Managing Brexit risks is necessary but not sufficientby Jonathan Portes / December 23, 2019 / Leave a comment
The choice of Andrew Bailey as the next Governor of the Bank of England has been almost universally described as unexciting but safe—signalling the government’s desire for a steady pair of hands, who will not rock the Brexit boat either in public or in policy terms. And indeed on Brexit the Bank has little to gain by making waves. But that doesn’t mean it, or its new chief, will have an easy job.
The most urgent task will be to manage the UK’s disengagement from the EU single market, as far as financial services are concerned, while protecting the competitive position of the City. Brexit means the UK will become a third country from the point of view of the EU’s financial regulators.
That does not mean that the UK and the continent will be cut off from each other. The new relationship is likely to be governed by the EU’s “equivalence” regime, where EU regulators determine when a third country’s regulatory standards are up to EU standards.
Securing equivalence—in a dozen or so different areas—is emphatically not the same as the EU’s “passporting” regime, which the UK will lose access to after the end of the Brexit transition. Equivalence is incomplete, piecemeal and unilateral, meaning it can be withdrawn at any time. But failure to secure equivalence would be very damaging indeed—and time is short, with an initial deadline of July. And the UK will need to put its own regime in place too.
This will mean a lot of detailed, unglamorous work in a short time. The UK has long faced the challenge of maintaining the economic and fiscal benefits of having a large and highly productive financial sector while managing the associated huge risks to financial stability. Leaving the EU doesn’t change that basic dilemma, but it does sharpen it. European regulators and finance ministries know that European businesses need access to the City—for the moment.
But the need to worry about the direct implications of Brexit for the City shouldn’t mean that the Bank takes its eye off the wider economic ball. The Carney period was one of unprecedented stability in monetary policy—with interest rates not going higher than 0.75 per cent or lower than 0.25 per cent. Perhaps in reaction to the prevailing view that there was little policy could achieve (or perhaps with an eye on his next job) over the period of his term Carney talked less and less about macroeconomics and more and more about climate change. Meanwhile the Bank’s leading intellectual, Andy Haldane, decided to take up a part-time job advising the government on industrial policy and productivity.
Meanwhile, Bailey was firmly on the regulatory and supervisory side of the Bank, so could hardly be expected to pick up the slack. But, in my view, this was a major missed opportunity for the Bank, and one Bailey now has a chance to remedy.. The Bank has been operating under broadly the same mandate—the inflation target—since 1992. This mandate was designed, both explicitly (in academic economic models) and implicitly (by politicians) for the “4-2-2” era; that is to say, a period when macroeconomic stability meant that if you set interest rates to hit an inflation target of about 2 per cent, then you could expect real growth of about 2 per cent, and nominal GDP, wage growth, and long-term interest rates of about 4 per cent.
Following the financial crisis, this relationship broke down completely. The combination of sluggish growth and the persistence of historically unprecedented low long-term interest rates—“secular stagnation”—prompted a debate about whether the mandate needed radical reform. With interest rates very close to zero, and the connection between unemployment and wage growth and hence inflation much looser than in the past, the Bank seemed to have lost its main lever to manage the economy.
Various ideas were floated—nominal GDP targeting, nominal wage growth targeting, or an even more radical approach recognising that the formal institutional separation of monetary policy (implemented by an independent central bank) and fiscal policy (politically determined, but not primarily directed at steering the economy) was no longer appropriate. Moreover, with interest rates still close to zero, what should the Bank do in the event of another recession? Should it—and/or the Treasury—have the power not just to engage in quantitative easing (buying government bonds from the private sector) but to effectively print money and distribute it to households?
Given the UK’s previous record as being innovative and forward looking in monetary policy design, and Carney’s international reputation, the Bank could have made a major contribution to this debate, domestically and internationally. But he and it largely shied away from doing so, and then with the onset of Brexit the immediate risks and threats meant other debates were relegated to the back burner.
All of the options for radical change carry risks, both to the Bank’s hard-won “credibility” and its largely successful efforts to avoid the politicisation of monetary policy. But so does the status quo. It is more than likely that the UK will face another significant economic downturn at some point over the next few years (whether resulting from Brexit, global forces, or both). We will do so with a monetary and fiscal policy framework which wasn’t really designed for today’s challenges. If Governor Bailey wants to make his mark, in policy terms and intellectually—but without wading again into the politics of Brexit—reviving this debate would be an excellent start.