Donald Kohn and Martin Wolf.

Q75 The Chair: Good afternoon and welcome to this hearing of the Economic Affairs Committee. I am delighted to be joined by two great authorities on central bank independence. Donald Kohn is joining us virtually and Martin Wolf is here in the room. Would you like to introduce yourselves for the record?

Martin Wolf: I am the chief economics commentator of the Financial Times.

Donald Kohn: I was an external member of the Financial Policy Committee for 10 years and, before that, I was the vice-chair of the board of governors of the Federal Reserve through the crisis. I am now at the Brookings Institution.

Q76 The Chair: Thank you both very much for joining us. As a broad scene-setter, we went into some detail in our previous hearings, quite understandably. At times, we also get quite critical of central banks and how they are operating. Taking a bird’s eye view, could you both give us your broad overview of the performance of the Bank of England since it was given independence? If you were speaking to a layman, what would you say to him or her about the benefits or weaknesses as you see them?

Martin Wolf: I think that is a fairly simple question, with one real qualification, in that we do not know the counterfactuals. If we look at what happened before we gave it independence, and after, with the major objective it was given after independence—in essence, price stability as defined in its mandate—it has clearly achieved this overall to a stunning degree, compared to any previous period in the post-war history of this country. It has managed to hit its target in easy times—the nice decade—and in very difficult times. It has done so very successfully compared with its obvious peers.

I did a little work in one column that showed that, prior to the recent upsurge, whose effects we do not yet know, the Bank of England has managed to get closer to its announced target—the Government’s, in this case—than either the ECB or the Fed. We will not even discuss the BoJ. In those terms, it has been really successful. It hit its target very well and has continued to do so despite the financial crisis, when it received many new responsibilities relating to the financial sector.

Obviously we do not know what would have happened in an alternative world in which we did not do this. It would have depended on how the Government operated the system we had then. Of course, the system when it was given independence was very different, because we had adopted inflation targets. Although we had what we called the “Ken and Eddie show” then, it was clear that, as a result of previous disasters, there was an inflation objective. That might have worked fairly well.

In addition, when looking at this, one should remember that the general environment for low inflation globally—we will probably come to this later—was relatively friendly until very recently. How far one attributes its success to its being given operational independence is difficult to assess, because we cannot analyse the counterfactual. Ex post, compared with the preceding period, one cannot define this as anything other than a success in terms of its principal objective.

Donald Kohn: I agree with the thrust of what Martin said. I am not an expert in UK monetary policy, but operational independence and an arm’s-length relationship to the political process are essential for economic and price stability. I think about the experience of the last 10 to 15 years in the United States. In the early 2010s, you had Republican Members of Congress telling the Fed that it needed to tighten up, to stop buying securities and to raise interest rates, when that would have cut off what was already a very slow recovery from the global financial crisis.

Then, just a few years ago, you had Donald Trump leaning heavily on the Fed to cut interest rates. Fortunately, the Fed’s independence allowed it to keep its eye on its legislative objectives and apply the best analysis it could. We may come on later to where that might have slipped in recent years but, overall, the independence of the Federal Reserve and the Bank of England has been essential to the stability of prices and, to a considerable extent, to economic outlook over long stretches.

To reflect a little on the Financial Policy Committee, it is harder to judge where you do not have the feedback mechanism of continuous readings on inflation. The job of the committee is to spot threats to financial stability and to take steps to deal with them. We did a very good job of establishing an intellectual framework for that, looking for tail risks in the system which, if they came true, could have externalities, spillover effects on the economy and the amplification of bad shocks to the economy. We took a lot of steps to make the UK banking system much safer coming out of the global financial crisis, by raising capital requirements and making it less procyclical with a countercyclical capital buffer.

In addition, we took a lot of steps to deal with other kinds of risks, including cyber risks, and with payment systems et cetera. It is hard to judge. As soon as you say you did a good job on financial stability, something will happen that proves you wrong, but the Financial Policy Committee has a good system in place to spot and deal with risks to financial stability.

Q77 Lord Blackwell: I want to pick up on Martin’s reference to the counterfactual. You could argue that there has been a very high correlation between inflation rates in all the G7 countries over the last 20 years. Was that simply a combination of globalisation holding down inflation and a very good job by the Fed, as the dominant monetary authority in the G7, so the Bank of England’s independence is by the way?

Martin Wolf: You could argue that. The way I would put it is that there were various reasons in the background environment. There was also the massive disinflationary shock in the world, which in my view was related to China and certainly facilitated this. But if you try to make a mess of it all on your own, I promise you that you will achieve it. I will not be invidious by referring to the British experience but, in the inflationary 1970s for example, which was when I started as a professional economist, everybody was in inflation, but we managed to have higher inflation than any other significant country by a pretty large measure. That was to do with our own achievements. We got ourselves into quite a mess in the late 1980s, which Germany avoided. There were many cases when we did worse than our peers, which is why we shifted in this direction. I can give you examples of plenty of countries that are making very impressive messes right now, but that would perhaps be invidious.

So, in my view, the background environment helped. The general current of opinion among economists, the people at large and politicians on the cost of inflation in the world was a big help; there is no doubt about it. We were really fed up with it after the final surge in the 1980s, so that helped too. The global conditions helped both directly and indirectly, but I am not confident that if politicians—this is a bipartisan comment, given that both parties have been in power—had really determined to mess it up, they could not have succeeded.

Q78 Lord Turnbull: In looking at the original model, were there any points at which you thought, “They left that out”, or, “They shouldn’t have done that”? Could you have designed it better? In particular, did anyone point out that, in controlling consumer prices, you could let asset prices run wild?

Donald Kohn: It is right that the focus is and was on consumer prices. That is the mandate of both the Federal Reserve and the Monetary Policy Committee of the Bank of England. Consumers do not like inflation; they are hurt by it, and high inflation causes instability and the misallocation of resources. So that is right.

I do think there is an interaction between monetary policy and financial stability, and you are right that the monetary policy that was pursued, of very low interest rates for a very long time, helped to fuel rises in asset prices. The virtue of having a financial policy committee is that you want to address the financial stability risks with a separate set of tools. You want the residents of the United Kingdom to have price stability, but also financial stability, and you need different tools for that. That is why you set up a financial policy committee and give it some things to do to address the potential fallout from monetary policy or from other things that might threaten financial stability.

Q79 Lord Griffiths of Fforestfach: The Bank’s recent performance has not been nearly as successful as in previous years. It predicted that inflation would be transitory through most of not only 2020 but 2021, when some outside economists predicted differently. What do you think went wrong at the Bank?

Martin Wolf: I would argue that I was one of the people who was concerned about this. My first column on this was in May 2020, but that was influenced in fact by a mutual friend, Tim Congdon. I will come to that.

First, it is very important to remember that the Bank of England’s view that high inflation was going to be transitory was shared by essentially all the significant official forecasters—certainly by the Fed, the ECB, the OECD and the IMF. The BoJ is something else, but as far as I know the others shared this belief, and it was understandable, at least through 2020. I will come to 2021 in a minute.

One has to remember that they have been grappling with too-low inflation and the concern that inflation would be persistently too low for a very long time. It had become the normal way of thinking about it. I would not know exactly, and I may be mistaken, but I suspect that there was nobody in the Bank of England in 2020 who had any experience of a relatively high inflation environment. This was the norm and everybody got used to the idea of low for longer—lowflation, as the IMF called it, or whatever it was called.

Then you had a large negative shock—a very complex, novel negative shock—in the pandemic, which launched massive financial instability at the beginning. The Bank had to respond to that and it was right to. They were bound to say to themselves, “That’s a contractionary shock too”. That is perfectly reasonable; people are not going to spend, and they did not because they could not get out.

