Yesterday, we saw how the Bank of England has been far from independent over the last 11 years, as it has been slimmed down and bossed around by the present government. The main blame for the current high level of inflation rests with the government. The Bankâ€™s failure to control price increases as advertised is understandable when you see how the government changed targets, arranged appointments and took powers away from the Bank.
Today we should ask: Can you have an independent Central Bank in a democracy? The answer, of course, is only if certain, very specific requirements are met. There are three necessities to create and preserve a so-called independent Central Bank:
1. All the political parties capable of forming or influencing government must support an Independent Central Bank, whatever it does, whenever it does it.
2. Government must refuse to interfere or override when the Central Bank gets it wrong, even though there will be strong pressure for it â€œdo somethingâ€.
3. There must be no other policy aim or requirement that comes to take precedence over the desire to keep the Central Bank independent.
The nearest any democratic country got to a truly independent Central Bank was post-1945 Germany. The folk memories of the hyper-inflation of the inter-war years were so strong, that the political parties all agreed that they would rest control of inflation in an independent Central Bank and live with its rulings. It had just one main task â€“ to defend the internal and external value of the currency – the newly created DM. The Central Bank made a fairly good job of the task, which made it easier for the political parties â€“ and the public â€“ to go on supporting it. In the end, however, two political priorities emerged, which meant the end of the experiment. The first was German unification. The German government was so determined to see it through quickly and favourably to East Germany, it overrode very good advice from the Central Bank. It created far too many DM to replace the Ost mark in East Germany, which blew the Central Bankâ€™s controls out of the water, and added to the economic turbulence created by re-unification. Subsequently, the politicians decided European integration was such a high priority that they would destroy the currency the German Bank was set up to defend. The death of the DM went through with scarcely a murmur from the Central Bank, which showed it accepted the supremacy of the German government.
Some say the US has a truly independent Central Bank. Certainly, if you want a so-called independent Central Bank, the US model is probably the best to follow and has proved to be relatively long lasting. National banking was established by the National Currency Act in 1863 to help finance the civil war. The banking system was subject to frequent crises, which led to a wide-ranging enquiry and public debate in the opening decade of the 20th century. In 1913, after endless rows over the relative roles of centralised and de-centralised banking, and over private banks and public involvement, a compromise was reached with the creation of the Federal Reserve Board and its system of banks.
The genius lay in the flexibility and the careful compromises in its constitution. The executive â€“ the President of the US â€“ appoints the Board members, but the Senate has a role in ratifying their appointments. The Fed has to work within the governmentâ€™s economic policy, and has wide-ranging requirements that relate to employment and growth, as well as to inflation. It works closely with the Treasury over government debt-management and the wider economic aims. The whole system is subject to Congressional oversight. If the political support for this sophisticated and balanced system ever did break down, Congress could legislate to change it. It has survived and flourished because the Fed has been responsive to the public mood, to the needs of each Administration, and to changing fashions in the worlds of banking and economics. The Fed system brings in all the important players and balances their views and interests. Its handling of the Credit Crunch has showed this flexibility, responding with the Administration to the change in priority, from inflation fighting to recession fighting.
The UK should study other regimes, and learn more about the need for commonsense and balance in the system. The UKâ€™s version of an independent Central Bank left a much enfeebled institution, shorn of important powers and duties, unable to deal with a government that decided to borrow far too much for comfort, and decided to change the one central target at a damaging time.