Transcript: Mervyn King Says the Bank of England Is Making a ‘Big Mistake’

Read the conversation between former BOE governor Mervyn King and Merryn Talks Money host Merryn Somerset Webb.

(Bloomberg) — In this week’s episode of Merryn Talks Money, Bloomberg Opinion writer Merryn Somerset Webb interviews former Governor of the Bank of England Mervyn King.

Here is a lightly edited transcript of the conversation. Listen in full below, learn more about the podcast here, and subscribe on Apple and  Spotify to stay on top of new episodes.


Webb:  Mervyn, hello. Thank you so much for being with us today.

King: It’s a pleasure to join you.

Webb: Well, I’m not sure there’s going to be too many pleasurable things to talk about today, but let’s give it a go. I think that the big question here, the big topic is obviously inflation. So let’s start by talking a little bit about how we got here with inflation at such high levels in the UK. It seems to us as though the Bank of England has along the way made a couple of pretty extreme mistakes and I wonder if we could just have your take on how we got here, 2% the target, we’re nowhere near.

King: The Bank of England’s in good company because all the major central banks have made the same mistake.

They did have some bad luck. You can’t blame them for the rise in energy and food prices resulting from the Russian invasion of Ukraine. But I think you can blame central banks for printing a large amount of money during the pandemic when there was no real need to do it. Now, I think the problem does not stem from central banks.

It stems from the economic profession, the academic profession, which has generated a large number of very brilliant young economists, but they’ve all been trained to believe the same thing and they’ve all gone to work in central banks. So what is, what is it that they believe that’s a mistake? The big mistake is to think that money has absolutely nothing to do with inflation.

This is a very odd viewpoint because inflation is a fall in the value of money. So you would think that the amount of money that central banks print would have something to do with inflation. And indeed, history tells us that if you print enough money, you will get inflation. So why did, why does the academic profession go down this road?

I think it’s because they wanted to be a very scientific discipline. And in the 1980s, the relationship between the amount of money in the economy and inflation didn’t seem very stable. It moved around. Now, in large part, that was because there was a good deal of financial deregulation. But it was also political that people like Milton Friedman in the United States were seen as very right wing and they wanted a more left wing view of inflation.

Now this itself is odd because if economics is a science, then it shouldn’t really be affect, what you believe scientifically, should not be affected by your political viewpoint. But people honed in on the idea that inflation was really entirely driven by what people expect to happen. There’s some truth in that, but of course, the real question then is what makes them expect inflation to be close to the target.

And you would think that what they would leave would depend on what they see in the economy and what central banks are actually doing. But in fact, this new theory said, no, inflation expectations and so inflation itself will always be driven by the target. Well, this is a very odd theory. It’s completely circular.

Um, and indeed, if you look at the computer models, which not just the bank of England, but other central banks use, whatever you do to monetary policy, inflation always comes back to 2%. Why does it do that? Because the model says it has to, it’s built in, it’s an assumption. Well, if you have a central bank saying we assume that inflation will always come back to 2%, what you’ve done is to replace Milton Friedman’s maxim that inflation is always and everywhere a monetary phenomenon by a new maxim that says inflation is always and everywhere a transitory phenomenon.

And this is simply demonstrably false. And it has been demonstrated as false by what central banks did in 2020 and 21, when they printed a very large amount of money, despite the productive potential of the economy falling quite sharply because of lockdown, the economy could not produce as much as when we didn’t have a lockdown.

Well, the worst thing you can do in that situation is to try to boost demand, because what you end up seeing is too much money created by central banks chasing too few goods created by the lockdowns. And if you’ve got too much money chasing too few goods, that is the absolute classic recipe for inflation.

So this was predictable. It was indeed predicted. And I don’t want to blame individuals in central banks or even actually a particular central bank, such as the Bank of England. They were all following. the same conventional wisdom which had arisen over the last 10 to 15 years in the academic economics profession, completely contrary to the lessons of history and the sort of textbooks that people were reading in the 1950s and 1960s.

And indeed, there’s hardly anyone left in a central bank now who remembers not only those textbooks, but also the inflationary experience of the 1970s. So people got lulled into thinking that just because they had a target of 2%, that they could assume that inflation would always come back to that, whatever they did.

And that clearly was very foolish, and it led to the inflation that we’ve seen.

