What Is To Be Done? Proposition One

Towards a Truly Independent Bank of England

The recent Labour Conference was abuzz with rumours as to the fate of Mervyn King and the "independence" of the Bank of England. The betting line, by many members, was that the good old days of "Old Labour" would be back 'ere long. "All we need is for the PM to cut rates before the election and the housing market will be right as rain." "Inflation isn't as much a worry as building a solid majority." "With five more years in Number 10, we can wait out this cycle." The rumours were wild then, and are still continuing, that a reform of the Tripartite Authority was in the offing. Labour stalwarts want the Chancellor and Treasury to come out on top; they would handle any "future crisis" with the Bank of England handling monetary matters and the FSA regulatory ones and both doing what they are told when it came to "matters of national (for national, read party political) interest."

As Anatoly Kaletsky wrote in The Times, "Labour backbenchers sounded like liberated religious cultists, suddenly freed to return to the old patterns of thought that were brainwashed out of them ten years ago."

Less you think I am overlooking them, the Tories have also added their bit of non-sense to the present arguments. At their party conference the Shadow Chancellor, George Osborne, posited his party's solution to keeping the Bank of England independent: replace the Governor every five years! What a novel idea; let's throw the baby out with the bathwater. George, just to make absolutely sure that we've gotten rid of the baby, why not throw out the bath, too? With ideas like that, Mr. Osborne should stay in the shadows.

This is all too reminiscent of the chatter at the Republican Party convention in 1972 when delegates praised Richard Nixon's ability to lead and for Arthur Burns, then chairman of The Federal Reserve Bank, to follow.

I know there are those who will argue with me, but it is my belief that the damage caused by this surrender of monetary independence was far greater than the damage caused by the cover-up of the Watergate break-in. From the time he took the Fed Chairmanship, Dr. Burns pursued an expansionist monetary policy. This strategy, coupled with wage and price controls, that he agreed to at Mr. Nixon’s behest, led to inflation soaring from 5.4% in 1970 to 11% in 1974, when Mr. Nixon resigned. In point of fact, during his tenure as Fed chairman, Dr. Burns presided over a 78% increase in the consumer price index. Although part of this can be laid at the door of the two oil shocks that occurred in the period, the majority of the effect was due to a Fed policy aimed at keeping unemployment to 4% and interest rates low.

The parallel continues when one examines the source of Mr. Nixon's motivation -- his loss in the presidential election of 1960. In his book, The Six Crises, Mr. Nixon laid the blame for this loss on the recession that started in April 1960 which he believed was brought about by the tightening monetary policy (aimed at curbing inflation) put in place by then Fed Chairman William McChesney Martin in 1959. After Mr. Nixon won the presidency in 1968, he appointed Mr. Burns chairman with the proviso that the Fed would ensure a plentiful credit supply prior to his re-election.

It took the chairmanship of Paul Volcker and the presidency of Ronald Reagan to bring the era of stagflation to an end by targeting inflation, rather than interest rates and unemployment. Whilst this resulted in a major recession in the US from 1981 to 1983, with unemployment rates higher than at any time since the Great Depression, the long-term results of this strategy -- low inflation and a moderate but over-all growing economy -- are still with us today. A key element in this recovery was the decision by Mr. Reagan to give Mr. Volcker his pledge of neutrality. President Reagan allowed Chairman Volcker to set the target for inflation and to use the means necessary to bring about the resurrection of the American economy.*

History’s views, or at least current researchers' views, of the two men are as different as their methods and the outcomes that followed.

Dr. Burns is in the odd position of being viewed as a lamb led to the slaughter whilst being at the same time one of the slaughterers of the lambs. That is, he was a chairman who was overly influenced by political pressure in his monetary policy decisions and who thus left the national economy in a nightmarish state.

I would argue that this is less a than a fair assessment of Dr. Burns' entire career and his body of works, which have influenced the likes of Milton Friedman, George Stigler, Anna Schwartz and others. Nonetheless, it is his current epitaph.

