Mervyn King on Brexit, crisis supervision, economic rebalancing and reforming the IMF

Former BoE governor shares insights from a 50-year career

Mervyn King
Photo: Juno Snowdon Photography

What do you make of the 'surprise' UK referendum decision for the UK to leave the European Union?

I deliberately stayed out of the campaign, as I did not want to make life difficult for my successor, and nor am I prepared to say much after the event. But the way the government conducted the campaign turned out to be counterproductive. As I travelled the country, the word that came up most frequently was 'scaremongering'. They could see it on both sides. People wanted to be given arguments and facts in a calm, measured way so they could make up their own minds. But they were not treated like that. Much of the campaign was insulting to the intelligence of the voter. The bewilderment and disbelief by those who voted to remain [in the EU] reflect how out of touch they have been for a long time with many people around the country, especially outside London. That's a lesson that needs to be learned. It was a real contrast from the dignified, honourable and straightforward statement from [then prime minister] David Cameron on the Friday morning [June 24] in which he resigned. He said: "We have the result. We must make it work." That's the only sensible reaction to this.

Does Britain's exit from the EU – or 'Brexit' – provide an opportunity for the UK economy to be rebalanced?

The UK economy has to be rebalanced one way or another, 'Remain' or 'Leave'. We need a level of the exchange rate of sterling much closer to the level we had in the middle of 2013. The fall in sterling we've seen since the vote has merely brought the effective exchange rate of sterling back to its level in mid-2013. That rose by over 16% between the middle of 2013 and late 2015, and was very unfortunate in terms of our ability to rebalance the economy. We are now in a better position to rebalance the UK economy.

What would be the main priorities of the UK's negotiation with the EU?

There are four areas where it would be sensible to have in separate baskets. One is trade negotiations relating to trade in goods and services. Second is a separate basket on financial services. That's going to be a highly politically sensitive area. The third is agriculture because we will have an opportunity now to recast the way in which we construct subsidies for agriculture. There is no reason why we should stick with the EU-type subsidies, even though vested interests will argue for it. The fourth area is Northern Ireland, something that received far too little attention in the campaign. People in Dublin are nervous about what Brexit means for the broader UK, as we will now have a land frontier with the EU. We need to think through very carefully what this means for a whole range of policies – not just security and border control, but also tariffs in general and addressing electricity pricing. This is an opportunity to have a greater collaboration between north and south.

What did you think of the Bank of England's (BoE) immediate response to Brexit?

The Bank approached it in the right way, which was to make a short statement – these are not occasions for lengthy press conferences – to reassure everyone that there is no threat to the financial system, and I don't think there is a threat. Then it is a question of business as usual. Monetary policy carries on, and that's the right thing. An unfortunate aspect of the campaign were government forecasts of what the consequences of Brexit might be, which inevitably were highly speculative – in particular for the long run. The problem is that the long run judgement then feeds back to the short-run forecast because it was assumed that people would anticipate the long run. The only honest answer about the long run consequences is we don't really know. If businesses are transacting with each other now, buying and selling from each other, they'll want to do it today as they did last week. There's no immediate change in this. I do think it is possible to find a way in which most trade carries on. Businesses want to do it, and it would be very difficult to stop them doing it. You can't rule out that Brexit is going to have an impact on the level or growth rate of UK GDP, but it isn't a certainty or a fact. Nor in the long run is it very plausible. The mistake of the 'Remain' campaign was to portray these extreme outcomes in the future almost as inevitable, rather than what they were, which were highly speculative forecasts.

People in Dublin are nervous about what Brexit means for the broader UK, as we will now have a land frontier with the EU. We need to think through carefully what this means for a whole range of policies

What should members of the BoE's monetary policy committee be thinking at a time when people are looking towards them to do something to calm markets?

I'm not sure that they should be looking at them to calm markets. The Bank has already done that. It would be a mistake is to jump up and down and say: "Don't worry, we're in charge" – and create a sense of excitement that's not appropriate. The Bank has made it clear that it is monitoring what's going on very carefully, and stated that the banking system is more stable than it was before the financial crisis. The markets are being driven very much by politics – after all, the political events were wholly unprecedented and quite remarkable. At a time when the country needed senior politicians to work together, the last thing you wanted was for them to be utterly absorbed in intra-party fighting. The Bank will try to show it is business as usual and set monetary policy in light of the judgement about the risks in the future.

Major central banks have cut rates (with some now negative), deployed quantitative easing (QE) and there is now talk of 'helicopter money', which you appear to believe is the combination of tax break plus QE. They all seem to have diminishing returns. Should they give up on these policies?

No, they shouldn't give up on them, and I don't think they are. But people must come to the realisation that these policies will not be sufficient to generate a sustainable recovery.

[US economist] Larry Summers has a nice phrase when talking about the US: "We got into this crisis through too much spending, too much borrowing; and the only way to get out of it now is even more spending and even more borrowing." What he means is that the correct short-term response was to be willing to use monetary and fiscal policy to stimulate the economy, and that was absolutely right. It's what countries did in 2009 and 2010. At that point, it became pretty clear that there were other considerations. The phrase that Larry uses is another way of saying there may be an argument for taking one step back to take two steps forwards, but it is a step backwards. It's going in the wrong direction. Ultimately, other policies are required to ensure that you can go forwards. We can't keep taking steps backwards.

