Having consciously uncoupled nearly 20 years ago (yes, the UK authorities were clearly way ahead of their time with this one!), is it finally time for monetary and fiscal policy to repair their relationship?
In 1997 the UK government introduced the Bank of England Act*. This enshrined into law that monetary policy decisions would no longer be taken by the Chancellor of the Exchequer and the Governor of the Bank of England. Instead, they would be the domain of a committee (the Monetary Policy Committee) made up of bank insiders (including the Governor) and external experts appointed to the committee for a fixed term.
This move, described as the most radical shake-up of the Old Lady in 300 years, was widely applauded. Many experts and observers had long felt that politicians had previously had too great a sway in interest rate decisions.
Lending credence to such views was the fact that interest rates were cut significantly in the run-up to each of the five UK general elections between 1951 and 1970 and again prior to each of the three elections between 1983 and 1992. In all but one of those cases, rates rose in the aftermath of the election - in many cases to higher levels than they had been prior to the election.
In the style of Chris Martin and Gwyneth Paltrow, fiscal and monetary policy “consciously uncoupled”
Politicians will be politicians
This behaviour is hardly surprising since nobody likes making tough, unpopular decisions – least of all politicians. Relationships are inherently complex. But it became clear that this relationship was in dire trouble and in order to keep inflation under control, monetary policy needed some space to work things out. It needed to be independent, to go and find itself; in the style of Chris Martin and Gwyneth Paltrow, fiscal and monetary policy “consciously uncoupled”.
Following the separation, the Bank had a clear mandate – to target inflation at a specified rate without causing undue volatility in output. The tools at its disposal were restricted to standard monetary levers – interest rates and the money supply. (More recently, the Bank has also been granted a regulatory role, due to the perception that under-regulation of the banks was a major contributor to the global financial crisis). The honeymoon period for this new model was as successful as anyone could have hoped for. Output grew at a steady pace, yet inflation remained remarkably steady around the Bank’s target.
Usually, though, honeymoon bliss is followed by the intrusion of reality. Inevitably, real life eventually kicked in.
The Bank’s narrow mandate lulled them into a false sense of security with regards to some of the financial imbalances within the system and the government, comforted by the seemingly endless growth and historically low volatility being generated by the economy (“The Great Moderation”) abandoned its fiscal prudence policy and began to run pro-cyclical deficits.
This meant that when the crisis hit and output plummeted the government deficit, particularly the deficit as a proportion of GDP (Gross Domestic Product), soared. And that left the UK government (and other similarly affected governments, most notably those of southern Europe) in a sticky situation. The economy was crying out for demand stimulus but the government coffers were dry. This forced the bulk of the burden of economic stimulus onto the central bank.
Unequal burdens: I’m not angry, just disappointed
Things could have been so different. Fiscal policy doesn’t suffer from the same inefficiencies as monetary policy (at least not if managed properly). The government can spend money directly in the economy without heavily relying on actors within the economic game behaving in the desired way. For example, if the government decides that it wants to build a new road or a repair a bridge, this will not only improve infrastructure (which has discernible long-term benefits), but it also provides short term stimulus through increased employment, leading to a direct boost in spending capacity.
However, the major Western governments were wary of following this path. With deficits already high, they felt that the risks of markets punishing them for fiscal irresponsibility via higher borrowing costs outweighed the potential growth benefits. Furthermore, there is a labelling problem associated with fiscal policy. For one thing, the term is too all-encompassing; furthermore, too often “fiscal” is associated with “welfare” - and this is simply anathema to the political right.
For a time this renewed “fiscal responsibility” seemed like a prudent approach. Yet with interest rates still at the zero lower bound (or even lower) more than five years after the crisis began, the question is again increasingly being asked – if monetary policy is not working or not working fast enough, isn’t it time for fiscal authorities to get more heavily involved?
An eternal bond
Of course, no central bank is ever truly independent. After all, if the central bank is not answerable to the elected government, then how can the people be sure that the central bank is acting in their economic interests?
Perhaps a more pertinent question is: as an extreme example, do we think that governments (if they were still in charge of both fiscal and monetary decisions) would have chosen to engage in some of these extreme monetary experiments, if they knew they would be held responsible for their actions in five or 10 years’ time?
Central bank independence was the answer to the sustained political interference, high inflation problem of the 70s and 80s
Central bank independence was the answer to the sustained political interference, high inflation problem of the 70s and 80s. And this excessive reliance on monetary policy to do the heavy lifting seems to be an inevitability of the post-crisis period. But it is fit for purpose in the low demand, low inflation environment which has now been with us for seven years and counting?
While we certainly don't foresee or advocate monetary and fiscal policy ever fully living under the same roof again, maybe it’s time to re-think the true costs and benefits of operationally independent central banks. Perhaps a long-distance (or weekend) relationship is the answer.
NB. The US Federal Reserve has been “independent” since 1951 (although it is described as independent within government as opposed to independent of government) and the European Central Bank was created as an independent institution in 1998.