to 1979, by Forrest Capie, Cambridge
University Press, 890 pages
By Bill Allen
The period which Forrest
Capie’s new history of the Bank of England describes, from the 1950s to 1979,
the first year of the Thatcher administration, was a turbulent one. It began in
the long aftermath of the second world war and the associated overhang of
government debt, and was marked by the return of current account
convertibility, the Radcliffe Report, the devaluation of sterling, the
breakdown of the international monetary system, the end of credit controls, a
banking crisis, rampant and uncontrolled inflation, two unsettling encounters
with the IMF, and a seemingly endless sequence of sterling crises, among other
things. Professor Capie has had access to written records and many interviews,
including some conducted by Tony Coleby before Professor Capie got started. It
is a remarkable achievement to have assimilated all this material and produced
a coherent and comprehensible account of what happened. The book is easy to
read and, even for someone who was (like me) slightly involved in some of the
events described, contains interesting new information. This new history will
be an essential source of information on British monetary history.
During the 1950s, when the
narrative begins, the rate of inflation averaged 4.3% and never exceeded 9.2%%.
In the 1970s, when the narrative ends, it averaged 12.6% and reached 24.2% in
1975. These facts pose an obvious question about the performance of the Bank of
England, which later was to guide its policy and have its performance judged by
reference to an inflation target. Was it really as bad as the bald numbers
suggest? Professor Capie’s answer is, essentially, yes it was, though he expresses
it in the nicest possible way: “In a paraphrase of the Book of Common Prayer: the Old Lady left undone those things she
ought to have done and did those things she ought not to have done.”
The main thing that the Old
Lady left undone was keeping inflation under control. There can be no dispute
that inflation was a major and destructive economic problem, particularly in
the 1970s, that it was worse in the UK than in most other countries, and that
the monetary authorities failed to deal with it. Anyone wishing to defend the
Bank of England against Professor Capie’s charge would have assert that the
Bank did the best it could, but was unable to prevail.
There are some grounds for
such a defence. The Bank of England was in no sense independent or autonomous
in those days; in the words of John Fforde, it was ‘best regarded as the
central banking arm of a centralised macroeconomic executive’ (‘Setting Monetary Objectives,’
(in ’Central Bank Views on Monetary Targeting’, ed Paul Meek, Federal Reserve
Bank of New York, 1982). The prevailing
orthodoxy among establishment economists during nearly all of that period was
what would now be called naïve-Keynesian. It was only in 1976 that the Treasury
macroeconomic model finally acknowledged that there was no long-run trade off
between inflation and unemployment (at about the time that Prime Minister James
Callaghan made the same point in a famous speech).
What could the Bank have done
in the prevailing ideological environment to secure a better inflation outturn?
Could it have mounted a full-scale intellectual challenge to the Keynesian
orthodoxy? Needless to say, it did not, for a number of reasons.. First, such a challenge would have required
whole-hearted commitment from the Governor of the Bank; but none of the Governors
during the period were trained economists with the requisite views. If one of
them had been such a person, it is a fair bet that his successor, chosen by the
government, would have been quite different. And for a long time there was in
any case no inclination to mount such a challenge. The Bank, to the extent that
it thought systematically about monetary policy at all, was lulled by the
Radcliffe Report into a kind of nihilism about the use of quantity-measurement
in the conduct of monetary policy. It failed for a long time to engage with
serious critics, treating many of them with disdain. Among the critics, it was
only the IMF that could not be ignored, as Professor Capie relates, and it
should be acknowledged that the IMF enforced necessary changes in British
official thinking about monetary policy in the late 1960s. It was not until the
Richardson era (1973-83) that the Bank saw any need for a serious dialogue with
other critics.
Second, while the then-dominant
Keynesian school really had no explanation for inflation (other than bad luck),
and no cure (other than ineffective incomes policies), the opposing monetarist
position had its weaknesses, too. How should money be defined, exactly? No exact
answer. What about the awkward fact that, after Competition and Credit Control
(1971), the demand for money, on any definition, turned out to be unstable? No
real answer to that one, either. When the Bank did begin to express a view on
monetary policy strategy, Gordon Richardson was careful to make it clear that
he was embracing ‘practical’ monetarism (borrowing Paul Volcker’s phrase), and
not an ideology. He didn’t want to be caught offside by a sudden change in
intellectual fashion. His caution made him, and the Bank, deeply unpopular with
the newly-elected Thatcher administration, but it was well-justified, as was
demonstrated in 1980-81 by the coincidence of rapid growth in broad money and
deep recession in the economy.
And third, such a challenge,
if it had been public, would have completely undermined the Bank’s ability to
conduct operations on the government’s behalf in financial markets. If you are
responsible for marketing a government’s debt, you can’t really feel free to
denounce its macro-economic policy at the same time. Yet if the challenge had
not been public, it would have failed anyway.
Nevertheless it is clear from
Professor Capie’s book that, throughout the period, opinion in the Bank was
generally concerned that there was something wrong with government policies,
especially fiscal policy. This manifested itself for much of the time as the
reaction of ‘practical men’ rather than economists. These ‘practical men’ were
however not ‘the slaves of some defunct economist’, in Keynes’ condescending
phrase, but people who had to manage as best they could the financial market consequences of those
policies.
So the Bank’s strategy could
be described as ‘collaborate and complain’. The Bank collaborated by doing its
best to smooth the government’s path in financial markets, for example by organising
seemingly-endless programmes of external support for sterling. It could hardly
do otherwise without appearing unpatriotic and inviting the government to get
someone else to do the job instead. At the same time, it complained that not
enough was being done to eliminate the need for such expedients.
