Maybe Central Banks Won’t Always Be So Powerful
(Bloomberg View) -- The modern central bank is a uniquely powerful institution: It enjoys a large measure of independence from elected officials, yet makes decisions that can profoundly affect the livelihoods of millions.
From a historian’s perspective, there’s no reason to believe that it will always be so.
In his new 879-page history of the Bank of England, author David Kynaston recounts how the 323-year-old institution went from financing foreign wars to running monetary policy and overseeing the country's financial system. It’s an intricate tale, involving the battlefield beheading of a deputy governor in 1695, the swearing in of staff as constables to fend off a feared Chartist attack in 1848 and the gradual rise of academics to the commanding heights. It's also relevant to the present day, providing valuable context at a time when many are questioning the models and methods that central bankers use to manage the economy.
I spoke with Kynaston about the insights history might offer into the nature, conduct and future of central banking. Here’s an edited version of our conversation.
Mark Whitehouse: Economists have faced criticism since the 2008 financial crisis for being too focused on theoretical models -- such as the ones that inform policy at central banks -- and ignoring the actual history of how economies act and how disasters happen. What do you think they can learn from historians?
David Kynaston: When I was working on a four-volume history of London's financial center (known as the City), I had the insight that the pre-1980s City was very much like a village, which could be treated in an anthropological way. It was quite an intimate space, the old square mile. Later, in one of my initial conversations with Mervyn King about writing a history of the Bank of England, he said that since the 2008 crisis, he'd noticed that the economists at the bank were starting to read my City history.
This is all a way of saying that human beings matter. Sure, financial institutions have become a lot bigger. But when a few years ago I was co-writing a history of HSBC, one of the things that struck me was how the really key decisions were taken by a quite tight-knit group of people at the top. So even at such enormous institutions, human beings still matter.
MW: You tell the story of an amazing transformation, from an entity set up to finance the Nine Years' War to a public body responsible for managing the economy and overseeing the financial system. Does the emergence of a powerful, independent central bank seem inevitable to you? Have we arrived at the right model?
DK: It was a very slow transformation. On the eve of World War I, when the bank was well over 200 years old, it was still a long way off from what we see as a modern central bank. Only gradually, in a checkered sort of way, did the bank come to see itself as serving a public as well as a private function. It was a fairly haphazard process, partly driven by financial crises.
The bank now is arguably more powerful than at any time in its entire history. Is it the right model? One has to look at it holistically. It's not just a question of economic utility. It's also a question of democracy. There's a feeling here that the high tide of independence is perhaps over. The whole take-back-control motif that we hear now is about taking back control from unaccountable people.
Personally, as a citizen, I am rather skeptical about the bank's power. Back in 1995, when the debate was about whether the bank would get its independence, I wrote an essay arguing that monetary policy is about tradeoffs and value judgments and has real consequences in the lives of real people, so it is better if elected politicians are responsible for those decisions as opposed to technocrats.
In terms of monetary policy, over the last 20 years the bank has had a pretty decent record. And there are some decent levers for accountability: the Treasury Committee in Parliament regularly gives the governor some pretty close questioning, and we have quite a critical media as well. But I'd rather see a small loss in economic utility in return for a bigger gain in a better-functioning democracy.
That said, there's no doubt that when politicians had the power, they abused it. They imposed the monetary policy that served their own short-term political ends. So when you look at the sweep of post-war British history, you can say that they had it coming. You could also hope that they learned their lesson, but who knows?
MW: Montagu Norman, who served as governor from 1920 to 1944, seemed ahead of his time in advocating a “freemasonry of disinterested central bankers as a necessary counterweight to grubby, vote-catching politicians.” Is his the first expression of what would become today's independent, technocratic central banks?
DK: I think that's right. Norman was in a position to make waves in part because he was governor for so long, and he was the first governor in the age of universal suffrage and mass democracy -- all of which made him acutely uncomfortable. It's almost an unvarying constant throughout history that central bankers don’t trust politicians. It's in their DNA. And the politicians become even more suspect in the eyes of central bankers when they are doing the bidding of the masses.
Norman anticipated the technocracy, although he was hardly the model technocrat. When asked once how he reached his decisions, he answered not by saying anything, but by solemnly tapping his nose three times. When he reluctantly hired the bank's first economist in the 1930s, he said "you are not here to tell us what to do, but to explain to us why we have done it." This attitude would permeate the central bank for a long time to come.
MW: Which of the bank's governors most stand out?
DK: Norman seems to me psychologically the most interesting of all the governors. It’s pretty clear that he had a difficult life before he went to the Bank of England, and that becoming governor filled a deep psychological need for him. He put a huge amount of time and effort into the financial reconstruction of Europe after World War I, but he got some things badly wrong -- most notably the return to the gold standard, which had disastrous consequences for British industry. He wanted to get back to the way the world was before the war. The people running institutions in the 1920s looked back longingly to the pre-war period; they wanted to return to a world in which London was dominant. It was an emotional thing.
Norman allowed himself to be demonized by the left to a greater extent than probably was fair. He was so wedded to mystique that people assumed the worst and most sinister of motives. He was a PR disaster.