Mr. Volcker is viewed as a hard-nosed leader with the tenacity to hold fast to his beliefs despite political and media pressure and who, ultimately, turned around the US economy.

As an avid fellow fly-fisherman I would say of Mr. Volcker that he made the prize catch of the day while Mr. Burns missed his cast; Mr. Reagan got to ride off into the sunset

To return to the present, I do agree that the Tripartite Authority needs to be reformed, but not in the way that the politicos and bureaucrats wish it to be. I believe that what the UK needs is a truly independent Central Bank that not only handles issues of the monetary supply but is also, once again, an integral part of the regulatory process.

Why take such a step you ask? My answer, like Gaul, is divided into three parts. First, to quote The Captain,

"What we've got here is failure to communicate."

Whilst the jury is still out as to where responsibility lies, it is abundantly clear that something failed in the regulatory due-diligence process with regard to Northern Rock. The first jury, a political one, namely the Treasury Select Committee of the House of Commons, will determine if, in their view, the FSA fell short in its duty to the people of this nation to provide proper oversight. Whilst the issues at Northern Rock were made known in mid-August by the FSA Chairman to the Chancellor of the Exchequer, the Treasury Permanent Secretary and the Bank of England Governor, my sources tell me that they were told that the FSA did not consider the situation to be "dire." Indeed, even up to the morning of Wednesday 12 September, the day that Governor King sent his letter on "moral hazard" to the Treasury Select Committee, he received assurances that a direct intervention would not be necessary. It is becoming clear as well that the situation at Northern Rock over the prior 7 months was not communicated, without varnish, to the Governor of the Bank of England.

The main communication from the FSA on Northern Rock, in particular, and on the credit crisis in general, from mid-August to mid-September, was an incessant call for Mr. King to liberalise the BoE rules and accept mortgages and other less-than-gilt assets as collateral for short-term lending. Not winning him over, his "colleagues" in the Tripartite Authority used the media to launch a campaign against Mr. King. They touted the policy of Fed Chairman Ben Bernanke “to accept a broad range of collateral for discount window loans, including home mortgages and related assets," and pushed aside Mr. King's concerns with the moral hazard of bailing out the perpetrators of this crisis. The fact that the Fed had long-accepted a mixture of assets for discount, whilst the BoE had not, was of little matter. Why let the facts get in the way of an effective tool, pressure in the press, which could be picked up by MPs and used to hammer on Mr. King?

Yet Mr. King stood firm. As he said in his letter to the Treasury Select Committee, "this was no time to compensate banks that had accepted too many risks too cheaply. If a central bank provided implicit insurance to lenders the next period of turmoil will be on an even bigger scale." What he did not know was that he was about to be mugged on his own doorstep by the Chancellor, the Treasury and the FSA. The very next day he was handed an ultimatum to change or be damned in the form of the virtual collapse of Northern Rock. The Chancellor, like a good marionette with his strings controlled by the Puppet Master (PM), reminded Mr. King of the Mephistophelian bargain that had been made in 1997: the BoE was free to be an "independent monetary authority" except when called upon to be the "lender of last resort" (a phrase soon to be changed by Treasury in its frantic attempt to show that the Northern Rock panic needn't have been a panic at all, at least not outside the stately rooms of Whitehall). With his back against the wall, and with as much pride as he could muster, Mr. King succumbed.

Mr. King’s first face-saving effort, his testimony before the Treasury Select Committee on 20 September, was fascinating to watch as he so very carefully led the MPs away from himself, like hounds following a drag, and towards his opponents in Treasury, the FSA and inside his very “house.” The truly remarkable fact is that Mr. King was damaged not only by the actions and words of Sir Callum McCarthy, Chancellor Darling and Chief Secretary of the Treasury, Andy Burnham, but also by the inaction of Sir John Gieve, Deputy Governor of the Bank of England. Sir John admitted that he had neither read the Northern Rock’s interim financial statement of July 25 nor communicated its details to Mr. King. As John McFall, MP, chairman of the Treasury Select Committee, asked Sir John, "So, were you having a sleep in the back of the shop while a mugging was taking place?" Poor Sir John could only reply that, no, in August he had gone off to a funeral and then on his annual 'hols' to the South of France.

