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BofE and Inflation

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So finally some attention is turned to the inept Bank of England who have really emerged from the whole financial crisis surprisingly (at least to me) unscathed. It continues to amaze me how little blame has been laid at the Bank’s door for their role in creating the bubbles that have characterised our economy in recent years. Why this is, God (or Allah or Buddha or Xenu or whatever your deity of choice might be) only knows. Perhaps organations like the BBC simply assume that Joe Public is too much of an ignoramus to understand the structure of central banking. (There may, unfortunately, be more than an element of truth in this.) Perhaps they themselves don’t really understand these things (again: quite likely). Or perhaps it’s all just a lot easier to bring in an angry lefty to shake their fist and rant about bankers and their vulgar bonuses than to actually produce any analysis of substance.

Anyway, the debate posted above centred around the inflation figure and its divergence from the Bank’s target. ¬†Now I’m not going to discuss here the relative merits of inflation targeting – perhaps I shall do another time. No, the question here is just how political is monetary policy? One of the key problems that has always plagued¬†macroeconomic¬†policy is the ever-present conflict between sound economics and political expediency. In an attempt to remove this conflict in the domain of monetary policy, the Labour government in 1997 granted independence to the Bank of England. Now whilst there are legitimate questions about the democratic impact of such a transfer of power, the move does at least have an air of macroeconomic sensibleness about it. And as far as Labour go, doing something with even a faint whiff of sensibleness to it is about as good as you can hope to get.

So, does the nominal independence of the Bank and their MPC really remove the tendency to form policy in a politically expedient, short-termist manner? Well, it seems it does not. Firstly, as with any policy structure, it is worth considering the psychology and incentives of the agents involved. Is it realistic to assume that Mervyn King and the MPC would be happy to simply devote themselves to sticking to their inflation target, over and above all other macroeconomic considerations? They have their reputations to consider, just like anybody else operating in the public domain (well, maybe not Jordan), and macroeconomics is primarily characterised in the public eye by growth. Wherever there may be a policy conflict between inflation targeting and growth, the MPC will always have an incentive to break with their targets. This has been plain to see throughout the MPC’s history*. It seems the MPC face the same incentives to act in a populist fashion as the politicians.

So what if they do do choose to break with their targets? Surely there is a system of accountability? Well, technically, yes: the Chancellor can reprimand the MPC. The problem is – as the chap from Europe Economics points out in the video clip – that no Chancellor has so much as even let out a mildly disappointed sigh on hearing the news that the inflation target has been missed, let alone done anything of any significance. What has basically happened is that by giving the politicians the choice on whether or not to enforce the target, what is meant to be a constraint on policy is merely a constraint only if chosen to be enforced. Or in other words: not a constraint at all.

Thus, by granting independence to the central bank, we have simply moved from a situation where monetary policy decisions are made by government for short-termist, political reasons to a situation where decisions are being made by an unelected institution based on similar reasoning, but where now government can easily disavow themselves from any erroneous judgments if need be. Moral of the story: even if a policy sounds good, and stems from good intentions, the actual set of incentives involved always needs to be examined.

*It should be obvious to anybody with half a brain, who has applied any amount of time to thinking about the subject that not only do the central bankers in general have an incentive to sacrifice their inflation targets in lieu of a more populist growth agenda, but at the moment they also have huge reason to discount the importance of controlling inflation. That is, we have a huge public debt. Now, I don’t suggest that their has ever been an explicit decision made amongst the MPC to inflate our way out of debt (although I certainly don’t rule this out!). No, but on a more subtle level, the prospect of eroding the real value of public debt is always going to be in the back of the central bankers’ minds whenever the prospect of controlling inflation is considered. One doesn’t need a huge imagination to see how this might affect their decision making.


Written by theunfashionabletruth

February 16, 2011 at 3:24 pm