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June - July 2009
The role of the Bank of England in the current crisis
by Satjit Singh
In an attempt to effect monetary easing, the Bank of England (the Bank) has, since October 2008, reduced its base rate from 5% to 0.5%. However, lowering interest rates to their current unprecedented level has failed to have the intended impact. The origins of the problem are to be found in the Bank’s actions in the months leading to this period. During Nov 2006-Oct 2008, bank rates were increased to and maintained at 5% or higher. In its efforts to contain inflation, the Bank relentlessly pursued a policy of keeping base rates high; choking demand. Those coming off fixed rate mortgage deals struck when base rates were low, were suddenly faced with a doubling or even trebling of their interest payments. Consequently, defaults increased, and coupled with the stifling of demand for mortgages, led to falling asset values and in some cases, negative equity. This was also the time that businesses, especially small businesses, began to feel the pinch.
It was this policy of keeping interest rates high, in my opinion, that contributed directly to the problems we face today. True, it was a world-wide problem; but Britain, until 18 months ago, was well poised to weather the storm. Employment was high and climbing and more importantly, so was confidence. Enter Mervyn King, the Governor of the Bank, a self-styled ‘hawk’. He pursued the interest rate target to the exclusion of everything else and kept interest rates high long after they needed to. Indeed his work had been done in the months up to summer 2007, by when the measures to stop the economy overheating were well and truly in place. An economist with a standard set of forecasting tools could have seen that these measures had begun working through the economy and that inflation was set to ease. Instead he ploughed on, regardless until the demand tap was well and truly dry. The consequent airlock in the demand pipeline has meant that more drastic surgery is needed to restore this. I believe that gentle easing of monetary policy would have helped, without compromising inflation.
To counter the effects of this tight monetary policy, the government has been forced to inject a large fiscal stimulus into the economy to bail out banks and is looking at other industries on a selective basis. There is a link between monetary and fiscal policy and one cannot act in isolation of the other. The lack of confidence arising from the Bank’s monetary policy is being countered by the government’s fiscal boost; this in turn, will be paid for by the fiscal measure of higher taxation.
The Bank’s independence to set interest rates has been hailed as one of New Labour’s finest achievements; however, it can also be seen as an abdication of duty. We elect representatives to represent our interests; their role requires a degree of judgement beyond what is found in theoretical models. If that were not so, we would happily be ruled by civil servants with advice from academics. Contrast this with Ken Clarke’s tenure as Chancellor. He often overruled the late Eddie George and kept interest rates low when he felt that his ‘feedback from the doorsteps’ was telling him otherwise. In the event, he was proven right. Instead we have delegated key decisions like setting interest rate to unelected and unaccountable official servants. The very same people, who have difficulties accepting ‘unelected and unaccountable’ Eurocrats making decisions for the UK, are strangely silent in regard to the role of the Governor of the Bank of England.
I believe that it was the actions of Mervyn King that exacerbated our current situation, yet criticism of the interest rate policy, seems to have bypassed him entirely. He is a clever man; however, cleverness and wisdom is not the same thing. He also appears unable, or unwilling, to balance a number of, often conflicting, variables e.g. the conflict between growth and inflation. His approach to the issues has appeared to be more about maintaining his hawkish economic policy credentials than about ensuring the well-being of UK Plc. I have been surprised how his role in the whole sorry saga has escaped censure.
Finally, the policy of an independent Central Bank has faced its first real test and found wanting. Perhaps the issue is not the Bank’s independence; it could be the narrow remit of tracking inflation. Whatever the reason(s), it needs urgent examining. Will Gordon Brown, the architect of this policy and who trumpets this as one of his greatest triumphs, be man enough to review it?
I am not holding my breath!