Many will remember Sir John, the former Treasury mandarin and Permanent Secretary at the Home Office, from the David Blunkett "give a visa to my mistress' nanny" scandal, as well as being the person who failed to have 1,000 illegal alien former-felons deported under Charles Clarke. He culminated his career in the Home Office under Jack Straw by failing to obtain the National Audit Office’s sign-off of his department's financials due to irregularities (which he dismissed as "niggling"). He also ran the Chancellor's private office for Nigel Lawson, John Major and Norman Lamont, and was responsible for the first two Labour spending reviews under Gordon Brown. Whilst he served these masters well and remained, in Gordon Brown's words, "well respected in the civil service," it was clear that because of his cock-ups he would be given neither the job of cabinet secretary nor the top job at the Treasury; so he walked the well-trodden path to the Bank of England.

This takes us to the second part of my answer, which is best illustrated by quoting Oscar Wilde on puppets,

"There are many advantages in puppets.
They never argue.
They have no views about their art.
They have no lives, only those of their masters."

For the record, it is not my intention to pillory Sir John Gieve as an individual, but rather who and what he represents. Whilst he was reputed, at one stage, to be an excellent economist, his latter years in Government have been noted for a plethora of poorly thought out, poorly handled and poorly explained decisions and policies that have rendered him unfit for the position of Deputy Governor. He simply does not have the attention to detail and the facility for analysis and action that this post requires. What he does have, in the words of one of his colleagues, is “the ability to withstand the withering fire of a parliamentary committee.” That may play well in the labyrinths of Westminster but that alone is not enough to merit his position.

Now, I am fully aware that the norm in all Governments is to pass out political plums to the "boys" and even, on very rare occasions, to the "girls," as it is all too often not what you know, but who you know that matters most. However, if this crisis teaches us anything, it teaches us that we need to place our Central Bank in the hands of professionals who owe their positions to merit and not in the hands of cast-off career bureaucrats or recipients of political patronage.

This brings us to the third and final part of my answer. To quote Sophocles,

“What you cannot enforce, you do not command.”

The plain truth is that the Tripartite structure has failed for the same reason many committee forms of governance fail: the lack of a leader who is accountable for the decisions and actions taken or not taken by his or her organisation. In the world of monetary and regulatory control, which is the essence of a Central Bank, such a leader cannot be beholden to a political regime (Dr. Arthur Burns) or be the erstwhile stalking horse for a political/bureaucratic regime (Sir John Gieve) or receive the office as the reward for faithful service to any and all of the above (Sir Callum McCarthy), without creating an inherent weakness in the very structure they pledge to run. No, an independent Central Bank must have an independent head who is focused on the task at hand and can actually deliver what is required, as St. Paul said, “in season and out of season.”

For whilst one of the Bank of England's two core purposes is monetary stability (meaning stable prices, low inflation and confidence in the currency, which the Bank seeks to meet through the decisions on interest rates), the other core purpose is to maintain the stability of the financial system. The BoE states on its own website, “The Bank has to make sure the overall system is safe and secure and that threats to financial stability are detected and reduced. By monitoring and analysing the behaviour of participants in the financial system and the wider financial and economic environment, the Bank aims to identify potential vulnerabilities and risks, with a view to making the system stronger.”

The question we need to ask is, “How well has this been accomplished under the Tripartite structure?” As Mr King testified, the BoE has had difficult obtaining critical information on this country’s banks. It has had to rely either on its own ability to scout out matters in the market or on information passed to it by the FSA. We now know that this information has been subject to the judgement of political appointees "having a sleep in the back.” This situation is untenable.