Webb: Extraordinary situation, isn’t it? I mean, if you look back to those beginning days of the pandemic, when we were destroying supply chains across the world, destroying productive capacity, the correct thing at that point to do would have been to dampen down demand at the same time, rather than to try and shovel demand up to save the situation.

It was completely the wrong way around, but there were voices then, and you were one of them, and you and I both know several other economists who spoke about this kind of thing from the very beginning, who insisted that money would make a difference. Their voices weren’t heard, so it’s interesting that in any science, if we consider economics as science, you can get to the point where there is full groupthink.

King: This was genuine academic group think right across the industrialized world and in part it’s because although there are central bankers from many different countries involved in this, they all went to graduate schools with exactly the same assumptions built into their courses, namely that inflation really has nothing to do with money and we can forget about money altogether.

Webb: Well, it’s the, it’s the same, isn’t it? The idea that you can, you can always create inflation if you print enough money and you can always get rid of inflation if you come down on it hard enough, which brings us to the next bit, which was because of that original mistake, the Bank of England, like other central banks, failed to take action soon enough.

And possibly if they’d started coming down very hard last year and putting interest rates up to anywhere where any, anyone with an eye to history might’ve thought they should have been, we might not be quite where we are now, but they didn’t. And here we are. Is it too late?

King: Interestingly, the risk could be the other way around now, that, um, having printed far too much money through quantitative easing, as it’s called, literally electronically printing money in both 2020 and 2021.

Then they did try to correct policy in 2022. I think having made a big mistake, it would have been better to have tightened much faster in 2022, even better not to have printed the money in 2020 and 21. Now we’re in 2023, and the impact of the interest rate increases and the end of quantitative easing is beginning slowly to feed through, and what you’re seeing, especially in the United States, which I suspect made the biggest policy mistake, is that the amount of money in the economy in the hands of whether it’s households or businesses is actually falling.

You don’t want it to fall in normal times. You want it just to grow in a low positive rates that will support growth, but not lead to either inflation on the upside or to a recession on the downside. And I think it’s quite possible that having lost control of inflation and therefore having lost a good deal of credibility that central banks will see, you know, that the safest course for them is one of overkill now so that they do bring inflation back to 2%.

And if they carry on for the next six months or so. Tightening monetary policy, it could well be that they generate both a recession as well as a sharp fall in inflation. After all, we know it takes a long time between when you change monetary policy and its effect on inflation. You know, these are the so called famous long and variable lags. 18 months to two years, maybe a bit less in some cases, longer in others. You know, 18 months ago interest rates were still very close to zero. So if what we’re seeing is the consequence of that, it’s not surprising that inflation has not yet started to fall sharply, at least in its underlying sense.

And I think, therefore, the risk is that having. ignored money when inflation was rising. They’re now ignoring money when money is, uh, ignoring money when inflation is actually about to fall. And what we could see, therefore, is a mistake in both directions over a period of three or four years.

Webb: Yes, I did say at the beginning that this wasn’t going to be a particularly cheerful conversation, but it is the case that broad money is, uh, broad money supply in the UK is falling, isn’t it? On a month on month basis?

King: It’s, it’s a bit erratic in the UK. It’s clearly falling sharply in the US and there are signs that it’s falling here too. Um, since it’s erratic month on month, you can’t be entirely sure how long that will persist, but certainly there are lots of signs now that the tightening of monetary policy is beginning to feed through.

Um, but of course, having lost credibility, it’s tough now for central banks to, you know, to take a balanced view because they may feel that the worst thing for them is to be proved wrong again on the upside. Uh, and we just have to wait and see what actually happens, but the intellectual failure here, that is to ignore money, uh, means that I worry that central banks are now setting policy by looking at the latest inflation number. And since there are lags in monetary policy, just as there are between when you steer a boat and the change in the tiller actually affects the direction of the boat, if you’re not careful, if you just look ahead of your nose, then, you know, you’ll end up in the bank. And I, I worry here that, you know, they haven’t got a theory of inflation having thrown money out of the, uh, out of the theoretical framework they do use. They haven’t replaced it with anything. All they had was inflation’s bound to come back to 2% because we say it will.

