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Take central banks down a notch Samuel Brittan The Financial Times 30/07/10 Following the Peter Principle, we should expect people to be promoted to the level of their incompetence. It may be unfair, but that thought crossed my mind in a week in which the Bank of England has been given unprecedented responsibilities. It retains the operational independence for monetary policy conferred on it by Gordon Brown in 1997 as chancellor. In addition, it regains all the responsibilities for financial oversight of which it was deprived by the Labour government - and then some more. These aspects are not confined to the UK, although the thoroughness and relentlessness of the operation are perhaps typical of the not-very-pragmatic British. Central bank independence was one of the theme songs of the end of the 20th century. It became associated with - although it was not necessarily the cause of - what became known as the Great Moderation, that is the combination of steady growth with low inflation throughout the industrialised world. If policy were conducted by benevolent and knowledgeable dictators, monetary and fiscal decisions would be run together. The academic case for central bank independence was avowedly a second best one, in response to what was called the credibility problem. The full inflationary effects of an excessive stimulus might be delayed for a few years, while the favourable effects on output and employment might come much sooner. There was therefore a powerful incentive for governments to overstimulate in the run-up to an election, all statements to the contrary notwithstanding. The central bank, by controlling the monetary tap, could make sure that a government behaving in this way was punished by high interest rates that would inhibit the boom. Before briefly discussing how well central banks have actually performed, we should take a glance at their origins. These usually were remote from control of inflation or output or anything resembling modern macroeconomic policy. The Bank of England was established in 1694 by a group of City merchants lending money to finance the wars of William III. Even the US Federal Reserve, which was founded much later in 1913 in response to the bank crisis of 1907, was primarily concerned with the stability of the commercial banks. In the 19th century rough price stability was expected to result from using gold as the ultimate form of money. The role of the central bank was to ensure that, despite any paper money or other credit instruments issued by governments, the gold convertibility of the currency was maintained. In the course of the 20th century the gold link was both cut and restored (in attenuated form) at various times. It was not until 1971 that Richard Nixon, US president, cut the last remaining link of the dollar to gold. Thus central banks were left by default with the task of maintaining the value of the currency. Even then many were just as concerned with the welfare of commercial banks and the financial system as a whole. How have they performed in their enlarged role? At a cursory glance, none too well. So far from curbing the notorious German hyperinflation of the 1920s, the then head of the Reichsbank plaintively observed that he was printing money as fast as the machinery at his disposal allowed. At the Bank of England, governor Montagu Norman bullied Winston Churchill into returning to gold in 1925 at an overvalued parity, which helped trigger the General Strike the following year. Later he prevented the 1929-31 Labour government from embarking on public works to counter rising unemployment. Worst of all was the unwillingness or inability of the Fed to prevent a massive decline in the US money stock at the onset of the Depression. There followed a gap of several decades in which central banks were demoted. But it can hardly be said that they have achieved distinction in more recent years. Unlike many sound money people I believe that the Fed under Alan Greenspan was largely right in its low interest rate policies at the beginning of this century in response to Asian savings surpluses. But no major central bank had any inkling of the weakness developing in the world financial system. There was the obstinate refusal to take asset bubbles seriously and the wrongheaded preoccupation with short-term targets for narrowly defined inflation indices. In the background was a shift from an excessive preoccupation by central banks with financial institutions to the other extreme of their becoming virtual econometrics factories. Yet despite everything I would still support central bank independence, if for no other reason than that no body has a monopoly of wisdom. A division of responsibility between governments and central banks might make for fewer blunders than having either of them in sole command. But that is no justification for treating them with the excessive reverence they sometimes command in Conservative circles. The fact that the Bank of England has supported, or even insisted upon, chancellor George Osborne's fiscal austerity should be treated not as a knock-down argument in support but, if anything, ground for re-examining its basis.
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