Economics: The buck is passed to the Bank

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The Independent Online
Yes, the changes to the role of the Bank of England are important and welcome. But they are important as much as an indication of the future direction of UK economic policy as they are in themselves; and though they are welcome, they carry dangers.

On the changes themselves: there are two key things to realise here. First, handing the setting of short-term interest rates to a monetary committee at the central bank is merely applying in Britain a version of the new standard international practice. It may sound revolutionary and Eddie George may be over the moon, but we are catching up with Germany, the US and others, not pushing ahead.

Second, setting short-term interest rates has a different form of importance now than it used to have, say, 20 years ago. Then it was fine-tuning the economy. To some extent it still is, but this has to be done in a different context. The growth of the global capital markets and the disappearance of exchange controls has meant that bond markets are completely beyond national control. So setting short-term rates nowadays is largely determined by the need to retain credibility in the eyes of the world financial markets.

Last week, by giving the Bank operational responsibility for interest rates and increasing short-term rates slightly, UK long-term interest rates (yields on gilts) actually fell very sharply. So the Treasury has handed over something that looks like power - the power to determine interest rates - but actually such power as has been transferred to the Bank is quite limited.

Nevertheless, limited or not, the changes are welcome not only because Britain is adopting standard practice, but because they show that the new government does what it says it will do. The Chancellor managed to take the markets by surprise: there were a lot of red faces among the City scribblers, many of whom had written to the effect that changes in the Bank of England's role would not happen for many months. But the surprise was one of timing rather than substance, for this idea of a monetary committee had been widely trailed before the election. The best parallel is the abolition of exchange controls by the Tories in 1979. Everyone knew they would do it, but no-one expected it to be done so quickly; and, a further parallel, all we were doing was adopting a global standard.

The fact the Gordon Brown has done what he said he would do gives a clue to the tone of his first budget. There is widespread pressure on him to increase taxation. True, most of it comes from manufacturing industry, anxious that the economy should, in general, be slowed by higher taxation rather than higher interest rates, as higher rates are likely to increase still further the value of sterling on the exchanges. This raises the practical question of whether the economy should be run for the convenience of the 20 per cent of the economy that is in manufacturing or the 80 per cent that isn't. But since the handful of large manufacturing companies are a more vocal lobby than the millions of the rest of us, they are liable to get their way.

There is, however, a commitment by both the Prime Minister and the Chancellor not to increase taxes significantly. The specific commitments referred to income tax rates and VAT, and as many commentators have pointed out, that still leaves plenty of room for manoeuvre. But the swift decision to carry out a pledge over the setting of interest rates, plus the (I think) real effort to become a government which is trusted by the electorate, suggests that the Chancellor will stick to the spirit of his pre-election commitments, not just the letter. Jamming up taxes a couple of months after you have said you won't is not a brilliant way to win trust, as the previous government found out to its cost. The idea that a government will do what it says it will do may be novel, but it is encouraging in this case.

But there are medium-term dangers associated with the shift of responsibility - that is a better word than power - to the Bank. The chief danger is that central banks will, as a breed, become discredited if global deflation takes hold. There is a real risk of this.

You can see how close countries like Germany and France came last year to a bout of negative prices. The chart shows the best measure of inflation - the GDP deflator - for a number of European countries. Switzerland has experienced falling prices for much of last year, and Germany and France probably would have done so this year had it not been for the fall in the value of their currencies. If the dollar (and sterling) now decline, they could quickly be back into negative prices - the economics team at Deutsche Kleinwort Benson, for example, believes that this is a real danger. And of course stable overall prices means that some prices will be falling, while some will also be rising.

Looking ahead it may well be that the entire developed world will move to a prolonged period of price stability, or even slowly falling prices as it did for most of the last century. That in itself need not matter. Indeed in many ways it is desirable that the benefits of economic growth should be widely shared by the entire population through falling prices, rather than be enjoyed by those who happen to be in work. But the pace of transition is disturbing: to move from a world in inflation to a world of deflation carries enormous problems of adjustment. People have to learn to behave differently and that takes time.

Why has this move from inflation towards deflation happened? I don't think we know yet because the change is all too recent. But while part must be a function of the rising power of savers, expressed through the bond market, part may also be a function of the efforts of the world's central banks, and in particular the Bundesbank, to kill inflation.

While the general move to a world of stable prices is welcome, for price stability enables the markets to signal more clearly how savings should be allocated and therefore should improve economic performance, there is a danger that the move will go too far. We have had enormous errors of policy which led to the great inflation of the 1970s and 1980s and which inflicted great misery, but it is at least possible that there will be errors of policy on the other side. If there are, central banks will get the blame.

That would be tragic because the notion that control over money should not be part of the direct role of politicians is a surely useful one. Whatever view one takes of the constitutional position of the Bundesbank and the US Federal Reserve, the results have been preferable to, say, the stewardship of the lira under the Bank of Italy or indeed the post- 1945 performance of the Bank of England.

The key point here is that while the present global fashion is strongly towards giving central banks independence, that fashion may well go into reverse if there is a prolonged period of deflation world-wide. To be cynical, Gordon Brown has not just rid himself of the power to be blamed for the pain of higher interest rates; he may also have rid himself of the power to be blamed for the next slump.

So see this change at the Bank as a sign of something bigger: politicians accepting that it is not in their self- interest to pretend to be able to do things that are, except in the very short-term, beyond their control. If, five years from now, another Chancellor (or maybe even the same one!) declares that there should be an over-riding constitutional rule that governments must balance their budgets, do not be surprised. Politicians might like to rid themselves of the power to be blamed for underfunding public services too.