I used to be rather puzzled by the fact that our central bank, the Bank of England, is ‘independent’, despite the fact that it’s owned by the Treasury, and the Treasury is part of the government. This seems to make it in effect an arm of government, but apparently it’s not. This is the official position anyway, and has been since the then chancellor Gordon Brown, ‘set it free‘ in 1997.
There are a number of historically interesting aspects to this move. One of the most significant, I think, is that it was part of an attempt to align of our financial structures to with the European Monetary Union system—the forerunner of the eurozone. But although the UK did not eventually join the eurozone, BoE ‘independence’ remains.
At the time Gordon Brown was ‘setting the BoE free’ the UK was still pretty much under the spell of Milton Friedman’s ‘monetarism’, one of the tenets of which was that money supply was key to controlling the economy. ‘Balancing the books’ was seen as almost a moral—and certainly a fiscal—imperative, and freeing the BoE from government control was seen as putting fiscal control where it ought to be—in the hands of the bankers in the private sector.
It also meant that the government could no longer ‘print money’ itself. If it wanted more it would have to borrow it or raise taxes. And just to make sure, the government was prohibited (by its own rules, of course), from borrowing from the BoE.
This was a crazy idea, but it was supported by business leaders and the Labour Party. Conservatives, who, being in opposition at the time, were perhaps able to take a more detached view, were split. Some thought it was a good idea. These tended to be the more economically ‘literate’ (for example Nigel Lawson, who had been chancellor during the Black Wednesday debacle 1n 1992), which at that time, as we have observed, generally meant they were monetarists. Others presumably saw it as an abrogation of government responsibility. (Just occasionally I find myself in agreement with Conservatives!)
So in effect the government, in attempting to adhere to a flawed idea of financial prudence, tied its own hands. Despite the fact that we had had fiat money since 1971, we were still to pretend that money was a rare commodity and be very careful not to waste it!
Interest rates and Inflation
Part of the BoE’s mandate when it was ‘freed’ was that its primary fiscal role was that it should use its ability to interest rates, to control inflation.
I don’t think it’s ever been proved that interest rates do control inflation, but monetarism—and classical economics in general—has a neat explanation that purports to show why it should. Basically the idea is that higher interest rates make saving more attractive relative to spending, so by putting interest rates up people will be deterred from spending their money and will save it instead.
But back in the real world where most people buy stuff because they need it, or at least want it, they will probably spend more when prices go up, not put their money in the bank, even if they would stand to get more interest on it than previously. Of course, if we were all currency speculators we might, after some careful calculations and well-informed predictions about the economic outlook, decide we would make more money by putting it into a deposit account. But most of us are not, and even if we were, well-informed predictions about the economic outlook are quite hard to come by.
Of course interest rates will increase in response to increasing inflation, but that’s as much a response to the demand for a higher return to compensate for the expected loss of purchasing power as it is a motivator to save. Clearly interest rates are, in part at least, endogenous, not exogenous.
How independent is ‘independent’
The Bank of England was set up in 1694. England had recently been defeated by France in the Battle of Beachy Head and the government wanted to rebuild the navy to rival that of France, but it didn’t have enough money, or good enough credit to borrow it. The solution was to set up a new bank, issuing shares to extremely wealthy individuals, who would be ‘incorporated as the Govenor and Company of the Bank of England’ and would be given the sole right to issue bank-notes, as well as other privileges.
That did the trick. Subscribers included King William III, and the new bank raised £1.2m—an almost unimaginably large sum of money at that time— in twelve days. The government used half of that to rebuild the navy.
(As an interesting aside, the money was provided to the government as bullion, and bank-notes to the same value were issued against the government’s IOUs (i.e.bonds). Clearly if these bank-notes had been presented the bank could not have paid them in the gold that had been passed on to the government—they had spent it on ships. This was fiat money in embryo.)
So for the most of its history the Bank of England has been a private bank, owned by private individuals and institutions. In other words it has been in the domestic sector. And for nearly all that time, although it had the sole right to print bank-notes, it also had the obligaton to pay gold bullion on demand to anyone presenting those bank-notes. Nevertheless the buck, even then, stopped with the government because it was the government that guaranteed payment, and it was this, and the fact that the government demanded taxes to be paid, either in bullion or in its own IOUs—thus either increasing its assets or reducing its liabilities—that supported the status of the bank-notes as a medium of exchange.
Surprisingly (to me, at any rate) the BoE was only taken into public ownership in 1998—after it had been made independent by Gordon Brown. Evidently that independence was not going to be complete. It is now ‘wholly owned by the Treasury Solicitor on behalf of the government, but with independence in setting monetary policy’ (Wikipedia). The Bank’s Monetary Policy Committee, which meets for a mere twenty-four days a year has ‘devolved responsibility for setting monetary policy’—devolved, that is, from the government. And the government, through the Treasury can issue instructions to the BoE ‘if they are required in the public interest and by extreme economic circumstances’. Such instructions must be endorsed by Parliament within 28 days.
This all makes it sound as though the BoE is independent almost in the sense that the judiciary is independent, but the crucial difference is that the judiciary is not owned by the government. The government makes the laws and the judiciary implements them, and can even, in exceptional circumstances such as constitutional or human rights violations, overrule them. These are powers that the BoE does not have. It must do what it is told to do by the government. The government limits the amount of control it exercises, but this is a self-denying ordinance and could be revoked at any time. The Bank of England is an arm of government.
Which brings us back to QE (Quantitive Easing). As I have noted elsewhere, the BoE, despite is alleged independence from the government, has so far issued £2.4 trillion in QE, essentially paying off government debts as alsmost as fast as the government acquires them. This is not the behaviour of an independent private sector business!
What will be interesting will be to see whether the government will revert to its customary deficit-phobia after the Covid-19 emergency is over and the economy is on its way back to something like normal—whatever that turns out to be.