1 Introduction
Three decades of monetary policy
Forrest H. Capie and Geoffrey E. Wood
The theory and practice of monetary policy has changed out of recognition in the past twenty-five to thirty years. The perception of how monetary policy works has in the United Kingdom and elsewhere undergone a profound change. To understand how this has come about it is instructive to look at the views of the leading policy makers and practitioners, and it is here that the Department of Banking and Finance at City University played a small part.
Founded in the mid-1970s as the Centre for Banking and Finance, the name was subsequently changed to the Department of Banking and Finance; that department was later subsumed into the Faculty of Finance of Cass Business School. The Centre was established following an appeal by the 1973 Lord Mayor of the City of London, Lord Mais. He took this initiative because of what had seemed to him (and to some others) an anomaly of long standing. The University was founded in 1894 and was the only University in the City. Yet it might as well have been in Birmingham or Leeds or Glasgow – for it neglected City-related subjects, and rather concentrated on science and engineering, including, perhaps particularly surprising given its location, aeronautical engineering. Lord Mais used the annual Lord Mayor’s appeal to raise funds to rectify this, and the Department of Banking and Finance was then founded and attracted Brian Griffiths from the London School of Economics as the Department’s first professor.
The original intentions were to contribute to the education of young people, equipping them for a working life in the fields of money, banking and international finance, and to conduct research in monetary economics and monetary history. Strong links with the City and government were formed at an early date. Among the achievements of the Centre was the establishment of two important annual public lectures. One of these was called the Henry Thornton Lecture in memory of the founding father of modern monetary economics. The other was named the Mais Lecture in honour of the contribution Lord Mais had made to the founding of the Department. The first of the lectures had an academic bias. The second was designed to appeal to the wider audience of policy makers and practitioners.
Thus the idea of the second was to communicate what monetary policy was, and did, and could achieve. To that end the lecturers invited were those endowed with the responsibility of shaping monetary policy and carrying it out in Britain and elsewhere. These were of course the governors of central banks, the chancellors of the exchequer, and shadow chancellors, and other leading politicians or serious commentators on the subject. On occasions lectures strayed further a field than monetary policy, to the working of the economy at large.
A representative collection of these lectures thus provides an interesting guide to the developing views on the subject over the late twentieth century.
This volume is a second edition, not simply a reprint of the first. It incorporates lectures given since the first volume appeared.1
The themes of the lectures
The principal theme is naturally monetary policy. Five of the original thirteen contributions deal specifically with that subject, while two of the new five lectures deal directly with that and the remaining three deal with subjects very closely related. The two that took us furthest away from that were Sir Samuel Brittan’s ‘Some presumptions of economic liberalism’ (1989), and the Chief Rabbi Professor Jonathan Sacks’ ‘Markets, governments and virtues’ (2000). Both of these were wide-ranging lectures on the nature of the economic system under which we live. Two other lectures, by Peter Lilley (1993) and Kenneth Clarke (1994) took the opportunity to discuss, respectively, social security, and the changing nature of employment at the end of the twentieth century. Tony Blair as Leader of the Opposition set out (in 1995) the economic framework of a new Labour government. Hans Tietmeyer (1998), President of the German Bundesbank, used the occasion to give a German view of the prospects for financial and monetary integration in Europe. Gordon Brown, as Chancellor in 1999, set out the framework for full employment under a Labour government. Lord Robbins, the highly distinguished public figure in British economics and artistic life (among many other things Professor of Economics at the London School of Economics and Chairman of the Financial Times), was an early contributor (in 1979) on what the objectives of monetary policy had been and currently were. Sir Geoffrey Howe set out what the recently elected and radical Conservative government in 1981 was doing about inflation, and in 1984 Nigel Lawson followed that up with a consideration of the achievements of the new approach to policy that had been inaugurated. The three Governors of the Bank of England, Sir Gordon Richardson, Robin Leigh-Pemberton and Eddie George, reflected, as might have been expected, on monetary policy.
In the five new lectures, in 2003 Ernst Welteke, then President of the Bundesbank, discussed European Monetary Policy, followed the year after by Otmar Issing, of the executive board of the ECB, on the first five years of the ECB and the euro. Then in 2004 the Governor of the Bank of England gave a wide-ranging discussion of the practice and theory (in that order, note) of monetary policy. The next lecture took us back to the eurozone, with Jean-Claude Trichet of the ECB on European financial integration. In 2008 Britain’s then Chancellor of the Exchequer, Alistair Darling, gave his lecture entitled ‘Maintaining stability in a global economy’. These new lectures are not discussed in a separate section in what follows, but discussed in the appropriate section with the older lectures in the volume.