Primus Inter Pares **

I checked “Google Map,” and they calculate the distance between Threadneedle Street and Number 25 The North Colonnade to be 3.5 miles. In reality, the distance is measured in light years, political light years. Whilst the arguments, the lack of unity of purpose and the failure to maintain authentic channels of communication (the real distance) may be papered over in the forthcoming “reforms” from Treasury, they will still remain unless a fundamental step is taken to overcome them. That step must be radical, in the real sense of the word, a return to basics, to the roots. In order to meet their requirement “to maintain the stability of the financial system,” all regulatory controls, including the FSA, must be brought under the aegis of the Bank of England.

This is not to say that the FSA must be subsumed into the BoE, but rather that the FSA must look to the BoE for guidance on policy, for sponsorship of its regulatory due-diligence and as importantly, for protection from political manipulation. Failing this, the BoE will need to replicate internally the regulatory structure of the FSA so as to re-build the credibility that once was their hallmark and by which they were viewed as the banker’s bank, an institution truly knowledgeable of each bank as well as of the senior bankers who ran them.

Whilst this level of duplication is common in the US, with the Fed, the Comptroller of the Currency, the FDIC, the SEC and the individual state regulatory bodies having joint and several responsibilities for different aspects of the regulatory regime, it is not the norm in the UK. Rather than duplicate bodies, the better route is to declare the BoE to be at the head of the Tripartite Authority.

The Governor, rather than the Chancellor or the Treasury Secretary or the Chairman of the FSA, must be recognised as the accountable leader thus removing the inherent weakness of the present Tripartite structure. At the end of the day, the hand at the tiller in a serious financial crisis cannot be that of a career politician or bureaucrat, whose motivations may be various and sundry.

No, in order to inspire and maintain confidence in the roiling seas of the financial markets, the leader must be the country’s most senior, independent, public financial official -- the head of the nation’s central bank.

We can argue long and hard about whether the incumbent is the right man for the job, but that is not the point. The issue is where is the right place to invest these powers in the UK and, in my opinion that can only be in the office of Governor of the Bank of England. The Tripartite structure needs to be revised to guarantee the independence and the primacy of the Bank of England in all matters monetary and regulatory, with said independence to be guaranteed by all parliamentary parties and to be deemed part of the Constitutional fabric. My first proposition to prevent a replay of the present crisis is as follows:

Resolved
That the Bank of England is, and of right ought to be, free and independent and that all political and bureaucratic manipulation by this or any future, Government of Great Britain is, and ought to be, totally proscribed.

The Old Lady of Threadneedle Street needs to change her emblem –

Britannia must give way to Bodicea

Cassandra


* Volcker always commended Reagan for his taking the politics out of the Fed, saying “People in the White House and Treasury put pressure on Reagan, but they could never get Reagan to criticize me.” “The president,” Volcker said, “had this visceral feeling that fighting inflation was a good thing. … He also believed that politicians come and go but economies endure. … He had an innate trust in an independent Fed with an independent chairman.”
Paul Volcker: The Making of a Financial Legend, Joseph B. Treaster,
New York: Wiley, 2004.

President Reagan wrote down a quote of Chairman Volcker on the cost of inflation in his daily journal that the President also used in defending the Chairman, "Inflation is thought of as a cruel and maybe the cruellest tax, because it hits in an unexpected way, in an unplanned way, and it hits the people on a fixed income hardest. And there's quite a lot of evidence, contrary to some earlier thinking, that it hits poorer people more than richer people."


** Primus inter pares, which translates as first among equals is, a phrase indicating that a person is the most senior of a group of people sharing the same rank or office. When not used in reference to a specific title, it may indicate that the person so described is technically equal, but looked upon as an authority of special importance by his peers. In some cases it may also be used to indicate that while the person described appears to be an equal, he actually is the group's unofficial or hidden leader.