Of course, we have to understand—and we have to be fair about this, because no one predicted it—that the supply side globally was such a mess. That is very important for a small open economy like ours. There was the effect of the pandemic on supply chains, notably via China and from its continued policy to close its economy, and then the war. I can easily understand why they got it wrong, and I might well have made all the same mistakes.

I think the Bank was imprudent in two ways. It should have decided around that time, fairly early in 2021 when it was clear that vaccinations were going to work, that economies were likely to recover very strongly. They were going to reopen and there was an awful lot of pent-up purchasing power, courtesy of the fiscal and monetary support given in 2020. Therefore, it would be prudent to normalise monetary policy to some degree.

It was more difficult here, because our normal had never even got to US levels, but the Bank did not seem to think that that was a possibility. I believe that it got trapped, although less so here than in the US, by various notions that forced its perspective on monetary policy to be somewhat backward-looking, particularly that history would matter and that you had to make up for history. That was less important here, but it was very important in the US, which changed its whole monetary policy framework. That was very ill timed for this reason.

The reason that matters so much is because it created what was decisive here: a very strong global demand coming out of the recovery. As a small open economy, whatever mistakes we made, this very strong global excess demand, a lot of which clearly came from the US, combined with these supply shocks, created a global inflationary environment to which we would inevitably be vulnerable.

I tend to think the Bank of England could have done better. There is little doubt now that it should have adjusted its policy sooner, but I do not feel that this error was unpardonable. Perhaps I am being too kind.

Q80 Lord Griffiths of Fforestfach: I well remember the summer of 2020. Commodity prices were rising: the price of gold and silver were rising. In the art world, prices were rising. The price of Michael Kors shoes was rising. You could tell that there was something in the air, certainly as somebody who had lived through the 1970s and who had taught monetary economics at the LSE.

In addition, we had a massive increase in public expenditure; it was huge by any post-war comparator. Interest rates were down to virtually zero and people were told to stay at home: “We’ll just give you the money”. In America, they were sent notes through the post and so on. Somehow you feel that the alarm bells should be ringing for a seasoned central banker. The bottom line of my question is: do you think there was a lack of intellectual diversity in the Bank? You mentioned Tim Congdon immediately in your opening remarks.

Martin Wolf: I thought that the Bank should have started normalising in early 2021. Some of those things bother me less than they do you; commodity prices move up and down. But the monetary data were pretty scary, and I wrote about that in early 2020. It is perfectly reasonable to argue that there should at least have been a ferocious debate in early 2021 about normalising monetary policy. From my perspective, that does not seem to have happened in the Bank, or in any of the major central banks, at that stage.

I am inclined to agree—and I was more struck by this recently than I was then—that the MPC, which has the great advantage, in principle, that everybody should be voting for him or herself, seemed to be all in lockstep for a very long time. I had not fully understood that, because it was not always so. I remember that when Mervyn King was governor, he was in a minority from time to time, but I do not think that has happened since then. I may be wrong. I think members of the MPC seem to have forgotten that they are being judged on their individual vote, and it would be a good idea to have people with rather different views on the committee. Many of them are admirable economists, but they are all a bit too similar for my liking.

I share your view, without thinking that it was absolutely obvious that the Bank had to tighten dramatically in this period of huge uncertainty about supply expansion and the capacity of the world economy, after we had started to normalise, but they were in lockstep too much.

Donald Kohn: Martin has raised a number of very good points. This was an extremely unusual situation. Covid shut down the global economy and both supply and demand at the same time. As economies opened up, with vaccines and the fiscal stimulus that Martin mentioned, demand seemed to increase much more quickly than supply. At least in the United States, into the middle of 2021, it looked like many of the price pressures were very related to the uneven opening up of the global economy’s supply side. For example, automobile prices were going up because chips were not available from China and elsewhere. It could be argued that, as vaccines became available and supply chains opened up, some of those pressures would go away.

I do think that there was a problem with mindset, as Martin pointed out, as we came out of 2010-19. This was a period when inflation was consistently below the 2% target, at least in the United States, and the Fed was having trouble getting it up to the 2% target. This was a period when unemployment rates fell much lower than economists thought they could and still inflation did not go higher.

The takeaway was that we could take chances on employment and not pay a price on inflation. That attitude or perspective was embodied, as Martin said, in the new framework that the Federal Reserve put out for its monetary policy and, even more importantly, in the forward guidance that it gave for interest rates. It said that it was going to keep interest rates at zero until the economy was at full employment.

Just saying that means a negative real interest rate at full employment and that naturally you will overshoot full employment. If that had happened in 2015 or 2016, there probably would have been very little cost on inflation, but, in 2021 and 2022, overshooting full employment put us on a very steep part of the Phillips curve: that is, there was a lot of inflation when we had this demand shock and constrictions on supply, and the Federal Reserve was not ready to deal with a situation that was different. This raises the issue of challenging the conventional wisdom.

The Chair: This goes very neatly into the next question.

Q81 Lord Rooker: Following on from this, what do you think can be done in practical terms to address the risk of groupthink in governance and appointments? Martin mentioned the committee members. I have looked at the background note and, from 2014 to 2019, of the eight people who served as deputy governor, only two ever dissented from the governor and they did it only once. Therefore, even forward guidance is, in effect, controlled groupthink. What can practically to be done to overcome this risk, if it is indeed a real risk that does happen?

Martin Wolf: My first view, which I wrote about long ago, is that I am against forward guidance, because it is bound to create groupthink. It is a machine for doing so, and it becomes very difficult to change it subsequently because you are then breaking your word and are seen to be breaking it. You always say that it is state-contingent and all the rest of it, but ordinary people do not understand that. If they are in business, they will say, “In my business, I assumed that when you said, ‘Interest rates are expected to remain at zero for the next four years’, you meant it, but now you have bankrupted my business”. In practice, once you have agreed on forward guidance, you are trapped.

I also do not believe that we will ever know enough to be that confident. Perhaps I would have gone for it at the BoJ, but thank God we have never been in that sort of trap. Of course, once you get into making that sort of commitment over a long period, it is credible among the group really only if it is unanimous, or near it. In practice, that means that we are going to be controlled by the governor. I have never been in the Bank of England, but I cannot imagine a process leading to unanimity, or near unanimity, on something like that which is not in some sense led by the boss—at least in my experience of other organisations; there are people here who have worked in the Bank who can comment on that. So it is not surprising that you institutionalise groupthink.

So, first, I would first say no forward guidance, except in truly extraordinary circumstances, which we have never faced. One is being in deep deflation, for example, which I can just about imagine.

Secondly, the personality of the boss, in all organisations, affects the way an organisation works. I have been around long enough. In my first 10 years I worked for probably the most dictatorial boss ever, Robert McNamara, and I know what that does to an organisation. It was a very big and powerful organisation, and he would march in. So the personality of the governor matters—I can say no more on that— and, I suppose, that of the Fed chair too, for good and ill. I suspect that if Paul Volcker had not been Paul Volcker, he would not have been able to do what he did, so there are pluses to this sort of personality too. It would be interesting to hear what Don thinks about that.

Finally, I have been very struck in the last two decades by how far respectable academic macroeconomics has converged on a certain view of how the economy works. Perhaps it is age or when I was taught, but I have the terrible problem that I think it is wrong. Having everybody think the same way in that sense, particularly if it is wrong, is very troublesome. So I think they should go out of their way to make sure that there is a significant membership in the MPC of people who have some understanding of the underlying economics but who do not necessarily look at it in the same way as everybody else.