Well, we know that’s no longer true. And therefore they’ve got to have some sort of theory about how the change in interest rates or the amount of money they print feeds through to the economy, and that’s what their models do not incorporate at present. 

And therefore, we could end up with a sharper fall in inflation and a deeper recession than they presently expect. But nothing is certain. That’s the big [challenge. You know, they can’t guarantee that. Therefore, I suspect that they will for the sake of their own credibility have to play very safe by keeping rates rates higher for longer.

Webb: Yeah, I’d be surprised if that credibility comes back in a hurry. One of the things that that we keep looking at at the moment is the extent to which the transmission mechanism of raising interest rates is extended. It takes longer than it used to take because of the way that the housing market is now set up in the UK with something like 36% of homes are owned outright and 28% being on, on mortgages, but the majority of those being fixed rated either two years or five years, et cetera. So instead of being able to snap your fingers and have everybody paying 6% all of a sudden, in fact, they only roll off very slowly month by month by month. So the effect of that on dampening demand instead of being maybe a year is definitely more like two years, maybe two and a half. And that may not be fully factored in to the bank of England’s thinking, or may not have been when they started this process.

King: I think they are conscious of that, and, and they, therefore they can try to incorporate that into their, their projections and their, their judgments. I think there is one factor which will operate in their favor, which is that the high energy and food prices that we saw a year ago are beginning to drop out of the 12 month measure of inflation.

And therefore we could see it over the rest of this year, you know, a significant fall in inflation, which might change people’s perceptions about whether or not the Bank of England can regain control of inflation. And that could be true even if underlying inflation, that is the consumer price inflation, excluding food and energy prices, even if that remains elevated and it, it may help the Bank to see some fall in headline inflation that people will feel are, well, at last it’s beginning to come down so we can calm down a bit. They seem now to have done enough to regain control. Um, and my guess is that, you know, I mean, I’m confident they can bring it back to 2%.

The problem they’ve got now is that having lost credibility  and control I think of people’s beliefs about it, people are talking about inflation a great deal now, that you may need to go through a period of significant labor market weakness in order for people to feel that, well, inflation is again, once again, something of the past and not the future.

But it’s this, this is difficult to judge it. We haven’t been in this position for a long time now, uh, and trying to guess how people will respond to movements in headline inflation is never easy.

Webb: No, but I think we can, we can see it in the labor market, can’t we? In that for a long period when inflation has been knocking around 1, 2%, not much more, people don’t really think about the effect that has on their real purchasing powers.

Everybody understands what inflation does to their purchasing power. So the idea that over the next few years people might again begin to say, actually it doesn’t really matter, it doesn’t make any difference to me, etc. That ship has slightly sailed. We now have a generation of people who are going to have an eye on inflation and how it affects their purchasing power long term, and that seems to be something that might change the dynamics of the labour market.

King: Yeah, I, I think that’s right. And my definition of price stability would be, uh, when people no longer talk about inflation and that we got to that point, we had a quarter of a century when people really didn’t talk about inflation. Now it’s right back again as the center of many conversations and, uh, we need to go through a period again in which by keeping inflation close to 2%, we can get back to the position in which people stop worrying about inflation.

It just isn’t part of how they think about their behavior, whether it’s in terms of the wages they will settle for or the investment decisions or pricing decisions made by businesses. It’s very, this is the unfortunate. consequence of having allowed inflation to get out of control. 

Webb: Do you still think that 2% is the correct target?

King: I think it is for a number of reasons. First, we’d like inflation really to be effectively zero on average. The official measures of inflation do not capture improvements in the quality of goods and services that happen from one year to the next.

And although the office for national statistics tries its best to take into account some aspects of that, there are still significant changes in the quality of goods and services that are just not picked up. In looking at prices, what seemed to be similar things in the shops this year to the ones that we measured the price of last year, and that accounts for easily 1%, possibly a bit more of an apparent inflation rate, but doesn’t correspond to any real inflation.

So I think you’d want to adjust. Indeed, there was a point when people thought, well, we should cut the 2% target to 1%.

Webb: Um, thank goodness. No one did that.

King: So, uh, I think it wouldn’t make sense to have an inflation target of sort of 1. 73% or whatever some academic evidence showed for quality change. Two is a nice round number. Uh, when we started with inflation targeting in the early 1990s, actually, most people didn’t believe we’d ever get down to 2%, but we did.

