In 1997 the Bank of England was given operational independence by the then Chancellor of the Exchequer, Gordon Brown. The Bank’s newly formed monetary-policy committee was presented with a mandate to use the institution’s main interest rate (“Bank Rate”) to maintain a RPIX (Retail Price Index excluding mortgage interest) inflation rate of 2.5%. Since 2004 the target has been 2% based on a CPI (Consumer Prices Index) measure of inflation. For much of this time, the Bank has been successful in keeping inflation low and stable. Between 1997 and 2021 average CPI inflation each year was exactly 2.0%.
However, 25 years after the Bank was given its independence, in the summer of 2022 inflation breached 10% for the first time in 40 years. Even with the government’s recently announced price cap, increases in domestic energy prices, expected to come into effect in October, are forecast by economists at investment banks to push CPI inflation to 11% or more this autumn. Further unanticipated rises in commodity prices globally or wages at home, or falls in the value of the pound, could easily increase inflationary pressure in Britain further.
The Bank has suffered severe criticism from politicians and the press for its recent poor performance on inflation. On September 15th, the Bank of England revealed that the public’s trust in its abilities to keep inflation under control, as measured by its own Inflation Attitudes Survey, slid to a record low. With this in mind, many commentators fear that the current inflation crisis could do serious damage to the support for central-bank independence among both politicians and the public.
So, what has gone wrong at the Bank? How can a repeat of the great inflation of 2022 be avoided in the future? And what can be done to ensure that the monetary-policy shock that will result from the Bank’s attempts to raise interest rates to curb inflation will not destroy British economic and financial stability? This paper uses the latest research about the relationship between monetary policy and financial stability in Britain over the past two centuries to provide new answers to these questions.
The Bank of England’s officials often blame the war in Ukraine for why inflation is off target. Yet this is not a complete explanation. It is true that the surging price of imported natural gas, thanks to Russia limiting its exports to Europe, is a severe supply shock that will make Britons poorer. Yet something had already gone wrong before Russia commenced its invasion; CPI inflation was already 6.2%, more than three times above target, in February 2022, the month hostilities began.
Policy plays a big role in terms of how much inflation at home is generated by a shock from abroad. Inflation that peaked at 27% year-on-year in August 1975 in Britain is often blamed on the oil shock of 1973 which saw global oil prices rise 300%. Yet Germany, which was then if anything more dependent on imported energy than Britain, saw its inflation rate remain in single digits for that entire decade.
In the past, Britain did manage to absorb shocks from abroad without threatening its financial stability. For more than a century, from the late 1860s to the early 1970s, the Bank of England operated monetary policy in a way that prevented Britain from having almost any major systemic banking crises (the main exception, the panic of 1914, was caused by the outbreak of the first world war rather than, unlike the others, credit over-issue by the Bank of England). This almost unique achievement for a major advanced economy was in sharp contrast to the frequency and severity of crises in the United States and continental Europe.
How did this come about? After 1866 the Bank of England developed methods of dampening external monetary shocks under the influence of a group of economists called the Banking School. Under this monetary-policy regime, interest rates were raised promptly in response to a range of indicators to cool speculative booms before they became inflationary, but also gently in small steps so that businesses and consumers could adjust to higher rates without defaulting on their loans and making the financial system go bust. Much can be learned from their general approach today.
This paper begins by briefly outlining the history of British financial stability over the past 200 years. What caused the series of financial crises seen in mid-19th century Britain? Why did they then almost disappear between 1866 and 1973? Why did they then return from the 1970s? The paper then goes on to describe how the practice of central banking has become less good at forecasting when inflation overshoots might occur, and how their management of inflation has made a financial crisis seem likely once again. The paper then lays out two sets of policy prescriptions to deal with the monetary-policy problems that Britain currently faces. These are (i) how to reduce the likelihood of the current inflationary surge causing an interest-rate spike that would throw Britain into recession and cause a wider financial crisis; and (ii) how to reduce the likelihood of the Bank of England causing an inflationary overshoot in the future.
