Countries with growing current-account and budget deficits were now able to obtain finance in the emerging international capital markets. Economic policy in many Western countries, Sweden included, drifted further and further away from Keynes’s basic tenets. Inflation, which in the Bretton Woods era had averaged around 4 per cent, soon rose to twice that. When unemployment began to increase in connection with the oil crises in the 1970s it was evident that Keynesianism faced a crisis. It offered no solution to the problem of stagflation. Earlier ideas were now revived and new approaches were developed. The difficulties decision-makers face over adjusting imbalances in good time had already been highlighted by economists, above all in the United States, in the late 1960s. There is a considerable risk, for example, that a demand stimulus when activity is low will not have time to act before an upturn has occurred. Policy is therefore liable to accentuate cyclical fluctuations instead of smoothing them. Perhaps the most pungent criticism came from those who argued that in practice, firms and households act in the light of their economic policy expectations. If, for example, the government tries to stimulate demand by increasing transfer payments and thereby the budget deficit, households will simply save the additional benefits because they expect that, sooner or later, the public sector deficit will have to be financed and this entails either increased taxes or decreased transfers. There would be no increment to demand because households strive to keep consumption stable over time.
Whilst these may appear to be self-indulgent memories, the comparison of the economy then and now does provide a thoughtful backdrop for what I want to discuss with you this evening. Compared with the economy in the 70s, maybe things aren’t as bad now as we sometimes like to believe! The first topic I want to cover will be what central banks can do to help achieve the holy grail of low inflation, stable growth and full employment. In particular I will take a monetary approach to explaining the issues. Second, I want to talk about the monetary policy decisions facing us right now and explain my own recent voting position. Third, I want to give an update on our latest initiative, the “Funding for Lending Scheme”. Money and the balance sheet of the central bank In the Acknowledgements to his 1988 classic “A Brief History of Time”, Stephen Hawking notes that he was told that each equation he included in the book would halve its sales. He only included one.1 You may be relieved to hear that there are no equations in this talk tonight. But I mention this because I am going to refer regularly to something which has been empirically proven to send some journalists to sleep faster than counting sheep. The Bank of England’s balance sheet. I hope you are all still awake? Good, because the Bank’s balance sheet is actually where all the action is.