By the way, this has nothing to do with where they come from or who they are; it has to do with intellectual diversity. In the first decade or so—I am not going to suggest or discuss names—I think they did a better job of diversity than subsequently, and the people responsible for appointing the senior officials of the Bank and the MPC should be thinking quite specifically about how we can make these relevant bodies diverse enough to have genuine diversity of opinion without being completely unworkable.

Lord Griffiths of Fforestfach: For clarification, Martin, the model you are referring to is the new Keynesian dynamic stochastic general equilibrium.

Martin Wolf: Correct.

Lord Griffiths of Fforestfach: That is the one.

Martin Wolf: That is the response of the Keynesians to Robert Lucas.

Lord Rooker: Donald, is there anything specific that the UK can learn from other countries?

Donald Kohn: The US has the same problem, obviously. We had dissent, actually, on the initial forward guidance. President Kaplan of the Dallas Fed dissented, because he thought it tied the Fed’s hands too tightly all the way up to full employment, which was very prescient. Unfortunately, no one else picked that up and it was not repeated, and the forward guidance was not rethought as the situation developed very differently from the way they had anticipated at first.

To support some of Martin’s points, I do think that the personality of the chair is important. The chair needs to encourage people to express diverse views. There is a tendency, at least in the United States in the Federal Open Market Committee, to find consensus, which is a very chair-led process. Actually, the consensus is formed the week before the meeting, which makes the process less nimble in the sense that, if things happen right before the meeting, it is very hard to react to that.

So I do think that the chair needs to encourage people to express diverse views. I think it is the job of the externals to do that. I certainly saw my job on the Financial Policy Committee to be to lean against consensus on the few occasions when I thought that the internal members were all leaning in one direction. If I thought that was the wrong direction, I certainly made that known.

I agree with Martin that external members in particular should be from a variety of backgrounds. It should not just be the standard academic Keynesians. In the US, the role of the external members is played by the reserve bank presidents. They have their own staffs and bring different perspectives and views, which they need to do. Having a variety of people in the role of the externals is very helpful. It was certainly helpful on the Financial Policy Committee, in part because we needed different types of expertise. The model external member, in my experience, was Martin Taylor, who had worked in a bank. He could say, “I know what your models are telling you, but let me tell what’s really going on in that boardroom”. That brought the committee around. They bring experience and expertise and, hopefully, different perspectives than those held by the internal members of the committee.

Lord Rooker: If there was a view that we should go down this road of diversifying the membership to include members who were independent of the others, should we have to wait for the terms of office to conclude? I have not checked how long they have, but I imagine that we would have to wait several years before those changes could be made. Would it be useful to make changes earlier to show the seriousness of the situation?

Donald Kohn: The terms of the externals rotate through, so you do not have to rotate too many years. Usually somebody is rotating off the committee almost every year, or at least every other year, so the Chancellor and the Prime Minister can begin that process very promptly, if they want to.

Martin Wolf: I believe the Bank of England’s senior officials are changing quite a bit about now, although I do not know whether all their successors have been appointed.

Lord King of Lothbury: The deputy governor for financial stability is leaving this autumn, and the deputy governor for monetary policy will have been in office for 10 years next year; it is his second five-year term.

Martin Wolf: That is what I was referring to. There is an opportunity for significant change if the people responsible for appointing them—as I understand it, that is effectively the Treasury—want it. So you know who you can complain to.

The Chair: Can I pick up both of you on the point that Lord Griffiths was getting at about the models? I want to get a bit more on those. I saw an interesting quote from someone giving evidence to the Bank of England’s own Court of Directors back in 2012. He said this: “In the MPC’s forecasting process, there are few mechanisms capable of acting as a trigger for a fundamental reassessment of the outlook”.

On the DGSE models, Professor Syll said: “The fact that the assumption of rational expectations is implausible does not necessarily mean the models using an assumption cannot be powerful tools in making empirical predictions. The problem, however, is that rational-explanations macroeconomic modelling makes systematically wrong predictions, in particular about the speed with which prices adjust”.

If you were to accept both those critiques, this is a really quite profound issue. We have the personality and the diversity of backgrounds on the one hand, but is there some far more structural process or operation that we should be looking at, not just in the Bank of England, per se, but in the Fed? Perhaps after you have answered that question, Martin Wolf, Donald Kohn could comment on that.

Martin Wolf: I have never been inside it. It was suggested to me a very long time ago and I made the brilliant decision not to get involved, but it seems to me that there are profound intellectual problems with these models. Some of them are celebrated. However, they remain significant, and it is almost impossible to incorporate the financial sector in them sensibly.

The core problem here is something I have often seen with intellectual analysis of unbearably complex decision-making under uncertainty, which is that you would rather be precisely wrong than roughly right, and the only way you can be precisely wrong is to have an agreed intellectual framework that is rigorous and estimated and will deliver precise outcomes. When things do not change very much, once they are calibrated to past data these things are going to be pretty good, because that is how they are structured.

The problem is that, when things change a lot, they are likely to give you bad advice, and sensible policymakers—we saw this dramatically in 2008—basically ditch them. That was wonderful. Of course, when things got back to normal, they naturally tended to go back to the forecasting under their multiple framework. One feature of these models, as I understand it—I am not an expert on this—is that inflation expectations are self-validating, which is wonderful except when they are not, which happens to be where we are now.

I think sensible people would say, in the debates back in 2000-01 that Lord Griffiths was suggesting, that that expectation is not very plausible given what is going on in the economy, and if it blows up we will be in terrible trouble. As I said, trying to be precisely wrong—in other words, to stick to the model—can be another trap for the committee. It will make them feel comfortable until it makes them feel very uncomfortable.

I would be shocked if the Bank did not come up in the end with some quite detailed analysis of why they were wrong. It is important. We should be told that. I hope the Fed will do the same, because we have to learn from these episodes, and I would be very surprised if it did not include an analysis of the mistakes that we have already discussed and the modelling problems.

Donald Kohn: I strongly agree with Martin’s last point. A review of what went wrong and why is very important, and the Federal Reserve should undertake this and in a public way. It is doing a review of the framework every five years, and that should be part of it.

We should be clear on the role of models here. At least at the Fed, the models were an input into the staff forecast, but they did not dictate the forecast. It was a judgment based on using model inputs, and then each member of the committee, particularly those from reserve banks where they had their own models, was free to do the same thing: bring different models to bear.

Actually, the Fed’s workhorse model is not strictly the DSGE model. But, to Martin’s point, it did not capture at all the 2008 disruption. Any model is built on history, so we are back to the 2009-10 period, and when you feed that kind of history into the model it does not do a good job of predicting something that is way outside of its history—the combination of supply and demand shocks. This would be Mervyn’s radical uncertainty, I think.

Models are useful, they are cross-checked, but they are not the whole forecast, and we should not pretend that they are, at least at the Federal Reserve, but I am sure that is also true at the Bank of England.

Q82 The Chair: Martin Wolf, given what you say, do you think there should be some institutional process to challenge the models and the forecasting of the Bank? It has been mentioned to us, for example, that we set up the OBR to give independent, impartial analysis of fiscal policy. Should there be something equivalent on the monetary side, or would that cause confusion, undermine independence and so on? I am just interested in your views on that.

Martin Wolf: I had not thought about that at all. My first reaction is that a running assessment by an outside official body of the Bank of England’s forecasting analysis of monetary policy would create a lot of confusion. I suppose we could ask the OBR, but we already have that body, which gives different forecasts from the Bank of England, which is very healthy.

