Keep on doing what you are doing

There were many reasons why we got into this crisis; poor financial sector regulation, distorted incentives, bonuses, speculation, excessive risk-taking. However, there is one reason that doesn't get enough attention; the policy remit of the Bank of England.

When the BoE became fully independent, the government gave it an inflation target. It said to the bank "go chase down the consumer price index. Make sure it doesn't increase by more than 2 percent a year". Ominously, the government didn't say keep asset prices under control and avoid speculative bubbles.

The BoE happily went along with this new target. Keeping inflation under control would be easy. Moreover, the Bank added an air of modesty to their objection about preventing speculation. It echoed the claim by Greenspan that it could not properly identify bubbles. Speculation was something that could only be ascertained once the crash had actually happened, and then it would be too late.

For about eight years, the BoE claimed that it had beaten inflation. It met the target and told the rest of us that everything was under control. House prices, it occasionally acknowledged, were increasing at double digit rates. So too was the money supply, but this didn't matter because the CPI was nailed down. Furthermore, the BoE managed to do this with historically low interest rates. In short, they implicitly told us "sit back, relax and if you feel like it, take out a loan."

However, the truth was that the CPI was declining because of the extraordinary increase in the world supply of cheap manufactured goods, mainly coming out of China and other emerging market economies.

During these years, the CPI should have been negative; a fact that the BoE were happy to ignore. Domestically determined prices were increasing sharply. (If you want proof, just take a look at the price of UK rail tickets or the council tax.) Putting a cap on this hidden inflation would have required higher interest rates, which would have put an end to the housing bubble.

The rest of the story we know. Throughout the decade, Banks were taking on too much risk, households were borrowing silly amounts of money and the housing market was out of control. This sorry mess hit the wall in August 2007. So far, the UK taxpayer has been forced to pump in 90 percent of GDP into the financial sector, just to prevent it from collapsing.

Have policy maker learnt anything from this dreadful experience? It seems not. Later this month, the Treasury will publish a White Paper on financial services. In principle, this offers an opportunity to extend the BoE's target to stabilising asset prices and preventing bubbles.

However, for the New Labour radicals that manage the Treasury, this idea is too extreme. They want to keep things pretty much as they are. The BoE will continue to target the CPI and asset prices can do what they want. In principle there is nothing to prevent a recurrence of the current crisis.

It is very much a case of "keep on doing what you are doing". So, is everyone ready? We have a one way ticket back to Bubbleville.