May 6, 2022
This week marks 25 years since arguably the biggest change to UK economic policy that no one voted for – the handing over of control of monetary policy and inflation to the Bank of England, a newly ‘independent’ central bank.
Established in 1694 and nationalised in 1945, the Bank of England has always had a close relationship with the government, from its early history helping the government finance its wars, to its post-war role guiding investment towards the government’s industrial priorities. But the role of the Bank of England has often flown under the radar of mainstream political debate. It therefore probably came as a surprise to most people when one of New Labour’s first acts of government in 1997 was to grant operational independence to the Bank of England – something that was absent from the manifesto they had just been elected on.
What this meant in practice was that the Bank of England was tasked with targeting inflation at 2% and given independence over monetary policy (setting the price of money through interest rates) to decide how to do this. The idea was that this would take the ‘printing presses’ away from elected politicians, who New Labour feared the public (and financial markets) didn’t trust not to turn on for short-term popularity. While this may sound like a well meaning idea, it has turned out to be unfit for purpose.
This separation of economic policy between fiscal authorities like the Treasury and independent central banks like the Bank of England has ended up exacerbating the crises of the past 25 years, from asset price bubbles and rampant inequality to the rising cost of living. This is chiefly because it has transferred responsibility for managing the economy away from government spending and taxation (fiscal policy), and towards central banks with monetary policy, doubling down on a growth model driven by high asset-prices and private debt.
New Labour’s running of budget surpluses is often celebrated as one of its economic successes. But for the government to run a surplus it means other sectors have to run a deficit – in other words the government is taking money out of the economy. With the government’s fiscal stance taking money out of the economy, it fell to the Bank of England to use monetary policy to stop the economy slowing down. To help get inflation up to its 2% target, the Bank of England took interest rates on a downward slope from 7.5% in 1998 to 3.5% in 2003, which put a rocket under house prices and enabled the economy to grow off the back of an explosion of mortgage credit and correspondingly household debt.
This was a mirror image of what was happening in the US, which ended disastrously with the collapse of a housing bubble in 2008. Yet no lessons were learned on either side of the Atlantic. Obsessed with the unfounded dogma of ‘balancing the books’, politicians responded to the great recession which followed the crash by continuing to take money out of the economy with austerity. It was once again down to the Bank of England to prop the economy up with monetary policy. To prevent the economy sliding deep into depression, the Bank of England cut interest rates to 0.5% in 2008. But banks, reeling from the crisis, still shied away from lending and credit dried up. With interest rates unable to go much lower, the Bank of England began buying up £50bn of government bonds with newly created money, in a process known as ‘quantitative easing’ (QE). This pushed asset prices up and meant banks had a lot more central bank reserves on their hands, supposedly giving them the confidence to lend again.
QE was only supposed to be a temporary measure, but over the next decade it became the crutch policymakers relied on to support the economy. As politicians took money out of the economy by cutting public spending in an effort to reduce government debt, it once again came down to the Bank of England to make up for this by creating £445bn of new money through QE between 2009 and 2016, while politicians were telling the public there was no money left for the benefits and services people rely on. The money was injected into financial markets, where it ended up inflating assets like shares and property, turbocharging inequality.
Ideally the Bank of England would have said its toolkit means it is unable to meet its inflation target without creating huge inequality, and called for the government to use much more effective fiscal policy. Or it would have undertaken overt monetary financing, giving the money directly for the government to spend into the real economy. But both options are taboo under its current mandate, which forbids the Bank of England to get involved in fiscal policy decisions.
Ironically, we are now in a situation where the Bank of England has seemingly no choice but to impact government fiscal policy. With inflation well above the Bank of England’s 2% target, the Bank of England has felt forced to raise interest rates, making the cost of government borrowing more expensive. This is despite little evidence that increasing borrowing costs will do much to help when inflation is being driven by supply-side factors, with governor Andrew Bailey admitting that “Raising interest rates won’t produce more gas, it won’t produce more semiconductor chips.”
There are a range of ways policymakers could help remedy the bite of inflation, but the current orthodoxy means it has been left to the central bank to attempt to do the impossible with interest rate rises. When asked if other tools may be more appropriate at a recent Bank of England press conference, this line of enquiry was closed down, with Bailey responding “we do not comment on fiscal policy, on other Government policies.”
What higher interest rates can do however is make the cost of living crisis worse, by making it harder for workers to win pay rises, which is a sacrifice the Bank of England appears to deem necessary. Lack of pay rises means households increasingly rely on credit to make ends meet, but this becomes more expensive as rates rise, as does any government spending which could soften the blow. Even small rises in interest rates will likely fuel a recession and perhaps even spark a financial crisis, seemingly pitting the Bank’s inflation goal against its financial stability goal.
Due to handing sole responsibility over inflation to the Bank of England and relying on monetary policy as our main tool of stimulating the economy, we’ve ended up with huge levels of debt being built up, which the Bank of England may now be required to burst.
The debate over central bank independence itself is something of a red herring – the government already has control over the mandate of the Bank of England which it can use to change the Bank’s mission without necessarily ripping up independence. What is clear however is that we desperately need a new, more democratic approach to economic policymaking, and this will require our public institutions working together better.
Luckily, the ideas are there. Both Nathan Tankus in the US and Andrew Jackson, Tim Jackson and Frank van Lerven in the UK have put forward new thinking fit for the crises we are facing, the essence of which involves fiscal policy rather than monetary policy taking the lead in managing the economy. This would mean using progressive taxation and restrictions on private credit creation rather than blunt interest rate rises or government spending cuts to cool down the economy when it’s overheating. Doing so would also allow more of the public investment we desperately need to solve the crises of our times. Indeed, such thinking has been echoed by the consensus view which emerged from experts in the latest report from the UN Intergovernmental Panel on Climate Change (IPCC), which called for a “new understanding of debt sustainability” to enable governments to spend more on tackling climate change.
While proponents of the status quo treat an independent Bank of England solely responsible for inflation as a sacred cow the public cannot touch, the reality is that the role of the central bank has evolved over centuries to meet the challenges of the day. This 25th anniversary should remind us that things can and need to change to get with the times.