To me, the most important thing is diversity. Don made the point that the Fed is structurally diverse, in some sense. We try to get around that with the MPC. I do not know how well that has been working recently, and I do not know—I have not been inside it—how dominant Bank of England staff and their forecasting are, which is obviously central to it, over what everybody else can do. I do not think anybody in the MPC, apart from the Bank’s staff, would have the resources that the president of the New York Fed would have. That is a different sort of thing altogether, and perhaps something to think about.

To me, the most important thing is who is on the MPC and how they are encouraged to think about it, and that when things go wrong, as they do occasionally, we really try to learn the lessons and they are internalised in the institution. Who should do that? Is that a job for the Court or for some other outside body? I do not really have a view on that. But we cannot pretend that this has not happened, because it has.

The Chair: I am sorry, I have triggered a question from Lord Turnbull.

Q83 Lord Turnbull: Is there something in the Bank that has the word “valuation” in it?

The Chair: It is the Independent Valuation Office.

Lord Turnbull: Does that contribute anything? Is it a busted flush?

Martin Wolf: It is probably my failure as a journalist—I do a few other things—but I have not been forcefully hit by its work. That does not mean that it has not done wonderful work. I might just not have done my job properly.

Donald Kohn: I think from the perspective of the Financial Policy Committee, the Independent Valuation Office made some valuable contributions when it reviewed our stress test and whatnot, so it was helpful on the financial stability side.

To add to our previous conversation, it might be helpful to bolster the Treasury committee’s ability to question the Bank of England, and the MPC and the FPC, by having the Treasury committee—maybe it does this from time to time—bring in outside analysts before their quarterly or semi-annual review of monetary policy or financial stability policy, and to set the stage by having other views very prominently, which they can then use to challenge the Bank. That might be useful.

The Chair: Very good. We might come back to scrutiny and accountability later.

Q84 Lord King of Lothbury: I cannot resist asking one final question, before I turn to my main question, about the issues that we have been discussing.

Way back, in the early days of the MPC, and very recently in the case of the ECB, people asked the staff to say what would happen if we followed different paths of interest rates. On both occasions, members of the committee concluded that it does not seem to matter what we do; inflation always comes back to 2%. That is built in not just to the computer models that central banks use to make forecasts, but to the underlying intellectual approach of all these models—DSGE, and so on—because they have no monetary anchor for the price level.

As Martin Wolf said, it is very difficult to construct a rigorous model with all these aspects of the financial system in it, but you would think that somebody might want to say, “It’s interesting. We have these forecasts, but we see that broad monetary growth is running at the highest level since the Second World War. What is this telling us? What is going on?”

That question goes beyond the issue of using models and may require not just diversity but people who can question the underlying assumptions of these very complex models. Do either of you have a reaction to that?

Martin Wolf: I understood and suggested that self-fulfilling inflation expectations are in the structure of the model. More profoundly, I have noticed—this is not about monetary policy—that the forecasting models of all the major institutions, notably those of the IMF and the OECD but I presume those of most Governments, are immensely powerful at mean-reverting from wherever you are. That is not a crazy assumption, by the way, but when it is not true it gets you into a terrible mess.

The point is that we are now trying to steer economies with economic policy, which we have to do to some degree, but our understanding of economies is not sufficient to do it with any reliability. On this, I remind you of an article that had a greater impact on me, when I read it, than any other single article in economics. It was John Maynard Keynes’ review of Jan Tinbergen’s Econometrics. To me, his criticisms of that exercise—and Tinbergen was a great man—still apply today.

Donald Kohn: Judgment is absolutely essential. What we are discussing is how to bring different modes of judgment or ways of thinking about things that are not embodied in the models. That is exactly this question of diversity, but the people need to be sufficiently sophisticated to know what to ask without having been brought into the whole thing. It is a fine line to walk.

Mean reversion is, unfortunately, in the data—and then something happens. The models have not been very helpful in this period of global pandemic, as it is nowhere in the data series that they are using. I do not think that either the Fed or the Bank of England was paying as much attention to the models as is implied by this conversation, because the models could not embody what was going on; it just was not in their experience.

At the Federal Reserve, I know that staff documents have a forecast, but they also have alternative projections under very different assumptions about what might happen. That is an effort for the staff to give some diversity of views up to the policymakers. My experience was that, if you put even the worst financial crisis that you could think of—say in the summer of 2008—into the Fed’s model, it would not produce anything like our experience in October, November and December. The models have their limits.

Q85 Lord King of Lothbury: I will turn to my main question. So far, we have been discussing monetary policy, which was the Bank’s main responsibility after independence. From 2010, the Financial Policy Committee came into existence and prudential regulation went back to the Bank of England. That was a big expansion of responsibilities—macroprudential and microprudential. After that, the remits given to the Bank by the Chancellor expanded in length considerably. Climate change was added as another responsibility, plus some tweaking of the so-called secondary objectives. Have the responsibilities given to an independent Bank of England now expanded too far? Don, you argued persuasively that the Financial Policy Committee was a good innovation that has helped the Bank of England in many ways, but how far should one go?

Donald Kohn: Is your question about the remits in particular? Is that right?

Lord King of Lothbury: It is about responsibilities and subsequently changing responsibilities by altering remits—adding, for example, climate change to the considerations that had to be taken.

Donald Kohn: The UK is well served by having microprudential, macroprudential and monetary policy in the same institution. I like the basic set-up. Do not do the US, where everything is scattered around 10 different regulators. That is a horrible way of doing things. The basic set-up is correct, but each of those committees has a very difficult task—price stability, financial stability, and safe and sound individual banks. When I was on the Financial Policy Committee, I worried about the secondary objectives. All the discussion on the secondary objectives always says, “Do not let this get in the way of meeting your primary objective”, and so we did not.

My concern is more about attention, staff time, committee time and losing focus on that primary objective. If there are two ways to address a risk to financial stability and one is more consistent with the Government’s goals for housing, productive finance or whatever, it is perfectly legitimate to choose the one that is consistent with the Government’s goals. There is a role for the secondary objectives, but the committees have difficult jobs, and giving them more to do can deflect their attention and intellectual energy away from doing what is necessary and what they are set up to do.

Martin Wolf: I will work backwards from the objectives that I can think of, as there are presumably many more—climate and the competitiveness of the financial sector, which is the most recent one on which there has been a debate. I will leave aside microprudential for the moment.

My general assumption is that we have learned that the Bank must have a focus on the macroeconomic or cyclical stability, which is embodied best in the price stability objective, and financial stability, because they interact. As one of you raised, managing those two independent objectives, price stability and financial stability, is the only way of having this institution that I can think of. I think of price stability as trying to maintain output at close to full employment, in the Keynesian sense; it is just a different way of phrasing it. The financial cycle is complex and long term and operates in a different way, so you need two sets of instruments. That is clear. The standard rule for monetary policy, from Tinbergen, is to use the instrument that is most effective for its main purpose. The most effective instrument for dealing with price stability is monetary policy; the most effective instruments for dealing with financial stability are broadly conceived regulatory ones.

Of course, you have to worry about the interaction between the two. I have always assumed—I do not know how this works—that there must be close discussion between the people in the two committees. However, since they are, in essence, run by the same people, that ought to be possible. Managing that would be a tremendous achievement, so throwing in lots of other stuff is likely to create problems. My general view about institutions is that they need relatively clear objectives if they are to operate well, and two is enough.

Indeed, in the book I wrote on the financial crisis, I was really concerned about whether the Bank could manage macroprudential and monetary stability well. But, looking at where we are today, I have to say that we have managed macroprudential better than I worried we would. We also seem to have managed microprudential, certainly better than the Americans or the Swiss. That may be a temporary statement, but it is quite good. It seems a good framework.

