Admittedly, the euphoric mood in the financial markets and the media on Tuesday was eerily reminiscent of the day that sterling joined the ERM, a decision that did not work out too well.
But Bank of England independence is a profoundly different matter from entering a fixed exchange rate system with narrow fluctuation bands. The point about the ERM - and this will apply in even starker terms if sterling joins the single European currency - is that interest rate decisions were externalised beyond the borders of the UK, and were taken by people (ie the Bundesbank) who did not include British economic variables in their set of objectives. Consequently, the setting of interest rates became somewhat random from the British point of view and, sadly, that randomness worked in strongly the wrong direction from 1989-92.
There is no reason whatsoever why any of these problems need apply to Gordon Brown's new mechanism. The Bank's nine-person monetary policy committee (MPC) will be setting interest rates based solely on UK economic criteria, so while monetary decisions will be externalised beyond the borders of British politics, they will not be externalised beyond the borders of the UK itself. Unless a mass attack of insanity overpowers the nine separate individuals on the MPC, each of whom will be given an equal weight in interest rate decisions, there is no danger of base rates getting stuck at levels which are inappropriate for British requirements.
Why, then, make the change? The scatter diagrams depicted in the two graphs basically sum up the case in favour more eloquently than a thousand pages of textbook economics. The horizontal axes measure the degree of independence of national central banks between 1973 and 1989, while the vertical axes measure inflation and output growth respectively.
It is immediately obvious that a greater degree of central bank independence has been associated with a lower rate of inflation, but that there has been no connection between independence and the growth of output. The implication which many economists have drawn is that it is possible to enjoy lower rates of inflation without any adverse costs in terms of output and jobs, by leaving interest rate decisions to central bankers.
Many economic studies - in fact, a remarkable 18 out of the 20 studies recently published - have now formally supported the results implied by the scatter diagrams shown here. In one of the most celebrated studies of the genre (Institutions and Policies, Grilli, Masciandaro and Tabellini, Economic Policy, 1991), separate indices of bank independence were developed according to economic and political criteria respectively. (In fact, the sum total of these two indices is the basis for the graphs shown here.) The maximum possible score is 16, and Martin Brookes of Goldman Sachs estimates that the new arrangements for the Bank of England would result in a respectable score of 10. This is similar to several other central banks in Europe, though it is somewhat less than the scores achieved by the Bundesbank, the Federal Reserve, and the planned European Central Bank.
The reason for the difference is that the new Bank of England will be subject to political direction on matters such as the inflation target, whereas the Bundesbank and Federal Reserve are left to set these targets for themselves. Brookes has rather ingeniously used the econometric results of the Grilli study to deduce what the UK rate of inflation might have been over the period from 1973-89 if the Bank of England had at that time enjoyed the degree of independence which it will enjoy from now on.
He concludes that the inflation rate might have been expected to have been around 3.5 per cent per annum lower than the 10.5 per cent rate which was achieved. And remember that this reduction in inflation would have been won at no cost in terms of lost output, at least if the econometricians are to be be believed.
Of course, the future gain to British inflation is likely to be much less than the 3.5 per cent per annum suggested by the history of the 1973-89 period, since we are already much closer to price stability than we were then. But let us assume that the independent Bank of England succeeds over time in reducing UK inflation to around 2-2.5 per cent per annum, the rate implied by the Government's inflation target.
Once the markets become comfortable that this will be the case, and build this expectation into their medium-term projections for inflation, the average yield on long-term government debt is likely to fall by at least one full percentage point, via a reduction in the inflation risk premium.
Eventually, this will reduce the Government's funding costs by around pounds 3.5bn per annum, an amount which can be used for extra public spending, or for tax cuts, by future chancellors. Since it will take many years for this to be fully reflected in debt service costs, Mr Brown may not himself be the chief beneficiary of this change, but his successors may have cause to thank him for last week's boldness.
Where does this leave the critics of Bank independence? Their case seems to be that the new MPC at the Bank will adopt "too hawkish" a stance on interest rate policy, that this will push the exchange rate upwards, and that this will eventually result in a renewed recession.
In particular, they argue that it will now be very difficult to conduct a co-ordinated switch in the fiscal/monetary mix, by raising taxes in the Budget and subsequently reducing base rates to get the exchange rate back down to competitive levels.
Obviously, there is a danger that the needs of domestic monetary policy will indeed force both base rates and sterling higher in coming months, but it is far from clear that the Bank's independence will make much difference to this. Eddie George made it perfectly apparent in his weekend interviews that he is sensitive to the behaviour of the currency, but that the health of the one quarter of the economy which is directly affected by the exchange rate cannot take precedence over the maintenance of the inflation target.
How would this have been any different if Gordon Brown had still been taking the base rate decisions? Only, presumably, if the Chancellor had been willing to take more risks with his own inflation objective, which would scarcely seem to make much sense this early in the Parliament. And if the Chancellor does decide to raise consumer taxes significantly in his forthcoming Budget, there is no reason the MPC should not take full account of this in future monetary meetings.
Nobody feels comfortable about the uncompetitive pound, but it will not be the fault of the MPC if its strength continues.Reuse content