Can central banks deliver us from evil?

The Prime Minister was talking to an obviously receptive audience yesterday when he said: 'Inflation is like a hard drug: you may feel better for a while, but in time its evil effects become apparent.' He was speaking at the Bank of England tercentenary symposium at the Barbican in the City - and if you are addressing more than 100 central bankers, it is hard to say you are against sound money.

The theme of the symposium was set by the initial paper* on the way central banking has developed over the years. At one level this is a thorough account of the way in which central banking, as an industry, has grown over three centuries, and the way in which three areas of tension keep recurring: between commercial banks and the central bank; over whether monetary policy should be set by rules or discretion; and between central banks and governments.

There are fascinating parallels here between the state of central banking now and in the 1840s, for in both these periods governments have looked to central banks to re- establish financial discipline after an unsettled period. In the first case this was in the aftermath of the Napoleonic Wars; in the second, the great inflation of the 1970s and 1980s.

But the paper is not just an account of past successes and failures, for it carries a powerful and explicit warning. Viewed from a long historical perspective, central banks have been particularly unsuccessful during the last 30 years in maintaining price stability. We have just lived through the worst peace-time inflation for at least 300 years. It is as a result of this failure that central banks are being given greater independence.

But suppose central banks now fail to deliver price stability? There is a danger that the benefits of independence have been oversold, but the threat goes deeper. The very fact that they are being accorded a greater role in the workings of the modern state transfers much of the pressure that had previously been placed on politicians to central bankers. If inflation continues, there will be no one else to blame. 'Central banks', the report concludes, 'cannot afford to be complacent. There is much to learn and much room for improvement.'

There are really two possible responses to the question of what happens if the central banks do not deliver. One is discussed by Charles Goodhart and his colleagues here, and one we can see day-to-day in the financial markets.

The first is what is called 'free banking'. That does not mean paying no bank charges, but rather giving commercial banks the freedom to do what they want without the interference of a central bank. In the past there have been various experiments in this around the world: in Scotland and in Canada, for example. Instead of the central bank having a monopoly over the issuing of currency, any commercial bank would be able to issue it, backed by some kind of reserve asset. This reserve could be gold, or a basket of real assets, or the government's index-linked bonds. Recently, the main support for such an idea has come from some academics rather than bankers, but if the notion of independence fails, then support may grow for money to be privatised.

Meanwhile, there is certainly increasing concern in financial markets about the performance of central banks. The markets at this stage may not want to privatise the creation of money but they are privatising the operation of monetary policy. Because they feel that central banks around the world are taking risks with inflation by running too-low short-term interest rates, they are driving up long- term rates instead. This is what the bond market collapse means.

Because this collapse is such a recent phenomenon it has not attracted much analytical attention. It can still be dismissed as a market error, and it is probably fair to say that most central bankers still think of it in those terms. But it is important to remember that central banks have really only one weapon at their command: control over very short-term interest rates. In an open world economy, with free capital movements and a plethora of new financial instruments, even this weapon has limited effectiveness.

For example, the Bank of England can cut base rates but if that reduction is not credible, the markets will drive up long-term rates. That may tighten policy by more than the cut in short rates. At the moment the implied UK base rate for the end of next year is about

9 per cent.

Listening to central bankers, it is not at all clear that they yet realise how distrusted they have become. It is ironical that at the very moment they are being handed more independence by governments, this independence should be taken away by financial markets. But that is the message of the bond market in recent weeks.

*The Development of Central Banking, by Forrest Capie, Charles Goodhart and Norbert Schnadt. Bank of England (forthcoming).