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Mervyn King was appointed Deputy Governor of the Bank of England in 1997 and became an ex-officio member of the Bank’s interest-rate setting Monetary Policy Committee when the Bank was cut loose from Treasury control that year. In June 2003, he succeeded Sir Edward George as Governor.

King has always been an anti-inflation hawk. Before becoming Governor, he regularly voted for tighter monetary policy than any of his colleagues. That pattern continued through his Governorship. Most notably, he opposed the interest cut by the MPC in August 2005 and was in the MPC minority voting in favour of higher rates in June 2007. This willingness to place himself in a minority on interest rate policy is exceptional among central bankers. In both cases, King was on the side of the angels.

Mervyn King’s wisdom has surfaced most spectacularly since the financial crisis began to impact the British economy. He is best known for (correctly) refusing Bank of England funding to Northern Rock when it ran into financial difficulties, and for refusing similar funding to other retail banks. He cannot be held responsible for the bank nationalisations that followed under the intemperate and unwise governance of Gordon Brown’s doomed Labour government. But his upholding of the doctrine of lender of last resort against extreme political pressure will go down in central banking history as a position of wisdom and high integrity.

Fully aware of the economic lunacy of excessive deficit financing as a tool for countering economic contraction, Mervyn King risked his career on March 24, 2009 by explicitly and publicly warning the British government against a second fiscal stimulus. More recently, he has warned publicly against excessive complacency about economic recovery, noting that it is likely to be plagued by stagflation as a direct consequence of past fiscal imprudence.

He has asked repeatedly, and justifiably, for the complete segmentation of British banks into separate retail and investment corporate entities as a means of avoiding the “too-big to fail” syndrome. Last month he criticised the British retail banks for their policies both of excessively remunerating their employees, and of paying out excessive dividends to their stockholders, all at the expense of refusing to extend justifiable wealth-creating loans to cash-starved small enterprises.

A number of years ago, at an annual meeting of the American Economic Association, I attended a lunchtime address by Mervyn King when he was Deputy Governor of the Bank. King chanced to mention that a central bank had an obligation to protect high levels of employment as well as price stability. Just a week earlier, Alan Greenspan had spoken about the absolute priority that should be given to price stability by the Federal Reserve. Smart Alec, that I may have been, I challenged Mervyn King on this discrepancy, asking whether this implied that the value of sterling predictably would decline against the US dollar as a consequence of this difference in central bank philosophies. King nervously checked out the room to determine that the press was absent. He then deferred in his reply to Alan Greenspan, stating that he could not compare himself with the Maestro on such matters.

Well, both Mervyn King and I were wrong on that occasion. Alan Greenspan turned out to be a Wizard of Oz, not a Maestro, whereas Mervyn King was much more of an anti-inflation hawk than I believed. So I am more than happy to extend my apology to Mervyn King for this grievous error of judgment.

I only wish that the Federal Reserve might have been blessed with a Chairman with the wisdom and integrity of Governor Mervyn King over the period 2003-2010. The world-wide financial crisis and economic contraction of 2008-2010 surely would have been far less pronounced than has been the case.

Visit Charles Rowley’s blog to read an earlier version of this article.

Over the past year there have been murmurings of expansive new proposals for a global reserve currency to replace the long suffering, yet still hegemonic, dollar. One such proposal has been the Bancor.

The Bancor is the theoretical world currency first proposed by Keynes and later brought back on to the agenda by Joseph Stiglitz in Making Globalisation Work. Stiglitz specifically believes that such an all-encompassing currency would usher in a new era of global economic stability.

The Bancor would be a one-world paper currency issued by an international reserve bank. These funds would be transferred to central banks around the world and would provide the reserves which these central banks could use to replace the dollar. However, the Bancor would not eliminate the problem of inflation. Indeed, inflating the money supply would be a global affair occurring in a coordinated, synchronised manner. Crucially, there could be no competing currencies to flee to if high inflation were to take place. 

