Shortly after leaving university, I joined the treasury. This was in the early 1990s, when the government still controlled all the levers of British economic policy, including interest rates. One afternoon, one of Norman Lamont's young advisers—it might even have been David Cameron—stuck his head around our office door and announced: "They've done it!" The Conservative government had ordered a cut in interest rates.
Monetary policy then was down to the whims of the chancellor. Everyone knew it was determined as much by the political calendar as by the economic cycle. This approach came unstuck on 16th September 1992. On that day, Lamont put up interest rates twice, to 15 per cent, to try to keep the pound in the European exchange rate mechanism (ERM). But traders continued to sell sterling in the belief that they would soon buy it back more cheaply. Within hours, sterling tumbled through the ERM's floor of DM2.778.
By then I was working at a bank in the City. Walking down Cannon Street that September evening—"Black Wednesday"—you could feel the gloom. Britain, economically weak after a recession, had been humbled by mighty Germany. Helmut Schlesinger, president of the Bundesbank, whose policies sealed sterling's fate, looked on intractably from Frankfurt, while in an office near Wall Street George Soros counted the £3.3bn the government had wasted defending the ERM link.
Following sterling's ejection from the ERM, a small group of politicians and policymakers in the treasury and the Bank of England set out to fashion a new stability for the macroeconomy, culminating in bank independence in 1997. These changes have contributed to 13 successive years of growth, the longest uninterrupted expansion for 50 years. And British inflation has been so stable and so low that the new chairman of the US Federal Reserve, Ben Bernanke, favours importing a variant of the British model. Moreover, Britain's monetary system has also proved far more open and flexible than that of the European Central Bank (ECB), guardian of the euro.
Yet the system that has underpinned Britain's recent economic success is today being questioned. Growth is slowing, and there are new doubts about Gordon Brown's stewardship of fiscal policy. At the Bank of England, governor Mervyn King's intellectual dominance has brought its own challenges. More broadly, critics are beginning to ask whether Britain's golden age is mainly the result of broader global factors, which may now be turning against it.
But first it is important to understand how much the macroeconomic framework has changed since 1992. In the 1960s, governments believed they could fine-tune growth by exploiting a trade-off between inflation and employment. By the end of the 1970s, however, inflation and unemployment were both rising—and monetarists had won the policy debate, saying government should control inflation by controlling the money supply.
Various factors in the early 1980s, including global financial deregulation, meant that the link between inflation and the money supply was breaking down. So Nigel Lawson, chancellor from 1983 to 1989, abandoned orthodox monetarism and began to shadow the Deutschmark and thus the interest rate movements of the Bundesbank as a way of reassuring the markets that monetary policy was in safe hands. Yet by the early 1990s this was tying Britain to Germany at a time when their economic cycles were going in opposite directions—a post-unification boom meant Germany needed high interest rates, but Britain, in recession, needed low ones. It was a conflict that pushed sterling out of the ERM.
The men left to tidy up the mess—Norman Lamont, Alan Budd (the chancellor's economic adviser), Eddie George, then deputy governor of the bank (appointed governor in 1993) and Mervyn King, then bank chief economist—came up with a new approach. This was inflation targeting, the simple idea that the government should announce a target for inflation and then strive to stick to it through interest rates—which influence money demand and the general level of economic activity. The difference with earlier periods was not only the idea of an explicit target but also the fact that the government tied its own hands with various rules so ensuring that the main economic actors trusted the new regime and adjusted their expectations accordingly.
In October 1992, Lamont adopted a short-term target for the annual rate of inflation of 1-4 per cent, with a further commitment that the rate would fall into the lower half of the bands. And because the government's credibility had reached a low ebb since the ERM exit, Lamont and the treasury encouraged the Bank of England to publish its quarterly inflation report. This opened up the internal workings of the bank and set out its analysis of the economy and where it believed inflation was heading. In the past, governments believed their influence lay in trying to outwit the market. After the ERM, transparency was the key.
