How should monetary policy operate in a democracy?


              There is no perfect answer. In practice, in any democracy, independent arrangements only last for as long as they have broad politcal and public support. If the independent bodies  do the wrong things or if the public loses confidence, then the elected authorities will change them.

              I do not favour relying on the chance that the electoral and political party system may just happen to put in the right senior office someone who understands the intricacies of monetary policy and is capable of making good judgements. The senior elected official can at any time override or make the important calls. Mr Darling, after all, seemed to take a very leading  role in cutting interest rates and loosening policy at the height of the banking crisis, when there was concerted action by the leading Finance Ministries of the world. It would be better to find a system where good official advice and delegated powers  can usually be operated without detailed reference to the senior elected official.

¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† In system with fiat currencies and single Central Banks it makes sense to delegate substantial power to the Governor and senior executives of such a Bank. Under the older UK system the Governor held regular talks with PM and with Chancellor. Differences could be ironed out in private, and a common view reached between the Bank and the government over correct interest rate and monetary policies in the light of the government’s tax and spending policies. Under the newer system the Bank has more authority to settle interest rates on its own, and to conduct more of the dialogue with government in public, by publishing forecasts and warnings about economic developments in the light of the government’s published decisions on tax and spend. The newer system does not, however, preclude private discussion about¬† the intersection of fiscal and monetary policy.

               What the public wants is for Bank and Treasury to follow policies which promote low inflation and good rates of growth. Within reason they do not much mind how that is done. The record shows that no  political party has avoided some boom/bust cycles. The record also shows that the two worst boom/bust cycles of recent years came about under regimes based on so called independent action designed to avoid political interference in key decisions.

                The truth is that an independent Central Bank is only a good idea if it is led by people with great judgement about the cycle. In 1989 we needed Central bankers to withdraw their enthusiasm for the ERM on the obvious grounds that the pound was going up and trying to keep it down would damage monetary and anti inflation policy. We needed a Bank which in 2005-6 made sensible adjustments to avoid excessive credit expansion, and a Bank who from the middle of 2007 made enough money available to markets and cut interest rates fast enough to avoid a run on banks. The fact that we did not get this shows that finding good Central Bank leadership is not easy, and the task itself is not easy for those charged with it.

                  In many other walks of life democratic government  is based on the theory that the generalist, the Minister answerable to the public, takes decisions based on best professional advice, but has the last word in cases of disagreement or difficulty. It is, after all, the politican who has to defend the decisions to the public, and who keeps or loses his job based on the success or failure of the decisions.

                          Some element of this needs to be included again in our approach to the newly strengthened Bank of England which will emerge from the latest reforms. I welcome the return of bank regulatory powers to the Bank of England. They need to understand bank balance sheets day by day and be able to control them to control the money supply. They should also act in the markets to raise money for the government. Armed with these substantial powers, they need from time to time to  confirm they have the support of the government. This could be done through a formal and public process, or through an informal one as used to happen. The senior elected official has to keep his confidence in the Governor, and satisfy himself that Governors in future are more likely to read cycles well than has happened in recent years.

                  In the end it comes down to people. The Chancellor has to carry the can and make any final or difficult decison. He is best equipped to do this if he has chosen a good Central Bank Governor with judgement and knowledge of the markets. He can then trust him and interfere little if at all.  If he has a Governor who is not good at judging he has to find ways of bringing better advice to bear on the problem, or he needs to change the Governor.


  1. norman
    November 17, 2010

    Someone has to be accountable, which we don’t seem to have at the moment – apart from those greedy bonus seeking bankers driving around Geneva in their Lamborghini’s and spending vast amounts that we can only dream of .

    Good riddance to them and their money!

    We shouldn’t be too harsh on them though, they do make marvellous scapegoats – just ask any politician or BoE employee!

  2. Mick Anderson
    November 17, 2010

    It’s also about the suitability of the tools available to those trying to use them. The BofE was charged with managing the growth of the economy, but only given one crude tool (interest rates) to work with.

