An Independent Bank of England: Is That Enough?

Article excerpt

This article argues that an independent central bank is not in itself sufficient to ensure the long-term success and stability of the economy. While there are strong academic arguments for making the central bank independent, these arguments are often developed in a closed economy setting. Where trade is important and the economy is open, making the central bank independent can lead to a strategic interaction between the bank and the fiscal authorities which can produce serious imbalances in the economy over time. In particular, the analysis below suggests that there could be excess demand in the non tradable sector combined with a recession in the sectors of the economy open to trade. Our contention is that the UK economy exhibits all the signs that we would expect to see if this argument were relevant.

Keywords: New monetary regime; independent central bank; fiscal policy

JEL classifications: C53, E12, E32, E42

I. Introduction

This article argues that an independent central bank is not in itself sufficient to ensure the long-term success and stability of the economy. While there are strong academic arguments for making the central bank independent, these arguments are often developed in a closed economy setting. Where trade is important and the economy is open, making the central bank independent can lead to a strategic interaction between the bank and the fiscal authorities which can produce serious imbalances in the economy over time. In particular the analysis below suggests that there could be excess demand in the non tradable sector combined with a recession in the sectors of the economy open to trade. This would happen even in a low inflation environment if there is a persistently overvalued exchange rate which would lead in turn to low investment and low productivity growth. Our contention is that the UK economy exhibits all the signs that we would expect to see if this argument were relevant.

There can be little doubt that the macroeconomic performance of the UK for a little over a decade has been remarkably good. Inflation has been low and, what is more, it has remained low in spite of the rapid fall in unemployment starting in 1992. Interest rates have generally fallen over the decade. For much of the time, the fiscal situation has appeared highly satisfactory; in several years there have been budget surpluses, and the net debt to GDP ratio--one of the key government criteria for fiscal prudence--has fallen steadily until 2002, although it has been rising since that time and there are growing concerns regarding the current fiscal stance.

Reactions to these developments have been generally very positive, even euphoric in some quarters. Take, for example, the description by one distinguished commentator recently,

"It is universally acknowledged that the current framework for monetary policy is sound and appears enduring" (Sir Alan Budd, 2004)

There is indeed a great deal to be satisfied with in recent performance, and careful economic management has played a role in this. However, there are two questions about the present conduct of macroeconomic policy in the UK which we explore here;

* How far is the independence of the central bank responsible for this performance?

* Is the underlying imbalance apparent in the UK economy due to the policy arrangements?

We review these two questions more fully in the next sections.

2. How far is the new regime responsible? We begin by questioning to what extent the new policy framework (by which we mean inflation targeting in 1992, and the independence of the Bank of England (BoE) and the statement of the fiscal rules in 1997) have been crucial to the recent macroeconomic success. We say this in spite of the large literature investigating the relationship between central banking independence and macro-economic performance, which has concluded that greater independence is negatively correlated with both average inflation and its variability (see for example, Eijffinger and de Haan, 1996). …