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Danny Blanchflower: Not Out of The Woods Yet

Danny Blanchflower, the renegade former member of the Bank of England’s Monetary Policy Committee, made some powerful points in his presentation at the Association of Investment Companies annual conference for investment trust directors yesterday. This included more details on his differences and eventual showdown with Mervyn King, the Governor of the Bank, and other members of the MPC as the global financial crisis deepened in 2008. He thinks the threat of a double dip recession and even a debt “death spiral” remains very real.

As a labour economist, Mr Blanchflower has little time for what he sees as the flawed monetarist polices pursued by the  Bank, which he believes were overly theoretical and led directly to the Bank’s failure to anticipate the recession or cut interest rates quickly enough as the financial crisis unfolded. His analysis is pretty damning, and I believe well supported by the evidence.

Inflation targeting, the key plank in the Bank’s policy, is an inadequate tool in times like the one we have just lived through. The feeble policy of doing nothing to spike the development of asset price bubbles, originated by Alan Greenspan, and faithfully followed by the Bank of England,  has had disastrous consequences with which we will all be living for years to come.

Here are three of the key slides that Mr Blanchflower deployed yesterday.

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The Bank’s reliance on outdated economic models that don’t work was perfectly illustrated in its June 2008 Inflation Report, just weeks before the Lehman Brothers collapse, which did not even mention the word recession and assigned a very low probability to the prospect of negative growth in 2009 (the left hand chart above). Mr Blanchflower’s arguments for more aggressive interest rate cuts fell repeatedly on deaf ears.

Compare that with the outcome (right hand chart above), with GDP falling by 6% peak to trough. Mr Blanchflower quotes J.K.Galbraith approvingly to this effect; “The only function of modern economic forecasting is to make astrology look good”. Two key reasons for the Bank’s failure are (1) that its models exclude the financial sector from its GDP forecasts and (2) they make no attempt to forecast interest rates, but merely take the interest rates implicit in market prices. Garbage in, garbage out, in other words.

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The Bank’s latest forecasts continue to take market interest rate assumptions and presume the continuation of Quantitative Easing. On this basis they assign a 0% probability to GDP being negative in either 2010 or 2011 and a minimal probability that it will be negative in the years beyond. Its central forecast (most likely outcome) is for growth of between 3% and 4% over the next two years. Mr Blanchflower described the assumption of certain positive growth over the next as “incredible”.

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His main objection to this assumption is that this kind of recovery has never happened in the past. In the United Kingdom in the 1930s it took four years for output to recover. The current slump, which has been almost as deep, is assumed to bounce back much more quickly, and without a double dip. What we are facing, in his view, is a “one in a hundred years event”. It is extremely dangerous to declare that victory has already been won. He expects QE to continue and for interest rates to remain at around 1% for five years.

He has a striking quote from Keynes, writing in 1931. “The duration of the slump may be much more prolonged than most people are expecting and much will be changed both in our ideas and in our methods before we emerge. Not, of course, the duration of the acute phase of the slump, but that of the long, dragging conditions of semi-slump, or at least sub-normal prosperity, which may be expected to succeed the acute phase”.

You can read a fuller account of his turbulent three years on the Monetary Policy Committee in the New Statesman, for whom he now writes a regular economics column. My view remains that his gloomy fears about future prospects will turn out to be overdone, and he is certainly no expert (nor I suspect would claim to be) on the non-linear relationship between economics and financial market behaviour. In keeping with thinking on the Left, his view is that public spending alone can keep the recovery going until or unless the private sector revives.

That is a contentious conclusion. But nobody should doubt that real risks remain, and his track record in identifying one of the major contributory causes of the crisis makes his views well worth studying.  His conclusions in any event about the Bank’s reliance on unreliable macro-economic models are undoubtedly well-founded.

Written by Jonathan Davis

April 21, 2010 at 4:17 PM