The lectures: monetary policy
The second lecture in the series, that by Lord Robbins (1979), is the most appropriate with which to start the overview of this collection’s contents. For Lord Robbins used his knowledge of economic history, the history of economic thought, and economic analysis, to review the objectives and conduct of monetary policy over some half a century, including in that review some policy decisions in which he had himself participated. In particular, he was concerned with the gradual acceleration of inflation that started, albeit initially very slowly, in the 1930s.
Opinion on the proper conduct and objectives of policy had fluctuated since then. Internal policy had shifted from the preservation of the gold standard to maintaining unemployment close to, in one period, 2 per cent. ‘This indeed had, in my opinion, very adverse results on conceptions of appropriate policy.’ The resulting rise in inflation, culminating in the disastrous policy of Edward Heath (Prime Minister from 1970 to 1974) was very damaging and, Lord Robbins notes, was warned against in advance. Those who gave that warning were of the intellectual persuasion known as ‘monetarist’; the meaning of this term Lord Robbins turns to later in his lecture.
His historical review covered largely the years of fixed but adjustable exchange rates run under the tutelage of the IMF. This system had essentially collapsed when Lord Robbins gave his lecture. The breakdown he ascribed to incompleteness in the rules specifying when exchange rates could be changed, and an inadequately flexible exchange rate for the US dollar.
So much for his view of the past. Then Lord Robbins turned to current policy.
The essential truth of the so-called monetarist attitude – the truth to which I should be willing to subscribe – is the contention that continuing marked disparities, either way, between the rate of change of output and the rate of change of the money supply lead to damaging changes in the value of money.
He differs from some monetarists, however, in an interesting and prescient way: for he recognised that cost-push pressures in turn put pressures on the monetary authorities, and that their resistance could not be taken for granted. Political institutions matter, in other words. Only recently has this been made explicit by other economists (such as Posen, 1993)2 who argue that the correlation between central bank independence and low inflation may depend crucially on the social and political structures which produced independence, rather than on independence itself. Very appropriately for the lectures by three governors of the Bank of England to which we turn in a moment, Lord Robbins concluded his review of methods for inflation control by observing that incomes policies, a fashionable measure just before he spoke, were pointless except as an emergency measure and the control of the total money value of expenditure was what was crucial.
The lecture concluded with consideration of international monetary arrangements. While recognising that so long as inflation differentials persisted between currencies floating was inevitable, he was not an enthusiast for floating rates. He feared, inter alia, that sharp moves in them, in response to government policies, would provoke the resurgence of the ‘totally illiberal system of exchange control’. He did not offer any solutions. But he did propose, at least as an interim measure for Western Europe, that the ‘Commission of the Community might … issue a new money run for parallel with existing currencies but … managed so as to maintain a constant value in terms of a representative collection of commodities’.3 In his concluding remarks, Lord Robbins restated the overwhelming importance of stopping inflation. That leads very appropriately to the lectures given by governors of the Bank, for they were charged with that task.
The first Mais Lecture was given, in 1978, by the Governor of the Bank of England, Sir Gordon Richardson. The timing was fortuitous, as it was then still only quite recently that monetary policy had re-emerged as a tool of economic policy. As the governor put it:
We are now at an historical juncture when the conventional methods of economic policy are being tested … the greater emphasis on monetary policy has occasioned new initiatives in the way of conducting it. The present is therefore suitable time to take stock.
What did that taking stock reveal? Monetary policy had just emerged from the shadow of neglect cast over it by the Radcliffe Report (1959). In so far as monetary policy mattered to the authors of that report, it did so by affecting ease of access to finance. The money stock did not matter; interest rates had modest effects; quantitative controls over credit were the most effective monetary instrument. The Governor asserted that the Bank did not entirely share these views even at the time the report was published. This purported scepticism of the Bank’s undoubtedly helped reassert the importance of monetary policy; but monetary policy’s importance was once again brought to the fore both by the theoretical and empirical arguments of Friedman (and earlier of Keynes – unlike his disciples he never neglected the importance of money) and, perhaps most compelling, the resurgence of inflation.4 That fundamentally weakened the underpinning of Radcliffe Report-type views. In part there was an interest, and for a time emphasis, on ‘monetary targets’. That is to say, an adjusting of interest rates so as to keep a particular measure of money growing within a particular range. This was not an end in itself, but because that growth rate of money was seen as being consistent with satisfactory price-level performance. As is well known, that approach to policy proved a disappointment. The relationship between money growth and prices that had been reliable for a century gave way; money growth accelerated and inflation slowed. Sir Gordon was writing before the evidence of that disappointment appeared. But his lecture did nevertheless set out some aspects of the conduct of policy which have proved of great and enduring importance, and not just in the UK.
