Should Governments Set Our Interest Rates?

01 Mar 2004

A version of this article appeared in The Scotsman on 1st March 2004

Should Governments Set Our Interest Rates?

Prices go up and down. But they have done so differently at different times over the past 250 years. A new study by the Office of National Statsitics (ONS) has measured price changes since 1750. The results show both the blessings and curses of living in the modern era. In the eighteenth and nineteenth centuries, prices fluctuated far more than then do today. This was because markets were more localised. A crisis such as a poor harvest had a dramatic effect on the price of food, for example. Today, we live in a globalised economy and trade flows from the ends of the earth. A poor harvest in Scotland, therefore, while bad for local farmers, has little effect on most of us. Free trade across the planet makes the supply of goods and services not only cheaper, more varied and of better quality, but also more secure.

However, the ONS data also tells a less encouraging story. While prices fluctuated in the old days, they remained stable over the medium term. That is to say that, after a temporary blip caused by something like a poor harvest, prices returned to normal. However, in the last hundred years, while prices have usually been less volatile, they have increased almost continually. In other words, we have let the inflationary genie out of the bottle. In a big way. The ONS figures show that while prices only tripled between 1750 and 1938, they have gone up forty times since then.

Who is to blame for this extraordinary laxity? Let me give you a clue: It can be no coincidence that the Bank of England was nationalised in 1946. Since then, political interference in the money supply has allowed prices to spiral out of control.

These days, of course, the Chancellor abides by a kind of self denying ordinance where he sets the inflation target and leaves the Bank to get on with meeting it. This is a much better arrangement than before, and both Gordon Brown and his predecessor, Ken Clarke, who started the ‘Ken and Eddie show’ of transparent decision making with the then Governor, must be saluted for allowing the Bank more independence. Even so, the inflation target is still 2% - enough to halve the value of the currency in a generation. And it is difficult to claim that central banks, however governed, are immune from political considerations in their monetary decisions.

In June we will be asked to elect members to the European Parliament. The question of who should set our interest rates will be central to the debate. Some will argue that Britain should join the Euro. There will be many reasons cited, some economic, most political. One of the most curious arguments is that because Scotland is ill-served by the London-skewed Bank of England, it should therefore switch to the Euro. The idea that the European Central Bank will take more notice of Scottish economic conditions as it sets its rates is peculiar, to say the least.

Arguing for a separate Scottish currency has more coherence. However, we can exaggerate the problem of a UK-wide monetary union. Currencies fluctuate against each other fundamentally to reflect changes in relative competitiveness. But such changes can also be compensated for by people moving to look for work and by financial transfers from one region to another. The latter are implicit in a national progressive tax system like the UK’s. And unlike in the EU, there is plenty of labour mobility in the UK too, so having the same currency and interest rates as England does not matter much.

But perhaps the ONS study suggests that we are all debating on the wrong premise. Maybe the argument should be not which government runs the currency, but whether government should run it at all?

As in so many fields, Scotland was a pioneer in the development of banking, one of the basic planks of industrial development. For many years, Scotland’s banks issued their own currencies, all competing with each other on stability, probity and credit worthiness. In 1826 there were 29 issuing banks in Scotland. It was not until 1844 that the Bank of England took over the issuance of currency in Scotland – fully 150 years after the founding of the Bank of Scotland. So for a century and a half, Scotland conducted a near unique experiment of operating a successful economy with no central bank whatsoever. The current Scottish notes in circulation are a colourful legacy of that time, though each has now to be backed by a deposit with he Bank of England.

A return to such a system may seem like a pipe dream. But before you dismiss it out of hand, look at the graphs and ask yourself the question – who would you rather run our currency? The politicians whose seeming touch turns good taxpayers money to waste? Or our banks, whose thrift and prudence deliver ever-greater profits year on year? Perhaps a good topic for any politician who comes knocking on your door in the run up to June!

For more information on the old Scottish Banking system try ‘Free Banking In Britain’ by Lawrence White, published by the Institute of Economic Affairs.