Webb: Pretty nasty recession in the early 90s. It didn’t just happen. It was a lot of unpleasantness.

King: It was difficult in the early 80s and 90s to bring inflation down, but it was achieved.

And once it was achieved, it stayed low. That was the great achievement of inflation targeting. Uh, and so I, I don’t think that aiming at that is, is a mistake. I think it’s the right sort of number. And if you want to explain to people what the inflation target is, you need a decent round number to explain it. Because at 2% people don’t talk about inflation.

This will be the worst possible time to change the target, you know, just because you’re having difficulty in meeting the target, you don’t just change the target. That would undermine the credibility of the entire regime. And the same academic approach to monetary policy, which I described earlier, is responsible for some people arguing that the target should be raised and on the grounds of, well, you know, 3%, is it so different from 2%? But the point is, if you, as soon as inflation goes above the target, you sort of move the target up and say, well, it doesn’t really matter that we missed it very much, does it? We’ll change the target to three.

You know, the next thing you know, it’ll be moved to four. People just will not believe that you’re serious about keeping inflation low and stable. So I can’t see any obvious merit in, in moving the target at all, it’s arbitrary to some extent, but it is, I think, a reasonable approximation to price stability.

We need to get back to 2% and then remember that money does matter.

Webb: Do you think the bank itself is in any danger? There is now a lot of conversation around, uh, around the fringes of the profession around Bank of England independence and, uh, maybe it hasn’t been got quite right and maybe that needs a bit of a rethink.

King: I think not. I mean, I’m on the House of Lords Economic Affairs Committee, and we’re conducting an inquiry into the way in which independence has been operated and how it’s functioned over the past quarter of a century because it’s exactly 25 years ago this month, since the legislation creating a Bank of England came into effect, creating an independent Bank of England came into effect.

I don’t want to front run any conclusions we may or may not reach in our report, which I expect to be published in the autumn. We’ve still got more evidence to take. Clearly, a lot of things have changed since the Bank of England was first made independent. In particular, it has a much greater set of responsibilities now than the bank had in the early 19 or mid 1990s.

Uh, this was partly, of course, the consequence of the financial crisis where, which led to the bank being given responsibility for financial regulation of banks and insurance companies, uh, and also wider responsibility for financial stability with new instruments to use in that context, but also because more recently, Chancellors of the Exchequer have been tempted to lengthen the remit of the Bank of England and to add lots more things like climate change and other issues, which the bank are supposed to take into account when making its decisions.

So I think there’s a lot to be said for simplicity. For not making things too complicated and for making sure that the Bank of England is responsible for achieving its main objectives.

Webb: Yeah, and it also means that we end up with, um, headlines like we had, uh, recently of, uh, Andrew Bailey putting in, or the Bank of England putting in heat pumps and this kind of thing, which makes everyone roll their eyes slightly, because it’ll make not a blind bit of difference to anything, but everyone would really rather that Bank of England was focusing on inflation than, than heat pumps.

There’s also something, uh, in the newspaper saying that the average Bank of England employee only works in the office two days a week, which seems to me something that may affect the way they operate, and that, uh, we certainly find that the more, the more you talk, the more you argue, the more likely you are to get the correct result, and it’s much harder to do that out of the office than in the office.

King: I’m sure that the, the, the management of the bank would like people to go in more often.

Webb: Why don’t they just tell them to then? 

King: Well, you might ask the same question of every institution in the city. I mean, the City of London is not full on Mondays and Fridays. And, um, partly it’s because after the pandemic people have discovered that they quite like working at home part of the week. It adds a greater flexibility to their lives. And if you want to get the best people to work for you, you need to offer a competitive package. The bank’s not really in a position to offer significant financial rewards. So anything it can do to make working for the bank more attractive clearly improves the quality of the package it can offer its staff.

But I think this is something which, you know, we have. We’ve no experience of this happening. It’s nothing like this happened in my lifetime. So up until now. So I think we just have to feel our way. It’s quite possible that three years from now, we’ll be back in a world in which everyone wants to work five days a week.

Uh, and the employer wants them to be there five days a week. We equally we could be in a different world where we’ve decided that people should work from home two days a week, go into the office three days a week, and everyone’s found a way to make that work. But I take your point, which is the seeing people is very important. 

