Independent Central Banks
'The Chancellor of the Exchequer essentially used interest rates as a "political weapon"'
Shoaib Hayat | 3 April 2017

On Tuesday 2nd May, the Bank of England celebrated the 20th anniversary of Gordon Brown’s historic decision to allow the UK’s central bank to set interest rates independently, and this interest rate is known as the ‘base rate’. This meant that the Bank of England was able to set the minimum amount of interest that banks could charge on loans - with the high street banking rate known as the ‘market rate’ - be it for your house, your company, or a new property of yours. People’s savings in banks were also affected by the Government’s choice. For the first decade, the Bank’s decision had been straightforward, but the financial crisis in 2008 made for a more difficult time, with Mervyn King, a former Bank of England governor, stating: “the BoE’s credibility made it possible to cut interest rates to their lowest level in more than 300 years without jeopardising the belief that inflation [an increase in the general level of prices] was under control.” But exactly what are the benefits and drawbacks of having independent central banks?

Before 1997, the Chancellor of the Exchequer essentially used interest rates as a ‘political weapon’, and it was usually exploited approaching elections. Interest rates were lowered just before people went to the polls, in order to encourage more people to spend and firms to invest, which would encourage economic growth. This also has the political benefit of making mortgages cheaper, because people would not have to pay as much on bank’s loans for their homes. It also stimulated exports as, with a lower interest rate, the pound is weaker, meaning that exports for other countries are cheaper. This gave people the misconception that the government was successful, perhaps detracting from other failures, when in essence all the government was doing was persuading people to vote for them.

However, in 1997 Chancellor Gordon Brown declared that the interest rate “must be free of political manipulation”. The Government wanted to give the Bank of England the power to set the interest rate independently, so they introduced a Monetary Policy Committee of nine members. This decision benefited the UK because choices on how interest rates are set would be made according to what is best for business, and inflation would be kept in line. People would also have more confidence in an independent central bank as they are acting on behalf of the country, rather than self interest, which gives them more credibility than if the Chancellor was in control of monetary policy.  

But there have been questions raised, particularly regarding how independent the central bank actually is. The Governor is appointed by the Prime Minister and the Chancellor. Given that these high-ranking politicians might pick someone who follows the same ideology as them, this may affect the central bank’s credibility. Also, people in the Bank of England have worked in commercial banks previously, and may not act in a way that is best for the UK, but in a way that benefits large financial corporations.

But there is also a moral hazard involved. Commercial banks, while they are regulated, may begin to take bigger risks. These banks know that they can just ask the central bank to provide money for them as they have done so in the past. This allows commercial banks to engage in more risky dealings and hold fewer liquid (or cash-based) assets than they might have done in the past.

The monetary policy (use of interest rates and other instruments to control the money supply) may also be ineffective as it has the potential to operate against the Chancellor’s fiscal policy, which is the government’s position on public spending and taxation. The Chancellor might adopt an expansionary fiscal policy, which is where taxing is increased as well as spending to boost the economy - with the aim of increasing total demand for goods and services in the economy by encouraging consumption and investment. But if there is an expansionary monetary policy in place, which is where interest rates are raised in order to encourage saving and reduce consumption, the two are effectively working against each other. This renders both ineffective and harms the UK economy.

20 years on, both praise and criticism can be given to Gordon Brown on his decision to make the Bank of England independent. However, in 1997 he made a decision no other UK Chancellor would have even thought of making, acting on behalf of the British people. Despite the many issues with the Bank of England, Gordon Brown acted with what he believed to be the UK’s best interests at heart.

 

Image sourced under the Creative Commons License.

 

James Routledge 2016