The reason easy monetary policy is not generating a sustainable recovery is because we're not facing temporary headwinds in the economy. We're facing the need for a significant, permanent rebalancing of our economy. That requires a much wider configuration of policies. It would be wrong for central banks to say: "This isn't producing a recovery, so we'll raise interest rates". You need other policy measures to be taken so that central banks then feel it's natural to raise interest rates. That's what needs to be done. Just relying on easy monetary policy won't get us there.

mervyn-king-5-16Mervyn King is the former governor of the Bank of England and chairman of its Monetary Policy Committee from 2003 to 2013. From 2011, he was also chairman of the Global Economy Meeting and the Economic Consultative Committee hosted by the Bank for International Settlements. In 1991, he was made the UK central bank's chief economist and executive director, before being promoted to deputy governor in 1998, a role he held until 2003.

King received a first-class degree in economics in 1969 from King's College, Cambridge, and an MA from St John's College, Cambridge, and Harvard (as a Kennedy Scholar). King now lectures at New York University's Stern School of Business and School of Law as a visiting professor and is a school professor at the London School of Economics.

He was appointed a life peer by Queen Elizabeth II, taking the title Baron King of Lothbury in 2013, and a Knight of the Garter in 2014. King is the author of The end of alchemy: money, banking and the future of the global economy (2016), which details his reflections on banking and money garnered from his near 50-year career.

Have central banks hit their monetary policy limits?

They are approaching the limits, and I'm not sure that much more easing will achieve very much. It might achieve a little bit, but it simply is not going to provide the ultimate solution. It's another step backwards. At this point, central banks probably need – even more strongly than they have been doing – to say: "We're not the only game in town. We can't be the answer to this. What monetary policy does is to buy time to enable you to put right what was wrong." The trouble is central banks have bought almost eight years, but nothing else has really happened. In part, this is because the models used by monetary economists and central banks may be useful in certain circumstances, but I don't think they're helpful now.

Why are the models not helping?

The models assume the shocks that hit the economy are temporary in nature, that they will eventually go away. These headwinds will disappear. But we're not facing temporary headwinds. I became less and less satisfied with the assumption of the simple models we used, whether it was in monetary theory or in terms of the econometric models the people at central banks were using. There were assumptions built into those models that were driving the results, and actually they were not useful models for the problems at hand. Models ought to be regarded as tools in a toolbox. No good workman carrying a toolbox around to go to people's houses to solve problems would ever dream of entering, saying: "Well I've only got one tool here, so let me find something in this kitchen that I can use the tool on." You have a whole box of tools, and you say: "There's the problem. What's the right tool for that?" That's the approach that needs to be adopted. It got turned on its head, with economists becoming infatuated with particular models and then insisting that the world had to be fitted into the model. That has been very damaging, and it is part of the reason why a lot of people still think the problem facing central banks today are headwinds and, by assumption, these headwinds are temporary. There's no reason to justify that assumption, and it is stopping people from seeing what is really going on.

The crisis revealed that many people had been spending more than they could justifiably spend, given their expectations about long-run income. They have lowered their level of spending with the realisation that the period of stability we had before the crisis wasn't sustainable. We confused stability and sustainability – perfectly understandably, in some ways. After the volatility of the 1970s and 1980s and the period of high inflation, we had achieved what looked like a highly successful macroeconomic outcome. It was stable, but it wasn't sustainable. The financial crisis revealed that clearly to people, so a lot of them lowered spending. In those parts of the world where spending could and should have risen – countries such as Germany, the Netherlands, China, some other Asian economies – domestic demand was suppressed by strategies of export-led growth. Although countries such as China, for example, said they had a clear plan to rebalance their economies and rely less on exports and more on domestic spending, in practice, hardly any resources have switched from the export sector to produce goods and services for domestic consumption. These changes will have to come at some point. Monetary policy is not sufficient. Obviously, monetary policy has been necessary, but it hasn't been sufficient.

But has loose monetary policy been necessary?

We would have had even weaker demand and output otherwise, even though we are now at a point where monetary policy has diminishing returns and is not going to achieve much more. There is a debate about the use of fiscal policy, and the appropriateness of its use depends on the individual country. It's fascinating to hear talk about helicopter money, because some people seem to believe it is possible to create an asset without a liability. There's only one natural law in economics. That's the law of double-entry book-keeping. You can't abolish that.

Do you think the regulatory reform, Basel III in particular, has value?

A lot of good, well-intentioned people are working hard to try and make it operate. But I was struck by two things after the crisis. The first was that the Basel framework in place before the crisis was flawed – not because of any incompetence on the part of the people responsible for it but because a crisis almost by definition occurs when something unexpected happens. The risk weights and the other regulatory details are not able to anticipate that. So a system that depends on getting that detail right doesn't make much sense. You need something much more robust. That's why I favour a simple leverage ratio – not so much as a backup, but actually as the main method of deciding how much equity finance banks should issue. We should not worry too much about what happens when banks are not actually at risk of failure. Regulators should worry about them only when there's a risk of failure.

