The limits of freedom: considering the future of central banks

Ed Balls, one of the principal architects of BoE independence (Image courtesy: Strand Group).

It’s been 20 years since the Bank of England won the freedom to decide interest rates, and doubts over the settlement are growing. Gavin O’Toole hears the concerns of some of those closely involved in that historic decision

Cracks are appearing in the consensus that central banks should be free from political interference, 20 years on from one of the boldest acts of banking independence of recent times: the decision of the incoming Labour government to give the Bank of England (BoE) its autonomy in 1997.

Since the banking crisis and the ‘great recession’, political and economic questions over central banks’ independence have grown increasingly loud. And in the UK, following critical reviews of the Bank of England’s performance during the credit crunch and Brexit referendum campaign, a discussion about reform is now underway. Given the Bank’s historic role as a model for other countries, the debate is likely to be closely watched in financial capitals around the world.

That debate was aired earlier this month at a Strand Group seminar at King’s College London, held to mark the 20th anniversary of BoE independence. Whilst speakers were confident that giving the Bank its independence had been the right decision, they drew attention to some of the unforeseen consequences.

Giving a central bank its independence is a way of insulating it against pressure from politicians tempted to boost economic activity before an election. Until 1997, UK elections were often preceded by an artificially-created credit boom and followed by a consequent recession, exacerbating ‘boom and bust’ business cycles which harmed investment and job creation. Depoliticising monetary policy was seen as a prerequisite for ensuring stable prices, and hence for maintaining the purchasing power of a currency.

However, central bank independence is not a binary matter: each bank’s freedom of manoeuvre lies somewhere on a spectrum of autonomy, its formal and informal powers of prerogative waxing and waning over time.

There are two aspects to those powers – the concepts of ‘operational’ and of ‘political’ independence. The first refers to a bank’s ability to decide monetary policy, setting interest rates in pursuit of a goal set in legislation – typically, that of keeping inflation within a set range. The latter covers the bank’s freedom from softer forms of political control exerted, for example, through ministerial appointments to key roles and any duty to consult with ministers before decisions.

Many economists and central bankers believe that the operational aspects of independence are the most crucial, freeing banks to decide the procedures, instruments and timing of the interventions required to maintain economic stability. These operational freedoms are seen as having been highly successful in the battle to avoid see-sawing inflation and growth rates.

But in these days of low growth rates throughout much of the developed world, banks’ roles in taming inflation have less political salience. And the deliberate reduction in political oversight and influence is in stark contrast with the growth in banks’ powers and responsibilities – a product of the 2008-8 financial crisis and its aftermath.

Since that crisis, countries have expanded the duties of central banks beyond traditional monetary policy objectives, setting them stability goals and the task of policing systemic risks to financial systems. The powers of the BoE, for example, have grown considerably as it has taken on these ‘macro-prudential’ tasks, extending its remit into new areas where politicians and Treasuries traditionally called the shots.

Partly as a result, political challenges to central bank independence are evident almost everywhere. In the US, for example, Donald Trump has frequently criticised the Federal Reserve, and some members of Congress have demanded more oversight over its activities. A survey by the Centre for Macroeconomics and Centre for Economic Policy Research in January indicated that nearly a third of economists polled agreed that central bank independence in the UK and Eurozone is set to decline.

In the UK the 2007–08 crisis was a turning point, highlighting points of confusion over the BoE’s role, responsibilities and remit. It raised uncomfortable questions about who is in charge when a bank collapses, and which institution should be the ‘lender of last resort’ to resolve the crisis.

Lord Burns, permanent secretary of the Treasury in 1997, told the Strand seminar that in the UK the notion of operational independence has become “clouded” over time, with observers continuing to confuse this with the notion of complete independence from political oversight. “We certainly saw in 2007-08, at the beginning of the financial crash, the whole question of just how far the BoE’s independence stretches – did it really stretch to where they could make decisions about Northern Rock [the first British financial institution to collapse in 2007] and other banks, or not?” he said. “It seems to me that there is still great confusion about where the line of independence begins and ends.”

When the 1997 Labour government gave the BoE its independence, it stripped it of its responsibility to supervise the banking sector – passing this role to the Financial Services Authority (FSA). Ed Balls, a key adviser to then-chancellor Gordon Brown and one of the principal architects of BoE independence, devised a “memorandum of understanding” (MoU) between the BoE, Treasury and FSA to divide up responsibilities for banking supervision and stability. But Balls told the seminar that gaps in the MoU were tested to destruction when the credit crunch hit 10 years later. “The reality was that the MoU between the bank and the Treasury wasn’t up to it,” he said. “When I became a minister again at the Treasury in 2006, we knew it wasn’t up to it.”

Underlining these ambiguities, Lord Macpherson, permanent secretary to the Treasury from 2005–16, told the Strand seminar: “One of the slightly strange things in 2008 was whenever a bank collapsed – which they did with some regularity from the summer of 2008 – the BoE did not act as the Treasury’s agent in resolving banks. It was left to the Treasury… It was puzzling: the BoE is a [central] bank, surely it would operate as our agent? But it didn’t.”

Then, during the Brexit referendum campaign of 2016, the BoE came under fire from quite a different direction – with Brexiteers attacking the Bank and its governor Mark Carney for releasing projections warning of the economic dangers of leaving the EU. Although the Bank enjoys considerable freedom in developing objective assessments of the economic outlook, some campaigners thought Carney was doing the government’s bidding.

The BoE’s formal independence is not imminently at risk, but these examples illustrate how the political pressure on it has been increasing – potentially weakening its de facto independence and affecting its operational decisions. And current political changes may increase those pressures.

As the UK charts a more independent economic course following its departure from the EU, for example, pressure is likely to increase for the BoE to revisit its duty to champion growth. The UK’s monetary policy framework tasks the bank with delivering low inflation – but a second clause ties this to supporting the broader economic objectives of growth and employment. And new prime minister Theresa May has a more interventionalist approach to the economy than most recent predecessors, championing the production of industrial strategies whose success will, in part, rest on supportive central bank policies.

Senior figures – including Balls – are now advocating change, arguing that historically low inflation has weakened the empirical case for central bank independence and that further reforms are needed, both in both the way monetary policies are co-ordinated with fiscal policies and in macro-prudential policy.

Dame Kate Barker, a former external member of the bank’s Monetary Policy Committee (MPC), suggested at the Strand seminar that a rigid focus solely on inflation targeting may have distracted MPC members from acting in the interests of the economy as a whole. “Because we focused too stringently on this two-year current inflation target, it distracted us to some extent from what I describe as ‘doing the right thing’,” she said.

The 1997 Labour government’s decision to give the BoE independence, along with the task of achieving steady, low levels of inflation, was an important moment in a global shift towards insulating economic management from the short-term interests of political leaders. But as the seminar’s speakers noted, that formula has had its weaknesses. The challenge now is to retain the strengths of that politically disinterested management role, whilst ensuring that governments have the tools and powers they need to meet the wider economic needs of their citizens in a fast-changing world.

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See also:

Bank of England independence kept UK out of the euro, says former Treasury adviser

Bank of England governor to see through Brexit negotiations

Bank of England’s independence under threat in EU referendum row

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