I have always felt, as we have this framework, that climate fits in perfectly well as one of the things to look at from the point of view of financial stability. Any sensible institution would ask, “What big risks are we exposed to?” It is certainly arguable, although debateable, that climate is one of them. However, and I have been very clear on this, I do not see any role for a central bank to have climate among its objectives. We have a whole government to do that. Similarly, I have always felt that there is a real danger with competitiveness as an objective, because it could cut across stability. That is not a purely theoretical notion; that is what happened before 2008 and everybody knows that. I have been very opposed to that.

I understand and agree that, when thinking about what financial stability instruments to use, you should take their wider impact on objectives that matter into account and try to introduce instruments that minimise indirect consequences of that kind. That is perfectly reasonable. Think about mortgage controls: they have very profound social consequences. If you can have the same outcome for financial stability with slightly looser mortgage restrictions, that would be perfectly reasonable. My general view is that there are two overwhelming objectives and you need enough instruments to achieve them. That is enough. If the Government are really concerned about the competitiveness of the financial sector, they should think of some other tools that would allow them to deliver that. I can imagine one or two that might do that.

I read the evidence from the session with Paul Tucker and John Vickers. On Paul Tucker’s arguments about the problems with having microprudential regulation in the Bank, it strikes me that these are not small issues. The problem is that, if you make a mistake with microprudential regulation, you might be tempted to fiddle macroprudential regulation.

The Chair: Do you think that the rambling rose of the expanding remit—if one sees it that way—is a distraction, which can in itself be damaging because of the opportunity cost in time or resources. Is it at the distraction end of the spectrum or is it more damaging than that? How worried should we be about these new aspects of central bank responsibility and remit?

Donald Kohn: My concern was the opportunity cost and that it is a distraction from doing some very hard work. At no time in my 10 years on the committee did I sense that the secondary objective steered us away from the primary objective.

Martin Wolf: I am tempted to agree, but I regard it as a slippery slope. That slippery slope might take a generation, but it goes something like this. This is a political observation, which I can make because I have no responsibility. Governments are always desperately looking for institutions that are effective and powerful. That is why they have historically done terrible things with central banks, which is why we wanted to make them independent. That is historically correct. From a Government’s point of view, here is an institution that is fairly competent and has really powerful levers. It controls the regulation of the banking and financial sector, and interest rates. A Government would like to use that for its purposes. It is completely obvious that that will happen, so the central bank must be protected at all times.

Of course, the most likely thing for the Government to want—and I worry about this in the next 20 years—is financial repression. I think that is coming down the pipe. In general, we should defend the Bank from being overburdened by Governments wanting to pass over to it responsibilities that are properly theirs.

Q86 Lord Londesborough: Can we get your thoughts on two of the Bank’s key responsibilities—price stability and financial stability? To what extent should these be regarded as separate areas for consideration? What tension do you see between these two objectives, especially in an era of high inflation? I am mindful of events in recent months, such as failures of mid-tier banks in the US and the takeover of Credit Suisse. Do you agree with the views of some of our witnesses that the Bank’s reliance on a limited monetary policy toolkit has served to undermine financial stability, distorting the market, such as by creating asset price bubbles, increasing indebtedness and perhaps incentivising undue financial risk-taking in the chase for high yield?

Donald Kohn: The Monetary Policy Committee and the Federal Reserve have their tools. You referred to their tools as “limited”. They have interest rate, QE and, for better or worse, forward guidance to reinforce interest rate and QE. I certainly agree that that can have an effect on financial stability, but it is generally a mistake for central banks to steer away from their 2% inflation target if they are worried about financial stability. We need other tools to bring to bear.

Since the financial crisis, an important tool in central banks’ kit has been stress tests. It was important for the Financial Policy Committee and the Prudential Regulation Authority to test the banks against low-for-long scenarios to see what risks might build up and then to test them against rising interest rates to see what happens. The US did not do that second one. Every year, the US stress test was just a severe recession with zero interest rates.

I think the stress tests are important to find out where the weaknesses are, as a result of monetary policy pursuing its objective, and then to build capital and liquidity structures into the banking system to keep them safe. When you get out of the banking system to non-bank financial institutions, it is much harder. We have a limited ability with them and it is harder to do stress tests. The Financial Policy Committee has tried to ask itself what would happen when stresses hit and has done some limited stress-testing of non-bank financial institutions, but I think there should be separate tools, so that each committee can pursue its goal recognising that there are important interactions.

Martin Wolf: This is a complicated debate and I hear the views of Edward Chancellor, with whom I have debated. How I get this down to a manageable length is very important.

It is obvious that you are likely to get conflicts if you have two big objectives, one being price stability, which, as I said, goes all the way back to Wicksell and is essentially a measure that you have neither excess demand nor deficient demand in a big way in your economy, and the other being wanting to ensure that you hit the macroeconomic target. The financial system has its own internal feedback that will not necessarily coincide with the former, with real activity, and your instruments are monetary policy instruments, which basically means standard monetary policy and more complex interventions in financial markets such as QE or yield curve control, which we have not done. So you are likely to get conflicts because you have two objectives that could diverge substantially, and you really only have a set of tools that work in complex ways, but you are really trying to hit the macroeconomic target.

What is the response to this? Financial regulation, in one way or another, is designed to solve this problem, but, as Don has said, it will be imperfect. There are two sorts of critique of what has happened. One is that the central bank completely misunderstood the situation and did not need to pursue the sort of monetary policy that it pursued. If it had pursued a more normal monetary policy, with significantly positive nominal rates throughout the last 10 or 15 years, everything would have been fine, and financial stability would have been there too because we would have less monetary fuel in the system and nothing much would have happened to the economy.

That would be perfect, of course, but I find it impossible to imagine that anybody could take that argument seriously, given that whenever central banks try to do that—they did not try that here, but they did elsewhere—they got into terrible trouble, starting with the Japanese back in the 1990s; that is how they got into deflation. Unless you are arguing that it would be a good idea to pursue a monetary policy that gives us deflation—we do not know how high; it could accelerate deflation—that would not make sense.

So we are stuck, it seems to me, with these two sets of instruments, with feedback between the two—there is clearly feedback between the two—which has to be discussed and analysed meticulously and carefully. Obviously the really big question is why we got into this situation. There have been numerous debates about this. So many central banks around the world were in this situation for so long—a situation in which real interest rates were spectacularly low, and where nominal interest rates in a low-inflation world were therefore spectacularly low—and, even then, they were not very supportive of demand.

Why was the world in this situation? My own view is that we have basically been coping with some truly exceptional shifts in the global economy which these critics have tended to ignore. The biggest real shock that you could imagine, short of a world war, has been the arrival of 1.4 billion Chinese people into the world economy. It is a stupendous shock. In that situation, I think these institutions have done the best they could. If you are optimistic at the end of this period, we will go back to a more normal world and do not need to worry about this anymore. One of the most interesting questions is whether that will be true. I am sorry that was so lengthy a reply.

Q87 Lord Londesborough: Donald, could I ask you briefly about the structure of the Bank of England? These two key responsibilities sit in separate committees, with no overlap among the external members. I know that you were formerly a member of the FPC. Do you think that is a good structure, or do you think there is scope for improvement?

Donald Kohn: From my perspective, it is a good structure, because you need different expertise on the FPC than you do on the MPC. Going back to our discussion about challengers, if you want the people with the expertise to challenge the internals, the groupthink that might be happening at the Bank, you need people with that particular expertise on the committee.

We discussed, and I know the Monetary Policy Committee discussed, the interactions between the two policies. We always met the staff of the Monetary Policy Committee while we were meeting so that we could understand what was happening in monetary policy and see what risk that might lead to. There has to be a lot of communication between the two committees—there is a lot of overlapping membership in the internal part of it—but I think something would be lost by trying to find an external who could do both committees.