The first lesson of British financial history over the past two centuries is that the most severe crises in this period were partly caused by monetary-policy shocks. In the run-up to the 1847 crisis interest rates rose from 3% to 8% in just ten months. In the 1857 crisis, they rose from 5.5% to 10% between July and November. In the year of the 1866 crisis interest rates rose from 3% to 10%. In the year before the secondary banking crisis of 1973-75 rates rose from 6% to 13%. And in the lead-up to the 2008 global financial crisis it was action by America’s Federal Reserve in raising its rates from 1% to more than 5% in less than two years, that helped to trigger the US subprime mortgage crisis, the contagion from which then spread to Britain and the rest of the world as the “credit crunch”, which triggered the global financial crisis.
The mistake made in each of these crises was that interest rates were kept too low for too long and then rose too much too fast to over-compensate for the previous error. In the crises of 1847, 1857 and 1866 this involved raising the Bank Rate to levels that had never been seen in the Bank of England’s history (since 1694). However, locking the stable door after the horse had bolted had a cost. Many banks and other businesses could not cope with sharp rises in interest rates to levels they had never seen before.
What changed after 1866? Economists and historians have hitherto emphasised the Bank’s embrace, from the 1866 Overend’s crisis onwards, of Walter Bagehot’s dictum that it should promise to lend on good securities ‘quickly, freely, and readily’, though at a penal rate of interest, to prevent runs on the country’s financial institutions. However, recent research has found that the Bank of England did not fully commit to its role as lender of last resort until several decades later— the important point being that pre-commitment by the central monetary authority is needed for “Bagehot’s dictum” to work. The Economist later wrote that the Bank of England was more the “mender of last resort” rather than “lender of last resort” in this period, organising and subsidising the bailout of Barings Bank in 1890 and of the secondary banks in 1973-75. Indeed, Walter Bagehot himself saw his own dictum as a second-best solution to prevent contagion from a crisis from spreading, not as a method to prevent crises themselves from beginning.
For that, economists and historians have to look at the Bank of England’s management of monetary policy. The crisis of 1866 marked the end of a period in which the Bank attempted to keep its interest rate as low as possible in the run-up to a crisis, only then to make it worse by raising it very sharply at the last moment to defend its bullion or note reserves. This situation had been made worse by its relatively low bullion reserves, its “thin film of gold”, on which its note issuance was based. Worse still, much of its bullion used by its issue department to back up its bank notes was not owned by the bank itself but came from the bullion deposits it received from its customers in its banking department, adding to the Bank’s unstable financial position.
It was only subsequently, under pressure from the Banking School, that the Bank began to raise the amount of bullion it held in reserve. It was then able to use the policy space this created to deploy its Bank Rate to dampen the effects of economic shocks on credit markets at home, whether that be from inflation, from adverse capital flows out of Britain or from interest-rate spikes abroad.
It did this in two main ways. First, it began to monitor a wide range of indicators—from prices in the wider economy to bullion and note reserves at the Bank and capital flows and interest rate differentials between countries. This enabled it to raise its rates promptly but gently at the first sign of trouble. Second, just as suggested by both Bagehot and Stanley Jevons, another economist, it began to build up a bigger bullion reserve—borrowing from colonies such as India and other European central banks when needed—so that it could slowly raise its rates when the shocks hit Britain in full force, rather than having to do it in a panic at the last possible moment to protect the Bank’s liquidity.
This system worked until the 1960s, carrying on through a variety of economic-policy paradigms, both fixed and floating exchange rates, and even the Bank’s nationalisation in 1946. A growing aversion by post-war politicians to raising the Bank Rate then brought this era to an end. Growing political interference in monetary policy threatened the century-long policy of raising interest rates promptly to stem a bullion drain or inflationary episode before it accelerated out of control, forcing more aggressive action. Relations became so strained over this issue that Rowland Baring, 3rd Earl of Cromer, decided in 1966 not to seek a second term as governor of the Bank of England because of disputes with the government of Harold Wilson over its refusal to raise its Bank Rate sufficiently. The devaluation of the pound in 1967 was one of the results of the government’s intransigence.