Webb: I’d go and work at the Bank of England to find benefit pension schemes. It’s the best one in the world, isn’t it?

King: Well, it’s not available now to new entrants, no.

Webb: Okay, I take it back, Bank of England, I’m not coming.

King: So, I think it’s very difficult for employers in the City. One of the great disadvantages which London has over other centers is that if, once people have started a family, they are not paid enough to enable them to live comfortably in central London. So they live a long distances away and that makes commuting difficult. So, that’s exactly a situation in which the ability to work from home, you know, has a lot to be said for it.

Webb: On the plus side, we’ve got a nice house price crash on the way, haven’ t we?

King: I don’t like to forecast. I won’t forecast where the economy is going and certainly not asset prices, but it just goes, it goes back to what I said earlier, which is the, the impact of the tightening of monetary policy that we’ve seen. I think has pretty much eliminated the monetary overhang that was created in 20 and 21.

Going forward, we need to be careful. But if you move from a world of very low interest rates, where people expect this to continue, and return sensibly in my view to a world of higher interest rates of the order of where we were before the financial crisis, then you would expect asset prices relative to incomes to fall back.

And that’s what we have and are seeing. And that’s true of all asset prices, both of stocks, bonds, houses, and all other assets. So I think we were living in a, uh, a world that was clearly unsustainable between the end of the financial crisis and more recently in which people believe that very low interest rates could actually be around for a very long time.

Webb: Can I ask you about, um, about Brexit in terms of inflation? One of the things that people often say is that we have it much worse in the UK because of Brexit.

Do, do you see evidence of that? Because when, when we look across to the EU, we see not all countries, but several countries with inflation rates, at least as high as ours, there doesn’t seem to be that much difference, but nonetheless, it’s an idea that has definitely taken hold. 

King: The problem is that Brexit was such a divisive issue in the UK that roughly one half of people who talk about this want to believe that anything bad It’s the consequence of Brexit and the other half want to believe that if only Brexit were implemented appropriately, our economy would be better than all other economies.

I find it very hard to come up with any evidence really for either side of this. We didn’t leave the EU until the end of January 2020. Within a month we were plunged into a global pandemic, which led to a fall of GDP of 20%. Uh, that clearly wasn’t the result of Brexit. It was a global pandemic. Now we’ve got the Russian invasion of Ukraine.

Now, whatever view people take about Brexit, I don’t see how you can argue that what’s happened since January 2020 sheds any light at all on the long term consequences of Brexit that everything has been, uh, overwhelmed by the effects of the pandemic and now the Russian invasion of Ukraine. So, you know, people do take different views on Brexit, but I just can’t see that there is any evidence there that one could use to argue strongly that all of these things are the consequence of Brexit.

I think you can understand what’s happened to inflation in different countries. By looking at the common intellectual mistake that was made, the extent to which each country generated a monetary overhang, and then the direct impact of higher energy and food prices on domestic households, and the consequences for CPI inflation.

Webb: Did any central banks not make the mistake?

King: Well, I think in the emerging markets world, they were much prompter, but they didn’t create vast amounts of money. They were prompter to raise interest rates when they saw some of the consequences of higher energy and food prices for their own economies. Um, Japan is in a situation where they have had, you know, reasonably low growth rates of broad money for a long while, which is why they haven’t had high inflation that continued. So it’s not the case that everybody had higher inflation. You could just simply assume that because central banks announced the target, everyone would believe them completely and inflation would never deviate, uh, in a longer run sense from the target.

Webb: It reminds me of, um, uh, young people often talk about manifesting things. You know, there was a book, I can’t remember what it was called, that taught everybody how to manifest, and, uh, if you think about something and want it badly enough, it will come to you.

I know we’ve been talking a while, but just a couple more things that I, that I know everyone listening is going to, to want to hear from you.

The first thing. Is, um, central bank digital, digital currencies, you know, we talk about this a lot and John and I, we think to ourselves, we can’t, we can’t really see the point, it’s like a solution looking for a problem. Um, but do you see it differently?

King: Oh, I mean, the same House of Lords committee that I mentioned earlier, wrote a report on this, and we subtitled the report, a solution in search of a problem.

Webb: Well, there you go.

