At a meeting in the House of Commons yesterday, I was asked to describe the characteristics which should be possessed by the next Governor of the Bank of England. These were my thoughts.
The first attribute the new governor must have is that of humility. Specifically, the sort of humility he will come to understand by reading F. A. Hayek. I am not going to focus on Hayek’s work on monetary policy or on Hayekian views about the abolition of central banks. But, the governor will be a much better governor – indeed, any public servant would be a much better public servant – if he understands the limits of human knowledge. This necessity was summarised by that famous quotation from Hayek: ‘The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.’
You get no sense of that in the current Bank of England as you walk into their museum and see an exhibit which is supposed to mimic the way in which the Bank controls the economy by pumping air into a balloon. Economic processes are not like physical processes and this is the most important lesson of economic science – the analogy used in the museum is flawed in its crucial characteristic. But, it is not just the museum exhibits: you also get no sense that the Bank understands this problem in its approach to equilibrium modelling of economic processes in its day-to-day work.
More generally, people in regulatory bureaus are prone to the belief that the use of regulatory levers can somehow bring about a state of near perfection in markets or, at the very least, effectively remove imperfections. They are deluding themselves. The next Governor of the Bank of England has to understand the limits of what a nationalised central bank can achieve. Central banks cannot abolish boom and bust by fine tuning but they can do a lot to ensure that their systematic errors do not create boom and bust. Central banks cannot hit an inflation target within 0.25% 90% of the time or prevent banks from failing by telling them to hold exactly enough capital so that they have a probability of failure of 0.5% per annum in line with the Basel Accord. All the Bank of England can do, as the monetary policy agency and financial regulator, is ensure a stable purchasing power of money over a reasonably long time period and ensure that, when problems arise in financial markets, they do not become systemic and bring down the whole financial system and the economy with them.
In fact, when the Bank of England last regulated banks it understood that well. The old Bank understood that it was its role to stop the failure of a bank bringing down the system – it was not its role to stop the failure of a bank. The new governor must ensure that the new bank is not infected by the flawed reasoning of the Financial Services Authority.
The second lesson the new governor should take on board rapidly is the ability to distinguish between the important and the measurable. Mervyn King showed some signs of doing this, but the institution as a whole has not. Again, the new governor can look to Hayek and his Nobel Laureate lecture which is the most widely cited of all Nobel Laureate lectures. As Hayek said (with some slight amendments to clarify the point):
‘Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones...all the circumstances which will determine the outcome of a process...will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often the variables treated as important are those which happen to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.’
Hayek went on to say that relationships that cannot be measured are therefore often disregarded and he particularly cited the problem of focusing on measurable magnitudes when looking at the process of inflation and continued rather than focusing on money – the root cause of inflation.
Mervyn King seemed to implicitly understand this – indeed, arguably, echo this - when he said in 2002 that he believed inflation was a disease of money, that there were real dangers in central banks relegating money to a ‘behind-the-scenes’ role. Specifically, he said: ‘My own belief is that the absence of money in the standard models which economists use will cause problems in future.’
Well, the Bank of England ignored that message as far as its own models were concerned, but Mervyn King was right. The Bank was warned several times in 2005-2007, via letters to the Financial Times by members of the Shadow Monetary Policy Committee, about the problems that were building up because of the growth of the money supply. It is not so much that money should be included in econometric models – it may not be possible. But the role of money should be understood and the Bank of England should not rely obsessively on equilibrium models for decision making as the Bank of England and financial regulators did in the run up to the crisis.
Of course, the governor must have other attributes too. He should understand the principles of all the areas of economics with which he has to deal. He should be able to think innovatively about how technology might entirely change the role of money and central banks in society – perhaps rendering them unnecessary. Perhaps this will be the last Bank of England Governor who will be appointed by the government rather than by private shareholders. It would be nice to think so.