follow Matthew on Twitter @FlatFootTory

The financial and Eurozone crises have changed the face of politics forever

Sara Benwell 6.45am

Economic policy has always been important in politics, and people have always cared about fiscal policies that affect them directly, but not such a long time ago broader economic strategy only made up a small percentage of the issues that mattered when people decided who to vote for.

Essentially, voters cared if their taxes were going up, but when it came to broader economic strategy the issues were sidelined compared to other policies that had more obvious effects on people’s lives. Moreover, much of the banking world and financial terminology remained a complete mystery to the majority of the electorate, so as long as things were going well, economic policy was seen to be less important. Everyone presumed that the government and the bankers knew what they were doing.

Then came recession and the onset of the Eurozone crisis - and everything changed.

Now more people have a better working understanding of finance. Almost everybody I meet has an opinion about Greece, about Spain, about whether the Eurozone will break up and most importantly about whether or not the Government is doing the right thing to deal with the financial crisis or whether now is the right time for a credible plan B, or even C.

People don’t merely care about the areas of policy that effect them; they now care about the broader economic strategy. The space allocated to business and financial news - not just in the broadsheets but also in the tabloids - is increasing and is reflective of a growing public interest. These days it’s rare you’ll see any business stories in the national press that don’t have a direct link to finance and the economic situation; more often the stories will reflect job creation or losses, financial results, or economic indicators.

While the economic crisis is clearly not a good thing, it’s arguable that the increase in public knowledge and awareness has to be the silver lining to the debt crisis cloud. How many people fifteen years ago knew about monetary policy decisions, about inflation and about quantitative easing, let alone had a good working understanding of these terms as well as an opinion on them? Wider comprehension has to be a good thing.

There has also been a shift towards people wanting their financial institutions and their government to be held accountable. Now that everybody has seen the impact of the poor financial policies of the last labour governments and the problems that can arise when the bankers are given a free rein with little or no fear of retribution, there is an increasing focus on making sure that somewhere somebody is held responsible.

This has been reflected by the recent ‘shareholder spring’. While I think this is an exaggeration, and the term is used too widely and too often, there is no denying that the recent spate of chief executives like Sir Martin Sorrell being denied their bonuses would have been unthinkable a few years ago and reflects growing popular demand for more accountability in the business world.

Furthermore, policies like the ring-fencing of the banks, which I have written about here before, illustrate a move by the Government to introduce financial legislation designed to protect the electorate. This policy has recently been watered down, but that doesn’t change the fact that political parties have recognised the importance of bringing in policies to ensure that an increasingly aware voting public are sheltered from having to bail out the banks once more.

One can quite easily argue that the Coalition will stand or fall on the success of its economic policies. And it is increasingly clear that you cannot spend your way out of a recession, despite what the Labour party might claim.

So the question confronting us now is whether the Coalition Government has enough time left for its economic policy to come good, or whether ministers need to be considering a new plan.

Rest assured that whatever the answers to those questions, the British public is no longer ignorant about economics. And if the Coalition partners, particularly the Conservative party, wants to win the next election, they shall need to prove the credibility of their economic strategy.

Follow Sara on Twitter @sarabenwell

While the Euro remains on life support, it’s business as usual for the City

Daniel Cowdrill 10.04am

Listening to David Cameron’s opponents during the weekend, you would think his veto signals the end of civilisation - or at least the UK’s participation in it.

One of their scare stories is that the City of London is worse-off than before the EU summit. In reality, however, it is in much the same position.

The sticking point was the financial transaction tax (FTT). This is a tax on every sale or purchase of stocks and bonds or other financial products by banks. On these pages, Craig has dismissed a FTT as an unhelpful ‘soundbite tax’, while Alex described it as ‘misguided’. Elsewhere, Sir John Major has labelled it a ‘heat-seeking missile aimed at the City of London’.

As 75 per cent of the EU’s financial services industry is located within the City of London the burden of this tax would fall disproportionately on the UK economy and the two million people who are employed in financial services in this country.

Unfortunately, France was not willing to listen to British demands. President Sarkozy’s refusal to concede led to a fiscal ‘pact’ rather than the fiscal union the markets had desired. What is set to be agreed over the coming months without the UK is unlikely to be enough to stop the deterioration of the European debt crisis, and President Sarkozy won’t be so ‘heartened’ if (or when?) France’s credit rating is downgraded.