The Treasury and the Bank tried to resolve this impasse with a new policy called Competition and Credit Control in 1971. This policy was intended to depoliticise rises in Bank Rate and tackle rising levels of inflation. It replaced ceiling controls on bank lending with tighter control of the money supply using higher interest rates. However, in spite of the new policy, the new Conservative prime minister, Ted Heath, also initially refused to allow interest rates to be raised, in fear of the impact of high rates on industry as well as mortgage holders. His government made the situation worse with a big fiscal stimulus that became known as “the dash for growth”. Unsurprisingly, the broad money supply then grew by an unprecedented 71% between 1971 and 1973, and the result was unprecedented inflation. To try and kill this inflation, interest rates had to be raised sharply from 6% in early October 1972 to 13% by December 1973—a new all-time record, just as in 1847, 1857 and 1866—and the resulting credit shock triggered the secondary banking crisis. As The Economist put it in 1975, the result of the Heath government’s policies was simply ‘an old-fashioned banking crisis’, very similar to the crises of the mid-nineteenth century. The lessons of more than a century of experience were lost in less than a decade.
Subsequently, inflation targeting and central-bank independence have made an important contribution to “the great moderation”—the period which saw low inflation in Britain and much of the West between the early 1990s and 2021. Several academic studies, supported by a wealth of empirical data, have shown that independent central banks could deliver lower inflation because they were not subject to short-term political pressures to give a reflationary boost. However, the growing problems with the models used to produce the inflation forecasts that independent central banks use to guide their monetary-policy decisions are increasingly threatening financial stability. This is because they can easily reproduce the situation that caused financial crises in Britain in the 1840s, 1850s, 1860s and 1970s, as well as the global financial crisis in the 2000s.
In the Bank of England’s inflation forecasting models, based on New Keynesian ideas, the key question being investigated is whether there is enough spare capacity in the economy for the current interest rate to be maintained without generating inflationary pressure. This requires calculating the output gap - a comparison of the actual output of the economy with the maximum output that can be achieved without generating inflation. This is approximated by calculating the ‘natural rate’ of unemployment, which is the lowest rate that unemployment can fall to when the economy is running at full capacity. America’s Federal Reserve and the European Central Bank also use models similar to that of the Bank of England.
The problem faced by central banks across the world is that it is becoming harder to accurately calculate an economy’s natural rate of unemployment. The Bank of England’s failed experiment with “forward guidance” in the 2010s illustrates the increasing difficulties that central banks face with forecasting the output gap in this way. In August 2013 Mark Carney, the Bank of England’s governor, announced that it would not raise interest rates above the zero-lower bound (0.5%) until unemployment in Britain fell to 7%. However, when unemployment did fall to 7.1% in the last quarter of 2013, inflation was still only 2.0% as there was still plenty of spare capacity in the economy. The expectations that Carney had hyped up for a rate rise went unfulfilled. When the Bank of England finally did raise rates above 0.5%, in August 2018, unemployment had fallen to 4.2%, still with little sign of inflationary pressure. The failure of its forward guidance to identify accurately when inflationary pressures would emerge only showed how wrong the Bank of England’s calculation of the output gap was in 2013.
Other central banks have also faced similar forecasting problems and errors since the global financial crisis. In response to this, many have chosen to simply wait until inflation actually emerges, and then try to react to it when it arrives, rather than be guided by leading metrics or other forecasts. This, in basic terms, is the position that America’s Federal Reserve has recently reached. In August 2018 Jerome Powell, its chair, admitted that the Fed did not really know what the natural rate of unemployment was. In August 2020 he went on to announce that, as a result of this uncertainty, the Fed would wait to see strong evidence of inflation emerging before it acted so that it did not start tightening policy before the lowest possible unemployment rate could be reached. On the surface, it seems the Bank of England has adopted a similar policy stance. It only began to raise rates from pandemic lows and to end quantitative easing in December 2021, when inflation had reached 5.4%, nearly three times higher than target.