Having a sufficiently large equity cushion will lower that risk of failure. The second thing that struck me was that many of the important financial centres decided that the whole complicated, bureaucratic, and inevitably slow, exercise of getting agreement across a large number of countries was not well suited for them. They would deviate from the minimum capital requirements from Basel and impose their own higher ones. This was something that no one had really anticipated before. The idea was that Basel would set a level playing field – it all started due to the concern that Japanese banks were able to operate with lower capital requirements and hence expand their business abroad.

This was completely turned on its head after the crisis, when countries like the US, the UK, Sweden and especially Switzerland, decided it was in their own self-interest to have higher and tougher capital requirements than the Basel minima. It was good for their banking system to be seen as safer, and made it easier for the banking system to attract funding and to get customers. With better access to funding, they were more able to lend to the real economy. This is likely to continue. You also see a wave, particularly in the US, towards the 'subsidiarisation' of foreign banks, so there is no reliance on overseas regulation.


Can you explain the role of a 'pawnbroker for all seasons' for central bank collateralised liquidity? The UK now has around £600 billion ($796.3 billion) of pre-positioned collateral arrangements with banks. But can such a system work in isolation?

Regulators are moving unilaterally in that direction because they want to make their banking systems safer. The background to this is that, for a very long time, people have understood bank runs can occur. These are destabilising, threaten the banking system and can prove very costly. I don't want to argue that the cause of the financial crisis was simply that people lost confidence in banks. But the crisis in 2008 was obviously strongly amplified by runs on banks.

How do you get around this?

Many of the most well-known American economists of the 20th century were attracted by getting rid of fractional reserve banking. This was discussed again after the financial crisis. People looked back again to the 'Chicago plan' of the 1930s. It is remarkable how many respectable economists backed this. The reason they backed it is because they could see the cost of having a banking system prone to bank runs. The trouble is if you simply mandate 100% reserve banking, then essentially you eliminate banking. It raises the question of who finances long-term risky lending. It's impossible to know whether it will be easy to finance as much long-term risky lending as we want purely through equity finance and long-term debt. So we have to exploit the mismatch of maturities, provided we can put in place another insurance scheme to make sure banks can get the cash they need in the short term before a run emerges.

What [19th century British writer] Walter Bagehot had in mind as the context for a lender of last resort (LOLR) to prevent bank runs was completely different from the banking system of 2008. Central banks made a series of speeches about "never lending to an insolvent bank". But it was pretty meaningless, as you have no idea whether a bank is insolvent or not in a crisis – and, indeed, whether it's insolvent may depend on whether there is an LOLR. The essence of Bagehot is the assumption that banks would always have enough safe collateral and that, when in danger, they could give it to the BoE and obtain as much cash as they needed to satisfy their depositors. The problem was that in 2008, unlike in Bagehot's time, the banking system didn't have 30% of its assets in short-term government paper – it had less than 1%. At that point, it became pretty clear central banks were not LOLRs. They were pawnbrokers lending against the equivalent of gold watches.

So things are very different now to Bagehot's time?

In Bagehot's world, there were no costs to doing things on the fly when a crisis occurred. In essence, what he completely overlooked – because there didn't seem to be any need to in his time – was the idea that banks might say: "Well, if the central banks can be an LOLR, then what's the point in us holding liquid assets?" The resulting moral hazard meant that over time the safe liquid assets held by banks fell to less than 1% of their balance sheet. Also, in Bagehot's time, when a bank took collateral to the BoE, it didn't take more than about two minutes to check that the collateral was perfectly safe and secure, and you could lend without any haircut on it at all.

So it does make sense to work out in advance what the collateral looks like. The BoE started this before I left, and has continued since. The idea is to make banks pre-position collateral. Once that's in place, then it makes access to liquidity much more straightforward. The US Federal Reserve also does some of that, too, now. Central banks are moving in this direction. My idea was to say: "Well, you could stop bank runs not by eliminating fractional reserve banking, but by constraining the degree of maturity mismatch linked to the terms on which central banks provide liquidity."

One could constrain the degree of maturity mismatch by making banks pre-position sufficient collateral such that after the haircut – which should be a pretty high haircut compared to some haircuts we look at today because the central bank would give a guaranteed credit line for five years or more – they would have sufficient funds to pay off all the people in a run tomorrow or over whatever period you care to define. If you don't want to go all that way, but only eliminate 80% of the risk, you could do that. It's pretty flexible in that sense. But recognition of this is very important because what became very clear to me when I was chairing the meetings on the liquidity coverage ratio was that it made absolutely no sense to think about a regime of liquidity for banks in terms of the assets they have to hold without actually thinking about the provision of liquidity by the central bank. It's about designing a regime that incorporates the provision of liquidity by central banks to commercial banks as part of the regulation and sets this out clearly in advance. From this point of view, the tradition that grew up – very unsatisfactorily in my view – which was the idea that LOLR was all about constructive ambiguity, got it the wrong way around.

