The risk of a long-lasting economic depression is not over. There have been some positive signs recently, and the worst may be behind us - but we should not get too carried away. Retail sales have risen a little and there are some positive signals from the housing market. There was even some evidence of positive GDP growth in France and Germany. Nonetheless, in the United Kingdom, money supply growth remains weak, banks are still not lending and mortgages are hard to come by. The latest surveys for construction and manufacturing still show contraction. Negative equity is on the rise, as are mortgage defaults. Unemployment is climbing fast and a million jobless young people under the age of 25 are in danger of becoming a lost generation.
One year on from the financial crash and the ensuing recession, the question remains: how did we get into this mess in the first place? In my view, and as I have consistently argued over the past two years, the economy would have been in much better shape today had the Bank of England's Monetary Policy Committee (MPC) - on which I sat as an external member for three years until 31 May - not kept interest rates so high, especially from the beginning of 2008. House prices had peaked by the end of 2007 and business and consumer confidence surveys had collapsed. By the second quarter of 2008, based on both output and employment, the UK economy had moved into recession. But my colleagues on the MPC did not join me in voting for rate cuts until October 2008.
So why did the committee get it so wrong? From my perspective, it was hobbled by "group think" - or the "tyranny of the consensus". Governor Mervyn King, the old iron fist of the Bank of England, with his hawkish views on rates, dominated the MPC. Short shrift was given to alternative, dovish views such as mine. I focused on the empirical data suggesting Britain was heading for recession; Mervyn and the rest of the committee focused on their theoretical models and the (invisible) threat of inflation. In fact, the Bank of England may more suitably be called "the Bank of Economic Theory". Unfortunately, the economic theories failed just when we needed them most.
Throughout this crisis the MPC needed the advice of experienced bankers, lawyers, businessmen and market-watchers. Unfortunately, practical folk who knew how to spot and cope with banking crises were in short supply at the Bank of England. There were too few regulators on the staff. Instead, the Bank was stocked full of mathematical modellers who had never seen the inside of a commercial bank or a hedge fund - and the models they used failed to pick up on the greatest financial crisis in a century. Yet, in my view, it was clear from roughly six months before the Lehman's crash in September 2008 that a financial tsunami was heading our way from the United States.
Clever as Mervyn King may be, he missed the crash and the subsequent recession, and hence, so did the consensual MPC on which I sat. In August 2008, the MPC's quarterly Inflation Report did not even contain the word "recession"; it saw the economy standing still over the next year. I very nearly quit the committee at that point. In an interview that month with Reuters, I called the forecast "wishful thinking". Mervyn called me into his office to admonish me for that one.
My former colleagues on the MPC have clung to the narrative that it was the collapse of Lehman Brothers which changed everything and that, once the financial crisis had begun, the MPC responded rapidly to events. This argument ignores certain facts: that the UK had been in recession since April 2008, that unemployment had risen by 164,000 in the three months to August, and that house prices had been falling since the end of 2007. In addition, the United States had been in recession for nine months.
Next the claim was made that if we had cut interest rates earlier, it would not have made any difference. The implied logic of this strange argument is that there is no point in having an independent central bank - or that nobody could have seen the recession coming. Wrong.
Throughout much of the crisis, the four external members of the nine-member MPC were not kept well-informed. From my own base at Dartmouth College, in the US, I had to find out what was happening to the UK economy from the newspapers and the internet. The external members were briefed after the fact only, and after we complained. In the eyes of the Bank, it seems, it was none of our business. We were not told what was happening to British banks such as Northern Rock, Royal Bank of Scotland, Lloyds, Bradford & Bingley or Alliance & Leicester. Or to US banks such as Lehman Brothers or Bear Stearns. We weren't kept in the loop, but we should have been. With hindsight, Mervyn King's focus on moral hazard - the idea that banks are encouraged to take more risks because they know they will be bailed out - was a huge mistake. I sat across the pond watching in astonishment as Northern Rock failed in September 2007 - and I didn't even get a phone call.
In fact, it was in late 2007 that I became convinced there was much more slack in the economy than others on the MPC believed. Starting that October, at monthly meetings of the committee, I started voting for rate cuts, something that continued through every meeting in 2008. The collapse of Northern Rock had shocked me, and in January 2008, I warned in a Guardian interview that my MPC colleagues were "fiddling while Rome burns".
In the summer of 2008, I warned the Commons Treasury select committee that "something horrible" was going to happen. I was becoming even more worried about recession, and in September I voted alone, as ever, for a cut of 50 basis points (bps) - or 0.5 per cent - to the Bank's base rate. At my September appearance before the select committee, King, who was sitting two seats from me at the time, was asked by the MP Andy Love: "On unemployment there have been some suggestions, and Mr Blanchflower has said - and I think there are quite a lot of people out there who would agree with them - that it may go up faster than the projections in the Inflation Report. Is that a worry to you?"King replied: "At least the Almighty has not vouchsafed to me the path of unemployment data over the next year. He may have done to Danny, but he has not done to me." To say the least, I was rather surprised.
On 15 September 2008, Lehman Brothers collapsed. The following month, on 8 October, we made a co-ordinated rate cut of 50bps at a special meeting of the MPC, along with the Bank of Canada, the European Central Bank, the US Federal Reserve, Sveriges Riksbank, the Swiss National Bank and the Bank of Japan. I went along with the cut of 50bps and voted for it together with everyone else. I wanted more and to this day believe we would have been able to have had an even bigger rate cut, had there not been any international co-ordination.