Interestingly, the world has already had a de facto global currency. The gold standard – which effectively precluded high inflation – was in place from 1815 to 1914, a period which has often been termed “the golden age of globalization.” Unfortunately, the outbreak of hostilities in 1914 witnessed the deterioration of monetary discipline, as governments printed money to finance the protracted war.

Rather than further centralising the supply of money as the Bancor would inevitably do, a gold standard transfers control of money from the government to the people and helps insure that governments refrain from the fiscal indiscipline that tends to lead to inflation. As a former governor of the Bank of England, Montagu Norman, succinctly put it: “The gold standard is the best ‘Governor’ that can be devised for a world that is still human, rather than divine.”

The belief that a global reserve currency is requisite for greater global stability is very much rooted in Keynesianism and neo-liberal institutionalism in respect of the erosion of national economic sovereignty, faith in international institutions and the advocacy of fiat paper money. There are, however, numerous historical examples of economic crises resulting from nations perpetually expanding the supply of their fiat currencies and these should serve as a warning to those considering constructing such a scheme. Indeed, if competing currencies are absent, high inflation could be even more likely under the Bancor, while its global status could make the resulting crises more severe.

A trillion here, 500 billion there - it seems no amount is too much when the authorities want to fix a perforated economy. Keeping an economy on life support through extensive intervention has been the typical reaction to a crisis since elements of Keynesianism were applied for the first time during the Great Depression. Yet such Keynesian initiatives cannot be enacted without “big bank and big government” (Minsky); in other words, a reactive central bank and interventionist government.

I will use the Federal Reserve as a case in point as it is a relatively new institution. Interestingly, the US survived until 1913 without a central bank and enjoyed robust growth. Since then the Fed has essentially failed in its objectives of ensuring monetary and financial stability. Interest rates have fluctuated between zero and 21 per cent, prices have continued to rise, and financial crises have been frequent.

Vigorous booms in the US are generally characterised by an artificial expansion of credit followed by a proportionately vigorous bust (the more unremarkable recessions of yesteryear, although more frequent, tended to be shallower). Recessions or depressions that have corresponded to central bank manipulations have produced substantial shifts in the economic sub-structure - we have seen multiple sectors of the economy suffer in the current crisis. In the past, business cycles were just that. Their cyclical configuration led to redundant institutions being liquidated and growth continuing again. Since the Great Depression, however, this kind of cycle has in effect been prohibited though big government and big bank initiatives. But when a boom and bust has happened, it has had much deeper effects on the whole economy.

As the Federal Reserve has tried to prevent recessions, economic growth on average has slowed. While there may be many reasons for this, the assumption that central banks bring both stability and growth is questionable. Indeed, it could be argued that the attempted suppression of the business cycle has been a source of weakness to the US economy.

Growth and innovation can occur without the impetus of artificial credit. It is saving and production, not debt and consumption, that drive economic development. The recent boom was based on the illusion that property appreciation and consumption, rather than production and savings, are the path to growth and prosperity.

Language was created spontaneously and needed no act of creation or sanction by the state – it is owned by each and every one of us. Money was also created this way, but today we have government ownership of the supply of money. This has been devastating for its purchasing power.

There are many stories in history of wicked monarchs who, to fund their various despotic regimes or lifestyles, would call in the coinage of the realm, extract a small percentage of gold – a “clip” – and then add an impurity before giving the coins back to the public; this is debasing of the monetary unit. This embezzlement was unlawful for the minter in the private sector and many people over the ages have been executed for stealing from money owners. Yet it is not unlawful for the state to do it.

Before World War I, money was gold. This was the commodity over time that freely consenting adults had chosen. This was the most marketable commodity that allowed us to move from barter to indirect exchange.

One ounce of gold today is £766. So if a pound sterling pre-WWI was just a name in the UK for 1/4 of an ounce of gold, it would imply that the pre-WWI purchasing price was 1/4 of £766 or £191.50. Compared with gold, the pound sterling has therefore lost 99.5% of its purchasing power in 100 years. One pound should buy something like a good week’s food shop for a family of four and not just one daily newspaper like it does now.

