Don't bank on independence

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The Independent Online
The independence of the Bank of England is now firmly established as the British economy's panacea-in-waiting. It is only the latest in a long line of would- be miracle cures for our inability to sustain low inflation together with reasonable growth and low unemployment.

Advocates of independence believe control over interest rates should be taken from the Government and given to an organisation that is strongly averse to inflation, known to stick to its guns and free from the influence of feeble-minded voters. This would enhance the credibility of anti-inflation policy and allow price stability to be achieved at less cost to growth and employment.

The campaign for independence is certainly making headway. The former Chancellors Nigel Lawson and Norman Lamont are both in favour and there is growing support from City and academic economists. The Treasury Select Committee of backbench MPs is expected to join the chorus in a report due out early next month. The Bank itself, as one might expect, is also campaigning hard.

But the case for independence in Britain is much weaker than its supporters claim. It is based on ropy academic evidence, an inability to distinguish cause from effect and a failure to appreciate that interest rates, taxes and public spending must be co-ordinated in an economy with structural imbalances as severe as Britain's. The Treasury's failings in the past are in themselves no guarantee that splitting its responsibilities with the Bank will produce better results.

Strangely, the weakest argument against central bank independence is the one that appears to trouble the Chancellor and Prime Minister most - the need to keep the Bank democratically accountable while free from short-term political control.

It is perfectly feasible for a government to give the Bank a target - to keep inflation below, say, 2 per cent - and then leave it free to set interest rates. Provided that an incoming government was free to change the target, anti-inflation policy would be no less remote from the voters than any other. It would also be possible for Parliament to rescind the Bank's powers under extreme circumstances.

But what evidence is there that independent central banks can achieve low inflation with less damage to the real economy? Academic studies by Vittorio Grilli and Alberto Alesina in the late 1980s found evidence that countries with independent central banks were more likely to have low inflation.

The degree to which a central bank is independent can only be assessed subjectively, so the academics gave each bank a score to represent its degree of independence compared with its inflation record. Grilli argued, for example, that the US Federal Reserve was as independent as the Bundesbank, that the Bank of Australia was more independent than the Bank of England and that the Bank of Canada was more independent than the Bank of Japan. But Alesina disagreed on every count. If economists cannot agree on how independent a particular central bank is, it is difficult to have much faith in the link they find between independence and inflation.

The graphic below shows that Alesina's relationship between inflation and central bank independence relied heavily on the handful of central banks that, he argued, combined high independence with low inflation or low independence with high inflation.

He gave more than half the banks he looked at an 'average' score for independence, even though they presided over widely differing inflation rates. Small adjustments to the scores of these 'average' central banks would render the overall relationship with inflation virtually non- existent.

But even if these studies are taken at face value, they do not prove that central bank independence causes low inflation. Independence may only be achievable in countries that are already disposed to low inflation, perhaps because of efficient labour markets or low government borrowing. Independent central banks may also only be suited to countries where the electorate has a strong aversion to inflation - more true of Germany or Switzerland than Britain.

The theoretical case for central bank independence is based on the idea that governments always have an incentive to give the economy a surprise boost to increase growth and employment once unions and employers have settled on a particular level of wages. But unions and employers learn to expect this and compensate in advance for the rise in inflation that is likely to result by adding a mark-up to pay settlements and prices. So growth and employment end up no different, but inflation is higher - everyone is worse off.

One way to tackle this problem is to give control over interest rates to a central bank, which is more concerned about inflation than the government because it is never tempted to fuel unsustainable booms in order to win elections. Unions and employers might then be convinced that the policy-makers would not spring an inflationary surprise and therefore moderate their wages and prices.

But in Britain there may anyway be little scope for governments to steal a march in this fashion, which in turn suggests that an independent central bank may not make much difference.

Changes in interest rates and the exchange rate take a long time to feed through fully to prices, so unions and employers are able to adjust wage settlements before the government has a chance to gain much in the way of extra growth and employment.

The Bank of England's anti-inflationary credentials are also not as impressive as it claims. The Bank's Governor, Eddie George, supported January's cut in base rates to 6 per cent, which was simply a politically motivated panic reaction to a bad unemployment figure. Meanwhile, the Bank's Inflation Report last week demonstrated its unwillingness to demand tough action from the Government.

The report predicted that the Government's target measure of underlying inflation - excluding mortgage interest payments - could exceed its target next year because of the VAT increases planned for April. It rightly warned that this tax-induced blip could become entrenched if it was used to justify high pay settlements.

The Bank had few practical suggestions for avoiding this outcome, merely exhorting wage bargainers to look at another measure of underlying inflation that also excluded taxes. If the Bank was as hawkish as it claims, it should for months have been publicly banging home the message that the non-inflationary way to cut government borrowing is to cut spending, and that trying to establish anti-inflationary credibility by raising taxes is likely to prove self-defeating.

Separating control over interest rates and fiscal policy between bodies with different objectives carries other more serious dangers. Setting fiscal policy to protect growth, employment and votes, and monetary policy to achieve low inflation is a recipe for spiralling government borrowing and ever higher interest rates, as each policy-maker tries to offset the actions of the other. This sort of policy mix is the last thing Britain needs.

This bias need not be a problem if both government and central bank appreciate that their opposite numbers will try to compensate for their actions and therefore reach a tacit agreement to keep borrowing and interest rates low. Germany enjoyed this sort of arrangement for much of its post-war history, but unification demonstrated that a shock to the economy - not necessarily an act of bad faith by either policy-maker - can upset the balance and allow fiscal and monetary policy to become badly askew.

The German electorate has a loathing of inflation deeply rooted in historical experience, so it will probably enjoy the benefits of its independent central bank again. The British electorate does not have the same convictions and neither its Government nor its central bank enjoys the credibility of their German counterparts. Central bank independence here would therefore do more harm than good.

(Graph omitted)