1997: Gordon Brown Sets Bank of England free From Control

The Chancellor, Gordon Brown, released the Bank of England independence from political control. His surprise announcement – coming only four days after Labour’s landslide election win – is being described as the most radical shake-up in the bank’s 300-year history. Mr Brown has also announced a loan rate rise of a quarter-point to 6.25%. The increase was decided after Mr Brown’s first and last meeting with the Governor of the Bank of England, Eddie George.
The chancellor went straight from that meeting to a news conference at which he unveiled his plans to give the bank freedom to control monetary policy. He said: “I want to set in place a long term framework for economic prosperity… I want to break from the boom bust economics of previous years.”

Labour MPs applauded the chancellor’s announcement – but the Conservatives were divided, with former chancellor Norman Lamont congratulating Mr Brown while former home secretary Michael Howard deplored it. Business chiefs broadly welcomed Labour’s decision to give the bank its independence. Under the new regime, a monetary policy committee was set up to decide interest rates with a view to achieving an initial inflation target of 2.5% or less. The committee was made up of the Governor, his deputy, a new second deputy, two bank executive directors and four experts, appointed from outside the bank. It met monthly and each member had one vote. Previously, the Chancellor held a monthly meeting with the governor at which interest rates were agreed. It means the bank was now free to decide monetary policy without taking the short-term wishes of politicians into account.

Equally guilty was the new system put in place by Mr Brown. Fragmented among three institutions, and manned by people who were either unaware of what was going on or unable to communicate what they knew to one another, it failed its first big test. Sir John Gieve, the Bank of England’s deputy governor in charge of financial stability and also a non-executive director of the FSA, gave evidence to the parliamentary committee on September 20th along with Mervyn King, his boss at the central bank. “I was concerned in a general way about the growth of wholesale lending,” he said. “Did I know the details of Northern Rock’s position before this blew up? No, I did not.” This institutional deafness was to become an increasing problem as the government sought solutions to the bank’s worsening plight.

The problems at Northern Rock, and other financial institutions, did not appear overnight. The crisis in the USA sub-prime loans market was well documented, as was the fact that this dodgy debt had been repackaged and sold on to UK and EU banks. Major banks in Germany as well as Barclays Bank in the UK are rumoured to have significant exposure to these dubious assets.

Northern Rock’s profit warning led to a further slip in its share price. But banks do not answer to their shareholders alone. They are subject to special supervision, because a problem at one bank can undermine confidence in the whole system and do immense economic damage. The Bank of England had long been in charge of overseeing banks, and its record, though not flawless, was widely reckoned a good one. In 1997, however, when Gordon Brown, then chancellor of the exchequer, freed the central bank to set interest rates, he decided to hand bank supervision to a new Financial Services Authority. The FSA was to look after individual banks while the Bank of England remained responsible for the stability of the financial system.

It would seem that the Bank of England is independent of the UK government when it is pursuing government policy. However, if it pursues policies which it deems in the interests of the UK economy, yet are contrary to short term political expediency, then this independence is an illusion. In October 1997, the bank was “responsible for the overall stability of the financial system”. In the new version, however, it merely “contributes to the maintenance of the stability of the financial system as a whole”.

Mr King’s critics say that in his fixation on future crises he failed to deal with the one at hand. Mr Santes pointed out that logically the only replacement for private-sector liquidity, once it dries up, is central-bank liquidity. According to DeAnne Julius, a former member of the Bank of England’s monetary-policy committee, “The first duty of a central bank is to retain confidence in the banking system, especially at a time of illiquidity, and our central bank didn’t do that.”

As long as five years ago Tommaso Padoa-Schioppa, now Italy’s finance minister but then on the board of the European Central Bank (ECB), pointed out that the liquidity of financial markets had grown in importance. He gave a prescient warning: “The deepening of the markets has improved the ability of banks to access funds in normal times, but liquidity may be more prone to dry up when it is most needed.” In 2006 Moody’s, a rating agency, cautioned that some British banks were exposed to the risk of disruption in wholesale markets because they were increasing their loans faster than they could gather the deposits to back them. More recently, the Bank of England itself highlighted in April the danger of liquidity risk in its Financial Stability Report.

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