Setting the Bank free

By Ed Crooks, Economics Correspondent

In Gordon Brown's first year in power he audaciously gave control of interest rates to the Bank of England. What legacy did he inherit from the Tory Government? Is there a price to pay for handing over control of interest rates? Many protested that unelected bankers should wield such power, and that it would damage manufacturing industry. But a year on, is it too early to assess the long term effect of such a momentous decision? Ed Crooks attempts to answer these questions:

The Labour Party comes to power after many years in opposition, swept in by a wave of public dissatisfaction with what seemed to be a clapped-out and corrupt Conservative government.

Its charismatic young leader wants to build a new and modern Britain, based on an economy that can match the best in the world. Does he: a) Immediately take on the Bank of England and cut interest rates to help businesses and stimulate investment, or b) Immediately put rates up, and surrender all power over rates to the Bank, so the government will never be able to cut interest rates again?

In 1964, Harold Wilson and James Callaghan chose option a); in 1997, Tony Blair and Gordon Brown chose option b).

There is probably no clearer demonstration of the distance that New Labour has travelled, not only from its position in the eighties, but even from its traditional moderation in the sixties. It may well come to be seen as the defining action of this government.

Gordon Brown's decision to give the Bank of England independence over interest rates as his first act in power was breathtaking - audacious to his friends, profoundly undemocratic to his enemies. He did not consult the Bank, the Treasury or even the Cabinet beforehand. Labour had made no mention of Bank independence in its manifesto.

Labour-friendly think tanks and businesses had specifically advised against it just months before the election. It was very much a decision taken by Gordon Brown and his closest advisers alone, and its success or failure will determine how his Chancellorship will go down in history.

Ken Clarke's legacy

It has to be admitted that Gordon Brown picked a good time to make his move. The economy was in danger of overheating, and something had to be done quite quickly if inflation was to be brought inside the government's target and kept there. And Kenneth Clarke's last few months in office were the worst advertisement possible for political control of interest rates.

Kenneth Clarke displays extraordinary chutzpah in claiming that the difficulties the economy is in would never have happened had the Conservatives won the election, and his brilliant stewardship of the economy been allowed to continue.

He is right to say that the economy did very well while he was in charge, but by failing to raise interest rates in the months leading up to the election, as he was advised to do repeatedly by the Bank, he sowed the seeds of our present predicament.

We did not have a Clarke Boom to match the Barber or Lawson Booms of the seventies and eighties. But few people would now dispute that Kenneth Clarke kept interest rates lower than they should have been, partly for the obvious political reason that he was trying to protect the government from yet more unfavourable headlines as the election approached.

A free lunch?

The hard lesson of history is that politicians will, in general, tend to use interest rates for their own selfish ends, rather than for what is genuinely best for the country. That is the strongest single argument in favour of making the Bank independent. Eddie George and his colleagues do not have to court popularity, no one will ever get the chance to vote them out, and their incentive is solely to deliver the economic performance that the government is looking for.

What we can say fairly confidently is that: a) countries with independent central banks tend to have lower inflation, and b) countries with lower inflation have slightly higher growth in the long run.

In other words, bank independence is not a miracle cure or a magic bullet. It can help keep inflation low, but the process will not be painless. The reason the US and German economies have been so successful since World War II is not because of the independence of the Federal Reserve and the Bundesbank. There is no free lunch.

It is probably also worth remembering that the last miracle cure hawked to the British public was membership of the European Exchange Rate Mechanism. What is claimed to be a free lunch may turn out to have quite a big price tag attached.

Unelected bankers

The independence of the Bank of England has its critics on political as well as economic grounds. In fact, many politicians attack it for exactly the reason that economists like it - it removes the process of setting interest rates and managing the economy from democratic control.

That is not entirely true - the inflation target is still set by the elected government, and in extremis the chancellor has the power to override the Bank's decisions. That power is very definitely a weapon of last resort. But in general elected politicians do have much less say over economic management than they used to.

The government's answer has been to recommend an enhanced role for the Treasury Select Committee, but in practice this does not go very far. An attempt to give the committee power to vet appointments to the Bank's Monetary Policy Committee, in the way that congressional committees hold confirmation hearings in the United States, was defeated in the Commons. The committee's chairman Giles Radice is a government loyalist, and the most outspoken critic of the Bank's independence, Diane Abbott, was kicked off the committee.

The Conservatives say they would take control of interest rates back from the Bank of England. Their arguments tie in with a general theme - that the sovereignty of Parliament is being undermined, and ought to be upheld. And they also fit with another key position - over Europe.

The European Central Bank that will run the European single currency from Frankfurt is to be even more independent than the Bank of England is today. It will set its own target for inflation or the money supply, and ministers or Euro-MPs will have no power to overrule its decisions. If Britain is to join the Euro, the Bank of England must be made more independent first, by giving it those freedoms too.

The One Club policy

The fiercest criticism of the independence of the Bank, however, now comes from people who argue that it is doing needless and irrevocable damage to manufacturing industry.

The system now has an inexorable logic: the Bank of England has to control inflation, it raises interest rates to meet that objective, and the rise in interest rates sends the pound higher, which means that exporters and companies that have to compete against foreign firms get hurt the most.

Once that framework was put in place, it was inevitable that at some point we would get into exactly the mess we are in now. And the legacy of Kenneth Clarke made it likely that the crisis would come sooner rather than later.

There is not really anything anyone can do without demolishing that framework - it is impossible, for example, for the Bank to try to hit targets for the pound and inflation simultaneously. It has been argued - and Gordon Brown is said to believe privately - that the Bank is at fault for not putting up rates more rapidly, which might have taken some of the heat out of the pound.

The more legitimate criticism could be levelled not at the Bank, and not at the arrangements under which the Bank was made independent, but at the Chancellor himself. The economy is affected not just by what the Bank does with interest rates, but by the decisions the government takes over tax and spending too.

The idea that the economy can be "fine-tuned" using taxation may now be thoroughly discredited - it was sent up memorably by Michael Frayn in the sixties, who mocked Chancellors claiming to "keep the economy surging ahead by sticking a deft tuppence on smokes".

But that does not mean that tax changes have no effect. And it seems very likely that if Gordon Brown had imposed more taxes on consumers in any of his Budgets so far, the economy would have slowed more, interest rates could have been lower, and the pound would have fallen.

The Treasury argues that taxes have in fact risen quite sharply, thanks to changes in Corporation Tax and taxes on pension funds. But the argument is not over whether or not taxes have gone up, but over whether they have gone up enough.

The long term

Concluding that making the Bank of England independent has been a disaster after the experience of less than a year would be premature in the extreme. If Bank independence does have benefits, they will take years or perhaps even decades to become apparent, and there is bound to be some pain along the way.

This is one of the cases where Gordon Brown's stock phrases about being in for the long term really have some meaning. But if, as the OECD has predicted, unemployment begins to rise again, then resentment and opposition to the Bank will undoubtedly soar. Gordon Brown must hope that the seven men and one woman who have been entrusted the job of setting interest rates know what they are doing. He has entrusted his fate - and perhaps the government's too - to their hands.