This was not a particularly
glorious strategy, and that the Bank did not always pursue it as effectively as
it might have done; for example it seems to have been rather slow in advocating
radically higher interest rates as inflation increased in the early 1970s after
Competition and Credit Control had ended credit rationing and when the world
economic environment was turning seriously inflationary. The Bank gradually
supplemented ‘collaborate and complain’ by accumulating sufficient economic
expertise to enable it to take a leading role in designing monetary policy as
the inadequacy of naïve Keynesianism became more and more apparent during the
1970s. This meant that when governments realised that they would have to pay a
price to overcome inflation, and that the price was worth paying, the
intellectual groundwork necessary for a new strategy had been done. This is
surely the Bank’s main monetary policy achievement of the 1970s. It was highly
significant, because for example it enabled the Bank to resist the Thatcher
administration’s pressure for monetary base control, and thereby spare the
economy a disastrous experiment. More positively, it enabled the Bank to help
manage a successful anti-inflationary monetary policy in the early-mid 1980s.
Professor Capie also thinks
that the Bank was too timid in its market operations, for example being too
ready to support the gilt-edged market by making purchases when prices were
falling. He is probably right. However, it should be acknowledged that market
operations during the period were complicated by two important factors. One was
that market participants had not grown out of the idea that ultimately the Bank
of England was in control of prices – not just short-term interest rates, but
also gilt prices and the exchange rate, even after the breakup of Bretton Woods
– and therefore that its perceived actions were of paramount significance. Perhaps
they could have been weaned off it more quickly than they actually were, but
the problem was a real one. This, combined with indecision and incoherence in
official policy, explains for example the collapse of sterling in March 1976,
of which Professor Capie provides the clearest account that I have ever read.
The other was that the structures of domestic financial markets were pretty
fragile. In particular, the pre-1986 gilt market was dependent on the
market-making capacity of not-very-heavily-capitalised jobbing firms. In that
structure, auctions of gilts, to achieve certainty about the quantity of
official sales, were just not feasible, because the market makers lacked the
capacity to underwrite them. Against this background, it is hard to understand
the Bank’s lack of interest in alternative market structures, such as the ARIEL
project, which it rejected for rather feeble reasons in 1976.
The main thing that the Old
Lady did that Professor Capie thinks she ought not to have done is the Lifeboat
operation, and associated bank rescues, after the secondary banking crisis in
the 1970s. These ensured that no authorised bank failed. Professor Capie thinks
that it was a bad idea, though well-executed, and that “the same result might
have been achieved at much lower cost and without the danger of generating
moral hazard.” Such judgments are notoriously hard to make, particularly in the
heat of the moment. In this case, Gordon Richardson clearly thought that the
crisis threatened to have systemic consequences and that the operation was justified
in order to contain them, and in the light of the prevailing financial and
economic chaos of the time, it seems to me likely that he was right. These
days, an operation of that sort would have to be approved by the Chancellor,
because of the possibility of financial losses. Denis Healey was indeed consulted
at the time, and “indicated that he regarded it as a matter for the banking
sector to sort out.” (page 584) This may perhaps be regarded as tacit approval
for the rescue operation, from someone who was perhaps relieved not to have to
take responsibility for it.
Even for someone who worked
in the Bank of England for part of the period, the book contains some
surprises. One of them is the extent of the role and influence of John Fforde,
one of the first economists recruited by the Bank, but not widely recognised
outside official circles, except as the author of the preceding history of the
Bank. He is quoted extensively by Professor Capie, and the book reveals both
his intense clarity of thought and his persuasive mastery of the English
language. Charles Goodhart’s prominence is less surprising, and happily he is
still Britain’s leading monetary economist, more than 40 years after he first
joined the Bank.
All history, and all reviews
of history books, including this one, are written with the benefit of
hindsight. The recent financial crisis exposed a gulf between thinking about
monetary policy and thinking about bank supervision, which has been always
perceived by its practitioners as a mainly micro-economic activity. (For a discussion of an
earlier appearance of this gulf, see Ivo Maes, “Alexandre Lamfalussy and the
origins of the BIS macro-prudential approach to financial stability,”
forthcoming in PSL Quarterly Review.) Communication
between supervisors and those responsible for monetary policy in the Bank of
England was, in my recollection, not close. One reason is that it was hampered
by the confidentiality provisions of the Banking Act, and probably also by the
fact that the supervisors were preoccupied above all with the institutions for
which they were regarded as responsible. The latter was not entirely
surprising, since if any bank got into difficulties which became public
knowledge, the public reaction was (and still largely is) invariably to put all
the blame on the supervisors. Supervision was a highly risky occupation. More
fundamentally, the objectives of supervision were never, to my mind, adequately
defined or codified, so that it was impossible to relate them to the other
functions of the Bank. I think that this lack of communication was harmful to
the Bank of England, perhaps to other central banks as well, and, more
important, to the economy at large.
Professor Capie illuminates
all these issues with an impressive exposition, both of the facts and of the
debates that preceded important decisions. Recent events have been a reminder
of the importance of understanding economic history as well as economic theory,
and anyone interested either in the history of the period or in current
monetary policy is recommended to read his book.
Bill Allen was formerly Deputy Director of the Bank of England in each of its three main areas: Monetary Stability;
Markets; and Financial Stability.