This new openness did improve the government's credibility in financial markets; it was also a shift in power from the treasury to the bank. The chancellor still decided interest rates, but now that the bank's advice was public it was harder (though not impossible) not to do what it urged. The bank's authority was enhanced a few months later when Kenneth Clarke, who succeeded Lamont in May 1993, agreed to publish the minutes of his monthly meetings with the bank governor.
Then on 6th May 1997, New Labour astonished and delighted markets by taking the final step in this transition—granting the bank operational independence. Giving up political control over interest rates—while leaving the inflation target goal to the chancellor—helped to increase the effectiveness of interest rates in pursuit of that target.
The central banks of New Zealand, Canada, Germany, France and the US were all more or less independent. Brown and Blair had been impressed by America's more independent system on a pre-election visit to Alan Greenspan, chairman of the Federal Reserve. It was also a potential step towards Europe—an independent central bank was one of the requirements for joining the euro. Most important of all, Labour needed to make a strong gesture that would dispel lingering suspicions about its economic proficiency.
On bank holiday Monday following Labour's election victory, Brown called Eddie George into the treasury and told him of his plan: he, Brown, would set the inflation target, and it would be up to George to meet it. The new chancellor showed the governor the letter setting out this announcement (it is kept under glass in the Bank of England museum on Threadneedle Street). King, playing tennis near his London home in Notting Hill, got a call from George to come to the City. Over the following weeks, he and economists in the bank and treasury tried to work out what the system would look like in practice.
The framework that emerged included an inflation target of 2.5 per cent. The requirement that it be lower than this in the medium term was deemed to be deflationary. (In 2003, the target was changed to 2 per cent when Britain adopted a new common European measure of inflation.) The treasury's involvement in setting the target meant the bank remained politically accountable, a concern of some sceptics of the new set-up. The governor would also be required to write a public letter to the chancellor if inflation deviated from the target by more than 1 per cent, explaining the reasons and what action he planned to take.
A new monetary policy committee (MPC) was charged with setting interest rates. It consisted of nine members, each with a single vote. It was to be led by the governor, and staffed by four other bank insiders. But there were four chairs around the table for outsiders appointed by Brown. Most of the outside appointments, especially the early ones, were heavyweight economists such as Sushil Wadhwani and Charles Goodhart. Gradually a new calendar emerged, one of fixed meetings and publication dates. All the main economic actors knew that if interest rates were going to be changed, it would be at 12 noon on the second Thursday of the month, following a two-day closed meeting of the MPC.
They also knew that the reasons for the change would be made clear 13 days later when the bank published the minutes of the meeting, including a list of which MPC member had voted for what. In contrast to the ECB, where decisions are taken unanimously, Eddie George insisted that the bank adopt a one-man-one-vote system. King believes this, and the public record of the members' views, helps to make the system strong. No one can hide behind the majority view, or take an adversarial position, because his or her own reputation is at stake.
The framework's success was evident at once. The interest rate risk premium that Britain had paid on its borrowing compared with Germany almost disappeared.
Is it luck or judgement?
Neither George nor King has had to write a letter to Brown. And by autumn 2003 interest rates had fallen to their lowest level in half a century—3.5 per cent. They rose again to 4.75 per cent in 2004 but the latest change, in August last year amid a slowdown in growth, involved another cut to 4.5 per cent.
"Inflation has been very stable and close to target," says David Mackie, an economist at JP Morgan. "They have done a very good job. However, they have been helped by benign global forces and the absence of major domestic shocks." That, of course, is the rub. Britain has had a good economic run since the bank became independent, but it is hard to say how much of that success is due to the new structure and how much to a supportive environment. Inflation has been low everywhere in the world. In Britain, the past ten years have been what economists call a NICE decade—non-inflationary continuous expansion (a phrase coined by Mervyn King). And the recession of the early 1990s in Britain meant that just as the new framework came into being, the economy had plenty of room to grow without the risk of igniting inflation.