The essence of Bagehot was that if you got good enough collateral, then you could lend even to an insolvent bank. You don't need to ask the question: "Is it solvent or not?" And we'll never know in a crisis. What you need to do is to recognise that the role of a bank is to structure its assets to meet the structure of its liabilities. Some banks will want to have long-term risky assets – in which case, they'll have to have a bit more financing from equity and long-term debt. Other banks will want shorter-term assets – in which case, it'll be easier for them to finance it with deposits.

Wouldn't there be collateral arbitrage between jurisdictions?

Not if banks are subsidiarised in each jurisdiction. What was very apparent in the crisis is that there was no way in which you could guarantee that the state would not ultimately have to step in and put in money to prop up the banking sector. It's too important for the function of the economy, so the government is always going to be providing catastrophe insurance. That's a fiscal action, and therefore can only be taken by a nation state in the jurisdiction where taxpayers allow it. The idea that countries are going to be putting money into banks in other countries does not hold true in reality. You can see that within the euro area even. This is another reason why, inevitably, supervision of both capital and liquidity will drive more regulators to say: “We want a subsidiarised entity in our country”. The Americans are clearly pushing foreign banks to operate through US subsidiaries, and that is the way we will end up going.

When it comes to these big imbalances that developed in the global economy, you seem to put forward the savings glut hypothesis for this, rather than looking at net versus gross flows, as put forward by the Bank for International Settlements (BIS). Why is that?

What matters in terms of driving down the real interest rate – the big problem was the secular fall in long-term real interest rates, and that depends on the balance between saving and investment in the world as a whole – is the ex ante wish to save and invest. That is what is important. It's that that was revealed by the net position. How willing was a country to save, rather than invest? China invested a lot, but it wanted to save even more. It's these propensities to save that really matter, and those are revealed more accurately by the net flows. What is really important to understand is that it isn't just a question of international flows at all.

How willing was a country to save, rather than invest? China invested a lot, but it wanted to save even more. It's these propensities to save that really matter, and those are revealed more accurately by the net flows

Once interest rates started to fall, central banks got into a trap in which the only thing they could do on their own was to cut rates again. We had a mismatch between spending and saving in most major economies in the world. No-one seemed able to get out of this and get back to a position in which the interest rate in the economy actually could perform the function that it is supposed to. We should have realised that if long-term real interest rates were falling to such low levels and continuing to stay at such low levels, it's very hard to argue in any coherent economic model that this can be a sensible long-run solution. That's what we should have worried about.

We debated this on the monetary policy committee of the BoE in the late 1990s. The question was: "Should we raise interest rates ourselves to ensure that we could restrain the growth of domestic demand and rebalance our economy?" If we had done nothing else, that would have clearly slowed the UK economy. The argument for doing it was that, although we might have had a short-term downturn, it might have jolted the foreign exchange market into realising that sterling was overvalued, push sterling down, and then the growth of external demand would compensate for the weakening of domestic demand. Then we would have a balanced recovery and balanced growth. In practice, the concern was if we – and we alone – raised interest rates, then that was likely to push the exchange rate up, not push it down. The view of the committee, rightly or wrongly, was that two-speed growth was better than no growth. That may have been a misjudgement, we don't know. It is very difficult for any single economy to take the risk of a recession in its own economy, knowing that it wouldn't actually affect the level of real interest rates elsewhere in the world. Collective action by central banks might have achieved something, but we'll never know.

So you do not agree with the BIS analysis?

I have some sympathy with parts of the BIS analysis, but where I think they go wrong is they seem to imply that we should just raise interest rates. I don't see that as being beneficial at all, because that would simply weaken demand. We've seen that central banks have backed away time and time again from raising rates. You want other policies to be put in place first, and when they start to work, then central banks will naturally be able to raise rates. That's how it should go.

It also seems to be a challenge to inspire collective actions by central banks on policy spillovers, such as the traffic-light system put forward by Raghuram Rajan, the governor of the Reserve Bank of India. So what is the solution?

It isn't co-ordinated management of monetary policy. It is trying to put in place a set of conditions under which the spending/saving imbalance within each country – where some are spending too much and others are saving too much – can be corrected. It is not going to be easy, and there aren't any magic solutions to it, which is why nothing's really happening. But it does seem to me that part of the answer has to be a willingness to accept much bigger movements in real exchange rates. I don't see how we're going to get out of this in the long run without seeing changes in exchange rates to the US dollar, to sterling and within the euro area. Germany has got a much too low real exchange rate – many of the peripheral countries have a much too high real exchange rate. These big changes in real exchange rates have to be allowed to come about. But we haven't had a regime of floating exchange rates in the world, and I'm afraid that the euro area project has put a big spanner in the works because it's led to distortions in real exchange rates, and it is proving very costly and time-consuming to correct those through internal devaluation.

Do you believe the IMF needs to take more action?

