Carney Do It?

'Mark Carney has undermined what many viewed as a basic premise of the UK inflation-targeting regime'

Tim Congdon

Most economists are left-wing or at any rate left of centre in political outlook. They dislike Milton Friedman’s theories, and his straightforward enthusiasm for a free-market capitalist economy. However, the vast majority of them accept that one of Friedman’s works — his December 1967 presidential address to the American Economic Association — was among the most influential contributions to their subject in the 20th century. 

In that address Friedman repudiated the Keynesian claim that monetary policy could reduce the rate of unemployment on a permanent basis. He acknowledged that, over a period of a few years, an increase in the rate of growth of the quantity of money could boost demand and output, and so lower unemployment relative to what it might otherwise have been. But suppose that the rate of unemployment were pushed beneath what he termed “the natural rate”. The result would be not a high and stable rate of inflation, but ever-accelerating and hence unsustainable inflation. 

The natural rate was determined by underlying structural characteristics of the labour market and the economy, and could not be changed by tinkering around with interest rates, open-market operations or any kind of monetary gimmickry. In Friedman’s words, while “there is always a temporary trade-off between inflation and unemployment, there is no permanent trade-off”. It followed that “the monetary authority” should not use its control over nominal quantities, such as the quantity of money, “to peg a real quantity” such as “the rate of unemployment”. 

Friedman’s argument had massive importance for policy, particularly in Thatcherite Britain. Government attempts to combat unemployment should focus on the economy’s structural aspects or, in the phrase that was fashionable in the 1980s, on “the supply side”. They should not use monetary policy and certainly not “Keynesian demand management” by manipulating fiscal policy. A notably effective presentation of this viewpoint (in a speech entitled “Thatcherism in practice”) was given by Nigel Lawson, as Financial Secretary to the Treasury, to a Zurich audience in 1981. The gnomes loved it, and it was one of the reasons for the surge in international financial confidence in Britain achieved at that time. 

But more than 30 years have passed since then. A new generation of policymakers is in control. Mark Carney, who was all of 16 years old at the time of Lawson’s speech, has been persuaded to move from Canada to become governor of our central bank. He may or may not have read Friedman’s 1967 address and Lawson’s 1981 speech. At any rate, he has decided to forget or overlook Friedman’s prescription. He has given “forward guidance” that interest rates will not be raised until the unemployment rate is beneath 7 per cent. He is — explicitly, publicly and unapologetically — using control over a nominal quantity (the rate of interest) to peg a real quantity (the rate of unemployment). 

Carney’s forward guidance speech was hedged about by a range of caveats. Carney himself may know little about the bitter policy debates that made so many UK monetary economists hate each other in the 1970s and 1980s, but his new associates at the Bank of England grew up while those debates were in full swing. Privately, they may well be shocked. They seem to have done their best to dissuade him from too unequivocal a commitment to basing interest rates on an unemployment peg. 

All the same, Carney has undermined what many viewed as a basic premise of the UK inflation-targeting regime which began in late 1992. The effect of introducing that regime was to inaugurate a 15-year period of benign macroeconomic outcomes, the so-called “Great Moderation”, in which the various schools of economists — Keynesians, monetarists, new Keynesians, neo-classicals and so on — could pretend to be  in agreement. But during the Great Moderation very few members of the so-called “profession” believed that monetary policy should be based on an unemployment rate. However much they distanced themselves from the free market evangelism of Friedman and  Lawson, they endorsed the proposition that control over nominal quantities could not alter real variables in the long run. 

Will inflation now be on an ever-accelerating path, as it was in the 25 years to 1975 when British policymakers ignored Milton Friedman, the quantity of money and such like? No one knows what the rate of money growth will be in future, and therefore no one can give forward guidance on inflation in 2025 or 2030. Nevertheless, Mark Carney’s forward guidance on unemployment has not done his reputation any favours among those British economists who remember how inflation was defeated in the late 1970s and ’80s. 

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