This article is redundant since content was written in 2006-2007 just before the financial crisis of 2007-2008. Advances in RIO theory since that period also negates content. Left as record only.

Why Gordon Brown made the Bank of England "independent"

Hector McNeill¹
SEEL

One of the issues that surfaced during the discussions on Jeremy Corbyn's proposal on Quantitative easing for people (QEP) was that this would threaten the "independence" of the Bank of England (BoE). The BoE is not really independent and it is time this myth was dispelled. The reason Gordon Brown made the BoE "independent" was connected to the power strategy of minimizing policy risks. Gordon Brown saw this as being a major contributing factor in the Conservatives losing the 1997 general.

Much nonsense is exchanged concerning the "independence" of the Bank of England (BoE). I described why Gordon Brown made the BoE "independent" in a publication in 2007. I set out below an extended excerpt from this book.

The following is an excerpt from:

McNeill, H.W.,
"The Briton's Quest for Freedom - Our unfinished journey...",
Chapter 15,
pages 139-147,
418 pp.,
Portsmouth,
HPC,
2007.
ISBN: 978-0-907833-01-7.

The Economy & Policy Initiatives

Between 1945 to the time of writing political parties underwent a significant change in their use of policy tools and objectives. These changes arose from failures in economic theory in practice and which, at the time, reflected badly on the political parties. The existence of a "party risk factor", associated with too strong an association with failed economic policies, was the lesson learned. This resulted in political parties and their governments distancing themselves from heavily interventionist economic policies. A direct outcome has been a steadier growth in the economy as a result of this risk-averse behaviour of political parties. During the same period the methods of policy design have changed from party-based to executive-based activities.

These issues are reviewed under the following headings.

• economic management lessons
• policy & information flow

1. Economic Management Lessons

During the last 15 years, the Treasury has undergone a significant change from a comprehensive organization dealing with the macro-economy to one largely concerned with micro-economic aspects of revenue raising and intervention through policy. This change can be traced back to Black Wednesday.

Black Wednesday

On 16 September 1992 the Conservative government was forced to withdraw the Pound from the European Exchange Rate Mechanism (ERM) as a result of pressure from currency speculators. The most notable speculator was George Soros who is reported to have profited to the extent of around US$1 billion from his financial dealings around this event. This event became known as Black Wednesday. Black Wednesday did not just affect Britain, the Italian lira also left the ERM and the Spanish peseta was able to remain only as a result of a drastic devaluation. The ERM was supposed to be a means to help stabilize exchange rates, encourage trade within Europe and help control inflation.

Accordingly the inappropriateness of policy and decision-making surrounding exchange rates of the Pound within the European

We were told about stop go before it happened... Michal Kalecki (1899-1970) advised us that conventional policies, i.e. Keynesianism would create stop-go instability. He also developed many "Keynesian concepts" before Keynes. (See: The inevitable stop-go)

Exchange Rate Mechanism (ERM) was exposed with the Pound leaving the ERM. In 1997, the Treasury estimated that the cost of Black Wednesday was a loss of around £3.4 billion in reserves. The wrong decisions were taken as a result of ignoring some of the tactical options available to the Treasury to sustain the value of currency holdings. If the government had maintained adequate foreign currency reserves and the pound had fallen by the same amount, the UK would have made a £2.4bn profit on Sterling's devaluation (58).

The image and confidence of the Treasury was undermined by this episode since it demonstrated that the Treasury did not have an adequate grasp of macroeconomic realities. Somewhat like the past experience with Keynesianism and stop-go in the 1970s (see below), this raised doubts concerning the inherent stability of political decision-making on monetary issues. The experience with the ERM emphasized the difficulty of governments managing fiscal affairs, exchange rates and monetary policy (interest rates) within a system serving many different European economies at different stages of economic development, or at different stages in their economic cycles. Indeed, the system implicitly assumes that all member countries accept that some will be forced to operate at less than their potential (59) and would be required to undertake interest rate and fiscal (taxation) adjustments.

Stop-go

The ERM debacle was not the first major demonstration of the incompetence of the lack of expertise and economic management capacity on the part of British political parties. Conservative and Labour governments had been consistent in their failure to exert a sufficiently refined control over the economy through policy interventions. In the post-1945 period this was largely the outcome of the use of crude and simplistic policy instruments (60) such as interest rates, taxation and government spending as the main "governors" of the economy. In short, post-1945 policies, largely based on based on Keynesianism (tax and government expenditure) and subsequently Monetarism (interest rates) created too much instability (61). This instability was generally referred to as the evil of stop-go policies.