Q88 Lord Turnbull: I wonder whether we are locked into a two-box model. In one box is something called monetary policy and interest rates, and in the other are all the other things that we take into account. However, they can include very different things. They could include macroprudential or microprudential regulation, which are very much part of the Bank’s business. Then there is a whole series of policies, whether on equality, fairness, climate, competitiveness, levelling up or whatever.

If we are to have two boxes, it seems to me that the things that are monetary policy or very closely intertwined with it ought to be in the primary box. I do not think you would ever say that financial stability is a secondary objective of the Bank. It is as much a primary objective as price stability. Having these three committees all in the Bank, as Donald said, is a good thing, and you keep the things that in a sense have regard to it; things where the Bank can have an effect but is not the prime player, such as house prices or capital for small companies. That is how I would reframe the boxes, and I wonder whether that is the correct way of thinking about it.

The other feature is how that then works. One problem in the way the Bank is working is that you have these three committees, and the governor and three deputy governors—it is always the same three; we call it the blob or the caucus, or the Court. They turn up on all three committees, and that will give them a particular status and a particular knowledge. It must give them an inside track. I would have thought that it was much more difficult for external members of each of the committees, whether prudential or financial stability, to challenge. By the time the three of them come along, they have all basically concerted their views. It needs to be made easier for externals; maybe the Bank representation needs to be more varied.

Another minor thing—I am now talking against my old institution—is whether the Treasury is acting as a kind of prep school for the Bank. By the time these people arrive at the Bank to take up senior positions, they are already conditioned into a certain way of looking at the world. It has been a very good outlet in career terms for a number of Treasury officials, and they have often done a very good job, but does sourcing so many senior people in the Bank from a particular school of thought make it more difficult to get diversity?

Martin Wolf: Don served on this committee, so he is a much better commentator on this than I am.

Donald Kohn: I cannot comment on the HMT school of thought and how that might play over. Your point about two boxes is important, because it comes back to our discussion about the remit.

The main box has the three committees and their primary responsibilities. Then there is another box over there that has a lot of other things going on that might be very important to the UK economy and the UK populace but has a more distant effect on those three things.

Going back to the discussion about the remit, what was concerning was when stuff was trying to leak out of the second box into the first box. My view was that it served as a distraction. So you make a good point.

Your second point was about how the externals can challenge bank personnel. It is hard, because you are dealing with internals who deal with these problems every day. As an external member of the Financial Policy Committee it was a part-time job. I certainly did a lot of work preparing for meetings and getting up to speed, and so on.

Over time, I think the Bank did a better job of getting us ready for the meetings, giving us more background briefings, making sure that we started on the same footing in information and knowledge as the internal members of the committee, and having advisers for the external members who had the expertise and could walk us through. Challenging people who are extremely knowledgeable and deal with this every day is a hard role to play. The Bank needs to work on building up external members’ ability to make those challenges. That is part of the answer to the series of questions.

Martin Wolf: I am not going to comment on this. I notice that Paul Tucker talked about the structure of the Bank. I have no views on that.

I agree completely about the need to build up the outside members. Some of them can make huge contributions.

On your main point, this is no comment on the senior Treasury officials in the Bank of England, who I know and respect, but I dislike it as a practice, for a very simple reason: the Bank of England needs to be seen and to see itself as a fully independent institution, and the Treasury has its own culture and view of things, which in my view is not necessarily the culture that the Bank of England should have.

In particular, and I am not saying this has happened with any of them, the Bank of England must get up every day and say, “We are not the Treasury”. I would add, by the way, that over a fairly long time of observing it, I do not think the Treasury is as effective and sensible and wise as it likes to think it is, but that is another matter altogether.

Q89 Lord Turnbull: There can be times when monetary policy or the direction of interest rates is pointing the action in one direction—it might be wanting to tighten—and there is a disturbance in the financial markets where you want to loosen. There was one, for example—it only lasted for 12 days, or something—with derivatives and pension funds.

Some people say that you cannot have two things in the same place where there can be conflicts. The alternative way of looking at it is that it is precisely by having them in the same place that you are in a better position to resolve those conflicts. I do not think the fact that you can get conflicts is an argument for splitting these things again.

Martin Wolf: I agree completely. It is only because the conflicts are within one institution that can recognise and deal with them that we will cope with situations in which monetary policy and financial policy pressures are moving in opposite directions. There is not the slightest doubt that that has happened and will continue to happen as long as we have a monetary and financial system that is anything like ours. That is another thing altogether, but as long as we have that there will be times when monetary policy and financial stability policy go in opposite directions—like right now.

Donald Kohn: I thought it was very helpful that the actions to deal with the LDI problem were taken by the Financial Policy Committee. It sent a signal that this is not a monetary policy issue; it is a financial stability issue. Then those actions were unwound. That is a good example of where having a separate committee meant that you could at least try not to muddy the two issues. I know there was a lot of discussion in the UK that they had got muddied, but I think the Bank did a good job of trying to keep them separate.

Martin Wolf: Just on the other aspect, as Don just hinted, the US has very recently given us a very good demonstration of the importance of an integrated regulatory system.

Q90 Lord Davies of Brixton: I will ask in a moment whether we have learned anything from the recent problems that we have had with certain banks, but, first, I will ask Don a question, because he served on the FPC. I might have misunderstood, but my understanding was that the MPC as a culture votes, and that is it. The FPC works by trying to build a consensus. At least one of our witnesses has suggested that maybe the FPC should adopt an approach more like that of the MPC. I just wondered whether that fits in with your experience, Don.

Donald Kohn: Yes, it does. I am guessing it was Paul Tucker, who made comments like that at a conference at the Bank of England last summer. We are instructed under the law and try to arrive at a consensus. That was wise when we were setting the framework for bank capital requirements, for example. You do not want to set a framework by a 7 to 6 vote that might reverse in a couple of months, so you set something longer term.

However, we recognised when we started to vote on the countercyclical capital buffer that it was like voting on the bank rate. You could have differences of views, you could have people dissenting on whether it should go up or down, and we put something in the record of the meeting, at Governor Carney’s insistence, saying that this might not be subject to consensus, but it has been.

There is more disagreement and good conversation in the Financial Policy Committee than is echoed in the record of the meetings. Paul made that point at this conference last summer when he was at the Bank. The record could note, and should note, that there were different views that were reconciled in a certain way. I would not rule out voting on something like the countercyclical capital buffer. There were even times when I thought we might get to a vote on how tough the stress test would be; there was some resistance from time to time on how stressful the stress test was.

So I would not rule out voting, but the committee can do a much better job of expressing the alternative perspectives that come to bear. It is a good discussion, and when I was on the committee I never felt that I was being restrained from giving my views, especially when they did not agree with the emerging majority. Often, my goal was to drag the majority a little in my direction. I counted that as a bit of a victory. So we end up with consensus, but it is a somewhat different consensus than when you go into the meeting.

Q91 Lord Griffiths of Fforestfach: Would you be an advocate of a positive move to having people voting? I took from earlier evidence we had that, in the way it is done at present, it is very difficult to get a handle on exactly what is being discussed; it is put in such general terms. If votes were necessary, it would be a way for outsiders to appreciate the issues much more clearly. At present, there is a slight mist that hangs over the work of the committee.

Donald Kohn: I would have no problem with votes, but I think you would find that they would almost all be unanimous, given the way the committee works.

Another approach to what you are getting at is the hearings of the Treasury Committee. The committee correctly calls up at least two members of the Financial Policy Committee and the Monetary Policy Committee, in addition to the governor, and it is free to quiz those members about where they are. That is another way of uncovering some of the discussion that went on in the lead-up to the decision. There would be no problem with voting, but I suspect that it would not give you a lot more information than you already have.

