The United Kingdom’s economic policy is adrift. That was the main conclusion of the House of Lords Economic Affairs Committee’s investigation into the Bank of England’s (BOE) inability to predict the worst inflation in 40 years. In a recent report, the Commission criticized the BOE’s internal culture and forecasting models, casting doubt on its ability to bring inflation back to the 2% target by 2025.
The UK’s annual inflation rate hit a four-decade peak of 11% in October 2022, while overall prices have risen 22% over the past three years. The House of Lords report attributed the BOE’s errors to “groupthink” among authorities, an increasingly vague mandate (which now includes considerations such as climate change) and “inadequate” forecasting tools. Former US Federal Reserve Chairman Ben Bernanke, commissioned by the BOE to review his performance, highlighted the bank’s outdated software. The Commission also raised valid fears about the “unelected power” of central bankers.
In 1997, then Chancellor of the Exchequer Gordon Brown set the UK’s annual inflation target at 2.5% (later reduced to 2%) and gave the BOE “operational independence” to achieve it. Since then, the bank has exerted even greater control over economic policy, injecting £875 billion ($1.1 trillion) into the British economy through its quantitative easing program in response to the 2008 global financial crisis. -09. As Economic Affairs Committee Chairman George Bridges observed, this delegation of government macroeconomic policy to central bankers – now standard practice in developed economies – represented “a gigantic transfer of power from elected representatives to unelected officials.” ”.
Considering that interest rates affect not only the value of the currency but also unemployment, growth and distribution, one could say that monetary policy, like fiscal policy, should be administered by governments, which are responsible to voters. . However, despite criticism of the BOE’s performance, the report did not question the principle of the central bank’s independence. Instead, it focused on ways to align the bank’s freedom to set interest rates “independent of political pressure” with the government’s responsibility for economic policy.
The notion that central bank independence is sacrosanct dates back to Milton Friedman’s monetarist counterrevolution in the 1970s, which ended the hegemony of Keynesian social democracy. Friedman argued that market economies are “countercyclically stable” in their “natural rate of unemployment,” as long as market participants are not fooled with variable inflation rates. This argument, effectively, limits the scope of macroeconomic policy to maintain price stability.
Since monetary policy, like fiscal policy, affects economic activity with “prolonged and variable lags,” entrusting inflation control to independent central banks—insulated from political interference and operating according to mechanical rules—would prevent politicians manipulate the money supply.
Bankers and economic policy experts quickly embraced Friedman’s monetarist gospel. In a 1984 speech, the then chancellor of the exchequer, Nigel Lawson, turned previous Keynesian orthodoxy on its head. The objective of macroeconomic policy, he asserted, should be “the conquest of inflation,” not “the search for growth and employment.” On the contrary, macroeconomic policy should focus on “creating conditions conducive to growth and employment,” rather than eliminating inflation.
Lawson’s speech represented a return to the “classical dichotomy” of pre-Keynesian economics, which treats real variables (such as employment) and nominal variables (such as price levels) separately. According to this view, supply-side reforms would improve economic efficiency, and interest rate policies would maintain price stability.
Macroeconomic history tells a mixed story. The postwar era can be divided into two distinct periods: the Keynesian golden age (1947-1973) and the “Great Moderation” of monetarism (1997-2019). Excluding the intervening years, UK inflation averaged 4.5% during the Keynesian era, and unemployment averaged 2.1%. Under the central bank’s management, the inflation rate, on average, was just above 2%, while average unemployment was 5.6%. The growth rates in the two periods were 2.8% and 2%, respectively.
In other words, the macroeconomic outcomes in the two regimes were markedly different. Likewise, the “misery index” (the unemployment rate plus the inflation rate) was 6.6% during the Keynesian era and 7.8% in the era of central bank independence. Since 2020, it has increased to 9%.
It is certainly impossible to determine whether these events were the product of politics or external events. In early 1968, economist R.C.O. Matthews questioned whether the full employment of the Keynesian golden age should be attributed to government policy or a secular postwar boom. One could also say that the low inflation that characterized the Great Moderation had less to do with central bank policies than with the entry of billions of low-paid workers from Asia into the global labor market.
But since economic policy significantly affects economic performance, it is difficult to argue that fiscal and monetary policy should be kept separate. Central banks control the money supply through the rates at which they lend to commercial banks. This sets the structure of long-term interest rates, determining the rates at which borrowers can access funds, which in turn influences investment and unemployment.
In short, if governments are going to be responsible for investment and unemployment, they must also control monetary policy. Furthermore, while central banks strive to maintain an appearance of independence, the reality is that they often do what governments want. While it is impossible to predict what macroeconomic framework will emerge from our current era of turbulence, it probably bears little resemblance to Friedman’s ideal.
Robert Skidelsky, member of the British House of Lords, is Emeritus Professor of Political Economy at Warwick University. Project Syndicate, 2024.