It's been engaging too much, in my view, in giving political support to the euro. As a result, people in Latin America and Asia have lost faith in the IMF. The Europeans criticised the fund for lending so much to Latin America. Lo and behold, the fund now lends far more to Europe than it ever did to Latin America. I don't think the Asians will ever go back to the IMF again after their experience during the Asian crisis. The IMF needs to devote its energies to trying to get countries to realise they will have to rebalance their economies. The only way that's likely to happen is if they have confidence other countries will rebalance their economies too. One of the things we saw at the BoE in the late 1990s was that we may take measures that will rebalance our economy, but if other countries don't do it, it may not work. I do not underestimate the difficulty of this – there are no 'magic bullets'. There are not any simple, new policy solutions, such as helicopter money or anything else that is going to work – which is why we've had weak demand for a long while, and it looks like continuing.

You seem to believe future creditors may not be repaid on their sovereign debt. Indeed, in a recent article, you were quoted as saying: "Over the last decade or so, the claims by some emerging market countries on the US have grown. Who knows what the future holds, but China and other countries do not want to be in a situation where all their international assets are in effect dependent on the US. Of course, the US would not want to renege on its debts, but if some awful conflagration occurred, then all China's assets in the US might be annulled." Is this really likely?

A better example would be Germany. If you are trying to run a current account surplus of over 8% of GDP a year indefinitely, you will accumulate assets or claims on the rest of the world that the rest of the world will not be able to repay. The interwar period in Germany is very revealing on this. The German central bank rightly pointed out at the time that, irrespective of whether you thought Germany could afford to meet reparations claims – and historians take different views on that – that wasn't the issue. The question was how a country could earn the foreign currency to pay the reparations if it was never allowed to have a trade surplus, which is what France and other countries tried to stop Germany having in the interwar period. The result was that the only reparations that Germany ever paid were financed by borrowing from the very countries to which the reparations were paid. In the end, they defaulted on that debt.

So this is a very similar situation to Greece these days?

It is very similar to Greece and, indeed, other countries in the euro area. There's a game of pretence going on here, in which German taxpayers are told that they're not making transfers to other countries, and this isn't a transfer union, but the longer this goes on, the bigger the liability that will eventually have to be accepted by Germany because people will simply default on their claims, which the European Central Bank [ECB] – with Germany as the single largest shareholder – will eventually have to pay. Other forms of debt also lead to an inability to repay. It's better to face up to this problem now and say: "What is the strategy to enable countries to be able to finance full employment external deficits?" If they can't regain competitiveness, then they will have a full employment trade deficit. Who's going to finance it? When it looks like being a permanent deficit because they can't regain competitiveness, then it is no longer a loan, but a gift. It won't come from the rest of the world. It'll have to come from other members of the euro area.

You speak to some of Germany's top officials. They must be aware of this, mustn't they?

Some of them will say: "Of course, we understand in the end Germany will have to pay. But we can't tell our voters yet." It is an enormously risky strategy, because when people do find out they've been misled, then the reaction is likely to be pretty strong. You can see it's growing in Europe already.

Could something happen after the German elections next year?

I don't know. What we're seeing is paralysis now. Policy-makers don't want to go backwards because that would mean they're admitting that they started monetary union prematurely. They want to go forwards.


What about the role of the ECB?

It's very important to note that the ECB has been a very successful institution. It was managed extremely well. It had excellent leadership over the years, and it has got excellent staff. If there are problems, it's not the result of poor performance by the ECB, but the ECB now feels that change has to come. President Mario Draghi is talking about the increasing urgency of the need to create, for example, a euro area-wide Treasury and finance minister. This is a pretty extreme measure. It was in the five presidents' report. These are the things about which the people actually responsible for running the euro area say: "We need it."

The problem is that there is no political support for it among the peoples of Europe. When you speak to the finance ministers of Europe, they recognise that. The reason is because people are not prepared to say to their taxpayers: "I'm afraid we're going to have to pay something to either Spain or Portugal". They are hoping that at some point it'll be possible to conceal the transfers that take place, but that's not a very satisfactory basis on which to proceed with any institutional reform that has a degree of democratic legitimacy. That's why many economists in Germany are not arguing that the need now is to move to a transfer union, but to go back to the original conception of the monetary union, which is each country being responsible for its own debt.

Do you think the ECB is somewhat complicit, even if it had little choice?

The problem is that it's quite difficult for them to say: "Look, unless we move to a political union, the system is going to fail." They put it in a somewhat different way, but they clearly feel that that is the only way to make the monetary union work. This point was made by Germany very clearly when the monetary union was created – that there has never been a successful monetary union that has not yet gravitated to some kind of political union. For some, it was a perfect opportunity to force political union by starting a monetary union, waiting for the crisis, and then saying: "We've got to go to a political union". But that is a profoundly anti-democratic view of how to make things work, and it is getting its comeuppance from the response of peoples around Europe. The poor politicians stuck in the middle of it have no idea which way to go, and this is going to become more and more serious as time goes by.

