Independent central banks: new and old.

• Author: Wood, John H.

In the 1990s, several governments gave their central banks operational independence to pursue low inflation, and steps were taken to make the new monetary policy more credible by making it more transparent (Bernanke et al. 1999). The governor of the Reserve Bank of New Zealand is subject to dismissal if inflation is outside the assigned range. In the United Kingdom, if inflation misses the target by more than 1 percentage point, the governor must explain publicly why the divergence occurred and what steps the Bank of England is taking to deal with it. The new transparency "facilitates public understanding of monetary policy and increases the incentives for the central bank to pursue the announced goals of monetary policy" (Svensson 1999: 631-32). Accountability is increased, indeed made possible, by the choice of a unique objective, which implies "a stronger commitment to a systematic and rational optimizing monetary policy than other monetary policy regimes" (p. 608).

These institutional changes are consistent with the literature on time inconsistency that shows the impossibility of employment-promoting monetary policy under rational expectations (Kydland and Prescott 1977, Fischer 1977). But they are not without precedents. The Bank of England Act of 1998 was like the Bank Charter Act of 1833 in its antecedents, design, and purposes. The latter also increased the Bank of England's independence, and provided the transparency and accountability needed to make the step credible. Furthermore, it also came on the heels of developments that had rendered the Bank less useful to governments--namely, the end of war finance, which served the same purpose as the end of belief in the Phillips Curve.

The main purpose of this article is to elucidate, by comparing the Acts of 1833 and 1998, the unsurprising necessary and possibly sufficient condition for the independence of central banks from governments--namely, the independence of governments from central banks. The first section sets the stage by examining the relation between the British government and the Bank of England from its founding in 1694 until 1815, during which England was constantly at war or preparing for war. In the next two sections, I discuss the Bank Charter Act of 1833 and the Bank of England Act of 1998. The final two sections examine two American examples of the principles of those acts: (1) Andrew Jackson's veto of the renewal of the charter of the Bank of the United States, which had originated in the War of 1812, and (2) a brief comparison with the Federal Reserve during the Greenspan era.

The First 121 Years of the Bank of England (1694-1815)

In his classic Lombard Street, Walter Bagehot ([1873] 1931: 90) described the Bank of England as "probably the most remote from party politics and from financing" in the world. Yet, "in its origin it was not only a finance company, but a Whig finance company. It was founded by a Whig Government because it was in desperate want of money, and supported by the 'City' because the 'City' was Whig." Under Charles II, England's credit rating had sunk "to the lowest possible point, and the Government created by the Revolution of 1688 could hardly expect to be trusted with money more than its predecessor."

During the war with France under Louis IV, the British had raised taxes "as far as they dared" and borrowed from "every one who would lend.... And almost as a last resource, they founded the Bank of England" (Feavearyear 1931: 114-15). In 1694, a corporate charter was offered to "the Governor and Company of the Bank of England" on the condition that they raised capital of 1,200,000 £ to be lent to the government at 8 percent. The charter was to expire on repayment of the principal, with a year's notice, but not before 1706. Although 8 percent was below the market rate, the Bank's stockholders were attracted by the expectation of profit from privileged banking activities (Wood 2005: 37).

Earlier proposals had failed for various reasons, not the least of which was the fear of a powerful government able to circumvent the financial discipline of Parliament by access to a client bank. That uncertainty was addressed in the Bank of England's charter by the prohibition of loans to the government or purchases of Crown property except by an Act of Parliament.

The charter did not wait 12 years for renewal. In the summer of 1696, William III wrote to his ministers from the Continent: "In the name of God determine quickly to find some credit for the troops here" (Ogg 1955: 433). After "hard and close bargaining," the Bank of England extended another loan for an extension of its charter and Parliament's promise to recognize no other "Corporation, Society, Fellowship, Company or Constitution in the nature of a Bank" during the life of the Bank of England (Clapham 1944: 47). Such exchanges were repeated several times over the next century: as in 1708, during the War of the Spanish Succession; 1781, when the charter was extended to 1819, and the Bank lent the government 3 million £ at 3 percent; and in 1800, when the charter was continued to 1833 "on condition of three Millions being advanced for the Public Service, without Interest, for six years" (McCulloch 1858: 42; House of Commons 1832: app. 1; and Wood 2005: 39-40).

Government demands endangered the Bank's reserves on several occasions, and in 1782 it registered a formal complaint with Lord North (Clapham 1944: 2.52). The pressures increased with another French war, however, and in 1797 rumors of invasion led to a run on the Bank of England and the government's order to suspend payment. Those events inspired Richard Brinsley Sheridan's reference in the House of Commons to "an elderly lady in the City of great credit and long standing who had ... unfortunately fallen into bad company," and James Gillray's cartoon of the Chancellor of the Exchequer and Prime Minister William Pitt attempting to possess the Bank's gold represented by the "Old Lady of Threadneedle Street" crying "rape, ravishment, ruin" (Acres 1931: i, 283). The suspension of convertibility continued until 1819. The "paper pound" traded on international exchanges at significant discounts from its prewar coin value (Cannan 1919).

Criticisms of the Bank of England, which denied responsibility for the depreciation of the currency, were hampered by its secrecy. Pitt told a committee of inquiry" that he had "received...