Interest rate debacle

Following the UK's expulsion from the ERM, interest rates were raised and there was a mild economic decline. The result was that around one million householders who could not pay their mortgages suffered home repossession and there was a significant rise in unemployment. In spite of a sound economic recovery, the Conservative party, because of the Black Wednesday and this interest rate-related repossession debacle, lost much of its image as a competent manager of the economy. This was a contributing factor to the Conservatives losing their control of governance in the 1997 election.

Strategic lessons in political risk

The example of the expulsion of the British pound from the ERM and the social impacts of the necessity of raising interest rates to bring the economy back on course served as a chilling warning to the Labour party. The power strategy was after all to gain and remain in power. They recognized the very damaging political impact the Conservative party had suffered as a result of the house repossession debacle caused by a rise in interest rates. Labour also appreciated how both of these events had helped them win the 1997 election.

The significant strategic lesson was that the setting of interest rates by government political parties represented a significant political risk of exposure as a result of any possible damaging over- or under-shoots. Finding ways and means of stabilizing the basis of economic management and distancing political parties from any inherent management risks became the first priority of all parties and not just Labour. No one wanted to be identified with financial mismanagement since this determined their ability to hold on to power.

The logic

The end of an era? The Bank of England has promoted a monetary policy that "succeeded" in reducing the value of the pound in the consumer's pocket to less than 2% of its value in 1945, but the banks have done well, even when they "failed".

One of the popular themes of discussion in economic circles and a favourite question in economics courses in UK universities during the 1960s used to be, "Explain the advantages and disadvantages of passing the responsibility for setting base interest rates from government to the Bank of England." The answer according to the students who got the higher marks, and academics in general, has always been that interest rates should be managed independently by the Bank of England to remove the political vector from of the decision and thereby achieve a more stable economic environment.

No more stop-go

It was therefore no surprise that this was the first thing Gordon Brown did as Chancellor when Labour won the 1997 election. In May 1997, the Government granted the Bank of England, just over 300 years since it started operations, the independence to set domestic interest rates. The Government retained control of the final objective of monetary policy, setting the inflation target, within which the Bank must operate when carrying out monetary policy decisions. The Bank of England Act 1998 set out the role and constitution of the Monetary Policy Committee (MPC) which in relation to monetary policy should aim to maintain price stability (sustain low inflation) and, on this basis, support Government economic policy including its objectives for growth and employment. The Bank of England's record since independence has been good with inflation remaining close to the target measure. The MPC has demonstrated an ability to agree their decisions free from political influence in spite of pressure from lobby groups, trade unions and the media prior to each MPC meeting. However, in mid-April, 2007, Mervyn King, the Governor of the Bank of England, had to write the first ever letter to the Chancellor forewarning of a temporary overshoot of the agreed upper margin for inflation; even perfection has blemishes!

Broadly speaking this change in policy has been the only decision by the Labour Government to be completely successful in achieving its objectives. This decision has remained an entirely uncontentious issue. Although harbouring some initial doubts, now all of Britain's main political parties accept that the Bank of England should remain independent. It continues to be successful because it is free from political influence and is run in an independent fashion.

Need for more ways out.... The Bank of England's pretence at being independent needs to be dismasked. The Bank should have the power to create more productive ways out of the current financial predicament in the interests of people...

The reorientation of the Treasury

The removal of the setting of interest rates from the ambit of political parties, government and the Treasury meant that Gordon Brown created a significant change in the orientation, focus and the nature of the Treasury. Overall emphasis shifted from a general macroeconomic approach related to interest rates to an emphasis on the relationship between techniques for collecting government revenues and the scope such revenue could provide for the funding of policies. This caused an inversion in general policy development orientation with the Treasury becoming more concerned with policy development as well as deciding budgets available to departments. This model has its roots in the Labour party response to losing the 1992 election when Gordon Brown, as shadow Chancellor, introduced a close economic and financial control over all portfolios and which continued when the Labour Party won the 1997 election.

After the lingering effects of Black Wednesday, the Treasury was in a relatively weak position when George Brown assumed the Chancellorship in 1997. His immediate decision of providing the Bank of England with independence over the setting of interest rates also meant a significant analytical role of the Treasury surrounding interests rates and macroeconomic policy were made largely redundant. In essence Gordon Brown came with an already working government policy development model more geared to questions related to the impacts of various types of taxation on individuals and firms. This heralded a new phase of an emphasis on microeconomic questions related to policies as opposed to macroeconomic variables.

Preferences & freedom issues

What one can observe, however, is that the £550 billion raised annually by the government comes largely from tax and excise (62) and these sources do not map over the areas of expenditure on policies (25). Policies are therefore not directly related to a clearly stated source and therefore voters are not completely aware of the amount of money taken from their contributions to support specific policies. Government revenue is essentially a large budget from which a Chancellor can pick and choose amounts to be allocated to different policies. The electorate is therefore not really involved in any way other than paying tax.