    The Chancellor has many more tools which can be tuned much more finely, if only in the way that taxation works. A bad Chancellor can do more damage than a good Central Bank can resolve.

    It would be nice to think that the Chancellor would “carry the can” for the resulting events. In practice, the preferred method seems to be to use BofE “independence” as an excuse for why it’s all somebody elses fault.

    The Chancellor might be elected, but a General Election every five years is not a sharp enough instrument for electorate to keep him in check (or cheque if you prefer….)

    Reply: The Bank has a single task which is to control inflation. It has no duty to encourage growth.

    1. libertarian
      November 17, 2010


      “The Bank has a single task which is to control inflation. It has no duty to encourage growth”

      Maybe that is part of the problem. The BoE only has one target so they tend to focus on one issue which appears to be keeping interest rates stupidly low.

      I agree with Mick A to some extent our “democracy” is too blunt an instrument to react effectively in the 21st century dynamic.

      The role of the Chancellor is to affect all the other growth, tax and spending issues. which is highly worrying as the people “elected” to this role of recent decades have NIL experience in finacial markets

    2. Mick Anderson
      November 17, 2010

      JR: I appreciate in that the bank has only been given a single task in inflation control. I just don’t believe that this can be done either in isolation of other aspects of the economy, or with the single tool of interest rate adjustment.

    3. Mark
      November 18, 2010

      Once upon a time the Old Lady had rather more strings to her bow. She could raise an eyebrow at activity she disapproved of: a call from Threadneedle St was far more effective and far swifter than drafting another 10 pages of FSA rulebook after extended negotiations. She could draw in her corset – which was how the money supply was controlled: banks could be required to deposit extra eligible liabilities, and were limited in how much gearing they could use by law. She could fiddle with interest rates, which were rather more effective than foreign exchange interventions at influencing and stabilising trends in exchange rates, although those too were permitted, with the side effect on inflation. More modest damping of irrational exuberance could be achieved through mopping up excess liquidity via bond and bill issues ahead of actual requirement. She could act as lender of last resort.

      The idea that a single policy instrument controls a particular economic variable with no other side effects is surely quaint. You need to use the steering wheel as well as the accelerator and brake to drive a car. It helps to demist the screen and use headlights to see where you are going. A good driver not only reaches the destination, but avoids crashes and provides a smooth ride for passengers who may help with the map reading. Driving the economy is like relying on the rear view mirror: you only have some idea of where you have been somewhat after you have moved on.

      Of course if you allow more tools there is more scope for their misuse by those tweaking them. But in the main, abuse of the economy comes from politicians seeking to buy the next election or implement an unaffordable radical spending programme: hands up Barber, Lawson, Thorneycroft, Healey, Callaghan, Brown and Darling for starters.

  3. Will J
    November 17, 2010

    Can you apply for the job?!

    1. Acorn
      November 17, 2010

      Where do you want George to send you the Application Form. If you want a self taught amateur macro-economist to carry your bags, I am available.


      1. Stuart Fairney
        November 17, 2010

        Quite the best suggestion on the blog this month, now if only you could get Peter Schiff to replace George Osborne!

  4. lifelogic
    November 17, 2010

    You say “In practice, in any democracy, independent arrangements only last for as long as they have broad political and public support.” so that pretty much rules out the UK and the the EU then.

    Also “The Chancellor has to carry the can and make any final or difficult decision” well yes he might carry the can, loose his job and get a better paid one in the city and a very good state pension .

    I remember during Major’s ERM fiasco when Thatcher was pushed in to the mad scheme by Major and his likes. Everyone in touch with the real world – local bank managers, businessmen, landlords, engineers knew it would all end in disaster as they could see it all around them. Only the “experts” John Major and the group think in government & civil service circles kept pushing it over the cliff (hence no proper Tory government since the wets removal of Thatcher).