I then started a campaign to get rates down further by talking to various British business leaders, journalists and pressure groups. By the end of October, there was growing pressure from the media that rates needed to be cut again. I gave a speech at the University of Kent on 29 October 2008 in which I said: "My view remains that interest rates do need to come down significantly - and quickly. If rates are not cut aggressively we do face the prospect of a relatively deep and long-lasting recession." My view was bolstered the very next day when the influential commentator Martin Wolf wrote in the Financial Times: "Professor Blanchflower has voted for a cut on every occasion since October 2007. In retrospect, he was right to push strongly in this direction, usually against majority opinion on the MPC. His views on the economy deserve respect now."
A few days later, Professor Tim Besley of the London School of Economics, one of the more hawkish members of the MPC, who had beenadamantly opposed to rate cuts in previous months and had even voted for a rate hike as recently as August 2008, came to see me to say that he realised he had been wrong and to ask what he could do to help turn things around on the committee. I will always have the greatest respect for the courage Tim showed in doing that. He is an honourable man and a fine economist.
I told him I wanted us to cut rates by 150bps. He agreed and said he would talk with the two other external members of the MPC, Andrew Sentance and Kate Barker. I wanted to persuade them to join in our plan. I said I would go to see the governor and tell him what we wanted. I did that the next day, and thankfully he, too, signed up to the idea and agreed to speak with the other four, internal MPC members. At our rate-setting meeting a few days later, on 6 November, we were unanimous in voting for 150bps.
The markets were hugely surprised at the size of the cut. I remember pumping the air with my fist on the way back to my office after the meeting. It was an exciting day and I felt vindicated. We lowered rates by a further 100bps in December and by an additional 50bps at each one of the January, February and March meetings of 2009, bringing the base rate to its current record low of 0.5 per cent.
In March this year the Bank of England announced its plan to begin quantitative easing (QE) - pumping money directly into the economy by buying up assets from financial institutions in order to prevent deflation and kick-start lending. It is a move I strongly supported, and the big news from the Bank of England since my own departure in May has been the MPC's vote on 6 August in favour of increasing the level of quantitative easing by a further £50bn to £175bn. Most commentators had expected no increase at all. The markets were in for a further surprise a fortnight later when the minutes of the August meeting were published and it was revealed that three members - the governor, Mervyn King, Professor Besley and my own replacement on the MPC, Professor David Miles - had voted unsuccessfully for a further £25bn of QE, on top of the £50bn agreed. I have since referred to them as the "courageous three". Their argument was that "insufficiently stimulatory monetary policy would cause inflation to remain below the target for a sustained period of time, depressing inflation expectations, and might harm public confidence in the recovery, causing it to falter".
That seems right.
So, for me, the biggest problem has been to understand why it was that the other, "feeble six" - Kate Barker, Charles Bean, Spencer Dale, Paul Fisher, Andrew Sentance and Paul Tucker - voted the other way. In the latest Inflation Report, published on 15 August, the MPC forecast that, at market rates, inflation would remain below the target of 2 per cent set for it by the Chancellor, even with the quantitative easing of £175bn. If interest rates were to remain constant at 0.5 per cent for all of the next two years, eventually, in 2011, inflation would reach 2.1 per cent. Yet if they were to follow what the market expects, inflation will never get as high as 2 per cent.
The feeble six argued that "the most immediate downside risks to the economy seemed to have receded . . . The substantial injections of liquidity into the economy might result in unwarranted increases in some asset prices that could prove costly to rectify or in inflation expectations moving upwards. Moreover, if the asset purchases proved to be more effective than anticipated, an early withdrawal of some of the monetary stimulus might prompt a sharp rise in market interest rates that was unwarranted by the economic outlook." Notice the "if" and the "mights". QE can always be reversed. The only way they could be right is if either the yield curve comes down a lot or the economy leaps into a growth phase, or both. I hope they are right, but I suspect that, as usual, they are not. The danger is that if they are wrong they will simply make the recession worse and kill off any chances of a recovery. They missed it on the way down, so why should we trust them on the way up? This is "fingers crossed" policymaking.
In recent months, however, there has been a sudden transformation at the top of the Bank of England. Mervyn King's support for a bigger boost to QE shows he now understands what has to be done to tackle this crisis. This makes a pleasant change for me, as I have spent the past three years criticising his decisions.
He and I differed on most things, but we always disagreed politely and calmly, and never once argued with raised voices. That is how the MPC does things. By the time I left the committee in the spring of this year, our opinions had converged on where the UK economy was heading and the risks it continued to face. The economic death spiral seems to have been avoided, but banks are not lending and the withdrawal of the secondary and foreign lenders is a big problem. The recovery remains fragile.
It should be said that this is not the first time King has been in the minority and subsequently proved to be right. He learns fast and is capable of changing his position quickly when necessary. Others on the MPC are more plodding. One has only to think back to the 25bps rate cut in August 2005 which, with hindsight, surely fuelled the surge in house prices. King voted against; other members of the MPC, such as Barker and Bean, were on the wrong side of that vote, too. What happens now? Unless some very strong data is released soon, in my view, King cannot, and will not, continue to vote in the minority for very long, as his credibility with the markets would be threatened. Changing his vote to "no change" on QE would be a sign of weakness - but, thankfully, voting against him will not be easy either.
My bet is that he will get his way and the MPC will approve further quantitative easing by November at the very latest. He may even manage to get rates down below 0.5 per cent. He obviously now understands how serious is the economic situation facing the country. He deserves our respect for that. Perhaps his power has lessened just when we need him to assert it. My worry is that most of the other MPC members are not on board. Time for a rethink? It is certainly the moment for Mervyn to show leadership and rap a few knuckles for the good of us all.
David ("Danny") Blanchflower is professor of economics at Dartmouth College, New Hampshire, and is the co-author, with Andrew Oswald, of the prize-winning "Wage Curve" (MIT Press). His NS weekly column on economics starts in our issue of 28 September