What endures in particular are two points. First, prudent monetary policy is essential to the control of inflation. Other factors can, of course, put upward pressure on prices – the Governor noted wage increases, and others such as oil prices, could be added to that list – but, as he put it, ‘there is an observable statistical relationship between money growth and the pace of inflation. A great deal of effort has been devoted to the study of his relationship over long time periods and in many countries; and that there is such a relationship cannot, I think, be doubted.’ Or, to look at the matter another way, while if money growth resists these price pressures they will not produce inflation, it would make the task of monetary policy much easier if these pressures were removed or mitigated. That point almost brings us to the Mais Lecture given by Sir Edward George when he was Governor. But before moving on, one other point that Sir Gordon made must be highlighted – for it has been key to the conduct of economic policy since that date. ‘It is right that people should know what the broad lines of policy are, and that such policy should be kept on its stated course until circumstances clearly call for a reappraisal.’ There should, in other words, be no attempt to manipulate the economy almost from month to month, certainly from quarter to quarter, to fine-tune, as the expression was; rather, policy should have a pre-announced and clear medium- to long-term focus.
How to achieve that focus? That question was examined in Sir Edward George’s lecture. But the world did not move smoothly from that described by Gordon Richardson to that of which Eddie George spoke. There was a period when, though it was recognised that monetary control was important, it seemed hard – on occasions almost impossible – to attain. In 1987 Robin Leigh-Pemberton discussed aspects of that turbulent episode. His lecture had as its main theme the role of the interest rate which the Bank controlled in affecting the economy. A key point was there is no direct mechanical linkage from the rate to the economy.
Outside commentators on monetary developments sometimes create the impression that those responsible for the operation of monetary policy sit in front of a battery of switches and levers, each one of which will produce a precise and certain response in some area of the financial markets or directly in some more distant part of the economy. I can assure you that there is only one switch in my room, and that is the light switch.
Having made that clear, the Governor ruled out controls as a way of controlling the economy, and then went on as follows.
The instruments we are left with then are the terms on which we provide liquidity to the banking system, government funding policy (or as some prefer long-term interest rates), and foreign exchange market intervention.
Particularly in view of the attention given from time to time (in autumn 2000, for example, as a result of the weakness of the euro) to the third, it is worth continuing the quotation:
There are practical limits to the extent to which we can rely upon either funding policy or intervention, as well as limits to their effectiveness … when you come right down to it, the only effective instrument of monetary policy is the short-term interest rate itself.
How does that interest rate work? What are the mechanisms by which it affects the economy? Expectations matter.
As in other areas of economics, behaviour in response to interest rate changes is probably influenced at least as much by people’s expectations about the future … as by perceptions of the cost of money at any particular time.
Against that background, the governor reviewed a variety of mechanisms. The list comprised effects on bank lending to the private sector, company borrowing, effects of wealth through the impact of interest rate changes on the value of financial assets, and the effects of interest rates on the exchange rate. His conclusion was that, although all these channels mattered, it was impossible to say precisely how much they mattered.
That is in fact an issue – the channels of transmission of monetary policy – on which our knowledge is little further advanced than it was when that lecture was given. But despite that, it has become increasingly clear, and increasingly widely accepted, that sensible monetary policy is vital to the control of inflation, and a vital prerequisite for prosperity. This wide acceptance was demonstrated very clearly just after the Labour government led by Tony Blair took office in May 1997.
On 6 May of that year the new chancellor of the exchequer created the Monetary Policy Committee (MPC) of the Bank, and gave it freedom to set interest rates. In his lecture Eddie George reflected on that change, considering it ‘against the background of the monetary policy framework being developed in Europe’ and ‘in the context of the approach to the economics management more generally in Europe and this country’. It is that last point which links this lecture so closely to that given by Sir Gordon Richardson.
The change that had taken place over the previous few years was that there had emerged a widespread consensus, across countries and across political opinion within countries, that economic policy ought to be focused on the medium and long term rather than responding to, and trying to manage, every small fluctuation in the economy. There was consensus, too, that growth can be increased only by supply side measures – making markets more flexible and efficient – and not by boosts to demand.
Where did this lead for monetary policy?
The objective remained price stability – as it was, albeit expressed slightly differently, for Sir Gordon Richardson. As Sir Edward pointed out, this is in many ways, including the commitment to stability over the longer term, very like the arrangement in the euro area. But there is at least one significant difference. In Britain the government sets the...