In the labour market, worker shortages have not fed through to wage inflation partly because they have been met by a rise in immigrant labour—as King himself pointed out in a speech last June in Bradford. At the same time, the internet and more open and competitive markets, domestically and worldwide, have forced companies to hold down costs and prices—Tesco is an anti-inflation engine. Moreover, the US economy has grown quickly and there have been few of the external shocks—such as the 1970s oil price rise—that have fractured the British economy in the past. Some commentators, such as Anatole Kaletsky (see Prospect, May 2005), also argue that the cycles of the past have been ironed out because of the 1980s supply-side reforms and by the shrinking of the manufacturing sector, which is more cyclical than services.
Given this benign climate, does the new British system remain untested? This is a view that King—and several former members of the MPC—aggressively contest. In its brief history, they say, the MPC has faced many challenges: the 30 per cent appreciation of the pound against the euro in the mid-1990s, the 1997 Asian financial crisis, and the 1998 Russian debt default and subsequent collapse of the big hedge fund Long-Term Capital Management.
"The storms have been out there," says DeAnne Julius, former chief economist of British Airways, who served on the MPC between 1997 and 2000. The Bank of England, its defenders argue, steered Britain through the dotcom bust of 2000, recession and recovery in the US, and has begun to tackle Britain's own housing market bubble. The latter has been one of the bank's toughest challenges. By the early years of this decade, annual house price inflation was in double digits. Such rapid asset price inflation seemed to be a weakness of inflation targeting—by focusing on retail price inflation, the framework risked letting other types of inflation get out of hand, which in turn threatened to fuel an unsustainable surge in consumer demand. But through some well-timed interest rate increases since 2003, the MPC hopes it has calmed the housing market, without—so far—causing a house price crash, although many economists such as Martin Weale, director of the National Institute of Economic and Social Research (NIESR), warn that house prices are still too high.
King accepts as inevitable a shock at some point that will propel inflation more than 1 per cent away from the target—thus requiring an explanation to the chancellor: "A true test of the MPC is not whether it hits the target when the sea is calm, but how it reacts to the storms."
An overmighty King?
But whatever dangers lie outside the bank, some fear that a potential source of weakness lies within. One remarkable aspect of the MPC, some say, is the degree to which King has come to dominate it. A small, owlish, intense man with arching eyebrows and silver glasses, King is one of the pre-eminent economists of his generation. He grew up in Wolverhampton, the son of teachers, and after grammar school went on to study at Cambridge, Harvard and MIT. He has kept his Midlands connections—he is patron of Aston Villa supporters' trust and a keen supporter of Worcestershire cricket club. But he now also sits on the advisory council of the London Symphony Orchestra, is a trustee of the National Gallery and a fellow of the British Academy. He made his name in public economics writing a standard textbook on tax with John Kay; he joined the Bank of England from the LSE in 1991, months before the ERM debacle, which he calls "our ultimate crisis."
It is King's analytical and presentational skills that are largely responsible for making the new regime work. King, who became governor in 2003, also gave the Bank a new "mission": to convince wage bargainers and others of the low inflation case; to "build the constituency for low inflation," as he puts it. King has become such a model central bank governor that, before the nomination of Ben Bernanke as new head of the Fed, a US treasury official mused that it was too bad King did not have a US passport, because he would be the ideal replacement for Alan Greenspan.
But King's drive, say several present and former colleagues, can also manifest itself in a prickly personal manner, combined with a belief that he is always right—an approach the governor is said to bring to the MPC.
"The intellectual power of the MPC outsiders has certainly waned in recent years," said one commentator. "That's not Mervyn's design but it helps him. He now has complete control of the bank. That is a problem. It has become less independent."