The problem with this type of policy—whether followed intentionally or unintentionally—is that it repeats the problem faced in Victorian Britain and the 1970s of leaving rates too low for too long and then raising them too late, too fast. There is a scholarly near-consensus that the full effect of monetary policy takes between 18 to 24 months to fully take effect. If the central bank waits for inflation to appear before making its first move, at the end of this time lag, inflation expectations may have become completely de-anchored from the target of 2.0% before its tightening has its full effects. As it takes time for the effects to fully appear, returning inflation to target quickly requires bigger rate hikes. This increases the risk of overshooting and creating the sort of monetary-policy shock that could trigger a credit crunch and financial crisis. The sharp increase in interest rates would not need to be so sudden or so sharp, nor the great inflation of 2022 so severe, if the Bank of England had abandoned quantitative easing or had begun to raise rates earlier in 2021, as this would have helped inflation expectations remain anchored nearer the Bank’s target.
Since financial stability was added to its remit in 2013, the Bank of England’s main tool to address this issue has been macroprudential regulation. This approach involves targeted rules on how financial institutions can behave that are intended to help prevent the development of asset bubbles and to increase the stability of the banking system against shocks. The introduction of stricter affordability tests for borrowers and the stress testing by regulators of banks to ensure they have enough capital in reserve to survive a future recession are examples of this.
However, many financial historians and other commentators are doubtful that macroprudential regulation is a complete solution. One important reason is that regulators will always be one step behind the yield-searching investors. Limits on one asset class will simply divert the hot money into another. There are numerous examples of this in British financial history. The latest is that since regulators cracked down on the causes of the global financial crisis of 2007-09—excessive leverage by big banks and high-risk mortgage lending—the flow of easy money, added to by two bouts of quantitative easing, has been diverted into less heavily regulated sectors, particularly corporate lending by “shadow banks”. These firms—that manage assets worth at least $63trn at the time of writing—are not banks but still provide financing for other firms in the same way as a bank would. The world’s major stress-tested banks may initially emerge unscathed in the next downturn, but the largely unregulated shadow banks might not. The contagion from their failures might then take down the rest of the financial system. And so, rather like proverbial generals, financial regulators tend to use their experience of the last war to fight it again rather than the new one which is about to break out.
So, what is to be done? It may be easier to start off with what is best not to be done. That is to remove the Bank of England’s operational independence. Its monetary-policy committee’s performance in meeting its inflation target has been poor in 2022. Nevertheless, to meddle directly with the monetary-policy committee’s decision-making would be to make a bad situation worse. The vetoing of interest-rate rises proposed by the Bank under both Wilson’s Labour government and Heath’s Conservative government contributed to the severity of the inflation Britain endured in the early 1970s and the secondary-banking crisis that was triggered by belated action against it in 1973-75. The empirical evidence is clear: independent central banks really do keep inflation lower by keeping the reflationary antics of politicians at bay. Any move away from it would also weaken confidence in sterling and British government debt, both of which have already taken a pounding over the summer of 2022 because of political uncertainty.
There are, however, measures that the government could take, without infringing the Bank’s independence, that could help slow down its interest-rate rises. One way would be to lower inflation with a significant cut to VAT across the whole economy, in addition to capping energy prices. This would reduce the headline rate of inflation immediately (rather than in 18 to 24 months’ time when using monetary policy), reducing the pressure on the Bank to tighten its monetary policy so quickly, and thus helping to prevent the sort of interest-rate overshoot that harms financial stability.
To make sure that such a policy does not stoke inflation by raising aggregate demand or increase inequality by disproportionately subsidising the expenditure of the wealthy, it could be made fiscally neutral and fair by raising funds from those higher up in the income distribution. That could be done without raising marginal direct tax rates by reducing the sorts of reliefs and tax expenditures mainly enjoyed by wealthier firms and taxpayers, for instance, by equalising the way that income from capital and income from earnings is taxed or by moving to a single rate of tax relief for pension contributions. This would also bring benefits by producing a simpler tax system with low and uniform marginal rates and a broad base, in line with IMF and OECD guidance.
Cutting VAT (paid for by increased revenue from changes in other tax reliefs) also offers the promise of being able to both cut inflation and raise real GDP, at least in the short term. As VAT cuts, or rises in energy subsidies, feed through immediately to taxpayers and their spending and investment decisions, the economy would get an instant boost, and help avoid a recession in 2022-23. The tax rises generated by relief reductions would not fully feed through to taxpayers until their taxes are due in the January after the end of the financial year, thus cooling inflationary pressure in the medium term after the immediate threat of recession is over. The government of Margaret Thatcher did the opposite in the 1979 budget by raising VAT and cutting income tax: the VAT rises stoked inflation and contributed to an immediate recession, while the stimulatory effects of the income-tax cuts did not fully feed through into the economy until years later. The opposite policy, and consequences, should be now pursued. As it is possible to affect real GDP in the short term with a fiscally neutral budget, the government should examine the possible benefits of this sort of tax reform to get through the immediate crisis.
