We should not lose sight of the absolutely vital achievement of establishing monetary policy regimes that carry credibility with households, firms and markets. But, in terms of demand and output, underneath a surface of smooth growth at the aggregate level lay horribly imbalanced economies. And given the length of time this persisted, it may well have affected the pattern of investment, and so led to a distribution of the economy’s supply capacity that would be out of line with better balanced demand. It is hard to tell. I don’t much like slogans, but the “Great Threat” might have been a galvanising refrain. BIS Review 21/2010  5  The monetary transmission mechanism: we must embed the renewed interest in financial markets, money and credit As Mark Carney, the Governor of the Bank of Canada, observed at Jackson Hole last summer, 3 economists developed a habit of thinking of the financial parts of the monetary transmission mechanism as more or less fixed for practical purposes. But, in fact, the evolution of the financial system – due to regulation, innovation, and animal spirits – can, subtly or not so subtly, alter the ways in which our interest rate changes flow through to the real economy. Twenty years ago there was great interest in this kind of thing, perhaps reaching its apogee in the BIS’s Cross Report 4 on the effects of interest rate and foreign exchange derivatives on monetary policy and macroprudential policy.
On average over the past decade the UK ran a current account deficit of around 2% of GDP, increasing in the years immediately before the crisis. That is about double the post-war average, but compares favourably with the United States, which had a deficit of around 5% of GDP before the crisis. Sterling’s depreciation has already boosted the UK’s external balance sheet, and net trade should benefit too over time. Arguably, more serious imbalances were internal. Perhaps surprisingly, they did not show up in unusually strong output or consumption growth, in contrast to the inflationary booms that preceded earlier busts. In the five years leading up to the crisis, annual GDP growth averaged around 2½%, similar to the post-war “trend”. Much the same was true for household consumption growth, and its contribution to GDP even declined slightly during 2005–07. But, with slower income growth, the household saving rate actually fell throughout this period. Household balance sheets expanded rapidly, with debt and house prices rising in tandem. Access to cheap and readily available finance, and a willingness to borrow, led to household debt rising to over 150% of annual income. That inevitably made the household sector more vulnerable to adverse shocks; that is what leverage does! But there were also important distributional shifts. One way of thinking about the rise in house prices and increase in debt is as a transfer of wealth between older (house-seller) and younger (buyer) generations.