However, beyond all this the fundamentals remain the same for the City. The UK remains part of a single market that allows the (reasonably) free movement of people, capital and services across a trading block of 500 million people. The City will continue to benefit from the single market - Mr Cameron’s veto does nothing to alter this.

To be sure, it could be argued that the new 17+ euro block will foist regulations on the City when Qualified Majority Voting (QMV) is introduced in 2014. But these are future deals that are yet to be negotiated and agreed. When the time comes there is no reason why Britain can’t win support and obstruct the worst that might come our way.

In any case, there are some people who believe that had the UK not vetoed the new treaty the French would be less determined to impose other regulations on the City. This thinking is deluded. French dirigiste tendencies have been strengthened by a financial crisis that many in France perceive as the fault of speculators in the City of London. This isn’t going to change no matter how much sovereignty we sign away.

Furthermore, access to the single market is not the only thing that attracts business to the City. In the 1980s the ‘Big Bang’ attracted financial services to London from all over the globe, not just Europe.

The UK’s competitive regulatory and tax framework continues to attract financial services to these shores. We are also near the main European continent and, of course, we speak English. Even the EU tends to deliberate great matters in English - now the global lingua franca (such irony might be lost on the French).

The City will live to fight another day. The euro, on the other hand, may not.

Don’t forget Gordon Brown’s hand in Britain’s great big pensions mess

Sara Benwell 10.03am

Nobody can reasonably deny that public sector pensions need reform. They are unsustainable. We simply can’t afford them in their current format and schemes which require constant taxpayer subsidy, paid by those in the private sector who won’t be offered anything like the same schemes, just aren’t fair.

The other side of the debate, however, points out that private sector pensions aren’t all that great, and argues that yes, the disparity between public and private sector pensions is unfair, but why should that lead to a race to the bottom, where public sector pensions are forced to emulate the private sector, rather than lead to reform giving those in the private sector access to better pensions?

When put like this it almost seems intuitive: shouldn’t we be giving everyone access to a decent pension scheme rather than taking the private sector pensions model and using it as a benchmark for the public sector, meaning that they too will be faced with little or no access to proper pensions schemes?

This is the argument that the TUC general secretary Brendan Barber recently put forward, saying:

“Pensions in the private sector are deeply unfair, and making public sector pensions more like private sector provision has nothing to do with fairness. It is just part of a long campaign by those on the small-state right to cut public services.”

But the two arguments are being confused. While it is possible to argue that the private sector pensions model isn’t one to emulate, it doesn’t therefore follow that public sector pensions don’t need reforming at all.

The arguments for reforming public sector pensions still stand strong: they’re still far too expensive, they’re still unsustainable due to increasing taxpayer subsidy and for that reason too they’re still vastly unfair.

Furthermore, it’s clear that the gold-plated deal being offered to public sector workers at the moment, is a far cry from the private sector industry, so the argument that they’re just involved in a race to the bottom would seem to be overshooting the mark.

While this argument clearly doesn’t illustrate that public sector pensions don’t need reforming, or that the deal they’re currently being offered isn’t good enough, as some of those using it had clearly hoped, what it does highlight is that private sector pensions are widely considered to be not only a bit of a mess but also inadequate. This concept is worth exploring.

The UK’s private sector pension system used to be pretty decent. In fact, I even once heard UK private sector pensions described as the best in the world.

That was before Gordon Brown decided to cash in on the system and tax our pensions system into the ground. Crucially not only taking the decision to axe tax relief on dividends paid into pensions funds, but also doing so at a time when the stock market was at a low, causing a double hit on the funds needing to make up the income in other ways, causing a further downward spiral in the stock market.

The UK Pensions Crisis, a report from the TaxPayers’ Alliance and Terry Arthur in 2008, says that occupational pension schemes lost between £150bn and £225bn in growth as a result of the tax grab in the 1990s and that consequently, the Basic State Pension was down 20 per cent or more from its 1950 level, relative to earnings.

Furthermore, the report stated that in 2008 there were more than 17,000 retired public sector employees with retirement benefits worth £1 million each, while unfunded public sector pension liabilities were estimated to exceed £1 trillion, or more than 70 per cent of GDP.

Private sector pensions were treated as a cash cow, with Gordon Brown’s decision forcing companies to make up for massive shortfalls. It was this that led to the beginning of the widespread decline in final-salary private pensions schemes. Gordon Brown’s poor timing - a mark of astonishing economic and financial ignorance - only served to deepen the negative impacts on private sector pensions.

