Given the tendency for politicians to give undue weight to short-term political considerations, a strong case emerges for precommitting to a low inflation policy by removing monetary policy from immediate government control – hence the saying “The only good central bank is one that can say no to politicians”. Only an independent central bank under the control of professional bankers and free from political influence can credibly pre-commit to the objective of achieving low inflation. If the bank can be seen to be adhering to this objective in the face of pressure to change its course, it gains credibility with wage and price setters. Such a credibility gain increases trust in the bank’s predictions of low future inflation, and thus reduces inflation expectations. The bank can also act rapidly to choke off inflation before it became a problem, and will thus not be driven to the large and disruptive rate changes that are the inevitable consequence of acting too late. An additional, though less certain hope, is that a clear separation of responsibilities should improve the relationship between the Bank and the Treasury, and leave each free to concentrate on its particular objectives, without fear of interference from the other.
Despite the strong economic case for making the Bank of England independent, politicians have historically been reluctant to surrender key policy instruments to bodies that are not directly accountable to Parliament. The former Conservative government under John Major consistently refused to grant the Bank formal independence, although the decision to permit the publication of the minutes of meetings between the Chancellor of the Exchequer and the Governor of the Bank of England did strengthen the Bank’s voice in advocating lower inflation. Nevertheless, the Conservative government never supported full independence, and it was certainly not expected that Labour – a party that had not held office for twenty years – would entertain an idea so bold. This was the primary reason why the Chancellor’s announcement was greeted with such incredulity by observers.
However, though granting the Bank of England independence was seen as a radical move, it is important to note that this independence had many caveats attached to it. The bank has operational independence in maintaining price stability, but does not set the inflation target itself – this is determined by the government, in contrast to other leading central banks, which are at liberty to set their own policy objectives. The bank has to account for any failure to meet the established target. Equally, subject to meeting the set inflation target, the bank is obliged “to support the economic policy of Her Majesty’s Government”, which maintains both the prerogative to directly determine interest rates for a limited period in extreme circumstances, and control of exchange rate policy. The composition of the nine-person Monetary Policy Committee is also strongly influenced by the government. Finally, the network of relationships between the Bank and the Treasury are so dense that it is questionable whether the Bank even has complete operational independence – at the very least, the Treasury is likely to drop a few hints about what rate change it would regard as desirable. However, though the autonomy of the Bank of England is still limited compared to other major central banks, past and present, the decision to cede such a significant power as setting national interest rates to an unelected body was both politically bold and constitutionally unprecedented.
The economic and political landscape of Britain changed significantly over the 1980’s. The demise of traditional heavy industry, the emasculation of the trade unions and the growth of an enterprise culture severely weakened the cohesiveness of the groups from which Labour had traditionally drawn most of its support. At the same time, the Thatcher government was extremely successful in convincing the electorate that, in the context of increasing globalisation, neo-liberal economic policies were an unfortunate necessity, and that the Keynesian orthodoxy at the heart of Labour economic philosophy was simply no longer a credible basis for economic policy. Therefore, by the late 1980’s, the economic policies that were at the heart of Labour’s political philosophy had been rendered anachronistic in the eyes of a sufficiently large proportion of the electorate to deny them power. In an attempt to adjust to the new political landscape of Britain, the Labour party went through a period of self-styled “modernisation”, during which time many of its economic policies converged, conspicuously with those of the Conservatives. Nevertheless, Labour was historically a socialist organisation, and had only abandoned its commitment to collective ownership (Clause IV) two years previously. Equally, Labour had not occupied public office in nearly twenty years, and had no experience administering an economy according to neo-liberal principles. From the perspective of the financial markets and businesses everywhere, this was not a combination that inspired confidence. Facing this problem, if Labour was to have any success in implementing its economic policies, it was essential that it find some way to reassure both financial market and businesses that it intended to act with the utmost prudence. In this respect, the decision to grant the Bank of England independence was a political masterstroke. By implicitly accepting the prevailing wisdom that independent central banks are much more effective at pursuing low inflation than those subject to political interference, the government was able to project an image of an extremely strong commitment to fiscal and monetary conservatism. Such a commitment was regarded by international financial markets as essential to achieving a stable background for businesses to plan and invest, and did much to foster confidence in New Labour’s economic objectives.
The other major political motive for granting the Bank of England independence can be found in the 1991 Maastricht Treaty, which established the blueprint for European Monetary Union. There is little doubt that both the Prime Minister and the Chancellor are in favour of Britain joining EMU, both to reap the expected economic benefits, and to maintain Britain’s political influence within the European Union, which is likely to be eroded by continuing to remain outside.
Though the government has publicly stated that five economic tests would have to be satisfied before it would be willing to commit to joining EMU, it is widely believed that it is only the shallow “Euroscepticism” of the British public that is staying the government’s hand. Most political commentators believe that both the Prime Minister and the Chancellor would call a national referendum on the issue immediately if they thought that they could win by a reasonable margin.
One of the two principles on which the Maastricht Treaty was based was that entry into monetary union would be conditional on satisfying a number of “convergence criteria”. Two of the most important of these criteria are the requirements that a country can only join monetary union if:
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Its inflation rate is not more than 1.5% higher than the average of the three lowest inflation rates in the EMS.
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Its long-term interest rate is not more than 2% higher than the average of the three lowest-inflation countries.
