Home page The reason the Bank of England is not independent In a follow up to our article as to why the Labour party made the Bank of England independent we now turn to review the degree of success of this financial instrument in contributing to the management of the United Kingdom economy. According to Hector McNeill1, author of "The Briton's Quest for Freedom", the Bank of England is not in fact as independent as people think. "Since Bank of England independence inflation has remained close to the target measure. However, this success seems to be more related to very benign world market conditions in terms of steady demand and growth, low inflation and interest rates. The sustained combination of growth and low inflation is a direct result of supply side economies offering products and services at steady or even declining nominal prices resulting in an enhanced real income." Real News reported some time back that this change in policy has been the only decision by the Labour Government to be completely successful in achieving its objectives. This decision has remained an entirely uncontentious issue. Although harbouring some initial doubts, now all of Britain's main political parties accept that the Bank of England should remain independent. It continues to be successful because it is free from political influence and is run in an independent fashion. Speaking too soon? McNeill says, however, that: "..the independencec the Bank is a relative issue because although we do not speak so much about Keynesianism or Monetarism today the overall impacts of government sector activities on overall demand levels and economic activity continue to influence inflation as these approaches describe. There is therefore a paradox in that whereas the government policies create instability such as the splurge of unstable cash flow through the health service can generate ripples of inflation it is up to the Bank of England to iron those out. Thus what the Bank is ironing out sometimes is a direct outcome of government policy. The more instability introduced by the public sector activities resulting from fiscal creep and windfall government revenue gains being spent, the more difficult it becomes for the Bank of England to react to government-dependent instablity in a fashion "independent" from the same government. The term independence is somewhat abused in this context. Such a basis for independence is not cost-free "The important point to note is that this independent "ironing out" comes with a significant cost. House repossessions at the moment are rising as a direct result of interest rises and these seem to have reached the catastrophic levels experienced under the Conversatives after 1992. At that time this was clearly the result of an interest rate change directly attributable to the Conservative government. Now the situation is more smoke and mirrors but in reality the current fiasco is also attributable to government policy." Treasury dominance a problem McNeill added: "The political issue is the lack of transparency in the way national accounts are presented, the use of consumer price indices and the selective basis of those items placed in our estimate of inflation. Policy-derived inflation is purposely cut out. This has created a strange illusion of a smoothly operating economy measured by what are misleading performance criteria populated by deficient indices. This seems to be Treasury-related fixation. They have applied such criteria broadly across most public sector activities in the name of assessing "value for money". The problem is that these technocratic microindicators do not always measure the right targets and sustain an illusion which prevents the electorate coming to grips with how the economy is performing." Government tax burden encouraging debt "The higher the level of direct and indirect taxes the lower the disposable incomes of individuals and their families. A lower disposable income encourages the use of credit either through bank loans or credit cards. There has been a major growth in the device of using mortgaged houses as collateral for top up loans in the form of remortgages. This results in a quasi- permanent state of massive debt. This arose largely as a result of the demutualization of building societies following the Building Society Act of 1986 leading to a large number of building societies demutualizing and becoming banks during the 1990s." Credit card boom "One should not forget that in association with this the credit card debt boom is associated with exhorbitant annual debt charges which, rather than extending disposable income, are reducing sustainable real incomes in many cases leading to increasing numbers of unavoidable bankruptcies." The impact of imported financial derivatives "The recent financial derivatives fiasco is a direct result of the significant distinctions between the operational objectives of mutual institutions and banks. It is important to distinguish between the relative benefits of mutualization and bank operations. All building societies are mutual institutions meaning people who have a savings account, or mortgage, are members with rights to exercise one vote, to receive information and speak at meetings. This structure makes building societies focus on the best services and products to their members." Banks operate in a higher risk frontier "In the case of banks, there is a split loyalty between