AFTER BLACK WEDNESDAY: WHY UK MONETARY POLICY STILL DIDN’T WORK
The UK’s monetary policy arrangements from 1993-94 to May 1997 were inefficient because they kept power over interest rates in the hands of politicians and the financial markets knew this. That is the conclusion of David Cobham in an article in the latest issue of the Economic Journal. By implication, the new government was right to change the existing arrangements in May 1997, giving the Bank of England sole responsibility for setting interest rates.

Cobham’s research aims to evaluate the framework for monetary policy constructed by the government in the aftermath of Black Wednesday. He finds that:

The debacle of Black Wednesday prompted the government to 'piggyback' on the less-damaged credibility of the Bank of England. But the Treasury still kept the real power to itself.
The Chancellor, and to a lesser extent the Bank, had objectives in addition to that of hitting the inflation target. There were a number of policy episodes consistent with 'game-playing' by the Chancellor (and the Bank) in line with those objectives.
Between January 1994 and May 1997, the Chancellor of the Exchequer and the Governor of the Bank disagreed about interest rates in 17 out of 41 Monetary Meetings. On each occasion, the Bank was 'drier' than the Chancellor, arguing for higher interest rates.
Cobham sees the relationship between the Treasury and the Bank of England established in 1993-94 as a response by the government to its loss of credibility on Black Wednesday and the smaller damage to the credibility of the Bank of England (which was known not to have been in charge of monetary policy at the time). The government recognised its poor reputation, and tried to strengthen it by leaning on the reputation of the Bank. At the same time, it refused to allow the Bank to set interest rates.

Under the new arrangements, the Chancellor was still able to pursue political objectives (expanding the economy even at the cost of overshooting the inflation target after the election), and this required him to weaken the reputation of the Bank so that the financial markets would not react adversely to evidence that the Bank opposed his policies. The Bank was bound to respond at least partly in kind. Moreover, the financial markets understood what was happening so that the credibility of the arrangements remained strictly limited, as shown by the significant differential between UK and German long-term interest rates.

Analysis of the Minutes of the Monetary Meetings shows that disagreement between the Chancellor and the Governor was considerable and grew more frequent. Cobham classifies the views of the Chancellor and the Governor into five categories depending on the direction in which and the urgency with which they thought interest rates should be changed. For the whole period of these arrangements, from January 1994 to May 1997, there were 17 disagreements in 41 meetings. In the first 15 meetings, there was 1 disagreement; in the second 15, there were 8 disagreements; and in the last 11, there were another 8 disagreements.

The Minutes also show that the exchange rate remained the focus of debate even after the UK had left the ERM. Thus the new arrangements failed to solve the key problems of UK monetary policy.

Note: ‘The Post-ERM Framework for Monetary Policy in the United Kingdom: Bounded Credibility’ by David Cobham is published in the July 1997 issue of the Economic Journal. Cobham is Senior Lecturer in Economics at the University of St Andrews.

For Further Information: contact David Cobham on 01734-261781 (secretary: 01334-462420; fax: 01334-462444; email: dpc@st-andrews.ac.uk); or Melanie Dean of the RES/ESRC Economists in the Media Initiative on 0171-878-2913 (email: mdean@cepr.org).