Do you think the opportunity for creating a sort of two-speed euro has passed?

There was a clear opportunity to do that. It's much harder now because it's not clear where the dividing line between the first and second division is. There is a third division, which is Greece and Cyprus. It's not too late to deal with that, and many people in Germany would have wanted to have done that. In my judgement, it would have been possible if Germany and Greece together had said: "We tried our level best to make this work, but – with the best will in the world – it is too costly and punishing for Greece, so we have recognised that it was premature for Greece to join the monetary union. That was the decision taken by the previous government, and was a mistake. Greece will leave now. That will give Greece not only an opportunity to become more competitive, but genuinely to converge, which we now know it had not done when it joined the monetary union. We don't know how long it will take, but we hope that Greece will one day come back. That's the wish on both sides. But, at least temporarily, Greece will need to leave to put its house in order because, given the scale of the reforms that need to be made in Greece, they can only be made credibly by the people of Greece. We can't impose these reforms on them."

If I was in Germany, I'd be very nervous that anti-German sentiment in countries like Greece and Italy is stronger now than at any time since the end of World War II. This is a tragedy, because Germany made an extraordinary sacrifice when it gave up the Deutschmark – the global symbol of a successful, peaceful democracy in Germany – to create the monetary union. They gave it up to bind Germany into Europe to persuade people in Europe there was no need to fear Germany. The consequence of that has been that Germany has never been more powerful politically or economically than it is today. But anti-German sentiment has risen in the peripheral countries – and this is the opposite of what was intended and politicians continue to deny the significance of it.

International co-operation appears to be diminishing in the face of slowing global growth. Does that worry you?

It reflects weakness in demand in the world economy. Another way of putting it is to say most countries in the world could argue that if only the rest of the world was growing normally, they'd be fine – but since it isn't, they aren't. The natural, instinctive reaction is to try every policy measure one can think of. But they haven't thought deeply about how to rebalance their economies – they just want to push their exchange rate down. You can interpret the policy stance of Japan certainly and the ECB over the past year as taking steps needed to lower the exchange rate value of their currency. That is a zero-sum game. In itself, it isn't going to work if every country is trying to lower the value of its currency. That's why it's so difficult to get out of this. It is a prisoner's dilemma. It's very hard for any one country to get out of this trap. That's why I talk about a disequilibrium. We need a significant jump or move to a new equilibrium in the world economy. Unless we make those steps, it's going to be very difficult to find a method of boosting world demand.

Are you optimistic there is a way through this?

We should not be pessimistic about the long-run growth rate of the world economy. People in the US talk about demographics and decline in the growth rate of the labour force. But in Britain, it's the opposite. Our labour force and population are rising quite rapidly. The most important thing is productivity, not demographics. Productivity growth has been very weak for eight years. That isn't so surprising, given what happened in the financial crisis and the enormous uncertainty that's continued since. Why was investment so weak? Because hiring people is a flexible way to respond to movements in demand for products, whereas capital investment is a fixed cost. As uncertainty rises, inevitably you decide to meet increased demand today by hiring people, rather than putting in place more capital equipment because you can always get rid of the people tomorrow if demand turns out not to be so big. The enormous increase in uncertainty is, at least, in part responsible for a shift in favour of hiring more labour and less investment in capital, and that would itself account for some slowing in the measured rate of growth in productivity.

There are many other things going on. But I don't see why the growth rate of innovation, ideas, new products and new processes is going to be lower in the future than it was in the past. Some people argue that the big ideas we had in the past 150 years aren't going to be repeated. I see absolutely no reason to believe that because we live in a golden age of scientific discovery and technical discovery. All the people I know who work in those fields are genuinely very excited about the prospect of all the scientific discoveries that are being made now. We can't anticipate what that will mean – the same as it was 50 years ago. Exactly 50 years ago, I went to university as an undergraduate. I remember being excited reading in a newspaper that Cambridge University had a computer – one computer, less powerful than any mobile phone today. People were doing research into building a model of the economy. I don't think I could have imagined – and I don't think many other people did – that in the future we'd all be walking around with a device in our pocket more powerful than that computer used by the whole of Cambridge University and all those Nobel prize-winning scientists. Things have been transformed, and they'll go on being transformed in ways that we can't imagine today.

Given that, we've also got a level of demand and output that is clearly below where we would have been had we not had the crisis, we can make that lost output up, but it may take 20 years for all I know. It's impossible to forecast. But that gap can be made up – plus the fact that we can return to growth rates of productivity at least as high as the ones we've seen in the past. That's a tremendously positive outlook, because if we can deal with these immediate problems of slow growth and rebalance our economy and put monetary policy back onto a more normal path with real interest rates closer to the historic average, then we could experience an above-trend growth rate with low inflation for some time. We wouldn't just have a nice decade, but a couple of nice decades. That's within our grasp, provided we can find a way to get our economies to move together to rebalance the world economy. That's achievable, but it may require a greater degree of co-operation. I would like to see the IMF put that as the main focus of its work.

Do you think the IMF is in a stronger position now US Congress has passed the shareholder reforms? Or is more effort needed?