The 1990s tax hike led to a greater widening of the gap between private and public sector pensions. Amidst all the outcry about public sector pension reforms, what we need to remember is that private sector workers are subsidising public sector pensions. This is the inequality and unfairness that really counts, that public sector pension schemes are being bailed out by taxpayers, many of whom come from the private sector where they don’t have access to anything like the same level of scheme.

Follow Sara on Twitter @sarabenwell

The Eagle and the Dragon

Alexander Pannett 7.07am

The recent prediction by the IMF that, using purchasing power parity, China will overtake the USA as the world’s largest economy by 2016 has left many fearful of the coming century.  In Hay-on-Wye, where I spent last weekend hiding from rain clouds, there was much talk of the impact China will have on the world as it exerts its new economic strength.  China will certainly change the dynamics of world power but behind its fearsome economic achievements lie some dangerous weaknesses that may prevent the Middle Kingdom from ever truly usurping America as the world’s foremost power.

China’s economic growth in recent years has been staggering.  By some measures, China is already the world’s largest consumer of energy and accounts for half of the world’s growth in oil demand.  The World Energy Outlook report has predicted that China’s energy demand would jump 75% between 2008 and 2035, contributing 36% to the projected growth in global energy use.

China’s neighbours have had much to worry about recently from the rising dragon.  China has built its first aircraft carrier and has already modernised its blue water navy with submarines and destroyers.  It is becoming much more assertive and has made bold territorial claims over the South China Sea, stretching as far south as the Spratly Islands near Brunei.  Chinese coastguard vessels routinely detain Vietnamese fishing boats in the disputed waters.  In 2010, a Chinese fishing vessel rammed a Japanese patrol boat off the disputed Senkaku Islands.  Japan’s refusal to release the Chinese captain led to China imposing a de facto ban on rare earth materials to Japan.

However, China’s impressive annual growth rates of 8% to 10% hide some very high environmental costs that are already starting to have a huge impact.  Years of unrestrained industrial polluting has wrecked the water supply, with rivers full of toxic metals and chemicals.  Agricultural land is suffering without access to safe water.  Increased water use has led to shortages and and desertification in north China.  This is particularly serious in a country that is already 30% desert.  More than half of China’s 660 cities suffer from water shortages, affecting 160 million people.  The tremendous cost of this worsening environmental damage has likely been unaccounted for in China’s headlong growth rate raising speculation that it is much smaller than currently forecasted.

Chinese economic growth is coming to the end of a cycle.  Global demand of cheap products cannot keep pace with the growth of China’s industrial output.  Whilst China’s middle class has exploded in size, domestic demand will not be enough on its own to maintain China’s current growth rates.  An even bigger problem is that there are simply not enough resources in the world to support a Chinese population that would have the same consumption levels of the American population.  The Chinese economy will need massive restructuring away from low end manufacturing if it is to deliver the wealth that will rival the United States.

China also has a huge, looming demographic crisis.  The one-child policy may have been successful in slowing Chinese population growth but it has meant that China will soon have a very large elderly population.  People above the age of 60 now represent 13.3% of the total population, up from 10.3% in 2000. In the same period, those under the age of 14 declined from 23% to 17%. This will create significant welfare costs for the government and will require younger workers to pay disproportionately for the costs.  This will further dampen economic growth.

The political structure of China is much weaker than the one party imagery would let outsiders believe.  Transfer of power between generations is conducted via a lengthy, Byzantine process of committees and personal loyalties.  It can often take five years for a new president to finally weed out their predecessor’s supporters from positions of power.  This does not leave much influence or time for a president to control the teeming multitude of 1.3 billion Chinese, let alone consider an effective and consistent foreign policy.  With growing calls for political reform, independence movements in Tibet and Xinjiang and anger over environmental and economic issues, there is much internal instability that hampers China’s ability to exert itself on the world stage.  It says much about the true fears of the Chinese leadership that for the first time in March 2011, China’s internal security spending trumped that of its defence spending.

Whilst China has certainly become an economic power and will be a future superpower, there are many structural flaws to overcome before it can be secure enough to exert its weight in global politics.  Considering its weaknesses, it will be hard pressed to usurp the USA as the foremost world power, even if its GDP becomes the largest on paper.  Besides, this is assuming that America will continue to grow at its recent negligible economic rates.  As the most innovative, capitalist nation on earth, with still unparalleled intellectual and economic resources, it cannot be long before the eagle answers the dragon’s challenge.