Q92 Lord Davies of Brixton: We have had an interesting few months as observers of the banking sector, and international co-operation has been at the forefront of that. What lessons has the central bank learned from the recent experience of problems with certain banks?

Martin Wolf: I am interested in what Don is going to say. I have some views, but he is much closer to what is going on in the US, which was the epicentre. The Credit Suisse event was obviously very important in this context, but Don knows much better than anybody else about what is going on in the US and whether it has required any international co-operation—of course SVB has.

Donald Kohn: There are a couple of lessons from the US. The first is that just because a bank is mid-sized does not mean that it is not systemic if an event is going on. There could be contagion from your failure to other failures, and that has happened. The consequence of that is that we need a much closer view of the mid-sized banks to be sure that, if there was an idiosyncratic event abroad or whatever, they could fail and nothing would happen. When the banking system is under pressure because of, say, the rise in interest rates, the failure of one of these could spill over. We need better stress-testing of those banks and better regulation, reaching down further than it does now.

Another lesson is about capital. These were liquidity runs on the bank, but when did the liquidity run on SVB start? It started when SVB announced that it had to raise capital. It was selling securities at a great loss, which was depleting its capital. We need to make sure that these banks have enough capital. Maybe using the stress test more broadly and frequently is one way of doing that.

That is an important lesson, but the most important lesson from this has to do with supervision. I cannot compare the US and the UK very well, but I read the Fed’s report on US supervision and I was part of that system. The real problem in the US was poor supervision. The supervisors saw some of the issues, but not all of them. They did not pursue them or escalate their demands on management quickly enough to force management to address the issues. It felt like a very bureaucratic system, both within the Federal Reserve Bank of San Francisco which, along with the California regulators, was the primary regulator of this bank—there was too much deference from one supervisor to another—and between the San Francisco bank and the staff of the board of governors. It took a long time to write up memorandums of understanding and other things that would force the bank to do things.

The supervisors need to be better at spotting problems, but even better and more focused at forcing management to take steps to deal with the problems. The supervisors were too focused on process and not focused enough on the actual risks.

Martin Wolf: I have just two comments. The first is that this event has forcefully reminded me of the discussions that I had when I was privileged to be part of the Vickers commission. The primary aim of its proposals was to make it possible for the British banking system, particularly the core British banking system, to function efficiently and effectively whatever happened in the world. In these terms, we are a small country compared to the US, with a very open international financial centre. Constructing a system that allows us to operate freely and stably, even if things go wrong in the US, is incredibly important. The test of that system has worked rather well, so I am pleased with that, but the objective remains: we want to be part of the system and to be able to protect ourselves. That does not forgive us for making the credible mistakes we made last year, which I will not go into further, or to upping our insane pension regulation, which I will not go into either. But those are domestic mistakes. We have to be able to protect ourselves.

Secondly, it seems clearer to me the more I look at it that something very strange happened with Credit Suisse. I do not fully understand it. There was a proposal, a plan, and everybody knew how it should operate, but it was ignored. That is clear. That plan was agreed internationally and was in accordance with international procedures on how to resolve a major bank. I still do not fully understand why Credit Suisse decided it could not do it, but this is important to us because it means that, in a crisis when a systemically significant bank—Don has pointed out that it might not be one we think about much—goes into trouble, it will affect the global banking situation and us, because we are part of that. If people do not do what we expect, we have a problem. That is the second big lesson for me.

The first lesson is that we were right to do what we tried to do with the Vickers commission and subsequent legislation because of where we are. The second is that we should be concerned about some of the things that have happened in the US and with the Credit Suisse case, because of how well the global regulatory system will work and what challenges that creates for us. I hope that British policymakers are looking into this pretty carefully, because they should.

Lord Davies of Brixton: I accept the mystery with what the Swiss did, but is the answer, as is almost always the case, to follow the money?

Martin Wolf: That is indeed part of it. The key point then is that, if we draw the conclusion that the internationally agreed framework for resolution, which is a pretty big issue, is not going to work in politically sensitive cases, which is all cases—it is obvious that all big banks are politically sensitive somewhere—the British Government have to be absolutely sure that they are comfortable with managing the consequences. I take for granted that they are doing this, but it is a very strange story, except for the obvious point that it had to protect its shareholders. It is quite striking.

Lord King of Lothbury: Governments have been unable to resist getting involved in almost all resolutions that have been enacted. That is the big concern about resolution. Even here, the Government got involved by insisting that they would not go through what might be thought of as a standard resolution and had to be sold off to another bank. They relaxed the ring-fencing requirements, which you and the Vickers commission introduced, in order to get to their preferred outcome. This is the British case.

Martin Wolf: I never believed resolution would work, as you know. I am one of those dinosaurs who thinks that banks are chronically undercapitalised, because we cannot deal with their bankruptcies in any satisfactory, predictable way.

Lord King of Lothbury: That seems pretty clear in the Swiss case. There are other historical parallels, including from the UK in the 19th century, when Governments decided that the political cost of letting one group of people lose meant that it was preferable to change the order of credit rating. Now, they handled it better in the 19th century, in that they stuck by the rules for the case they were dealing with—City of Glasgow Bank—but then changed the legislation to allow banks to be limited liability companies. In the Swiss case, it was clearly a political decision that less damage would be suffered by allowing the bondholders to go under rather than the shareholders, even though, as you say, that reversed the standard ranking of creditor status.

Martin Wolf: I presume that it will have long-term effects on bond markets and people who buy bank bonds. Don knows much more about this, but I think it is a significant event.

Lord King of Lothbury: Our legislation would prevent the Government from doing that in the UK. That is why the House of Lords insisted on introducing a provision under which no resolution authority could change the order of ranking of creditors.

The Chair: Just to bring this back to our inquiry, we have been very clear all along that we are not going to look at individual decisions.

Martin Wolf: We just discussed it, that is all.

Q93 The Chair: This is key in terms of operational performance and it is obviously a grey area in our inquiry, of which we need to be very conscious. Given how important this is and what I just said about us not wanting to go into individual decisions, there is clearly a point on which we are all touching here. What would your recommendation on bank resolution be to the Government or the Bank from our inquiry? Should we be looking at the entire process or recommending that this is clarified globally? I am trying to be precise about a recommendation that is relevant to this inquiry.

Martin Wolf: I do not know whether you want to get into the British case that Lord King just related on SVB and the ring-fence. It surprised me, but it was not a huge thing. If you are to have an extensive discussion on financial policy, it would be reasonable to look at whether international events of the last period would or should change anything significant in the way we handle or look at these matters, domestically or in our international influence. We are a significant player on Basel, of course. I do not know where you would end on that, but it is clear that some things have happened that were not as we expected. It would be surprising if they did not have some implications on our handling of these matters, but I am not expert enough to know what they would be.

The Chair: There are two topics we want to cover. One is QE and its impact on operational independence. The other is CBDCs and what they mean, which we may cover more briefly. I am conscious that we are already over time, because you have been giving excellent answers, for which many thanks. Lord Blackwell will pick up on QE and independence.

Q94 Lord Blackwell: As interest rates have hit bottom, QE has expanded enormously in the last couple of years. Without commenting on whether that is a good thing economically, there is a question about how it impacts the Bank of England’s independence. It is seen perceptually as monetising government debt and, having built a large balance sheet, it is dependent on government guarantees or support for that balance sheet, as interest rates go up and the bond portfolio devalues. Should we worry that QE is impacting the Bank of England’s independence, or is it not relevant?