Pro-forma budgetary approach comes into its own

Pro-forma budget projections can be used as a device to project prudence and no interest in strong centralization. It seems to have gained momentum under Gordon Brown following Labour's failure to become elected in 1992. However this has matured into a very convenient device for controlling portfolios as well as establishing a "tradition" whereby the Chancellor can favour his own lines of expenditure irrespective of the views of the portfolio-holding ministers.

Unauthorized variations in funding

The nature of tax rates and excise is that most are applied as a percentage of the value of items being taxed and others as a set value, such as the motor vehicle road tax. In other words the revenue of government will vary not in proportion to the agreed basis for supporting policies but with the levels of activity in the economy and general income levels. As a result the "tax take" can vary. With interest rate setting being the ambit of the Bank of England the economy has grown more steadily and government, without any agreements with the electorate, simply reaps the rewards of the general levels of economic activity. In terms of economic growth justifications for the raising of revenues to support agreed policies, such windfalls are in essence unauthorized. They are used as the Chancellor thinks fit.

Not quite a slush fund - almost

It would be too strong a statement to call the bag of excess in tax generated from economic growth to be a slush fund. However, consideration does need to be given to the control of the activities of a very influential Chancellorship largesse and patronage resulting from his personal inclinations and preferences in how to spend the extra funds. Indeed, Gordon Brown has demonstrated that Prime Ministerial patronage can be effectively countered through the control of information, obscuring the real availability of funds and by favouring those policies he approves of with "extra" money. This carries with it risks associated with the capacity of absorption where previous plans assumed lower budgets. Where capacities for absorption and use of funds are limited through not having staff and facilities in place, performance in the use of extra funds can decline drastically.

This power has been used to generate headline-grabbing initiatives such as international development efforts through the Department of International Development (DfID). This boosts the "development business" where a proportion of such funds go to politically friendly associations, such as the trade unions, who have developed "international development" arms and other vehicles for this purpose. An interesting analysis could be the cash flow balance between such organizations and political parties and the from public funds back to such organizations.

Likely changes

With Tony Blair standing down as Prime Minister at the end of June 2007 and Gordon Brown assuming Labour party leadership and the Premiership, this level of independent power in the hands of the new Chancellor is unlikely to survive; indeed the power of the Treasury is likely to decline.

Transparency & participation

There is a lack of connection between the specific means used to raise government revenues and specific agreed policies. Because of economic growth there is even less connection between government budgets in support of specific policies and the revenues generated. There is therefore no connection between road tax or fuel taxes and expenditure on roads or fuel economy research, for example. The transparency from the standpoint of the voter simply is not there. Accordingly, voters are provided with no participation in the economic aspects of policy development before elections and are presented with biased information with no transparency at the time of general elections. There is no useful quantification of policy costs to the voter, just glib statements concerning pennies in the pound in tax.

The status of the British economy

By removing the setting of interest rates from the political arena Britain embarked on what has turned out to be a sustained period of economic growth and stability. This is to be expected when the interference of politically-based decisions from the overall macro-economy have been replaced by a policy aiming at price stability.

There has been much discussion in the media and indeed in Labour party declarations of the success of Labour macroeconomic management and of Chancellor Gordon Brown in particular. There are many factors which have contributed to this economic growth including the following factors:

• good MPC decisions
• low international inflation rates
• the Chancellor's skills
• more effective contribution of supply side management
• the de facto advance of a real incomes economy (63)

The actual cause of stable growth under relatively stable interest rate conditions can be argued to be the result of a more effective contribution of supply side economics. This in turn provides for the advance of a real income economy. These national economic and financial questions are discussed in more detail in another book, "The Economics of Freedom".

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¹ Hector McNeill is director of SEEL-Systems Engineering Economic Lab.

² See: McNeill, H.W., "The Briton's Quest for Freedom - Our unfinished journey...'", Chapter 7, "A General Election", pp: 75-90, HPC, 418 pp, 1970. ISBN: 978-0-907833-01-7. NOTE: This not a contribution to the evidence in support of the "proportional representation" alternative which in fact benefits political parties as opposed to the electorate as explained in: McNeill, H.W., "The Briton's Quest for Freedom - Our unfinished journey...'", Chapter 17, "Party Funding & Electoral Reform", pp: 167-174, HPC, 418 pp, 1970. ISBN: 978-0-907833-01-7.

Updated: 26th August, 2015: Mainly segments that escaped spell checker but required adjustment; sense maintained.