making a profit to deliver dividends to shareholders and delivering value for their customers. In addition, converted institutions have a management overhead which is somewhere around 35% more than the the mutual organizations once dividend payments to shareholders are taken into account. Therefore in the case of house mortgages the risk on the side of the lender is higher in the case of the bank. Nothern Rock is a prime example of this problem. Northern Rock started out as the Northern Community Fund about 150 years ago. It was established by a group of shopkeepers. In 1968 it merged with the Rock Permanent Benefit Building Society. The beginning of the end was its transformation to the status of a bank in October 1997 when it scrapped its building society status and amalgumated with another 53 societies." "The characteristic of the financial derivatives markets is that they rely heavily on short to medium term likelihood of their resale and this in turn depends upon the capability of associated debtors linked to and supporting a derivative to sustain their payment of debt premiums." Why the system failed "The decision analysis which needs to be applied to the acqusition of mortgage-based derivatives is the existence of realistic profiles of the debtors in terms of income and other commitments on the one hand and the balance between the percentage of the current value of a property supported by a mortgage and the impact of likely changes in interest rates on the debtor profile. Thus in an extreme case, if a debtor has a 100% mortgage and all of his diposable income is spent once the mortgage payment is made, then even a marginal increase in interest rates will cause that cash flow to fail. Even worse, if the interest rates rise too much the housing resales marklet will face falls in prices which means more people will face repossession and the banks will not be able to recover the mortgages outlaid from the resale of the property." Naive realists succumbing to greed "Alan Greenspan characterised the operation of financial markets and a balance between greed and fear. Greedy people often are the most likely to succumb to the opportunity to gain more, they are more likely to be misled by those who sell them poor quality products, especially when such a sale satisfies the seller's greed and removes his or her risk at the same time. It gets even worse when the seller knows that what he or she is selling is relatively worthless. But the history of derivatives in the USA is not one which holds out any confirmation that these markets operate on a transparent and honourable basis. Today well-respected names and rating agencies have become too involved in pushing dodgy derivatives. Sometimes these derivatives are sold through off-account "vehicles" with impressive sounding names and which are "vetted" by the very institutions who set them up for marketing purposes. This is almost the same as the criminal "laundering" of money to sever the link between origin and current state and parallels some of the operations observed in the ENRON scandal. In spite of the Sarbanes-Oxley Act of 2002 to sharpen up corporate transparency and executive responsibility it would seem that the financial services world has far to go in even attaining less than acceptable product and trading standards. This is a market where no matter who the seller, the more eager they seem to be to sell a derivative the more one should suspect that there is a good reason why they want to off-load it. Thus those financiers and bankers who in the main consider themselves to be realists but who do not impose their own acceptance criteria but rather accept those of the seller on trust, can end up to be shown to be naive realists." Standards & transparency "In essence this is an issue of standards and we all know that the old building societies had a fixed ratio between a size of a mortgage and someone's annual income. Banks trade in an international markets so when it comes to the Bank of England or the so-called Financial Regulators there is a need for these to become more proactive in setting stricter conditions for better information on debtor profiles and proportionate size of the mortgage to a house value. Part of the problem is that these profiles are generated by foreign banks and institutions and then the derivatives containing that risk are sold on to others such as British banks. In other words what we are dealing with is financial imports to the United Kingdom which can create a serious risk for investors in the British banks concerned." "The fact is that neither the Bank of England nor the regulators can do much about this because of the "self-regulatory" nature of all financial markets. A more robust response on the part of government would be to provide incentives to lower overall operational risks by favouring mutual building societies. This could be through some form of tax allowance." 1 Hector McNeill is a development economist and director of SEEL, the Systems Engineering Economics Lab. His main economic policy work is in the development of the Real Incomes Approach. This concerns the design of macroeconomic policy targets, variables and instruments which avoid the constraints imposed by Monetarism and mitigate, or remove, the impacts of public sector economic activity, as outlined by John Maynard Keynes, on real income levels. Posted: 17th November, 2007. Updated: 19th November, 2007.