Jacques Rueff was notoriously unafraid to speak economic truth to politicians of all persuasions—and we should heed his insights.
The Rise (and Fall) of the Modern Bank of England
The notion of “an essentially contestable concept” means an issue which by its very nature can never be definitively settled, no matter how much brilliance is expended on it, and about which no logic or evidence can ever force disputing parties to agree. Thus, they are, in the words of Stuart Hampshire, “permanently and essentially subject to revision and question.” In short, the debate never ends. How many such essentially contestable propositions have we seen! Macroeconomics, like politics and philosophy, is full of them.
In macroeconomics, one essentially contestable issue is what the ideal nature and functions of a central bank should be. Given the immense financial and political importance of central banks in a world that runs entirely on the fiat currencies they create and inflate, these are critical questions. But no answer, though it may be in fashion for a time, turns out to be permanent. Crises occur, theories run up against surprising reality, the debates resume, and central bank evolution has no end, no ideal final state.
Harold James’ Making a Modern Central Bank is a very instructive book in this respect. It relates in great and often exhausting detail the lengthy debates concerning the functions and organization of that iconic central bank, the Bank of England, in the midst of the financial events of the years 1979-2003, with a brief but essential update at the end on what has happened since then. “The Bank of England seemed to be engaged in a constant quest to determine what its real function might be,” James observes. The quest involved lots of brilliant minds and colorful personalities, and they remind us that it is easier to be brilliant than right when dealing with the economic and financial future.
In the longer historical background of these debates, and important to their psychology, is that “the Bank,” as the book usually refers to it, had had a great run as the dominant central bank in the world under the gold standard. It had impressive traditions going back to its founding in 1694. Then, in the wake of the financial destruction (as well as all the other destruction) of the First World War, the role of the world’s leading central bank was taken over by the Federal Reserve representing the newly dominant U.S. dollar.
Still, the Bank of England “punches internationally above its weight,” James writes, “not because of the strength of the British economy, but because [quoting Paul Krugman] of its ‘intellectual adventurousness.’” This intellectual flair is well displayed in the book. Moreover, in its institutional history, the Bank calls on long experience in the grand sweep of economic and financial evolution. In 1979, it was approaching its 300th anniversary, while the Fed was less than 70 years old.
At that point, the Bank of England was facing severe stress. “The 1970s were years of crisis everywhere, but especially in the U.K.” There was “in particular the collapse of the fixed exchange rate world of Bretton Woods,” which was the final disappearance of the gold standard over which the Bank had once presided. There were the two oil price shocks, generating “substantial instability.” The global Great Inflation was roaring. The British pound sterling kept getting weaker
According to James, “The policy discussions of the U.K. in 1976 were dramatic and humiliating. They turned into an indictment of a Britain that had failed. Because of the foreign exchange crisis, the Governor of the Bank of England and the Chancellor of the Exchequer could not make their scheduled journeys to the IMF [International Monetary Fund] Annual Meetings.” The prime humiliation was that Britain, once a vast imperial and financial power, had been forced to ask the IMF for a loan which imposed heavy cuts in the government budget. “’Goodbye Great Britain” said a 1975 Wall Street Journal headline.
Of course, there were different ideas about what to do: “There was a struggle between differing parts of the British economic establishment, a clash [between] Treasury and Bank.” The discussions, debates, and political dialectic between the Treasury and the Bank are a central theme of the entire book. Can a central bank be truly independent, or is it instead just a subsidiary and a servant of the Treasury, or is it something in between—perhaps “independent within the government,” as the Federal Reserve used to incoherently but diplomatically say? For James, “The relationship between Treasury and Bank remained permanently haunted by potential or actual controversy.”
Always in the background in the Bank of England case, James points out, is this provision of the Bank of England Act of 1946:
The Treasury may from time to time give such directions to the Bank as, after consultation with the Governor of the Bank, they think necessary in the public interest.
That’s pretty clear. There is certainly nothing in the Federal Reserve Act about giving directions in that fashion, although the U.S. Treasury Department and the White House always do want to give directions to the Fed and sometimes succeed. As Donald Kettl observed in Leadership at the Fed, “The Fed’s power continues to rest on its political support,” and James shows how true this is of the Bank of England.