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Putting a price on nature

Nik Darlington 9.43am

It is not often that I get hugely excited about a 2,000-page economic impact assessment but this morning I am flicking through the freshly published UK National Ecosystem Assessment (NEA), which is possibly the most important document of its kind in this country since the Stern Review in 2006. And if you don’t believe me, its website was running more sluggishly than a First Great Western this morning, so someone’s reading it.

The NEA is the first comprehensive overview of the UK’s natural wealth. Forget for a moment GDP, GNI, PPP, hydrocarbon reserves, you name it. This looks at the nuts and bolts of UK ‘ecosystem services’ - such as timber, farming, carbon storage, tourism, soil maintenance - and slaps a robust price tag on them. And the results are impressive.

There have been studies in the past that indicate the health and social benefits of living and working near green spaces. The NEA now puts the value of those spaces at £300 per person - that is three times as valuable as a resident’s parking permit in Richmond. The water quality improvements from inland wetlands are worth £1.5 billion annually (or 30,000 times Thames Water’s fine in January 2010 for polluting the River Wandle). British woodland’s carbon storage capacity is worth £680 million each year - significantly more than the couple of hundred million pounds the Government thought it could raise from selling them. Overall, the health and welfare benefits of the UK’s green spaces amount to £30 billion every year, which is thee-quarters of the UK defence budget, or five times the combined budgets of Defra and DECC.

Why is all this so important? Lord Selborne writes in his foreword to the report:

While we pay for some ecosystem services like food and fibre, we are often unaware of the importance of others such as natural water or air purification, and would be alarmed at the cost of providing these artificially. This under-estimation of the value of natural processes in economic terms means that we take inadequately informed decisions on how to use these resources. The result is pollution, loss of species and ecosystems and damage to the processes we need, with real economic costs to either recover them or provide artificial alternatives.

It has always been difficult convincing people about the need for investment of time, effort and resources in maintaining our natural environment. Of course, when confronted, the British public turn out to be vociferously environmental, such as during this year’s forestry fiasco. Yet when faced with the choices of building, buying and making stuff, economics tend to trump the environment.

For instance, the Business Secretary Vince Cable kicked up a fuss about the new UK carbon reduction targets and blamed Tata’s closure of a steel plant in Sunderland on burdensome British green regulations. Yes, there is certainly a case to make that decarbonising our economy, whilst providing new employment in green sectors, could result in job losses in other industries. But with the information contained in the NEA, there is now a countervailing case to make of the economic value to the country for protecting our natural environment.

Caroline Spelman, Environment Secretary, says the NEA, which has taken two years to compile, has “played a big part” in putting together the forthcoming Environment White Paper. One of the most important functions for the NEA is in re-shaping UK planning policy. Professor Bob Watson, who led the study, said:

Urban green space is unbelievably important - it affects the value of houses, it affects our mental wellbeing. This report is saying ‘this has got incredible value, so before you start converting green space into building, think through what the economic value is of maintaining that green space’ - or the blue space, the ponds and rivers.

London, for instance, is one of the greenest cities in the world, with parks (and in my south-western neck of the woods, golf courses) dotted all over the place - just flick on Google Earth to see the mossy patchwork. But in the most deprived, under-achieving and crime ridden areas, green spaces are neglected or lacking. Even Boris Johnson’s proposal to revive London’s lost rivers doesn’t seem so daft anymore.

The National Ecosystem Assessment ought not just be a useful plaything for journalists to tell us how much money our bumble bees are worth, and forgotten the next day amidst some employment figures or footballer’s missives.

Nor should it only feed into Defra’s upcoming White Paper. The lessons it teaches and the information it gives must prefigure just about everything we do. Nature is so much more than pounds and pence but in policy terms the NEA is invaluable.

Britain has always been an ingenious nation at buying, making and selling objects, knowledge and services. Napoleon’s little nation of shop-keepers has proven that it can slice, dice and flog just about anything of economic value (and even things of no value at all, like a certain few financial derivatives). It’s time we genuinely acknowledged the value of the the natural wealth beneath our feet and all around us: the fields and forests, the flora and fauna, the rivers and even, in this bucolic corner of Surrey, the greens and the fairways.

Twitter: @NikDarlington

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