 | Around the World in 80 Ideas |
|
ECONOMIC POLICY 69: Cash controls A monetary constitution The problem: uncontrollable inflation Inflation is hard to control. Treasury politicians are charged with keeping a country's economy sound: but they are politicians too, and it can be hard for them to resist the public's demands for inflationary spending. Sometimes, indeed, politicians exploit the system ruthlessly, engineering a spending boom just before an election - which gets them elected, but which leads to higher inflation afterwards. The idea: inflation management by contract Ever since the link between monetary policy and inflation was recognized, economists have urged that control of the money supply should be taken out of the hands of politicians so that it could be managed more rationally. But few governments have been willing to give up control of something that could be so important for electoral success. New Zealand is an exception. Faced with inflation levels which averaged 11.4% in the 1980s, its government passed a new Act in 1989 which radically altered its monetary constitution and which has become a model for reform elsewhere. Example: the Kiwi contracts concept Previously, the New Zealand central bank had struggled to meet conflicting targets - economic and social welfare, high levels of employment and trade, and stable prices. But section 8 of the new Act stated clearly that: "The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices." In other words, defeating inflation. The Act did not define 'price stability', but it required the central bank's Governor and the Minister of Finance to agree on a precise target, which has typically been a range of 0-2% in the annual rise of the consumer price index. The Reserve Bank Act allows the government to override the price stability goal in emergencies, but only by renegotiating and making public a new target figure. But once any target is agreed, the central bank may conduct monetary policy in any way it thinks appropriate. The bank Governor's salary is tied to the bank's performance in hitting the target; and a Governor can be dismissed if the target is consistently missed. After the Act was, passed, New Zealand began to enjoy a steady improvement in price stability. Inflation fell rapidly, and interest rates halved. But perhaps the most important result is that inflationary expectations have been reduced. This has allowed New Zealanders to focus on real economic events and invest more rationally. It has also forced governments to make hard decisions where these have been necessary, sacrificing short-term political gain for the longer-term goal of price stability. Before the introduction of the Euro, the Bundesbank in Germany had long enjoyed relative freedom in setting monetary policy, and more recently United Kingdom has gone some of the way down the New Zealand model. In the mid-1990s, the Chancellor of the Exchequer, its finance minister, decided to remain in charge of interest-rate policy, but leave the precise timing of any interest-rate changes to the Governor of the Bank of England. The aim was to reduce criticisms that both the direction and the timing of interest-rate changes were being engineered purely for political advantage (which they were). Very soon after the Labour Party's election victory in 1997, the incoming Chancellor of the Exchequer, Gordon Brown, went further, giving over direct control of interest rates to a new Monetary Policy Committee of independent experts. Drawn from the worlds of academe, business, and economic forecasting, together with officials from the Bank of England, this committee meets each month and decides both the size and timing of any changes. The minutes of each meeting, including the votes taken on whether to raise or lower interest rates, are published a few weeks in arrears. From these reports, financial analysis can see the factors which the committee judged to be important in making their decision, and the balance of sentiment within it. This enables them to make better predictions of which way interest rates are likely to go in the future, and thus to adjust their portfolios more quickly, than was the case when decisions were made in secret by the Chancellor alone. Political influence over such decisions has not completely gone - several committee members are the Chancellor's own appointments. However, the members of the committee come under very close scrutiny from journalists, businesspeople and financial analysts, and they have generally been keen to protect their own independence and objectivity. For further information:
|
Copyright 2002: Adam Smith Institute
Created and Maintained by: Cyberpoint Limited