Robert Pringle's Viewpoint: King’s efforts to be heard hit some marks

The cohort of G-7 central bank governors that has recently left office or shortly will do are able and honourable men who have battled hard against the financial storm. They leave to mixed reviews.

It wasn't supposed to be like this. When Jean-Claude Trichet, Mervyn King, Ben Bernanke and Masaaki Shirakawa took the top jobs at the European Central Bank (ECB), Bank of England, Federal Reserve and Bank of Japan respectively (in 2003 for Trichet and King, 2006 for Bernanke and 2008 for Shirakawa), the coming storm was no more than a distant rumble on the horizon. Inflation was under control, and though deflation remained a problem in Japan, the central bank expected even as late as April 2008 that the economy would escape the worst of the financial crisis then breaking in the US and Europe, and achieve steady growth near its potential growth rate.

Central bankers had clear mandates and were confident they had the tools needed to fulfil them. There were controversial issues, of course – should central banks adopt explicit, numerical inflation targets, over what time period should they aim to achieve them and, above all, should the asset bubbles emerging during 2003–06 be pricked or left to burst? In practice, they accepted the so-called ‘Greenspan doctrine' that it was better to ‘clean than lean' – that is, clean up after a bubble rather than face all the risks (and inevitable political and media hostility) associated with taking away the punchbowl before the party got going.

It is a rewriting of history to claim central banks were instructed to focus only on price stability. In fact, the Fed had clear responsibilities for supervision, the Bank of England was charged with overseeing systemic financial stability and issued a quarterly report scrutinising the risks, and the European Central Bank had to be concerned with any financial market development that might hamper the transmission of monetary policy. It is also incorrect to say there were no warnings of impending trouble – even setting aside the professional doom-mongers. King warned that times would get tougher. Still, in the main, the central bank governors sailed their craft into the eye of the storm with smiles on their faces.

Critics say the top central bankers were complacent; that they should have raised interest rates sharply when real estate prices started rising quickly and that they should have shown more interest in the behaviour of participants in financial markets – including, it now appears, some criminal behaviour. They are also charged with failing to shout sufficiently loudly about the way financial innovation was piling new layers of leverage and risk on an undercapitalised banking system. Many central bankers would agree. Yet their mindsets and models did not predispose them to do this, still less to take drastic action to stop the bubble when inflation itself was so well behaved. And what use would small interest rate rises have been anyway?

Given the models they were using – price stability under flexible exchange rates – it is hard even with the benefit of hindsight to conclude with a ‘guilty' verdict. The charges against them are what Scottish law calls ‘not proven'. Success of the regime encouraged the build-up of risks. Only draconian controls – and all-wise regulators – could have prevented a bubble.

Then along came the crisis itself and the threat to the world's financial system. The media has decided that the central banks had a ‘good crisis'. I take a different view – mistakes were made in the management of the crisis by governments and by some central banks.

But what I want to discuss in this column is policy and the broader lessons to be learnt for banking, monetary policy and international finance. And here I shall focus on the views of the outgoing Bank of England governor, as he will be the next of the top echelon of central bankers to hang up his boots, to be succeeded by Mark Carney on July 1.

The central banks appear to have saved the world banking system, but it is badly damaged and may never fully recover. Even if governments manage to recoup the direct costs of the bank rescues, guarantees and recapitalisations, public finances have been so weakened by recession that several governments cannot ‘stand behind' their banks in future without putting their sovereign credit at risk. At least their willingness and ability to do that is now in doubt – and confidence is of the essence. The contingent liabilities are too large – not just in the eurozone but in Japan and the UK also. Yet if we can no longer afford the kind of banking system we have, a new model will have to be developed.

King's speeches

This is where King has made his most original contribution. In a series of remarkable speeches he has set out with crystal clarity why the UK banking system is dysfunctional (and his comments apply to other banking systems). He played a major role in pressing for the setting up of the Vickers Commission, which has placed bank reform clearly on the political agenda. He has done this despite being met with determined behind-the-scenes resistance from the UK's coalition government. The Daily Mail revealed last month that George Osborne, the UK chancellor, met top bankers at 11 Downing Street almost 50 times in the two years after the coalition came to power. This included 44 one-on-one discussions and four meetings between the chancellor and a small group of bank executives. By contrast, the man responsible for policing the banks – Financial Services Authority chairman Lord Turner – had solo meetings with the chancellor on just four occasions in the same period – and between 2010 and 2012, the chancellor received just eight visits from British manufacturers.

King has ploughed a lonely furrow. But it is paying off. The political pressure in favour of reform keeps building – note how the Labour opposition has changed its views on the need for bank reform and the attention paid to the work of the Parliamentary Committee on Banking Standards.

Where none of the bank governors has quite come clean is in acknowledging the deep faults in their monetary policy models. These models led them into a blind alley before the crisis and into mistaken policies since then. Central bankers have done their best to make the flawed model work. What they don't see is that it is too intimately implicated in the global financial crisis for it ever to be a reliable guide to policy again.

Right now, central bankers are aware their policies of further quantitative easing are building up possibly lethal risks. They admit they are ‘flying blind'. Yet they carry on. I am sorry to see King voting for even more stimulus. True, the major central banks have the support of most academics – and the City of London loves quantitative easing! But what central bankers and academics fail to recognise is that ‘MP plus' (monetary policy plus) is a fundamentally different regime from proper inflation targeting. MP plus encourages activist monetary policies. It replaces a rule with discretion. It says: "Goodbye, Friedman, welcome back Keynes." Central bankers suffer from the illusion that keeping an inflation target as an ultimate ‘governor' or ‘control' means they still have a monetary rule. They should be honest with people and admit they are asking us to trust them to use their discretion wisely.

The basic question is whether globalised financial markets are consistent with national, inward-looking, inflation targeting under floating exchange rates. I don't believe they are. But King takes a different view. He has quite rightly connected the financial crisis to faults in the international monetary system. He has drawn the most important lesson of all – that the global financial system itself has to be the object of analysis and of treatment. He knows that no country can find a way out of this impasse – described in my book The Money Trap – on its own.