UK: DON'T LET'S DISTURB THE OLD LADY - BANK OF ENGLAND. - David Smith is not a believer in economic panaceas nor in an independent central bank.

by David Smith is economics editor of the Sunday Times.
Last Updated: 31 Aug 2010

David Smith is not a believer in economic panaceas nor in an independent central bank.

There is as yet no bunting bedecking its grey stone walls, but the Bank of England has had a thorough clean-up. Decades of City grime have been washed away to spruce up one of Britain's oldest institutions. The Old Lady of Threadneedle Street is 300 in 1994.

The Bank's birthday has coincided with an intensification of the debate over whether, like the German Bundesbank, it should be made independent of government. Under such a move, it would be given control, subject to Parliamentary accountability, over the operation of monetary policy. Changes in interest rates, to take one of the most practical and visible aspects of independence, would then be made irrespective of their political context.

Two former Chancellors, Nigel Lawson and Norman Lamont, revealed in their resignation speeches that they had, while at the Treasury, come round to the idea that the Bank should be made independent. Significantly, however, the one who came between them - John Major - was not similarly persuaded. Nor, as yet, is Kenneth Clarke.

But the tide is moving in favour of central bank independence. France, even in the middle of her European exchange rate mechanism (ERM) difficulties earlier this year, was taking steps to make the Banque de France independent.

Another example, which shows that central bank independence can work in an Anglo-Saxon context, is New Zealand. Since being made independent at the end of the l980s, and charged with achieving inflation of between zero and 2%, the Reserve Bank of New Zealand has surprised most observers with its success, albeit at a cost in terms of high unemployment.

Here, the all-party House of Commons Treasury and Civil Service Committee, citing both the European and New Zealand examples, has given its backing to greater independence for the Bank of England.

The Bank has, to a degree, already secured more independence than has been the case for most of the post-war period. When sterling was expunged from the ERM more than a year ago, Norman Lamont, the then Chancellor, quickly cast around for ways of reassuring the startled markets that the Government still meant business on inflation.

The solution was to beef up the Bank's public role as anti-inflation guardian. It now issues a quarterly inflation report, which sets out in detail its inflation projections and points out (or will when the time comes) when economic policy is inconsistent with the achievement of 1% to 4% inflation, which is the official Treasury target. The Bank's Governor, Eddie George, also attends, along with his senior officials, a monthly monetary meeting with the Chancellor and his team, adding to its influence in the policy debate.

Innovative though these moves were, they are some way from full independence. There remains a suspicion that the Bank would draw back from issuing an inflation report that not only embarrassed its political masters but also unsettled the markets.

The case for central bank independence is quite straightforward. Monetary policy has to be set in a medium-term context to ensure continued success in the battle against inflation. But when politicians set interest rates, they frequently think only of the short-term - the depth of the political hole they are in, the party conference, the by-election or general election they must win. Lamont, again, revealed in his resignation speech that there had been times during his Chancellorship when interest rate cuts had been decided for political reasons.

The low-inflation success of countries with independent central banks is supported by the weight of academic evidence. Alberto Alesina and Larry Summers set the inflation rates of a range of countries over the period 1955-88 against the degree of central bank independence, measured on a scale from one to five. (A central bank with an entirely free hand would score five, another with no autonomy at all, one. As the chart on page 13 shows, even the Bundesbank did not merit a five. The Reserve Bank of New Zealand, prior to independence, was subject to political control).

There is, on the face of it, little argument against central bank independence. Why, then, do I not think increasing the independence of the Bank of England is appropriate? The following reasons persuade me.

Countries with independent central banks may have achieved more success on inflation. But cause and effect are not proven. Germany's post-war inflation success may owe more to the deep fear of inflation in the German psyche, following painful historical episodes of hyperinflation, rather than an absence of political influence over interest rates. It could be that some countries naturally have higher inflation than others. Attempts to impose inflation-beating independent central banks on them would not be sustainable.

There is, in addition, the issue of accountability. Both the Bundesbank and the US Federal Reserve Board operate on the basis of regional representation on their decision-making bodies. Only some members of these bodies are career central bankers. The Bank of England, in contrast, is monolithic. The issue of accountability would not be solved by requiring its governor to submit himself to regular examinations on policy by a House of Commons committee.

An independent Bank of England would, inevitably, lean in the direction of a safety-first policy towards inflation. This could skew policy towards being much too restrictive, with adverse consequences for growth and inflation. Even if one accepts that there is no long-run trade-off between inflation and growth, this long run may be very long indeed.

Finally, I am suspicious of the way many commentators seized upon Bank of England independence immediately after sterling's departure from the ERM. Some people clearly believe in panaceas for the problems of the British economy. In my experience they do not exist.

Find this article useful?

Get more great articles like this in your inbox every lunchtime