The government will raise an estimated £498bn and spend £666bn this year. In the last 20 years, the economy has grown at about 2% on average. Even with the 3% Treasury growth forecast, we will have a £1.5 trillion debt at best by 2014. On the whole, quantitative easing – i.e. creating money out of nothing or debasement of our purchasing power – has “paid for this”. With no political will to cut public spending, there is a serious danger we will be faced with further debasement and eventual currency collapse. This is the elephant in the room during this election campaign.

For more on these issues see Ludwig von Mises – A Primer.

“Borrow as much as you like – the ECB will bail you out” – that was arguably the implicit message of European Central Bank president Jean-Claude Trichet last week as he announced that the ECB would continue to accept Greek sovereign bonds. The statement came after fears that Greek government bonds would be further downgraded and would therefore lose their status as collateral for ECB open market operations. In addition, a current relaxation of collateral quality requirements to BBB- is supposed to be extended.

Certainly, the ECB acted in the belief that their actions would safeguard the eurozone and the euro. If Greek government bonds were excluded from ECB monetary policy operations, Greece would find it even harder to sell their government bonds at “acceptable costs”. However, Mr Trichet’s rash promise to help Greece imposes a long-term threat for the eurozone.

Firstly, credibility is an important “tool” in today’s monetary policy. Markets must believe in monetary policy to make it effective. However, changing the rules to help Greece is highly discretionary. Accordingly, markets will anticipate discretionary policy in the future and they will treat monetary policy statements with scepticism. The resulting uncertainty in monetary policy (or even higher inflation), will not, however, help the eurozone economies recover from the crisis. Special aid to Greece will therefore have a negative impact on other members of the zone.

Secondly, the guarantee by Mr Trichet is virtual a “no-default-guarantee” and implicitly accelerates central bank financing of Greek government debt. Irrespective of rating or fiscal stance, commercial banks are likely to buy Greek government debt. They receive high yields and can use the junk bonds as collateral for low interest central bank loans. At the end of this process, Greek government bonds end up on the ECB balance sheet. This could have a “crowding out” effect on high quality collaterals. Yields of high rated countries could increase.

Thirdly, the ECB statement encourages moral hazard. Why should another country in a similar situation to Greece today (maybe Portugal) be willing to undergo painful austerity measures? Why should Greece stick to its announcements on public spending cuts? The ECB (together with the EU bailout plan) has created an environment where government debt can be rolled over repeatedly and increased. Market forces are switched off and the requirement to cut deficits and public debt is substantially reduced.

Although the ECB has acted to safeguard the eurozone, its guarantee to help Greece may prove to be counterproductive in the long term.

The world is filled with irony and idiocies aplenty. For how many years was inflation targeting the very essence of economic policy when the threat of inflation was hardly anywhere to be seen. How many booms did high interest rates cut short and how much wealth did these policies kill off, all with the intention of preventing an inflationary spiral which was never going to happen?

Now with inflation a genuine concern, we find the International Monetary Fund suddenly thinking that perhaps inflation targeting isn’t such a good idea after all, that allowing a bit more room for prices to grow might not be such a bad thing.

Olivier Blanchard, the Chief Economist of the IMF, has just released a paper looking to reduce the role of inflation targeting in economic management, and has apparently suggested that inflation should be allowed to rise to four per cent to give governments greater scope to manage downturns.

According to news reports, “in a radical paper calling for far-reaching economic reform, the fund says too much reliance has been placed on interest rates to control the economy, and budget spending and direct regulation of banks should play a greater role.”

The theory behind inflation targeting, to the extent that there actually is a theory, argues that recessions are caused by inflation. Avoid inflation, it was said, and you avoid recession.

That inflation is not the only cause of recession ought to have been known to one and all, but for those whose history does not go back beyond the 1970s, it might have seemed plausible. There is no doubt that the 1970s were a period of rapid inflation coupled with high unemployment.