It is clear from these criteria that monetary union has an anti-inflationary bias. This is primarily due to the influence of Germany, which has historically placed extreme importance on controlling inflation – the former Bundesbank was legendary for its inflationary discipline, and has provided the model for the new European Central Bank. In the negotiation of the Maastricht Treaty, the German position was essentially that only an ECB that was at least as strict in controlling in inflation as the Bundesbank would be acceptable. Due to her strong strategic position during the approach to Monetary Union, Germany succeeded in achieving this objective.
In order to meet the convergence criteria, Britain had to adopt a monetary policy that was as determinedly anti-inflationary as that of Germany. The evolution of the Monetarist economic theory since 1970, which stated that the long-run trade-off between inflation and unemployment illustrated by the Phillips curve was illusory, convinced many economists that monetary policy should concern itself solely with reducing and stabilising inflation, and should not be used to support employment policies. However, since the Phillips curve is still true in the short-term, central bankers can come under pressure from politicians pursuing short-term electoral gains, as discussed above. Consequently, a consensus emerged among central bankers, especially in Europe, that political independence was a necessary precondition to achieving price stability. This view gained empirical backing from a series of econometric studies performed in the early 1990’s that demonstrated the independent central banks had a better record in fighting inflation. Therefore, a politically independent central bank essentially became a condition of joining EMU. Consequently, it was necessary to grant the Bank of England independence to support the Blair government’s political objectives.
A final political motive can be found in an accusation, levelled at the time, that the Chancellor had granted the bank of England only such powers as were absolutely necessary to relieve the Treasury of blame for any subsequent monetary mismanagement. Though this argument may be tempting to the cynical mind, it is not really credible – if the Bank of England were to spectacularly fail in setting interest rates appropriately, the Chancellor who gave it independence would ultimately be held responsible for any subsequent economic problems. Nevertheless, it is probably fair to say that the deflection some of the criticism of interest rate policy towards the Bank was, from the Treasury’s point of view, no bad thing. It is also true that the Chancellor probably appreciated the reduction in his workload!
Thus far, the Bank of England has shown itself to be much more vigorous in its pursuit of low levels of inflation than the Treasury has ever been. Where the lag between changes in the output gap and subsequent changes in interest rates had hitherto been as long as a year, under the new arrangements the changes are nearly instantaneous. Equally, though the changes in the base rate have tended to be small, and have thus far remained within a range of 4% to 7.5%, they have been fairly volatile, as the Bank has endeavoured to react rapidly to changes in the inflation forecast. Ultimately the success of the new arrangements will be measured by how close the inflation rate stays to the target level. Since the Bank was given operational control of interest rates, the retail price index has averaged 2.3%, and has remained within a range of plus or minus 1% of this figure – very close to the symmetrical target of 2.5% set by the Treasury. By this measure, the new monetary policy framework would appear to be an unqualified success. An alternative measure of success is whether inflation expectations have been changed, and whether financial markets have enough confidence in the new arrangements to reduce the required interest payments on Sterling investments. Measured by the expected yields on long-term government bonds and the survey responses of city analysts and trade-union negotiators, inflation expectations do appear to have held constant at around 2.5% for some time. This stability of expectations, combined with the commitment to a symmetric inflation target, is extremely valuable, both in increasing the ability of the economy to absorb a shock, and in allowing businesses to make long-term investment plans with reasonable confidence in the predicted level of inflation.
One concern that has arisen over the decision to grant the Bank independence is that of democratic accountability. The primary reason for establishing an independent central bank was to prevent politicians from interfering with monetary policy for short-term gain. Nevertheless, though politicians may be short-sighted, they are the elected representatives of the people. The Bank is answerable to the Chancellor, not to Parliament, so direct ministerial responsibility for monetary policy is necessarily diminished. This has generated concern among a small number MP’s, who share John Major’s view that “the person responsible for monetary policy should be answerable for it to the House of Commons”. However, the decision to limit the Bank’s autonomy to merely operational freedom rather than target freedom, and the provision for the Chancellor to directly override the MPC, has largely addressed these concerns. Equally, setting a symmetric inflation target prevents the Bank from overreacting to inflation.
Though the Bank’s performance thus far has been a tour-de-force of monetary prudency, it is difficult to determine whether this is due to the new monetary policy framework, or to relatively benign economic conditions reducing inflationary pressures. It must be noted that inflation has increased relatively sharply over the last six months, principally driven by a combination of rising oil prices and high housing depreciation. Growing economic uncertainty driven by an increasingly likely war in Iraq, and its potential effect on oil prices, may erode the Bank’s ability to maintain the inflation rate at the specified level. If the Bank proves to be ineffective in controlling inflation in less favourable economic circumstances, the concerns over whether the reduction in political control outweighs the economic gains may acquire greater importance. Equally, if more widespread economic instability starts to generate problems within EMU, and political support for joining lags as a result, the necessity of a maintaining an independent central bank to meet the Maastricht convergence criteria will disappear. In conclusion, thus far the new monetary arrangements have stood as a triumph of economic and political expediency. However, the ability of the Bank of England to deal with major external shocks to the economy has not yet been demonstrated. Given the potential for the increasingly inevitable and immanent war in Iraq to affect world oil prices disastrously, the Bank may be put to the test sooner rather than later – its performance over the next six months may decide its future.
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