King: And, and I think it is. So the four words central bank digital currencies. Well, first, it’s not a currency because if it were to come into effect, it will still be in sterling. So the value of sterling would still be set by the Bank of England through the Monetary Policy Committee.

So it’s not a new currency. Bitcoin is a currency, perhaps may not be a very good one, but it’s a potential currency. Sterling is a currency, but if this bank of England introduced a CBDC, it would still be in sterling. It’s a tool. Well, there’s nothing new about digital. I, every day I go onto my bank account online and I can transfer money into my account, out of my account.

I can make transactions. I don’t have to carry notes around in order to pay for things. I can use a card. It’s all digital. So nothing new in it being digital. Why do we want a central bank version of it? And I think this is odd because we want a competitive payment system. We want our banks to compete with each other to ensure we get a decent service.

What you do not want is to create a state monopoly, particularly one that has no experience of dealing with large numbers of customers. So, you know, I pity Andrew Bailey sitting in his office and the phone rings and his secretary says, I’m afraid we got that Mrs. Smith from Guilford on the phone again.

She can’t log into her account. She wants to speak to you. So the, I just don’t know why people think that this is a great idea. I just don’t think that it really solves any of the problems that we’re concerned about. It is a solution in search of a problem.

And it has one potentially serious drawback, which is that if the banks were still operating bank accounts and there were to be some hint of a financial problem, such as we saw in the US in the spring with Silicon Valley Bank, everyone would have a very strong incentive to switch their money from their own bank account into an account with the Bank of England.

That would destabilize the  banking system, at which point the Bank of England would then hand the money back to the banks in order to support them. So they didn’t fail. This is wholly unnecessary and we don’t need to do it. So I just can’t see the virtue of spending a lot of money rushing into this sort of innovation.

Webb: Okay, all right, so that’s a no to CBDCs then, one of the places perhaps where second mover advantage might be the one to go for. The other question that will, that if I don’t ask you, everyone will ring in and ask me why I didn’t ask you, is about gold and the extent to which that still plays a part in the financial system and will do indefinitely.

King:  It doesn’t play a big role nowadays in, in retail transactions and decisions. Some wealthier people may decide to invest some money in gold. One reason for doing that would be to see what central banks are doing. And it’s quite noticeable that central banks have been increasing their holdings of gold.

One reason for that, I think, and it’s, it, it opens a Pandora’s box. Which will be, I think, a big issue in the next 10, 15 years is that the impacts of sanctions that were imposed on Russian individuals and institutions after the invasion of Ukraine means that it’s no longer quite so obvious that if you put your money into dollars in the United States, the rule of law will protect your holdings.

If it turns out that the US Congress or the US President doesn’t like who you are or what your political opinions are, it’s possible in the future that, uh, you may be subject to restrictions on access to your own wealth. And the one thing that, you know, has always been true in terms of international settlement of transactions is the use of gold.

Everyone will accept that and use it. So, I can certainly see why both countries and central banks have decided that, you know, having a bit of gold, not a bad idea. You could always make transactions using it. And if that demand for gold, you know, persists, that’s going to underpin the value of gold.

Webb: Okay, well, I think I know the answer to the last question I’m going to ask you, which is one that I ask all our interviewees. And given your position, you don’t have to answer it, but I suspect we can guess your answer even if you don’t. If you had to hold personal portfolio,  which of course you never reveal, for a decade, you would either gold or Bitcoin. Which one would it be?

King: It would not be bitcoin, but I think I could do better than either really. Uh, and I’d want a more diversified portfolio, but I would not hold Bitcoin or any other, um, currency like that because I don’t understand what gives it value other than I might be able to find somebody to sell it to at a higher price than I paid for it myself.

Uh, Bitcoin is not used widely in transactions. I’m not going to pay for my taxi fare or my restaurant using Bitcoin. And I personally would think that it is subject to, as we’ve seen in the past, extraordinary volatility, uh, and I, that’s not the kind of volatility I want to be exposed to. I would much rather hold a cross section of equities, including overseas equities.

But, and I should emphasize this for your listeners, that I am not qualified to give investment advice. I don’t wish to be prosecuted for doing it.

Webb: That’s not investment advice. That was a pure, uh, pure expression of personal opinion. Um, thank you so much for being with us today. That was really interesting.

King: Thank you, Merryn. 

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