Martin Wolf: I am probably lacking imagination, and Don’s imagination might be better. When I have written about QE for monetary policy purposes, I have said that it must be a decision taken by the Bank of England on its own that is reversable by the Bank of England on its own. You can have a very good debate about whether the policy was a good one, and I think QE was significantly overdone in 2020. I was reasonably comfortable with it until then, but that is quite separate from this. As long as it is clear that the Bank of England made the decision and can reverse it, I am not particularly worried about the impact on its independence.

It is reasonable to ask, from the point of view of the balance sheet of the public sector, if you are comfortable with where we have ended up as a whole. Since the prime function of this is to do monetary policy, to me the main question is whether monetary policy was done well. I do not really see how the central bank and the central government handle the question of the net worth of the central bank, which I presume is what we are thinking of here, is of any significance. I have never been able to convince myself that the net worth of the central bank is of any significance whatever, although some people get very excited about it. I do not think it is very important. For me, the question about QE is whether it is good monetary policy and whether it is good monetary policy to reverse it. Everything else is not even secondary; it is completely unimportant.

Finally, if that is what you are getting at, there is no doubt that, at the end of all this when the QE is all reversed, the British Government will have a lot of debt that is held by the public, possibly at significantly higher interest rates as it is rolled over. That is an interesting question of public finance for the Bank and the Government to decide in the context of their fiscal operations.

Donald Kohn: I agree with both Martin’s main points. As long as the QE decisions are made by the Monetary Policy Committee for clear monetary policy reasons and they can be reversed, there is no necessary impingement on independence from making those decisions. Secondly, I agree that central bank net worth does not mean anything positive, negative or whatever.

Importantly, although there is discussion about how buying all this debt has impinged on independence, long-term inflation expectations, at least in the United States, remain well anchored at close to the 2% target. As a result, long-term interest rates are still quite low by historical standards. Commentators enjoy talking about this, but it feels like market participants are not concerned about losing independence as a result of QE.

The Chair: I just want to clarify something. In 2017, William Allen of the National Institute of Economic and Social Research wrote about what we have just been discussing. He said that “the fact that the Bank of England depends on the Treasury's consent to deploy the main instrument of its monetary policy raises the question, to say the least, of whether its independence in conducting monetary policy has been compromised”. He is referring to the Bank’s possible request to extend the indemnity.

Martin Wolf: This is about asset purchases.

The Chair: I am just interested in the slightly opaque nature of this relationship.

Martin Wolf: It is deliberately opaque. I may be missing something but, from the British Government’s point of view, I do not really understand what the indemnity does. It is basically shuffling IOUs between two parts of the state. It might have institutional significance in the sense that, if the Bank of England did not have it and then had to report very large losses—if that is the concern—it would show that it had negative net worth. People would say, “Argh, the Bank of England has negative net worth. It’s the end of the game”.

My reaction to that is “What?” I do not really understand why it is necessary, because it is basically deciding where these losses will fall in the consolidated balance sheet of the state, for which the Bank of England is unquestionably a wholly owned subsidiary. I do not really get that argument.

If the Government wanted to subvert the independence of the Bank of England, they would not have to do any of these things; they would just have to change the law. They could do that perfectly easily although, I hope, over the dead body of the House of Lords.

Q95 The Chair: Before I come on to CBDCs, I want to take a step back. We have covered a vast range of topics, which highlights the complexity and scope of the Bank’s operations. Martin referred to Parliament’s scrutiny and, I would add, its understanding of the full impact of what the Bank does: how do you reckon Parliament measures up? I do not want us to get into what the Treasury Select Committee does or does not do specifically, although you are welcome to comment. Given the role of the Bank in our national economy and the global economy, I am interested in whether Parliament is doing its job to hold it to account and fully to understand the import of what it is doing.

Martin Wolf: The set-up we have now has radically increased the transparency of what the Bank does. This is true in all aspects: the reports, the minutes and the sorts of speeches we are getting. I do not know whether some of you remember the sort of information we used to get on monetary policy from the official sector, in the 1970s and early 1980s. It is a completely different world in terms of transparency. That senior members of policymaking bodies appear before a Select Committee is an incredibly important part of that transparency: we know what they think. That is a stupendous improvement. We have them and what they are doing on the record.

By holding them to account, if you mean whether somebody is producing detailed, potent, credible analysis of the decisions that they are taking, which are out there and make clear what a botch of it they think they are making, my sense is obviously not. I am not a constitutional expert and see no reason why the TSC should not do it, except that it would involve a stupendous amount of work and probably different membership. I do not know how you would go about setting out an accountability framework for the central bank that does not amount to second-guessing the whole operation, which does not seem a very bright idea.

So I am not convinced that there is a huge problem here. Beyond what we have already been discussing about membership, the people inside it and how they assess their own record, I am reasonably comfortable with this, leaving aside the mistakes they have made and the genuine questions about this ever-expanding remit, which we discussed.

Donald Kohn: As someone who has been in front of the TSC many times, I found it a very good forum. The members were well briefed and understood what they were talking about. The questions were good and probed; they often tried to find differences among the three people sitting in front of them. I thought it was a very good vehicle for accountability, but that does not mean that it cannot be better. I suggested earlier that it could be better by bringing in other people.

I am comparing it to the US Congress, which is miserable. It does not have good accountability. I sat behind many chairs who were being questioned and I was questioned myself, but I would say that the quality of the questioning, the accountability and the staying on subject at the TSC were far superior to what I experienced in the US.

Q96 The Chair: My final question is on CBDCs. We have been talking a lot about the remit and scope of the Bank, and I just mentioned the complexity of its operations. If a CBDC were to be introduced—I understand that a lot depends on its design, but take a broad perspective—what impact would it have on the bank’s independence, if any? What accountability issues might that raise? I realise that this is an enormous question, but I end on it even so. What is your view?

Martin Wolf: It very much depends on deep conceptual and design issues. You would need a clear idea of what you were trying to do with the CBDC and how it would affect the wider operations of the monetary and financial system. There are quite different models for this. If, in essence, the CBDC replaced cash, was not much more than that and could be held to that, it would not create vast issues. However, you could imagine a CBDC that replaces a large part of bank deposits to become the core payment system. There are pluses and minuses to that, but then we are in a different world.

Personally, I am very radical about this and I like the Chicago plan, so I would welcome it, but it would be a monstrous upheaval that we could not contemplate for a moment without thinking very seriously about what we want from our banking system. Do we want the sort of banking system that we have created, in my view, over 200 years of mistakes? It would be ridiculous to think about it outside that. We have to think just about what it would mean and this wider thing.

Of course, if the Bank then became the principal issuer of money in most of its senses and the principal manager of the payments system, and if its monetary creation was direct in this way rather than indirect through monetary policy, it would become a stupendously powerful and inescapably politicised organisation. That is probably why most people I know think the whole thing should be forgotten. But it depends on what you are trying to do with this. I think you did a report on this, if I remember correctly, and I know what your conclusions were. My view is the same as yours, unless you want to go down the really radical route of turning our existing banking system upside down. Since nobody wants us to do that, I would be perfectly happy if the issue were dropped.

Donald Kohn: I preface this by saying that I have not studied the issue closely. In Martin’s first iteration, if it is substituting for currency with a few other kinds of transactions, I do not see why independence and accountability could not be handled within the current structures. To Martin’s point, rebuilding the whole financial system is a very different problem.

The Chair: Thank you both very much. We were scheduled to spend an hour and a half together but, thanks to the excellent, insightful and wide-ranging answers that you have given us on so many topics, we have gone well over. That is a sure sign of how valuable this has been. Thank you for joining us.