economonkey

Although most people have a rough idea of how the UK economy works (or, if you’re being cynical, doesn’t work), the functions of the various components and their relationships to each other can be quite elusive. We’ve covered some aspects of money on this site in the past (here, for example), but there’s more to the economy than money itself. In fact, arguably more important than money is the way in which that money is moved around the economic system of the UK.

Over the next few articles I’m going to look at each of the main institutions involved in the movement and management of money in the UK. I’ll be looking at the Treasury, the FSA, the City of London as a whole and, to start with, the Bank of England (you may have spotted the one glaring hole in this list, more important than all the rest, which I’ll cover at at a later date).

The Bank of England is not a bank in the traditional sense. You can’t deposit your money there directly, and nor can you borrow from it directly. Banks, however, can. This is the fundamental aspect of one of the Bank’s stated core purposes: to maintain financial stability in the UK economy. By lending to banks that are suffering from cash-flow problems, unusual circumstances or moronic management, the Bank can act as a buffer to prevent problems in one area of the economy spilling over into others. Hopefully.

To quote from the Bank’s own documents: “Financial stability entails detecting and reducing threats to the financial system as a whole. Such threats are detected through the Bank’s surveillance and market intelligence functions. They are reduced by strengthening infrastructure, and by financial and other operations, at home and abroad, including, in exceptional circumstances, by acting as the lender of last resort.”

You may feel a hollow laugh coming on at this point, given the last year’s experience of a crumbled, nationalised bank, a bursting bubble of overpriced housing, rising inflation - especially in food and fuel - and incomes that fail to match expenses. It doesn’t look much like financial stability, does it?

But hold on a minute. While ‘financial stability’ is supposed to be part of the Bank’s remit, that aspect of things is also covered in part by the Treasury and the FSA, in the so-called ‘Tripartite arrangement’. Giving three people one job is rarely sensible, and the same has apparently been the case with these three organisations. Perhaps, had the Bank of England had sole responsibility in this area, Northern Rock wouldn’t have been allowed to develop such a ridiculous business model, in turn putting the whole of the UK economy at risk. Mervyn King, the Bank’s Governor, had been warning about lax lending for years before the bubble finally burst, and with extra powers he might have been able to do something about it.

As an aside, if you’re interested in this ‘lender of last resort’ aspect of the Bank’s remit, it would be worth Googling ‘Bagehot’ and having a good read. It could be argued - and this writer does argue it - that the Bank should have lent freely at punitive rates right from the start of the ‘Credit Crisis’ (aka ‘Return to Normal Lending Practices’). That could have prevented some of the fall-out and reduced the moral hazard element. As it is, we’ll have to hope that the banks that survive the current mess have had their fingers sufficiently burnt to avoid any chance of them going back to the days of idiot lending that put our entire economy in danger.

So, that’s one of the Bank of England’s stated aims. The other is to maintain ‘monetary stability’. Again, to quote from the Bank itself:

“Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government’s inflation target, which the Bank seeks to meet through the decisions on interest rates taken by the Monetary Policy Committee, explaining those decisions transparently and implementing them effectively in the money markets.”

Again, a hollow laugh is in order, given that inflation (or CPI, the government’s preferred measure of it) has been above target for most of the last year, and at the time of writing is at 3%. But it’s here that the bank has real problems. Despite the millions of people in the UK, the massive movement of money both in and out of the country, the varying prices of products and services and the uncertainties of local, national and international markets, the Bank of England has just one real weapon in its arsenal: interest rates.

More specifically, the base rate or Bank rate. Raise it and commercial banks have to pay more to savers and charge more to borrowers. Result (crudely): a slowing of the economy and a reduction in inflation. Lower the Bank rate and banks can lend more cheaply but savers suffer. Result (again, crudely): the economy speeds up but inflation becomes a real risk. For more on this topic, see my previous article on inflation (here). At the moment, with a slowing economy but rising price inflation, the outcome appears likely to be stagflation of some kind. Not good, and almost impossible to combat with interest rates alone.

The Bank of England has other important tasks: it prints most of the UK’s bank notes, for example, and provides reports on various aspects of the economy (most notably inflation, though its predictions in this area aren’t exactly impressive). But fundamentally its role is to keep inflation low and keep the UK economy stable. If it fails in either role, the loss of confidence in the pound could be devastating.

Copyright Alex Cruickshank 2008

The author has a lot of time for Mervyn King, rather less for David Blanchflower.