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mervyn king on central banking

November 2022
Marketing Material

When policymakers face radical uncertainty

Mervyn King, former governor of the Bank of England, talks to Renaud de Planta, Pictet's senior managing partner, about his theory 'radical uncertainty', about high inflation, the mistakes central banks have made and about the global economy's outlook.

de Planta: In your book, Radical Uncertainty, you question the ability of statistical models, econometric models and likes, as tools for making good decisions. So what is radical uncertainty? 

King: It is a situation in which you cannot quantify the risks involved… I think the best example I'll give you is really Covid. We knew that pandemics were possible… But there was no way that we had the information that would enable us to say that a virus would come out of China in December 2019… It would be much better for us to rely on qualitative statements of the sort: a pandemic is likely at some point in the future therefore, we better be prepared for it. And I think one of the big mistakes in economic policy has been overconfidence in forecasts, reliance on either point forecasts, or the belief that particular scenarios would be realized.

I think there is real risk in central banks trying to pretend that they can put a floor under the price of any asset.

King Mervyn
Lord Mervyn King

de Planta: We face all sorts of new radical uncertainties including geopolitical ones. For instance, debt levels have soared since the global financial crisis. Are we entering a new phase of radical financial instability? And where could that lead us to?

King: First, I think markets are beginning to realise that the era of exceptionally low interest rates is coming to an end... I think we are moving now into a period in which interest rates will move back up towards something closer to the historical average.

[Second,] is to tackle head on this problem of very large amounts of debt relative to underlying incomes, right across the world [through defaults or restructuring]… We have sovereign debt problems – something is going to have to give on this front. On top of all that, I think we have two other major sources of debt which concern me. One is corporate debt and the way it's distributed across companies… Companies that ought to have either restructured their debt or gone out to business have been able to survive… These so-called zombie companies you can find in every continent of the globe. 

And then on top of all that, I think you've got embedded leverage borrowing hidden in financial markets. A good example of that is…pension funds in Britain, [which] had borrowed, through derivative transactions, significant amounts that they could invest in riskier assets, to earn a higher rate of return. And they have not prepared themselves for the risk that was associated with that… if bond yields go up, they would have to meet cash margin calls, and they have not put in place any mechanism for dealing with that easily. So I think a lot of problems will start to emerge in different parts of the both financial system and the real economy as well as sovereign debt. And it's going to be a difficult period of five years, I think, for us to work through that. 

de Planta: Could we see a reawakening of a doom loop [a shock to one part of the financial system that then becomes amplified as it echoes through the economy, such as happened in the UK with the crisis in gilts]?

King: The whole point of a market is to reprice...when you get a situation where there is new information and people maybe realise there's a lot more uncertainty. So in the UK, does the government have a plan for ensuring that the public finances are sustainable? And if people question that, and they don't have the information about what the government will do in the future, then there is a lot of uncertainty… Whenever you get a big piece of news, you will get volatility as the price discovery process in markets operates when people are trying to find out what other people think. And they're buying and selling to test the market. 

You don't want the central bank to prevent that process from occurring. So I think there is real risk in central banks trying to pretend that they can put a floor under the price of any asset. And the role of a central bank is not to buy assets, but to lend cash against good collateral… You may end up generating more uncertainty and volatility by stepping in to try to slow the movement of a price, and then realising that you can't do it indefinitely and have to step back out again.

The mistakes made in 2020 and 2021 have not been repeated. Central banks are not printing money

King Mervyn
Lord Mervyn King

de Planta: What's the major difference between the inflation cycle we're seeing now to the one we saw in the 70s or early 80s? 

King: Both reflect a mistake by policymakers. In 2020, and 21, we entered the pandemic with broadly demand equal to supply. The pandemic reduced the potential supply of the economy, at least temporarily. And what central banks did was to try and boost demand. Well, if you've got too much money chasing too few goods, which was a classic description of Covid in the early months, then you'll get inflation. 

I think this was an intellectual mistake, generated by an approach to monetary policy produced by academics, who said that inflation is determined entirely by expectations, and expectations are driven by the [central bank] target… There was a similar mistake back in the 1970s, when policymakers thought there was a permanent trade-off between inflation and unemployment, and [that] by accepting a bit higher inflation, we could have lower unemployment. And that turned out to be wrong. 

The central banks that reacted strongly and quickly to the higher inflation in the 1970s, primarily the Bundesbank and the Swiss National Bank, were the countries that had not only the lowest inflation, but also the shortest recession. 

Now the difference I think, and this is important, [is] that it took a long time in the 70s and 80s for central banks to realise they'd made big mistakes, and to be willing to do what was needed to bring inflation back down. So they had a decade really of significantly higher inflation. The mistakes made in 2020 and 2021 have not been repeated. Central banks are not printing money… [they] have stopped doing additional quantitative easing, by and large. And as long as they stick to that, then the degree of monetary tightening that's being put in place now will bring inflation down… to target in around two years or so.

It means I think that we're moving back to an era in which not only long-term interest rates but also short-term interest rates will be well away from the zero levels that we've been used to for some while now.

Jay Powell, [chairman of the] Federal Reserve,… talks about Paul Volcker* in his speeches quite often now. And what that means is ‘we'll...keep raising interest rates, until we're pretty confident that inflation is on its way back down to 2 per cent.’ If that means a recession, it means a recession. 

I see absolutely no reason why we can't be optimistic about future productivity growth

King Mervyn
Lord Mervyn King

de Planta: Is there hope, in your view, for a more stable, and even more predictable future, for less radical uncertainty? 

King:
  We've been through an extremely unusual period, with very low interest rates, which have been very damaging… I think that era of very low interest rates has partly been responsible, through phenomena like zombie companies, for low productivity growth rates. And I think that if we now are moving back to an era of more normal interest rates, and that if we can navigate the problems of the high debt levels that have built up in that period of low rates, and bring debt levels down, then I think we'll be in a position where resources of investments and people can once again move from poorly performing companies, to good companies, and productivity growth will recover. And I see absolutely no reason why we can't be optimistic about future productivity growth, which is very good news for all children and grandchildren.

*Paul Volcker was chairman of the Federal Reserve from 1979 to 1987 and is credited with conquering the inflation of the 1970s and early 80s with aggressive monetary tightening.

This abridged interview is derived from Pictet's Found In Conversation podcast. The full conversation can be found here.