Why the Monetary Policy Committee did not see the problem . . .
I was walking to the pub last night, thinking about the economic crisis, and it struck me that part of the problem was that the British economic system, the bit the government tries to control, had been set-up with only one alarm system: it had been created so that alarm bells went off when inflation began to rise. Economic policy thinking between the years between 1974 and 1997, when New Labour took control, had been dominated by the fear of inflation getting out of control as it did between 1972 and 1976. The Monetary Policy Committee under New Labour had been tasked to worry only about inflation. All the other indicators – the money supply, the external trade deficit – were all subservient to inflation. And in the old system that didn’t matter because a rising money supply would produce inflation (too much money chasing too few goods pushing up the prices) and so would a rising external deficit as the value of sterling fell and pushed up the price of imports.
But neither of these two things happened. The ever growing trade deficit didn’t push down the value of sterling because the foreign currency traders didn’t care about the deficit, only about the relative earnings on money deposited in sterling. The ever-increasing money supply, or credit formation, didn’t cause inflation because the Chinese and Indian economies were producing very cheap – increasingly cheap – goods, which didn’t push up the retail price index. So the system trundled on, ever increasing credit formation and an ever growing trade deficit producing little inflation, except in the price of houses, and that wasn’t included in the inflation index.