The US administration was always in favour of reform and change, but it couldn't get Congress to agree. It was a very peculiar position for the US Congress to take – essentially a blocking power to what was a pretty minor reform of governance of the IMF. It threatened to damage the IMF, but Congress finally passed the reforms. There's obviously a lot more to be done. The whole idea of a full-time executive board is totally outdated. It was introduced at a time when the only way you could get to Washington, DC, from around the world was by ship. People would sail across, so you had to be there for a long time. So having full-time executive directors representing constituencies or currencies made more sense. That's not true now. People can fly in and fly out, and deputies can go there for a top-level board meeting having just conferred with their finance minister at home. One way of making the fund much more effective and responsive to change would be to get rid of the full-time executive board and replace it by a proper board. In fact, the International Monetary and Financial Committee could itself become the proper board. It could easily meet five or six times a year, twice in the spring and the autumn, with finance ministers present as they are now, and then two or three times a year, with their deputies flying in for a day or two to represent their countries. That would be wholly manageable and a lot more streamlined than now. The idea of having a board of executives in perpetual session is bound to end up with a very sluggish, bureaucratic organisation. Both the ECB and the IMF have been very successful in attracting extremely bright, talented people from around Europe and the world to come to work for them. This is not an organisation where you'd be worried that the staff could not do great things. What you do not want is for bureaucratic constraints on the fund to hold it back. The managing director has got more than enough to do without spending a lot of time each week chairing the board.


If there are problems, it's not the result of poor performance by the ECB, but the ECB now feels that change has to come. President Mario Draghi is talking about the increasing urgency of the need to create, for example, a euro area-wide Treasury and finance minister. This is a pretty extreme measure

Is this inhibiting its work in Europe?

I worry that the stance that's been taken towards countries in Europe has been far too close to the EU orthodoxy. It's obviously departed from it now in the case of Greece, but the fund got much too close to supporting a political project in Europe. Its role is not to be political. The only way it's going to be effective is by providing useful, helpful, technocratic advice better to enable politicians to achieve their objectives and to get them to realise and understand that a degree of co-operation will make everyone better off. That has to be the essence of what the IMF does.


Can the IMF hold China to task?

In the end, the success or failure will depend on the quality of the private contact between the fund and the government. It's this persuasive, advisory role that should take place out of the limelight. That's the real test of whether it works or not. The picture that everyone refers to is obviously [former IMF managing director] Michel Camdessus standing over Indonesian president Suharto. "Sign here" was the sort of caption. That was a mistake. It was done in public. You should never be quite as overt as that. There is this temptation to be seen to play a big role on the world stage, but the success of the IMF is based on the quality of its staff. That is not something that's best portrayed on the world stage publicly. What you want is for countries to say: "These guys are incredibly smart. Let's get them in to help us." Then it's most important for the IMF to realise that the credit should go to the countries themselves. They should persuade the country that the IMF is right, but should then let the country take the credit for it.

When did some of these ideas dawn on you?

The idea that there was a serious imbalance between spending and saving is something I was concerned about in the late 1990s. I gave a speech in 2000 that was all about imbalances and the risk that if we did not correct the imbalance there would be a bigger downward jolt to spending and output down the road. I came back to it in 2003 – the 'nice decade' speech. The point was to say it isn't going to be nice in the future because this is unsustainable. Those things I've been thinking about for a very long time.

The issues about the banking system I thought about during the crisis when we were dealing with it. In late 2007 through to 2008, the BoE was leading the argument for saying this isn't just a liquidity problem. The banks will have to be recapitalised. The leverage ratios are too high. Liquidity problems are rising because people now realise how fragile the system is. We have too small a level of equity capital to absorb losses. The problems of the LOLR role only came later. We were so wrapped up in dealing with the immediate problems that it was quite difficult to sit back and view the whole thing. When I was chairing the meetings in Basel, that gave me another insight into the difficulty of changing policy through collaboration and also the challenges to regulation and the problems with the current approach to liquidity. Out of all that came the idea of a pawnbroker for all seasons.

But it was only after I left the bank that I had time to research adequately the ramifications of what happened in earlier episodes, such as 1914. I had looked at such episodes quite a bit before through the financial history dining group I started in 2003 and kept going for 10 years in my term as governor – we met twice a year. A lot of those episodes of financial history turned out to be very illuminating when it came to the crisis. That was a really important aspect. I beefed up the role of financial history and the induction programme in the Bank of England.

Central banks are being given a raft of macro-prudential tools to help them to guard against future crisis. Is it a good idea?

There are a few risks. One is that people again get carried away by the fact there are new policy instruments that may be viewed as effective in this desperate search for something to use. Macro-prudential tools are in some ways simply sector-specific interest rates. If you impose a quantitative restriction on lending, then that's equivalent to, say, the effective interest rate on this kind of lending being much higher. I do not know if we want central banks to get involved in the allocation of credit. Even from a purely economic point of view, do you really know enough to go down that route? Many of the concerns people had about the housing market were either the result of problems on the supply side or the problem of very low interest rates. If there is a real problem in the housing market in the UK, it's on the supply side. Why do we therefore feel we can answer that by constraining demand? The other aspect of it is that people sometimes use macro-prudential instruments to complement existing regulatory tools. I am nervous that this increases complexity – complexity has not served us well in regulation.