    Just the same now with the global warming exaggeration and mad green power schemes
    that every sensible engineer knows to be economic madness, just ask them (not the ones who consult of the state sector or the state subsidised green gravy train that is).

    With modern IT might it not be better to consult a thousand such ordinary private sector businessmen, landlords, engineers, shopkeepers and the like across the UK on monetary policy. The chancellor is far to much in the thick of the London/EU political hot house to see a true overall picture. While you are at it you could ask them about mad regulations and the banking restrictions too.

    In fact we could consult the public much more in general very cheaply now – but then that might end in democracy and the UK leaving the EU and proper self governance so we have no chance of that.

    Just the chance to elect one of two rather similar party place men every 5 years – so they can go back on their manifesto promises shortly after the election. In order to toe the line, keep their party endorsement, a safe seat, tax free expenses and a very nice pension and the odd duck house.

  5. Nick
    November 17, 2010

    interest rates = function (inflation)

    ie set interest rates to 12 month average of inflation + x%

    Make it algorithmic. If inflation is still high, then increase x. If its still low, decrease x.

    Change the target to target the index. ie. We’ve had a period of high inflation. That needs to be balanced by a period of undershooting.

    1. Sally C.
      November 17, 2010

      I like this idea. As long as the inflation figure isn’t fiddled, it would take away the possibility of politicians manipulating the money supply and the price of credit.

      Unfortunately, that is also the reason why it will never happen.

    2. Suboptimal Planet
      November 18, 2010

      How about letting the free market decide interest rates, according the time preference of millions of consumers?

  6. waramess
    November 17, 2010

    “What the public wants is for Bank and Treasury to follow policies which promote low inflation and good rates of growth.”
    Not happened for the past fifty years except for a short while under Ken Clarke, and I can’t help thinking that might have been by accident. All this talk about monetary policy is just a high falluting way of suggesting some economists might understand what they are doing. Absolute nonsense and that is a statement borne out by history.
    When you all stop theorising about what you can and can’t do with fiat money we will all be the better off. Increasing and decreasing the volume of paper in the system does nobody any good and we would all be better off pushing for a currency backed by gold, silver, rice in fact anything that economists and politicians can not fiddle with

  7. Gary
    November 17, 2010

    In any case it is impossible for any individual or committee or politburo or benovolent dictator to plan the economy. By the laws of the Economic Calculation Problem it is not possible to organise the economy outside of a market. For if it were, there would be an alorithm that if implemented would acrue to the user all the welath in the world. Not even the nobel laureates at LTCM could get that program right and they nearly took down the world in their attempt. So, we should just forget about finding that God-man and just leave the market unfettered, especially removing moral hazard.

  8. Mark
    November 17, 2010

    The Chancellor specifically appoints four of the nine MPC members – although only one of those spots has fallen vacant since the election (Dr Weale appointed). To blame the Governor for policy when he has been so closely watched is surely to exaggerate the independence of the Bank. Besides, as you point out, the ability to monitor the markets was emasculated under the tripartite provisions. The lone hawk has been left watching from the sidelines. A guide to the present membership:

  9. Steve
    November 17, 2010


    Get rid of the BOE. Go to a Gold and/or Silver standard.Why would a group of ‘experts’ be able to set interest rates better than the populace as a whole acting through a free exchange? Between 1787 and 1913,the Dollar lost 8% of its purchasing power.Since the ‘FED’ (or private bank cartel)in 1913 in America,it has lost 97% of its PP. Debt based money is a tax on everyone,especially the poor. Give us a Gold standard and get the international bankers off our backs,for God’s sake.

  10. APL
    November 18, 2010

    JR: “How should monetary policy operate in a democracy? There is no perfect answer. ”

    You could of course remove the government from the economy to the extent that private enterprise represents 80% of economic activity.

    Then privitize the currency, abolish legal tender and allow the private sector to use the currency of its choice.

    This would raise economic activity, raise tax income, and reduce the ability of the government to strongarm the private sector.

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