Central banks need to avoid fighting the last war

The immediate task facing governments and central banks is to pull the world economy out of its tailspin. But our collective failure to forecast and avert this crisis carries important lessons for the longer term. The discussion so far has focused on regulation, but we also need to design a new framework for macro-economic policy and the roles of government and central banks.

After the booms and busts that followed the 1971 breakdown of Bretton Woods, we built a regime based on a powerful consensus in academic macro­economics. It appeared to work in stabilising inflation and providing a foundation for continuous growth. We thought we had cracked the problem.

According to this new orthodoxy, macroeconomic stability should be achieved through interest rates. Rate-setting should be entrusted to an independent central bank, whose commitment to low and stable inflation would anchor inflation expectations. Fiscal policy was discarded as an instrument of macroeconomic policy. Regulation, too, was seen as a microeconomic tool, to establish fair markets and resilient financial institutions. The split of monetary, fiscal and regulatory functions in the UK reflected this consensus particularly clearly; but it also underpinned policy in Europe and the US.

Meanwhile, the dominant school of monetary economics argued that central banks should be guided in setting interest rates above all by two factors: the gap between consumer price inflation and its target and the gap between output and its equilibrium level.

The past two years have shown the limitations of this approach. It has proved effective in fighting the last war: preventing 1970s or 1980s-style inflationary booms. But neither inflation nor the estimated output gaps in Europe and the US in 2006-2007 suggested we were on the verge of economic meltdown. Our modern macro models had little place for the long build up of global imbalances, and the credit and asset price bubbles that were to burst with such devastating consequences. Some models were still pointing to a tightening of policy right up to the summer of 2008, while the global financial system seized up.

During the crisis, the clear dividing lines between monetary, fiscal and regulatory functions have been replaced by close co-operation. Central banks and finance ministries have been drawn into decisions on the appropriate levels of capital and liquidity for individual banks. At the same time, regulators' requirements have become drivers of bank lending and thus of the broader economy. Fiscal policy has returned to a central place in macro­economic policy both through traditional tax and spending measures and through bank recapitalisation. As central banks have turned to quantitative measures and printed money, they have needed government underwriting.

The need for close co-ordination is not going to disappear when the crisis subsides. We have learnt that interest rates and inflation targets are not enough to secure stability. Macroeconomic policy needs also to address asset prices, credit expansion and imbalances between sectors and economies. That requires more than one policy instrument. Getting interest rates to mesh with fiscal policy will remain essential, particularly as central banks wind down their balance sheets and governments struggle with the burden of debt. As the Group of 20 leading nations agreed, we also need to damp the credit cycle by varying capital requirements, and that will require co-operation between monetary authorities and regulators. Finally, better international co-ordination means better national and regional co-ordination.

No one favours bringing the full range of fiscal, monetary and regulatory functions back together under political control. I don't know of any major economy that manages with fewer than three institutions, and most have more. So we need a structure that gives each body a clear remit, but recognises their interdependence and ensures effective co-operation.

In the UK, at the least we need greatly to expand the memorandum of understanding between the Treasury, Financial Services Authority and Bank, not just to redefine their roles in financial stability but to cover macroeconomic policy too, including the rate-setting monetary policy committee.

More widely, with finance ministries co-ordinating, playing a renewed role in macro policy, and being held responsible for the results, the challenge will be to preserve the advantages of non-political decision-making in central banking and regulation.