However, others point out that King is less dominant in the MPC than Alan Greenspan was in the Fed, or Jean-Claude Trichet is at the ECB. And, on the question of authority, there is an important difference between the Fed and the Bank of England. At the former's meetings the chairman speaks first, so any dissent from his views can be seen as a challenge. At the MPC the governor votes last, so can always avoid being outvoted if he wishes.
Moreover, the view of King as tyrant was further undermined in August when he was outvoted for the first time—King voted against a cut in interest rates, but the majority, including Charles Bean, the bank's chief economist, voted 5-4 for a cut. The governor's defeat shocked the central banking world. But inside the bank, it is described as a sign of the healthy functioning of the committee. The clash between King and Bean has been seen as a mature—and finely balanced—division over the latest evidence about the direction of the economy, part of a dissent-friendly culture in the bank; and both men are now in accord in arguing for no further rate cuts.
Whatever happened to the golden rule?
But if Britain's monetary policy still seems to be on a relatively safe course, new doubts are emerging on the fiscal front. At the time of bank independence in 1997, Gordon Brown also proclaimed new fiscal rules to ensure prudent spending and taxation, which the government committed itself to follow. Most important was the so-called golden rule, requiring the government to run a balanced budget over the economic cycle, excluding money for investment in infrastructure. From the beginning this was open to two ambiguities: what constituted permissible investment and the definition of the economic cycle. Last summer, faced with a rapidly growing deficit, and thus the prospect of being forced to raise taxes to meet his own rule, Brown adapted his definition of the cycle to include earlier years when the budget was in surplus—thus giving himself room to run larger deficits in the later years of the cycle without increasing taxes.
King believes that central bankers should not spend their time lecturing politicians; it is one of his criticisms of the ECB. But last August he broke with this practice, delivering a rare rebuke to Brown. It was not so much the deterioration of Britain's fiscal position that drew the governor's ire—British debt levels are still low by international standards—as the chancellor's sleight of hand on the economic cycle. Brown's about-turn was a challenge to the new rules-based edifice that King had helped to construct since Black Wednesday—the careful managing of people's expectations about the predictability of the way the economy is run, which has been central to the stability he and Brown have brought to the British economy. Brown's decision raised the suspicion that the politicians might once again intervene at will.
"The bank and the treasury have a very different view about how we think about the cycle." King told the bank's quarterly press conference. "If you change your view about what happened seven or eight years ago, it doesn't change the underlying fiscal position."
The tussle between chancellor and governor, two impatient, serious and self-certain men, continued later last year when they disagreed about what was responsible for the current slowdown in growth—Brown's growing tax burden or the bank's interest rate rises. Brown—or at least those around him—was unimpressed by King's straying into fiscal policy. But most economists and economic commentators have lined up with King against Brown. And Martin Weale of NIESR said the golden rule was now "discredited."
These worries, combined with slowing growth in Britain, have put the economy back at the centre of political argument. In November the European commission said that it expects Britain to come 18th in a league table of economic growth rates in the EU, and in January it ticked Brown off for his failure to rein in the budget deficit. GDP growth in 2005 was 1.8 per cent, the slowest since 1992, although it is forecast to rise to around 2.5 per cent in 2006. Exports are weak, the boost to the economy and employment from rising public spending is in the past, the housing market remains fragile, and there are questions about low productivity and investment.
Tougher questions are being asked about what lies beneath the NICE economic performance of the past nine years. Has King's transparent structure killed off inflation for good, or are we just enjoying a cyclical low?
Perhaps more important is the question of what is happening to Britain and its place in the global economy. Sceptics worry that the recent period of low headline inflation has reflected the final hollowing out of Britain's industrial base and a one-off shift of manufacturing to lower-cost India and China. But will Britain be able to cope when the Asian giants become more technologically sophisticated? The shift away from manufacturing has deprived Britain of a presence in a sector where technological progress is fastest.
King himself is starting to warn of tougher times ahead. The new monetary regime is unlikely to buckle, as part of the fiscal regime has, in the face of less benign conditions. But it will be tested as never before.
