Bank of England (Economic Affairs Committee Report)

Lord Frost Excerpts

Thursday 2nd May 2024 Lords Chamber

[Lord Frost (Con)]

My Lords, it is a pleasure to follow the noble Lord, Lord Burns, in this extremely interesting debate. I too thank my noble friend Lord Bridges for securing it, and all the committee members for their work on this thorough and interesting report. I congratulate my noble friend Lord Moynihan on his excellent maiden speech, with which, as noble Lords will hear, I have a good deal of sympathy in many areas.

I will make two points, one minor and one major. The minor point is one that other noble Lords have mentioned: the committee’s recommendations on the need for intellectual diversity in the Bank. It is still surprising that Bank officials and the MPC missed the significance of monetary policy in 2020 and 2021, and more intellectual diversity would surely have made this less likely. I would use the word “dismissive” rather than “defensive”, which my friend Lord Bridges used. The rather dismissive responses from the Chancellor and the governor suggest that they have not really taken this point on board. Indeed, perhaps they rather missed it by simply reiterating the existing processes and justifying them on the grounds of other kinds of diversity. As other noble Lords have said, since the report we have had the Bernanke review, with its heavy criticism of the modelling and forecasting, which perhaps reinforces the committee’s concerns. Perhaps the Minister, in responding, could indicate whether there is any chance of a rethink in this area.

I move to my major point. Although, like the committee and, I think, most noble Lords, I support Bank independence, one must acknowledge that, over the last couple of decades, central banks have, in practice, come to enjoy great economic powers with rather little accountability, scrutiny or democratic legitimacy. That is not generally because the Government have chosen to give them these powers—in this country at least. The gradual widening of the Bank’s mandate, set out so clearly by the committee, is a consequence rather than the cause of this development. The real underlying cause is the mistakes in global economic policy-making over this period. I will take a moment to spell this out a little more deeply. In doing so, I am in part indebted to the analysis of my friend, the brilliant economist Bernard Connolly, in his latest book.

Central banks and Governments the world over are now in a very difficult position because of policy mistakes over the last couple of decades. In brief, in the late 1990s and early 2000s, the Fed, and other central banks following it, held rates too low for too long and generated an unsustainable boom. When this became obvious, central banks had a choice between creating a recession by raising rates to choke it out or avoiding this by pushing rates down. That was an extremely political choice for a central bank to have to make. There was only one possible answer it could give in a democracy: to push rates down. This in turn generated another bubble, the credit bubble, which fed through to asset prices, which in turn collapsed in 2008. Central banks faced the same political choice, and again pushed rates down, this time to zero or sub-zero.

In 2020, we had the third crisis. The same choice was faced and the same solution was taken. Although there has been much criticism of the Bank for its massive boost to QE in 2020, I do not entirely blame the Bank authorities. I have vivid recollections of the atmosphere of panic and crisis in No. 10 at that time, as the economy came close to having a heart attack. Hindsight is a wonderful thing, and I am not sure the central banks could have taken any other decision at that point. The question is more: how did they handle the consequences and how quickly did they realise that some unwinding was necessary?

The negative supply shocks plus the huge US fiscal stimulus—let us not forget that—meant that there was finally a feeding through to inflation, which has had to be choked off by an effort at normalisation. Of course, we now have a financial structure, as we discovered in 2022, that has become used to very low long rates and is vulnerable if there is a sudden adjustment towards equilibrium. Hence the current situation. What can we do about it?

We can look at our economic performance, and one conclusion that I, and I think others, draw is that western economies generally cannot live with interest rates that would have been considered normal a generation ago, unless there is huge fiscal stimulus. That is a very serious problem, which opens the question of how long central banks generally, and the Bank of England specifically, can sustain the current near-normalisation. The impact of the US stimulus is now weakening and, very soon, central banks will face the same choice once again: will they hold rates relatively high, at the cost of a recession, or bring them back down, as so many are now urging, at the price of sustaining the imbalances and building them up further?

I have set this out at some length to underline just how political the decisions are that the Bank, and central banks generally, have had to take in recent years. Independent central banks may have started off as providers of inflation control services for Governments, but they now do much more than that. The political decisions that they have taken, in each case to defer difficult economic problems, have generated an environment in which we can only avoid liquidation and recession with super-low interest rates. Yet capitalism, as we have come to understand it, cannot function with super-low interest rates. The normal incentives do not work; there is malinvestment; asset holders are enriched and risk takers lose out; and—we are seeing this very much now—support for the system continually erodes, such that we have a whole generation now ready to take a punt on socialism.

Where do we go from here? I think that there are two routes. The first, which I think it is the route cautiously, or implicitly, suggested in the committee report, is to accept this status quo, recognise the broader political power exercised by the Bank and try to give it some enhanced democratic scrutiny from this Parliament. I understand the logic, but I am slightly unconvinced about the constitutionality of such arrangements. It seems to me that it is for the Government to get the relationship right with the Bank. That perhaps will, and ought to, involve more vigorous debate in public, within the framework of bank independence, than we have got used to. Then Parliament should scrutinise the Government on how well they are managing that relationship and its results, in terms of both fiscal and monetary policy.

I also fear the consequences of simply accepting the status quo. It is a palliative, and a fig leaf for a situation that is, as I have said, really very unsatisfactory. If we continue to repeat the cycle of the past couple of decades, we will end up with continued fiscal stimulus, ballooning debt, accelerating inflation once again, greater government control of the economy, greater direction of investment and business efforts and, in the end, very likely a quasi-socialist economic system.

The alternative is to try to roll things back, to limit the Bank to focusing much more narrowly and specifically on inflation control again, and to find a way of dealing with the economic consequences of the normalisation that would follow. This would at least be to deal with causes not symptoms, but to make it work would mean a major effort to raise the productive capacity and potential growth of this economy through a radical programme of, if you like, “recapitalismisation”—an ugly word, but an important reality. That would mean huge deregulation; a determined and sustained effort to get tax and spending down; and an end to the crushing burden of net zero, planning reform, labour market liberalisation and much more. Perhaps we will also get lucky with AI and it will, as so many hope, give us a magic free gift in productivity increase. I suspect, however, at least over our time horizon, that it is unlikely to do more than smooth off the edges of the turbulence of reform. Embarking on such a reform programme would, in my view, be the right thing to do, but it would require careful planning and a Government who were ready to explain it, win a mandate for it and push it through. Noble Lords will have their own views on how likely such an outcome is.

To conclude, formal bank independence is one thing, and it is important, but the most important thing is to discuss, debate and engage with the underlying political and economic reality. No Government, of any political colour, can avoid that, or abdicate their responsibility for managing the economy with the central bank and ensuring proper democratic engagement in the consequences. We have not had that properly for some time, but we have some extremely difficult choices coming, so we will need it in future.