The Bank of England Act of 1998 is more nuanced, but does not change who the senior partner is:
The objectives of the Bank of England shall be—(a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty’s Government.
It is the Treasury (Her Majesty’s Government) that gets to determine what “price stability”—that is, the inflation target— will be, not the Bank. The Bank thus has “operational” independence, but not target independence. In contrast, the Federal Reserve has had the remarkable hubris to assert it can set an inflation target (define “price stability”) by itself. In most other countries it is given by or negotiated with the government.
As the book proceeds, the Bank moves from 1970s humiliation to what appears to be a successful “modern central bank” by 2003, although that afterwards turns out to be ephemeral. Along the way were many crises, all interestingly related for those with a taste for financial history.
There was another foreign exchange crisis, involving more humiliation. On “Black Wednesday”—September 16, 1992—the pound sank in spite of very costly “and ultimately futile” support by the Bank of England, breaking the European Exchange Rate Mechanism of fixed parities and famously making giant profits for George Soros and other speculators. “The experiment in European cooperation had ended in failure,” bringing “a progressive distancing of the U.K. from Europe,” and was “an earlier version of Brexit,” James suggests.
There were multiple credit and banking crises and bailouts. These included a deep real estate bust, when house prices fell from 1989 to 1993 and many banks fell along with them. A larger one, National Home Loans, had “two-fifths of its loan book over two months in arrears.” There was the scandalous collapse of BCCI, the Bank of Credit and Commerce International, “popularly dubbed the Bank of Crooks and Cocaine International.” In 1991, “it looked as if there might be a panic and a run on the Midland Bank,” one of the largest banks. The Bank of England considered Midland “indeed too big to fail.”
The famous firm of Barings, “London’s oldest merchant bank,” collapsed in 1995 from the notorious losses of a rogue trader in Asia. Barings had also failed in 1890 from Argentine entanglements, when it was rescued by the Bank of England; this time it got sold to a Dutch bank for one pound. The 1995 Barings crisis involved a particularly British problem: “the worry that the Queen had very nearly lost some of her funds.”
Throughout these challenging events, the roles of the Bank of England as promoter of systemic financial stability, provider of financing to combat the panics and financial instability, coordinator and regulator of the banking firms, and creator of moral hazard by bailouts, are prominent—all in addition to its key monetary, inflation-controlling role. How many functions should the Bank of England have? This kept being debated.
“In the 1990s, the Bank began to specify essential or core purposes, in particular initially three: currency or price stability, financial stability, and the promotion of the U.K. financial service sector,” James points out. However, the Bank still had “fourteen high-level strategic objectives, twenty-seven area strategic aims, forty-nine business objectives and fifty-five management objectives.”
And then came the big redesign. Complex, intensely political, intellectually provocative negotiations among strong personalities in the government and the Bank, related in enjoyable journalistic detail, led to the 1998 Bank of England Act. This act sharply focused the Bank on the core function of maintaining price stability, which as defined turned out to be an inflation target. The Bank would get to choose the methods to achieve this, though it would be given the target. The act also took financial supervision away from the Bank and moved it all to a new, consolidated regulator, the Financial Services Authority (FSA).
The result was an “independent,” “modern” central bank in line with the international central banking theories and fashion of the new 21st century. As James explains: “A modern central bank has a much narrower and more limited set of tasks or functions than the often historic institution from which it developed. The objective is the provision of monetary stability, nothing more and nothing less.” For the Bank of England, “By the early 2000s . . . that task looked like it had been achieved with stunning success.”
It takes the book 450 scholarly pages to reach this outcome. The remaining 11 pages relate how it didn’t work. The “modern” central bank turned out to be far from the end of central banking history or the end of the related debates:
“The monetary and financial governance . . . which appeared to have been functioning so smoothly and satisfactorily, was severely tested after 2007-2008.”
“The crisis . . . required central banks to multi-task feverishly.”
“A new wave of institutional upheaval set in.”
“The 2012 Financial Services Act abolished the FSA.”
“By 2017 . . . Something that looked rather more like the old Bank . . . was being recreated.”
“The old theme of the Bank as provider or guarantor of financial stability came back.”
And so in central banking, the great evolution and cycling of ideas and of fashions continues. The essentially contestable concepts keep being contested.