Friday Flyer: It was Twenty Years Ago Today…Independence Day for the Old Lady

When reforming, the UK is more like a sprinter than a marathon runner. Long periods of inaction and arduous behind the scenes preparations, lead to sudden jolts of activity.  And so it was twenty years ago when the incoming Labour government decided to make a surprise announcement about the creation of operational independence for the Bank of England on its fifth day of office. Although a decision to reform some aspects of the monetary constitution was expected, the crucial and final step of operational independence for the Bank of England was a surprise to commentators, the financial markets, the Bank on the morning of 6 May 1997.

Previous periods of demand management and the policies of Stop-Go created excessive year to year fluctuations in the economy.   The lessons ultimately led economic policy to be conceived more in terms of long-run plans or ‘rules’ in preference to discretionary policy. Furthermore, if these rules could be pursued by individuals who were not perceived to have an incentive to deviate from them, the plans would be more likely to be believed.  And so it was argued that these rules would help ensure that the plans of households and firms would be consistent with the stated aims of policymakers and so jointly it would be easier to achieve non-inflationary growth with full levels of employment.

It was these ideas led to the granting of operational independence to the Bank of England to pursue the government’s inflation target twenty years ago.  Subsequently we also have had a long period of innovation with fiscal rules, culminating in the creation of the Office for Budgetary Responsibility in 2010, as well as the creation of fixed term Parliaments that were supposed to foster long term planning.  And yet both the Chancellor and the Prime Minister have shown in quick succession that these rules can be applied with discretion, with changes announced by the incoming Chancellor in last November’s Autumn Statement about the date by which the fiscal deficit will be eliminated and also by the Prime Minister’s calling of an early election with relative ease on 18 April, bringing forward the next election by some three years compared to the plan enshrined in the Fixed Term Parliaments Act of 2011.

The irony, to some great degree, is that the widespread adoption of rules for fiscal and monetary policy has not improved long-run performance and indeed may have done little to encourage addressing the more fundamental questions of productivity growth.   Indeed the economy is still suffering from the effects of the financial crash of 2007–8 and shows little sign of final rehabilitation.  We are not far away, rather like Japan in the final years of the twentieth century, from our own lost decade. The policy response has been to adopt easy money with policy rates at or near to the zero lower bound and for countercyclical fiscal policy to do little more than allow the automatic stabilisers to operate. And so public debt has increased as rapidly as it has ever done in peacetime and now stands at nearly 90 per cent of GDP.  And yet there is little sign so far that we can return to normal times with fiscal surpluses and nominal interest rates to their normal range.  The instruments of demand management are lying off the dial

The policy ammunition looks exhausted with both borrowing and interest rates hitting their respective ceiling and floor. And with the Bank of England, through its Asset Purchase Facility, holding some 30 per cent of the stock of outstanding public debt there is a case to consider that monetary and fiscal policy are operating jointly. Furthermore financial stability may be threatened as low policy rates do not allow financial intermediaries to make the kind of margin required on loans. There are also moves towards the issuance of digital central bank money so that negative interest rates could be charged on electronic balances, but we are running monetary policy without much of an external debate.

And yet, despite all these changes, the Bank of England retains operational independence for monetary policy in pursuit of a simple inflation target set by the government which remains at 2 per cent. It has also been charged with overseeing financial policy towards limiting the risk from financial sector operations in the new financial policy committee. At a time of increasing debt, tax receipts are falling relative to income. Financial stability has been assigned to a branch of the Bank of England, the Prudential Regulatory Authority. It is unclear that the interactions of monetary-fiscal and financial policy have been properly reflected in these new arrangements and so we have two possible routes. One is to keep these monetary and financial procedures lodged in the various arms of government and allow coordination to develop over time with the possibility of coordination failures, and the other is to explore the need for a new set of objectives for the monetary and financial authorities that can be jointly pursued.