MW: The Bank of England was originally run by merchants with no university education. As you note, its leadership was openly disdainful of economists as recently as the second half of the last century. How did economists gain ascendance, and is this an entirely desirable development?
DK: It's a most interesting story, one that hasn't been fully told before. The key figure was Mervyn King. He came in as the bank's economist in 1991. In the previous seven or eight years, the anchor for British economic policy had been the exchange rate. That was completely demolished when the U.K. was run out of Europe's exchange-rate mechanism in 1992. At which point King played a key role by arguing that the bank -- and broader economic policy-making -- needed to concentrate on inflation targeting, which ultimately led to the bank's independence. After that the economists gained ascendance, and monetary policy became the road to promotion and to the top.
My impression of the bank now is that there is quite a concerted attempt to get the balance right, with the academic on the one hand and more traditional, pragmatic qualities on the other. It is recognized that in the pre-crisis period the economists became too powerful. It seems to me right that there should be a balance. Economists are very useful, but they can be narrow and arrogant.
MW: Financial supervision is a relatively recent responsibility of the Bank of England. It started in the 20th century with moral suasion -- as you put it, "the governor raising his eyebrows.” This has since given way to a large body of written regulation. Does history suggest that this is the right approach, and that the BoE is the right institution to implement it?
DK: My theory is that it’s essentially a matter not of which institution does it, but how it's done. Even when, in the 1990s, financial supervision was taken away from the BoE and given to the Financial Services Authority, the latter was staffed mainly with BoE people. The FSA in due course was blamed for the financial crisis, so now supervision is back at the BoE. It's helpful if the institution doing supervision has the image and the track record and the solidity of the BoE, but that's secondary.
Initially, back when Montagu Norman began taking an interest in financial institutions, the bank took an informal, people-centered approach. Supervision was done by a person who really had his eyes open, listened to rumors, listened to the gossip and formed a judgment about whether the human beings at the top of institutions could be relied upon or trusted. It has since moved to a more impersonal model. You could argue that the size of institutions makes that necessary, but even at these institutions it's only a handful of people who really matter.
Consider the case of the Royal Bank of Scotland before the 2008 crisis. By the mid-2000s, there existed an awareness that RBS had become highly leveraged and that the man at the helm, Fred Goodwin, was unreliable and interested in self-glorification. I don't think it's just hindsight: I think it's a reasonable counterfactual that in the old "moral suasion" days, pressure would have been put on the key institutional shareholders to get rid of Goodwin. But the whole approach had changed.
MW: Some believe that the BoE hasn’t done nearly enough to ensure the resilience of the financial system -- for example, by raising capital requirements. Do you think we've reached the right balance of power between financial firms and their overseers?
DK: Back in the old days, 1920 to 1970, the high street banks were a cartel -- very unambitious, very little competition. Oliver Franks, chairman of Lloyds Bank, famously said that running a bank was like having a car that could go 80 miles per hour but is allowed to go only 20. Of course that's frustrating, but the fact is that it provides stability. In 1931, when many financial systems came crashing down, the U.K.'s didn't. By contrast, the consequences of the banking crash of 2008 have been profound, are still working themselves out and clearly are potentially malign and dangerous. So I would give priority to financial stability. And of course I'm in favor of raising capital requirements.
MW: Various experts are advocating ambitious new policies at the BoE. Some think it should worry less about inflation and, when necessary, do more to boost the economy, for example by printing money and giving it directly to the government or the people. Mervyn King has suggested reasserting the bank's control over financial institutions' creation of money, by giving it the power to decide which investments can be financed with deposits or other short-term debt. You wrote that "context is often all." Do you think the context will ever be conducive to such radical change?
DK: Here in Britain, it does feel like we're potentially at a moment where more radical economic policies are more likely to be countenanced. Whether those policies come from the right or the left is hard to know. Partly because of the crash, partly because of Brexit, it feels like the future is even more of a blank canvas than it usually is.
The emphasis on inflation came out of the 1960s and 1970s, and took hard form in the 1990s with targeting. When people come to power, their mental framework comes from when they were young, which is typically 30 years earlier. But the dragon of inflation is long gone, and the problem now has more to do with deflation and how to deal with the Japan-like experience of slow growth.
MW: Some of the so-called extraordinary policies that the BoE has pursued -- and that are being proposed -- are actually quite similar to things it has done in the past. Its initial mandate in the 17th century, for example, was to finance the government and purchase its obligations on the open market. Is anything really unprecedented here?
DK: Directly financing government was where we came in, so yes, you could argue that the bank has come full circle. It's an institution that people and society can make what they need to make of. It should be the servant of society.
And to be fair, that's how the bank sees itself. It doesn't get said often enough: Working at the bank in the City, you're surrounded by people in private institutions who are earning several times more than you are even though you’re better qualified and quite likely more intelligent. Whenever I come into contact with people there, I'm struck by their strong sense of public duty and service.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mark Whitehouse writes editorials on global economics and finance for Bloomberg View. He covered economics for the Wall Street Journal and served as deputy bureau chief in London. He was previously the founding managing editor of Vedomosti, a Russian-language business daily.
To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.
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