But it wasn’t the inflation that caused the unemployment; it was the combination of massively increased public spending, union militancy leading to a series of wage explosions, and huge increases in the price of oil. It was these that caused both unemployment and inflation to move beyond control and then continue for years on end.

So now we find the IMF apparently arguing that given the downturns we are all in, and the inflationary potential that the various stimulus packages have created, the answer is more inflation.

I have never been a fan of inflation targeting but inflation is about as bad an economic disease as one can find. Combining the useless unproductive public spending we have inflicted on ourselves already with a deliberate loosening of our inflationary restraints, which are not all that strong to begin with, will seriously undermine future rates of growth and reduce living standards for years to come.

There are still so many ways the current global financial crisis could morph into different and far more virulent forms of economic malaise. Allowing inflation to become entrenched once again would be one of the ways that the current downturn – which had it been handled properly from the start could have been over and done with in a couple of years – might yet remain with us well into the 2020s and even beyond. 

Bear in mind that the inflation that began in the late 1960s was not finally brought to an end until the early 1990s. This is surely not the kind of outcome anyone would like to see repeated once again.

The government’s economic recovery policy consisted of two tracks: one, a vastly expensive “fiscal stimulus“, involved ramping up spending at a time when tax revenues were falling by borrowing at unprecedented levels. Even Alistair Darling expects borrowing to reach £175 billion this financial year, around 12% of GDP, leading to a possible downgrading of the UK’s credit rating from AAA. Others think borrowing might be even higher. Yet the effectiveness of fiscal stimulus was largely dismissed for two decades prior to the recent crisis, during which time it also failed to lift Japan out of the mire despite massive public works projects during the 1990s.

Thank heavens, then, for quantitative easing (QE), the other track of the government’s policy. This, at least, was broadly supported by most mainstream economists: both neo-liberal and Keynesian. Milton Friedman built his reputation on A Monetary History of the United States, 1867-1960, where he argued (along with Anna Schwartz) that the Great Depression was caused because the Federal Reserve contracted the money supply at a time of deflation, whereas it should have flooded the economy with money to ensure that prices remained stable. This argument has become fundamental to macro-economic thinking.

So it is rather a surprise to discover evidence that suggests quantitative easing is not working as planned. According to the Bank of England, its £200bn programme of QE has been accompanied by a decline in broad money (M4) of 5.3% over the past three months; not the annualised growth of 6 to 9% that Mervyn King was looking for. Lending to business has also declined (by 3% over the same period). What seems to have been achieved is a roaring housing market and a stock market up over a quarter in a single year.

This seems to question mainstream economic theory, though it corresponds nicely with Murray Rothbard’s suggestion that, during the Great Depression, the Federal Reserve actually did expand those monetary levers over which it had control, but that the market nonetheless shrank the money supply because government could not fully control broad money.

Whatever the truth about the economic history, the economic practice in 2009 has arguably been disastrous. It seems £200bn has flooded into the money markets to achieve little but asset bubbles in the midst of a recession; and £175bn has been added to the public debt on the basis of dubious Keynesian theory. The twin tracks of the government’s economic recovery plan appear to have failed.

While quantitative easing has received much press, qualitative easing has been neglected. Qualitative easing consists of policies that deteriorate the average quality of the assets that a central bank holds. This can occur both with and without quantitative easing.

By selling high quality assets (i.e., foreign exchange, government bonds, or gold) to buy low quality assets (i.e., asset backed securities, or granting loans to a tumbling banking system), there may be qualitative easing without an increase of the central bank´s balance sheet (i.e., without quantitative easing). This was the strategy of the Fed before Lehman Brothers collapsed in September 2008. When the purchase of low quality assets is not sterilised, there is quantitative and qualitative easing at the same time. This has been the strategy of the ECB during the financial crisis and the Fed after Lehman.

Why is the average quality of the assets of a central bank important? There are four main reasons.

First, qualitative easing can be used to stabilise a tumbling financial system, by buying its troubled assets and injecting high quality assets. Of course, the sterilisation strategy is limited by the amount of high quality assets on the balance sheet. Qualitative easing waters down the average quality of these existing assets. When high quality assets are exhausted, quantitative easing becomes necessary if the banking system is to be supported further.

