Ask, and ye shall receive

The Monetary Policy Committee of the Bank of England obviously subscribe to the dictum (often attributed to Keynes) “When the facts change, I change my mind – what do you do, sir?” They cut Bank Rate by 150 basis points to 3 per cent. In contrast, the ECB cut its official policy rate by a mere 50 basis points to 3.25 per cent. For the first time since the euro area was created on January 1, 1999, the official policy rate in the UK is below that in the euro area.

Despite being pleased with this bold move by the MPC, I feel a bit of an idiot. On October 26 I had called for a cut of between 100 and 150 basis points in my Financial Times blog Maverecon. Yesterday, after the horror show of the PMI services survey, I argued for a 150 basis points cut in an interview on the Daily Telegraph’s Telegraph TV. My prediction of what the MPC would do was not the same, however, as my recommendation of what it ought to do. I predicted a 100 basis points cut.

If what I would have voted for is different from what I believed the MPC would vote for, there can be five reasons. First, we have different facts at our disposal. Second, we have different views of the transmission mechanism. Third, the objectives of the MPC are different from mine. Fourth, there are multiple equilibria (different contingent official policy rate sequences achieve the objective equally well). Fifth, we use different kinds of logic.

As regards facts, the MPC probably has more facts at its disposal than do I . They have their agents, whose information becomes public knowledge only with a lag and The Bank often gets official data slightly earlier than the rest of us. In this case, however, I think it unlikely that the evidence available to the MPC pointed to a lower future trajectory for inflation than the evidence available to me.

The nine MPC members together have at least nine different views of the transmission mechanism of monetary policy. These nine views are no doubt different from all three views held by me. However, the view of the transmission mechanism held by the median MPC member is probably not very different from my median view (I have to use the median rather than the mean MPC member’s view, because of the possibility of outliers that would skew the distribution – you know who I mean).

As regards objectives, despite no longer being an MPC member, I still make my own policy recommentations based on the MPC’s mandate.

The Bank of England Act 1998 states: “In relation to monetary policy, the objectives of the Bank of England shall be –
(a) to maintain price stability, and
(b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.”

I have to believe that the current members of the MPC pursue the same fundamental objectives. If they did not, they oughtn’t to be on the Committee. Ignoring multiple equilibria (see below) and faulty logic, I should be able to predict MPC actions different from my preferred ones, only if extraneous subordinate objectives or constraints influence the decisions of the MPC. Candidates for such factors include: a preference for gradualism for its own sake; timidity; innate caution and conservatism with a very small c; fear of reversals and general wimpishness.

Multiple equilibria are cool, but in this particular case they leave me cold. That leaves the fifth explanation: the MPC and I use different kinds of logic to reason from the same premises yet to arrive at different conclusions. I suppose that this is really a polite way of saying that the MPC aren’t as smart as I am (the opposite is logically possible, but, looking deep inside myself, I must admit that I am unlikely to have entertained that possibility).

So the reason(s) why I recommended a course of action different from the one I predicted must have been that I viewed the MPC as wimpish or not too smart, or both.

Obviously I was wrong in my prediction. I still believe I was correct in my recommendation, so I am very pleased to have been wrong in my prediction of what the MPC would do. But I should have given the MPC more credit – should have been less arrogant in assuming that the combinations of intellectual virtue and relentless logic that are optimal for monetary policy design can be found only among those born below sea level.

Lesson learnt. From here on it will be a new, humble me authoring this blog. Modesty and humility will flow like a mighty stream. I will be aggressively modest – display an in-your-face-humility that will dovetail beautifully with the resounding meekness of the explosive understatements that will grace this blog from now on.

It was the right decision – and a brave one. It remains to be seen how the spreads between current and anticipated future policy rates and market rates such as Libor respond to this cut in the days and weeks to come. We may well need Treasury guarantees for unsecured interbank lending (including cross-border lending), or have the Bank of England and other central banks act as universal counterparty of last resort in the interbank markets at all maturities. Such unsecured central bank lending to commercial banks could indeed have been tried already, given a solid indemnification guarantee from the Treasury covering any central bank losses due to counterparty default.

We are also likely to need much more capital injected into the banks. The case for mandating a large tier one capital ratio increase (to 11 or 12 percent, say) for all banks by a certain date (soon!) is becoming stronger every day. The evidence is mounting that banks now may have enough capital to survive but not enough to be willing to lend to households and non-financial businesses. Fear, conservatism, excessive caution and timidity have taken over from reckless lending and the dominant driver of bank behaviour. The bean counters are in charge.

Mandating the capital increase is essential, as most banks will not be able to attract the required additional capital from the markets (or might not be willing to do so, even if they could). The government will have to make up the difference in exchange for ordinary shares or convertible preference shares. Without the government mandating these further capital increases, banks may choose to remain undercapitalised rather than risk losing their independence.

A coordinated fiscal stimulus, led by the nations with the strongest public finances and external accounts (Germany and China, for instance, but definitely not the UK or the USA) may also be necessary to drag the world of economy out of a deepening recession. There is much that remains uncertain and much that is not in the hands of the monetary authorities. But as regards the Bank of England today, definitely: so far so good.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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