After the failure of the Exchange Rate Mechanism we had an interlude of successful economic policy. From 1992 onwards the economy recovered well. Labour continued the fiscal policy of the outgoing Conservative government for the first couple of years. By 2000 the UK economy was in good shape and the public finances were recovering strongly from the ERM disaster. There were still many in the Establishment who cast envious glances to Germany. If we could not import German discipline by hitching our currency to theirs, they reasoned, why not adopt a German style independent Bank to enforce our own teutonic controls?
Labour doubted it could command respect for an independent monetary and economic policy, so it was vulnerable to these siren voices. It offered two reassurances. It would follow Conservative spending plans for a bit, and would not raise Income Tax rates. Once in office it added the decision to “make the Bank of England independent”. As always in an age of spin it was important to look at what they did rather than what they said. They stripped the Bank of its bank regulating powers, and took away its job of raising money for the government in the money markets. Far from making the Bank overall more independent they all but demolished it, making it less in tune with how money and debt markets were moving. They created a so called independent Monetary Policy Committee. Their task was to set interest rates with a view to keeping price inflation close to a stated low target for RPI increases.
Every person on the MPC was a direct appointment chosen by the Chancellor, or was chosen by someone chosen by the Chancellor in the case of Bank employees. Some found their tenures renewed, others served just one term. There was no transparency over how you got selected or re selected. Treasury Ministers sometimes seemed alert to likely future interest rate changes. During the second Labour Parliament the Chancellor changed the target from RPI to CPI in a way likely to result in looser monetary policy, as he did not fully allow for the lower historic rate of increase in CPI compared to RPI. In more recent times Chancellors have become intimately involved again in monetary policy, as their consent is required for quantitative easing.
A body with a single aim should be judged by their results. For most of the last 60 months inflation has been higher than the permitted level. In their most recent report the Bank and the MPC have stated they do not have much idea of what will happen next in the economy. They stand ready to fight deflation and to fight inflation. They have had once again to revise their forecast for the inflation rate upwards. This has all happened against the background of depressed western world demand and very low price inflation in the US, Euroland, Japan and the other main advanced countries.
The apologists for the Bank claim that it was not the Bank’s fauilt that the UK economy lurched from a credit soaked boom in 2007 to the deepest recession since the 1930s in 2008-9. They argue that international factors were to blame. Alternatively they say it was the fault of the banking crisis where the FSA was the prime regulator. They still have to explain why it should be that against such a background the MPC was not even able to control price increases when practically everywhere else in the advanced world inflation had ceased to be a problem. They also need to explain why the Bank of England did not take its duty to avoid systemic collapses in the banking market more seriously at an earleir stage of the crisis.
The truth is the Bank of England lurched from money which was too easy and interest rates which were too low, to money which was too tight and rates which were too high in 2007-8. Their policy allowed or fuelled the bubble, and their policy helped burst it. They did an extreme version of what the ERM had done to the UK economy a couple of decades earlier. Many people and two Opposition parties warned that credit and mortgages were too easily available prior to 2007. We called for tighter policy. A few of us urged the Bank and government to loosen in the summer of 2007 to avoid the run on the Rock, but our well intentioned advice fell on deaf ears. There were even fewer of us offering an alternative to bank nationalisation, once the monetary tightening threatened to overwhelm bigger banks in 2008.
The Bank now accept that current inflation in the UK is partly the result of a major devaluation of the pound which the Bank allowed and facilitated during the crisis. If they wish to uphold the value of the currency they need to take actions designed to retain its external value as well as its internal value, as the two do have an intimate relationship. The combination of money printing and low interest rates has undermined the external value of sterling. In an open economy like ours where we import so much it has directly slashed our living standards. This site has been warning against excessive devaluation and inflation for many months, but the Bank seemed unable to see it when it mattered. As a result we have ended up with a stunningly high 5% RPI inflation at worst , and a 25% devaluation.
Meanwhile, what became of the bold German model for these two schemes? Germany gave up on the Exchange Rate Mechanism and moved rapidly into the Euro so other countries could no longer devalue against her. Her Central Bank remains, but no longer has a currency or an interest rate structure to operate. In the dying years of German monetary independence even Germany showed that her Central Bank was not and could not be truly independent in a democracy. On the two main questions of the day the politicians overruled the Bank. They ordered a badly chosen swap of ostmarks for DM on the reunification of Germany against Bank advice. Their chosen rate of one ostmark to one DM was boudn to cause economic problems. They ordered the abolition of the DM, the currency the German Central Bank had to maintain and defend as its main purpose in life.
Tomorrow we will look at what would be a better system for curbing wanton politicians and for curing Central Banks with bad judgement. Meanwhile both major parties, Conservative and Labour, should reflect sorrowfully on how their experiments with auto pilot monetary policy resulted in boom and bust, leading in both cases to bad election defeats. The autopilot model, whether exercised through exchange rate linkage or through an independent Central Bank, has both times done damage to the Uk economy and to the political parties in office at the time.