Second, besides supporting the banking system internally, central bank assets may be used to defend the currency on the foreign exchange markets. Qualitative easing reduces the average quality of the assets that may be used for this defence in relation to central bank liabilities – mainly the monetary base.

Third, in the case of a monetary reform or a break down of the financial system, the quality of the assets of a central bank in relation to its liabilities constrains the value of a newly issued currency. 

Fourth, low quality assets may lead to losses for a central bank and finally to balance sheet insolvency. In this case, a recapitalisation of the central bank involving higher public debt and, eventually, debt monetisation becomes likely.

The authors analyse the qualitative easing of the European Central Bank and its possible consequences in the December 2009 edition of Economic Affairs.

There seems to be near-lunatic policy inconsistency between the employment of the controversial and potentially dangerous policy of quantitative easing to boost broad money and credit, and the regulators’ desire to raise the capital and liquidity requirements of the commercial banks. The latter will almost inevitably cause banks to both restrict the size of their total balance sheets and substitute government debt for private lending within their diminished total asset books.

There is a parallel here with the argument in supply-side economics that the announcement – or even mere expectation – of future tax increases would cause a supply withdrawal well before the tax change was implemented. If I was the general manager of a clearing bank, I would already be giving instructions to reduce lending to the private sector so as not to be caught short of capital and/or liquidity when the new regulatory controls currently being discussed were imposed. Indeed, regulatory shocks imposed by international agreement may cause the entire global banking system to take a similar view, leading to a synchronised global downturn that would be similar to, but worse, than the US recession that followed President Roosevelt’s misguided decision to double the reserve asset requirements of US banks in 1936.

The solution to the ‘too-big-to-fail’ problem is to use existing anti-monopoly legislation to break up the big banks, or at least those dependent on state guarantees, not to pile new legislation on new legislation until the whole global and domestic credit creation processes grind to a halt.

Addendum:  According to the Financial Times, Lloyds Banking Group is planning to reduce its asset base by more than £180 billion to fill the £25 billion capital hole that regulators have demanded as the price for leaving the government’s toxic asset insurance scheme.

Professor David B. Smith is Chairman of the Shadow Monetary Policy Committee.

If the next government, of whatever colour, insists on not taking the bold step of getting the government out of the production and management of the money supply – and political realism leads me to the view that this is an unlikely move – then it could do worse than following the advice of Steve Ambler, former Bank of Canada special advisor, and move to price-level targeting. The idea is described in detail in the current edition of Economic Affairs.

There are two main advantages of price-level targeting. The first is that we can set up contracts in nominal (cash) terms today and have a stronger expectation that they will not be eroded by inflation. At the moment, if the Bank of England makes a mistake, and (say) inflation is 10% next year, then bygones are bygones. The price level will move up to 110 and inflation targeting will continue without the Bank trying to get the price level back down again. Under a price-level target, the Bank would have to take action to get the price level down again. This is much better for investment and labour market stability because it makes it less likely that wages or bond interest, over a long period, will be worth less (or more) than we expected.  

Secondly, price-level targeting helps the central bank avoid deflation traps. If the price level drops to 90 next year, then the Bank of England will have to get it back up to 100 (i.e. inflation will have to be about 11% over a period). This means that when interest rates are set at (say) 1%, a real rate of interest of -10% is being signalled – and a negative real rate of interest is just what you need to get rid of deflation.  

Price-level targeting would probably help to improve monetary stability – it certainly helps improve price stability. However, it cannot prevent reckless expansion of the money supply of the sort that creates financial bubbles. It is not a cure all. However, price-level targeting must surely be better than the current system of inflation targeting. This is not just the IEA author’s conclusion. Policy Exchange’s Andrew Lilico has been advocating this for some time (including in his earliest think-tank writings which were for the IEA). If the wonks are thinking about this, then why has the Bank of England not been as active as the Bank of Canada in promoting research in this area? It is being left behind.