My third comment is that it is very important for central banks to realise the success behind the growth of independent central banks was based on a clear but limited set of objectives for which central banks could be held accountable. After the experience of high inflation in the 1970s and 1980s, societies decided they wanted to delegate powers to a central bank because they were very keen that central banks stopped inflation going up. Politicians had failed to do it. If central banks become too involved in decisions that affect one part of the economy rather than another, or actions that are very like fiscal policy, then those decisions ought to be taken by politicians. Otherwise there is the risk is that politicians will say: "We're going to have some control over the central bank."

Is this an immediate threat of the politicisation of central banks?

I don't think it's an immediate threat, but there is a risk. The best example is the ECB. The proposal for outright monetary transactions is a transfer from countries that can borrow cheaply to countries that can't borrow cheaply. There's no point dressing it up with fancy language such as measures to improve the transmission mechanism of monetary policy. It's a straight transfer from countries that have credibility in their ability to run their public finances to countries that don't. From that perspective, it clearly violates the no bail-out clause of the European Treaty, and it runs completely counter to this vision of the monetary union. The German monetary economists say if you go behind people's backs to create a transfer union, you are undermining democratic legitimacy in the institution of the monetary union. Therefore, you need to go back to a system in which each country has to be responsible for its own debt. Only in that way can one proceed. Maybe in the future we will create a political union, but it's madness to try to rush it without strong democratic support. It's immensely attractive to the political class who feel they know better than others what the right thing to do is to try to do it by the back door. But it is a dangerous thing to do.

When it dawns on a senior policy-maker such as yourself when you were governor of the BoE that there are major problems that need to be addressed, how do you set about making changes while also being careful not to undermine the institution you are leading?

It is very difficult. We discussed this at the BIS. The problem was always that what had to be done to correct the imbalances – and not just the imbalances between countries, but within countries – was not something central banks alone could deal with. Even if we sat around the table and said: "OK, we're going to do it together," we had no remit to do it together. It required co-operation between governments. That's why the IMF was so important, because the IMF was the one body that did span both governments and central banks.

When meeting at, say, Basel, central banks were very reluctant to be seen to be taking the lead on international co-operation. This was something they felt should be left to their government. But the BIS is a very good vehicle for having discussions across countries. When I chaired the Global Economy Meeting, we had 95% of the world economy in quite a small room around one table. No other institution has such a small table around which such a large fraction of GDP in the world was focused. The people there were "merely" central bankers, and they didn't have responsibility for the instruments of policy that would be necessary to achieve the objective. It would have been better if there had been more discussion about the fall in long-term real rates and why it could not continue – even if the solution was elsewhere, we were going to feel the repercussions of it. I was frustrated at times that we couldn't get more collective discussion about how serious these problems were.

Why wouldn't people act to address the imbalances?

There was a view that held for much of the post-war period – but was not true – that, as these imbalances built up, the best thing a country could do to help the world was to run its own economy sensibly and keep inflation in line with the target. That's not true because of the prisoner's dilemma. If you're in a position where for some reason or another you've got long-term real interest rates out of sync with any plausible long-run equilibrium, and then you ask the question: if each country does the best thing in its own interests, what happens? The answer is everyone does what suits themselves, and everyone is worse off. You need to get to a new equilibrium first. We have never managed to make that step.

Who is in a position to lead efforts to restore balance in the global economy?

Leadership needs to be at the IMF. The BIS could do it. The trouble with the BIS now is that they have a very well-defined view. That's a good thing in some ways, but they haven't got the full analysis, in my view. Their policy recommendations tend to be that central banks should raise interest rates, as low interest rates are very costly. Of course, you can argue that low interest rates are very costly without thinking the right step to get out of this trap is just to raise interest rates. That may make things worse. If you do other things to enable the big economies to rebalance, then it will be natural for central banks to raise interest rates, and then you lose the costs of the low interest rates. It's the question of the sequencing of policies to get out of this mess to a new equilibrium.

The IMF really needs to focus its work on private communication. Come in and say to governments: "Look, we think this is going really badly wrong. Don't worry, we're not going to make all this public. What we need you to do is to recognise that if we can get some other countries on board for making changes, are you up for doing it too? You must work out the details of what you think is needed in your economy – but you've got to take steps that will not just temporarily boost demand or lower the exchange rate, but restructure the balance of spending and output in your economy. That's what you've got to do in the long run. There's no other alternative to getting to a point where we can all grow sustainability. We're not going to ask you to be the first to go, but we're trying to put together a coalition that is willing and see if we can't get agreement to do it. Then we'll bring you all together." Trying to make that point really clearly, but without grandstanding, is the key.

This interview took place on June 29, before the UK's new prime minister, Theresa May, was appointed.

Images: Juno Snowdon

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