Lastly, the government needs to ensure that the Bank does not repeat the mistakes of the great inflation of 2022, yet it should not compromise the Bank’s operational independence. It could do this by reviewing the Bank’s mandate, a process which has not taken place since 2013. Although this idea has been greeted as controversial by some commentators, in other countries independent central-bank mandates are reviewed on a more regular basis, for instance every five years in Canada. Britain is overdue for one.
The focus of this review should be to move away from the New Keynesian “groupthink” that has allowed the Bank of England to gravitate towards a situation where it only deals with inflation once it has happened. The current situation risks a return to the sort of financial crises seen previously in British history. One way to challenge the “groupthink” at the Bank of England would be to appoint individuals with a wider range of career experience to the monetary-policy committee, rather than just New Keynesian economists. They could bring other models, perspectives and metrics into consideration in terms of judging how to defeat inflation while maintaining financial stability. Recent research by Mark Harris and others, for instance, argues that individuals with careers in private industry are more hawkish on inflation than economists drawn from other backgrounds. Individuals from the financial sector could bring in more knowledge about how money flows around an economy and affects spending, while historians could bring in a longer-term perspective about inflation and financial stability than can be found presently on the monetary-policy committee. Alternative targets to the 2.0% CPI inflation rate could be considered, such as a nominal GDP target. Advocates of this approach argue that it ensures that the economy would always grow in nominal terms, creating greater macroeconomic stability for the banking sector, although critics point out that nominal GDP data is notoriously unreliable and is subject to significant revisions in the short term.
The lesson from history presented here is that the Bank needs to be able to react quickly, but gently, when setting monetary policy. Care should be taken so that the measures used to bring inflation under control do not cause unnecessary financial instability. It has been too easy in the past to ignore the damage done by financial crises. Some economists see recessions as useful “creative destruction” to eliminate weaker firms and to transfer the resources they use to more productive ones. However, as Carmen Reinhart and Kenneth Rogoff have shown, downturns featuring systemic banking crisis are deeper, longer and have slower recoveries than ones that do not. The growth lost in them, unlike that in an ordinary recession, is never recovered. Mainstream politicians also have much to fear from them. Several papers in recent years have found that electorates become more politically extreme after banking crises, compared with after normal recessions.
Financial crises in British history have also had a tendency to make humanitarian crises worse. Most notoriously, the crisis of 1847 prevented further borrowing to fund relief spending during the Irish famine—something that the government today should keep in mind when preparing to finance its response to the energy crisis of 2022. The inadequacy of Irish-famine relief alienated Ireland from the Union and sent it down the road to independence. More than ever before, on both economic and political grounds, policymakers should ensure that the mistakes of Britain’s financial history are not repeated again in the future.
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M. N. Harris, P. Levine and C. Spencer, ‘A decade of dissent: explaining the dissent voting behavior of Bank of England MPC members’, Public Choice, 146 (2011) pp. 413–442.
A. Hotson, Respectable banking: the search for stability in London's money and credit markets since 1695 (2017).
R. Michie, British Banking: Continuity and Change from 1694 to the Present (2016).
D. Needham, UK monetary policy from devaluation to Thatcher, 1967–82 (2014).
C. Read, Calming the Storms: The Carry Trade, the Banking School and British Financial Crises since 1825 (2022).
C. Read, ‘Laissez‐Faire, the Irish Famine, and British Financial Crisis’, Economic History Review, 69:2 (2016) pp. 411-434.
C. Read, The Great Famine in Ireland and Britain’s Financial Crisis (2022).
C. Reinhart and K. Rogoff, ‘Recovery from Financial Crises: Evidence from 100 Episodes’, American Economic Review, 104:5 (2014) pp. 50–55.
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