Following a discussion between members of the Workers Party and the Bevin Society, this article first appeared in the September edition of Labour Affairs magazine and is a valuable contribution to the discussion on our policy at Congress 2023.
“Independence”
Readers will be familiar with the term ‘independence of the central bank’. Of late, it has been much referred to in the media. The tone is always that this independence is a good thing. And Labour proudly remind us that the Bank of England (BoE) was made independent by Gordon Brown in 1998 when he was chancellor in Tony Blair’s first administration. It is worth examining what this independence consists of.
One of the main functions of the BoE is to create money. It, and it alone, has the ability to create money that the government will accept in payment of taxes. One would expect an independent BoE to decide when and how much money to create. In fact it has little power to control the amount of money created. Nor does that power reside with the government. Only Parliament can decide how much money is created. All this is carefully laid out in the 1866 Bank of England Act, enacted when Britannia ruled the waves. The 1866 act ensured that the BoE would be an effective tool for Britain’s imperial objectives.
The core principle of the 1866 act is that, when any expenditure is approved by Parliament, then the BoE must create and put into the government’s account the money required to finance that expenditure. The BoE has no independence in this matter. It is exactly the job of the Bank of England, as laid down in the 1866 Act, to finance whatever debts the government issues which have been approved by Parliament. By law it has to do so. As Berkeley, Tye and Wilson make clear in their detailed account of the
UK Exchequer:
“Once Parliament has authorised Supply there is no mechanism within the UK monetary system to stop that spending happening. The Bank has no power to refuse and there is no legal mechanism by which a balance has to be checked for available funds. The Bank accommodates the expenditure by balance sheet expansion … Parliament effectively legislates money into existence.” An Accounting Model of the UK Exchequer, Andrew Berkeley, Richard Tye & Neil Wilson p116.
The BoE cannot independently decide that it does not approve of any particular government expenditure and refuse to create the required money. By law, by the 1866 Act, it must create the required money. In one of its main functions, therefore, the BoE has no independence.
The BoE is also tasked with using monetary policy to achieve a rate of inflation chosen by the government, currently 2%. In this context, monetary policy means adjusting the Bank rate, the interest rate at which the BoE is prepared to create and lend money to the commercial banks. Over the last 18 months, that rate has increased by a factor of 50 from .1% to 5%.
This is where the claim to independence really lies. Before 1998, the BoE could only change the interest rate with the agreement of the Chancellor of the Exchequer. Gordon Brown’s 1998 act altered that, so that the BoE no longer has to get government approval for any change in the interest rate.
It’s an odd development. For instance, if the government believes that an expansion of state economic activity is required to minimise the chances of a recession, but the BoE believes a contraction in economic activity is required to reduce inflationary pressures, then the BoE might end up taking actions to counter the actions of the government. Since the government can only take action approved by Parliament, effectively the BoE could be acting against the wishes of the elected representatives of the people in Parliament.
There was an element of that in the Liz Truss debacle in October 2022. The government proposed a fiscal policy—lower taxes— that was supposed to increase demand in the economy and lead to growth. At the same time, the BoE was pursuing a policy of reducing demand by increasing interest rates. The government’s fiscal policy meant the BoE would have to further increase interest rates to counter the government’s fiscal policy. Since this would reduce the value of already issued government bonds, the markets rushed to dump these bonds. There was much nonsense in the main stream media that the markets would not want to buy government bonds. In fact, the markets were just positioning themselves to buy newly issued bonds at a higher interest rate. Nevertheless, it is remarkable that the BoE should have the legal power to raise interest rates if Parliament did not want them to be raised.
Legally, Brown’s 1998 Act does allow the Treasury to override the BoE in extreme situations. But in practice, it would be difficult for the government to do that because of the political repercussions.
The current government, led by Sunak, does however agree completely with BoE policy of creating a recession to control inflation. The 1998 Act works very much in Sunak’s favour since Sunak and the cabinet can pass responsibility for any recession on to the independent BoE. The independence of the BoE is a fig leaf for the government’s austerity policy.
A future Labour government under Starmer will take a similar approach. Indeed Labour is already adjusting the fiscal policies it will put before Parliament where those might clash with the policies of the BoE.
Brown’s 1998 Act has effectively gone against 400 years of English political development by ending Parliament’s sovereignty in monetary policy. The Act needs to be reversed, and Parliament’s sovereignty in monetary policy needs to be brought back.
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The money creation process is something understood by very few and the banks are very happy for it to stay that way. The way it works is as follows.
Let’s say you deposit £1000 into your account at the bank. What does the bank do with this? It lends it out or invests it. Now this is then like the Edgar Allan Poe mystery where the clue has been sitting on the mantelpiece in full view all the time. So isn’t it odd that the bank is lending of investing your money but that money is still in your account for you to spend. Suddenly, as if by magic, a second £1000 has appeared out of thin air. That second £1000 will necessarily find its way into other bank accounts so, just as inevitably, a third £1000 will be conjured out of thin air; and so on potentially ad infinitum,
This process has been variously described as the fractional reserve or the money multiplier. It is achieved by double entry accounting in a somewhat topsy turvey world where debt is seen as an asset.
So, in fact, virtually all money is created neither by government nor central banks (although central banks have the ability to do that which, recent QE aside, is rarely, if ever, used … more anon), but by private banks using this process. Only around 3% of the money supply is created by the central bank mostly in notes and coin. The result is that most of the money supply is the mirror image of the debt required to create it. This debt, in turn, is owed to private banks and investors in bonds. Thus we end up paying a lien to these corporate institutions to create our money supply for us, when we have a central bank well able to perform the same task but, in normal times, will not do so. Many monetary reformists estimated … and this was prior to the 2008 crash … this lien to be around £80 billion per annum. Naturally this puts huge wealth and power into the hands of the banks and the ‘investors’, not to mention an economy massively burdened by debt and the spending limitations this places upon both private and public sectors.
The justification for this lack of central bank activity is that for the central bank to create the money supply would involve ‘printing money’ which, the theory goes on, would be inflationary. Well, necessarily all money must be ‘printed’ or created by some means. As Aristotle observed two and a half millennia ago … money is the creation of law and not of nature. In fact virtually all money creation is now electronic, although some strange things have been used as money over the centuries and in different parts of the world.
It is all down the mv … total money supply multiplied by velocity of circulation. When this exceeds the productive capacity of the economy then, yes, we will get inflation. On the other hand, when it falls below that capacity we will get recession and possibly depression. But at least the hoary old canard about ‘printed money’ can be dispensed with.
This could go on, but I can cite quite a number of authoritative sources for anyone wishing to research this issue further,
FrankinShropshire (actually George Galloway’s former ‘shadow chancellor from the time he was on Talk Sport years ago!)
I would not want to dispute your account of how commercial banks create money.
However I am unclear how it relates to the question of central bank independence.
I would also add the following points:
A commercial bank can expand its balance sheet and create money when it gives someone a loan.
However, such an action does not affect the amount in the commercial bank’s account at the central bank – its reserve account.
This is important, because taxes can only be paid from money in reserve accounts.
The money, that commercial banks create when they make a loan, cannot be used to pay taxes.
Spending by the government will increase the amounts in the reserve accounts of the commercial banks.
Taxation will reduce the amounts in the reserve accounts of the commercial banks.
In short, only the state can change the total reserves in the system through spending, taxation and selling and buying of securities – usually government bonds.
I think it is worth emphasising this difference between the money created by commercial banks and money created by government spending.