Press Releases
CRACKS IN THE FOUNDATIONS?
PRESS RELEASE
30th April 2007
A Review of the Role & Functions of the Bank of England
after 10 years of Operational Independence
By Professor David B. Smith of Derby University
For the first time since 1992, Britain's CPI inflation rate has exceeded 3% and triggered a letter from the Bank of England to the Chancellor. The real figure for most people though is closer to the RPI - 4.8%. And just earlier this week, in a letter to the Financial Times, several leading economists criticised the Bank of England’s monetary policy for underestimating the likelihood of continued above target inflation. Clearly all is not well at the Old Lady of Threadneedle Street.
On the 10th anniversary of the granting of operational independence to the Bank, the Economic Research Council, Britain’s oldest economic think-tank, has commissioned Visiting Professor David B. Smith of Derby University, Chairman of the Institute of Economic Affair’s Shadow Monetary Policy Committee and formerly a well-known City Economist, to conduct an audit of the past decade and propose reforms to the existing structure.
Smith lucidly illustrates how over the last 10 years the following cracks have emerged in the intellectual and institutional foundations of British monetary policy:
• The removal of the Bank’s debt management and regulatory responsibilities was a probably an error, in part because of the resultant loss of market ‘feel’ when the Bank had to act as a lender of last resort.
• The sole reliance on base rates has left the MPC with an inadequate tool kit to deal with all monetary challenges.
• The Bank’s main forecasting model is flawed, relying too much on assumed theory and too little on empirical observation.
Smith recommends that some of these cracks can be closed with the following reforms:
• The introduction of additional monetary instruments.
• Re-integrating the Debt Management Office into the Bank.
• Restoring the Bank’s supervisory powers over the deposit-taking institutions whose liabilities correspond to M4 broad money.
• Making the Bank - not the Office for National Statistics - the main source for compiling and disseminating the UK’s macroeconomic statistics.
David B. Smith says:
"The granting of operational independence was presented as a fait accompli because the politicians concerned feared that otherwise the issue would get bogged down in a lengthy debate. This was probably a correct decision from a political economy viewpoint, and Britain’s economic performance has benefited noticeably as a result, but the downside was that the new arrangements were never properly discussed. The intellectual foundations of the MPC were arguably shaky from the start, particularly in the extent to which they ignored credit and broad money. We are today seeing these errors compounded over time in higher inflation and a large trade gap, which represents a form of suppressed inflation. Splitting up the Bank’s responsibilities reflects American ideas – possibly influenced by Ed Ball’s time at Harvard. The truth is that institutionally, the European Central Bank’s twin pillars approach offers a better model. Right now, the explosion in credit has been like the buzz one gets from hard drinking at a party. It is a pleasant sensation at the time but it is all too easy to forget there’s a nasty hangover coming. It’s time we put this right before the British Economy pays too high a price."
