How did the Bank of England get it so wrong? This is the question being asked by the current favourites to become prime minister and chancellor of the Exchequer, Liz Truss and Kwasi Kwarteng. On the face of it, it seems a reasonable thing to ask: inflation was identified as a growing issue last summer, and by that September it was high enough to trigger an exchange of letters between the Bank’s governor, Andrew Bailey, and Rishi Sunak, who was then the chancellor. Yet it took until December for interest rates to be raised at all, and another six months before they crept back over 1 per cent.
It’s not as if anyone kept this a secret from Truss and Kwarteng, however. They both sat in the front rows at the Conservative Party conference in Manchester in October and applauded Boris Johnson as he announced that wages were rising faster than before the pandemic while unemployment headed towards record lows. Nor is it possible they didn’t understand that these very clear indicators of a tight labour market would contribute to inflation; Kwarteng himself gave a radio interview the following week in which he explicitly commended the Bank’s caution on interest rates and committed to keeping the labour market tight with a “focus on higher wages”.
Kwarteng has revised his opinion. “The Bank’s job is to deal with inflation… Clearly something has gone wrong. Rates should have gone up sooner,” he told Sky News this month.
This is a wilful misunderstanding of both the current period of inflation and the job of the Bank of England. The Bank’s economists and rate-setters have not just a mandate to control inflation, but to control – or “anchor” – where people expect inflation to go. For inflation expectations to be “anchored” means that when prices rise slightly, it is not seen as a systemic shift in the economy and people do not immediately start charging double at the till or demanding pay rises. What economists and rate-setters dread are “unanchored” inflation expectations: if no one knows what to charge for anything, prices start shooting up all over the place and there is little anyone can do about it.
The importance of psychology in controlling inflation means that it is in fact the job of the Bank of England to be the very last institution to start worrying (in public, at least) about inflation. Like a pilot in rough weather, its leaders need to project unruffled competence or the passengers will start fighting each other for parachutes.
Truss and Kwarteng are also pretending to think that double-digit inflation has somehow sprung up, presumably because someone forgot to shut off a big valve in the Bank’s basement. In fact the big valve, if it can be said to exist, is in the Russian city of Vyborg, where the Nord Stream 1 pipeline enters the Baltic Sea on its way to Germany, and only one person – Vladimir Putin – can decide if the price of gas in Europe (and therefore inflation in an excessively gas-dependent Britain) rises or falls. Short of mustering the Bank’s economists into a hardened military unit and going after Putin personally – a plan with mixed chances of success – there is little that Bailey can do about this.
In fact, almost the only two people who can change the extent to which “exogenous” inflation caused by geopolitics impacts Britain and its economy are the Foreign Secretary, Liz Truss, and the Business Secretary, Kwasi Kwarteng.
But Truss and Kwarteng are not just pretending to misunderstand inflation because they don’t want to be blamed for the steep decline in living standards that it is causing. It is worse that that: they see this as a political opportunity.
Many in the Conservative Party, and especially in its powerful libertarian factions, see Britain as still held back by the kind of namby-pamby regulation we left the EU to escape. This is a party that has had more than enough of experts – Truss does not even want to see the economic forecasts offered by her own fiscal regulator, the Office of Budget Responsibility, before she produces an emergency budget next month – and it does not want them running the economy.
Truss has said that if she wins the Conservative leadership contest she will “look again” at the Bank’s mandate, and therefore its independence, which was given to it 25 years ago by Gordon Brown in an attempt to depoliticise monetary policy. As the new leader of a party committed to making every economic decision for political gain, it would be logical for Truss to seize the power to set interest rates in favour of Conservative voters rather than the wider country.
Truss has also said that she plans to merge the two financial regulators that were established in the wake of the 2008 crash, the Financial Conduct Authority and the Prudential Regulation Authority (which is part of the Bank of England), and to rewrite financial regulations such as Solvency II, which sets capital requirements in insurance companies to protect policyholders, and Mifid II, which sets requirements for disclosure and transparency in financial instruments. Together these plans amount to a promise to remove the guard rails that were put up during the last financial crisis, just as a fresh financial crisis arrives.
Why would anyone introduce this much risk into Britain’s economy at such a dangerous time? We could perhaps ask William H McGlothlin, if he hadn’t died in a mountaineering accident in 1980.
In 1956 McGlothlin, a psychologist at the Rand Corporation, an American think tank, collected three years of back-issues of the Daily Racing Form Chart Book. He compared the odds and bets placed at ten racetracks in New York and California, and found that in the eighth and final race of each day, long odds (horses with little chance of winning) became much more popular. The data provided a conclusion any schmuck in the stands could have told him: no one takes a safe bet at the end of the day.
A few decades later behavioural economics would arrive to explain why people bet more at the end of the day. Our brains act in the context of previous decisions, so the most common response to a losing bet is not to make the rational decision to stop gambling, but to attempt to redress the balance by trying again. By the end of the day, most gamblers will have racked up enough losses that only a long-odds bet will help them to break even (which of course it almost never does).
Such risk-seeking can be found in many situations in which it’s the worst option: tired drivers are more likely to speed, for example. And it may be that a party that has been in power for a long time finds itself seeking more risk as it grows ever more unpopular and its more percipient members seek employment elsewhere. This could be said to apply to today’s Conservative Party: behind in the polls, drained of talent and ideas, our government is now approaching the biggest economic crisis for a generation with the air of a gambler who, rather than saving the last of their money, bets the lot on one last go at the get-out stakes.
[See also: Can Liz Truss’s tax cuts save the economy?]