Financial policy: from gold to central bank independence

December 8, 2022 | Blog
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By Aaron Jacob (the author was previously a District Councillor in St Albans. He holds a Masters degree in Modern History from the University of St Andrews and a Masters degree in Politics from King’s College London)


Inflation is the most significant issue in macroeconomics today. Its significance arises primarily due to its quiescence in the 2010s, and that its rate today has seemingly come from nowhere. Its effects, too, are pervasive. Inflation hurts everybody: capital and labour share in the pain when consumer prices rise at the rate that they do today. The efforts to bring inflation back to ‘normality’ throws into sharp relief not how we got here, as that is obvious with demand colliding with constrained supply. Instead, it brings into focus how financial policy came to concentrate almost exclusively on consumer price inflation, over and above other macroeconomic variables. The history of inflation targeting is an important one, for it has shaped the type of economy we have, as well as the prevailing pattern of economic activity in the UK.

In the nineteenth century, Britain was the workshop of the world. The Gladstonian triptych of the gold standard, balanced budgets, and free trade saw Britain become the pre-eminent industrial nation, exporting its wares globally. The gold standard was integral to this success and received its legal institutionalisation via the Bank Charter Act of 1844. The gold standard was a fixed exchange rate regime, as countries on gold converted their domestic currencies into gold at a fixed, official price. The benefits were twofold. Firstly, it was thought that gold would prevent politicians debasing the currency for their own ends, as the domestic currency in circulation was linked to a country’s gold stock. Secondly, and more importantly, being on gold ensured the stability of international trade—how Britain earned its way in the world. The stability of external balance was the underlying basis of all financial policy at the time.

This Victorian and Edwardian success was disrupted by the First World War. During wartime, Britain came off the gold standard and ceased to export gold, as the tentacles of the state reached far into the economy as never before. With the cessation of hostilities, the Cunliffe Report of 1919 presumed that a return to gold was the foundation of Britain’s economic success, and that of its lodestar, the City. Deflation was the order of the day, and after much pain to bring sterling back to the pre-war parity of $4.86, Britain embarrassingly left the gold standard in 1931 following a bank run and financial crisis. The exchanges still mattered, though, and other macroeconomic variables had not yet risen in importance, largely because the very concept of macroeconomics had only just been born with the publication of Keynes’ General Theory in 1936.

The post-1945 period witnessed the ascent in importance of unemployment, inflation, and growth, alongside the balance of payments. The immediate post-war period witnessed a real contest between the variables in importance, which reflected the political reality of the day. Unemployment and growth assumed greater importance initially, as unemployment was still fresh in the political memory, and politicians thought that Britain was lagging behind her European neighbours. By the mid-1970s, a confluence of factors tipped the balance in favour of inflation: the ‘stop-go’ fiscal and monetary policy of the late 1960s seemed to produce unemployment and inflation in the wrong proportions, whilst an incomes policy together with powerful union barons seeking to maintain industrial obsolescence forced prices ever higher. At that juncture, an oil price spike resulted in inflation hitting 25 per cent—a level not seen before, nor since. The external balance began to cede market share to domestic inflation in the minds of Britain’s politicians, as Thatcher swept to power.

Enter the curious monetarist experiments of the 1980s. These were curious because they took a causal view of the volume of money in the system and the rate of price increases, seemingly reverting to the economic theory of the early twentieth century. This was a policy of means, not ends. Similarly, the entry of sterling into the European Monetary System was the practical assertion of means over ends. This latter experiment sought to act directly on the exchange rate as a proxy for tackling inflation. By pegging sterling to the Deutsche mark, Britain’s policymakers believed that the exchanges could prevent domestic inflation. What was not foreseen, though, was a German reunification which saw inflation rising quickly, forcing the Bundesbank to act.

Britain’s ultimate ejection from the ERM on Black Wednesday provided monetary policy independence, meaning that there was the freedom to directly target domestic inflation. Central bank operational independence seemed to be the natural corollary of such a paradigm shift, and by 1997 many other central banks across the world had gained operational independence with explicit inflation targets.

It is difficult to do justice to over 150 years of economic history in a few words. However, even a cursory look at history illustrates how and why financial policy has changed over time. The focus on the exchanges was borne out of a realisation of Britain’s role in the world economy and the prevailing pattern of economic activity, as advanced economies were manufacturing nations, Britain being the pre-eminent one. The gradual move to target consumer price inflation towards the end of the twentieth century acknowledged and accelerated changes in the pattern of economic activity, as a manufacturing economy gave way to a service one.

Yet perhaps the time is nigh to consider whether a further paradigm shift is afoot. The parochial focus on a consumer price inflation target of 2 per cent is arbitrary, and has always tolerated a sizeable level of unemployment. Exclusive attention paid to consumer price inflation has masked the distortive redistributive consequences of quantitative easing and has resulted in serious discussion about unconventional economic ideas centred around the zero lower bound. Asset price inflation, growth, and the quality of employment have all been neglected in the pursuit of consumer price stability in the last thirty years. It takes significant economic events to shift the focus of policy, and now might be the time consider things afresh.



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