Why the Bank of England's not so 'independent' after all

The old lady's in danger, and not for the first time.

As a political cartoon by James Gillray reminds us each morning, hung by the door here at BullionVault, the Bank of England's virtue came under attack in the late eighteenth century.

And today, just as in 1797, the politicians have now got their hands on her treasure chest at last.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The Baker Library at Harvard Business School explains:

'[Gillray's etching is a] satire on the suspension of gold payments by the Bank of England. Prime minister William Pitt was forced to implement the issue of paper money when the Bank announced a gold shortage, due to loans it had made to finance the war with France.

'Rumors circulated that the Bank's coin was merely being held in reserve to send to the Continent in support of the war. Hence the significance of the locked chest, and the coins in the pockets of the lady's paper money dress.'

For the first time on record, Gillray nicknamed the Bank of England the 'Old Lady of Threadneedle Street'. The tag has stuck ever since, and in his cartoon, Political Ravishment, the Old Lady's in danger.

'Murder! Murder!' she cries, using more exclamation marks than even the Mogambo Guru. 'Rape! Murder! O you villain! What, have I kept my honour so long to have it broke up by you at last? O murder! Rape! Ravishment! Ruin! Ruin! Ruin!!!'

Fast forward 208 years, and now Mervyn King a self-effacing career academic from the English Midlands is wearing the dress. The current prime minister is after the Old Lady's honor again, too.

Political ravishment of her virtue spells disaster for the British Pound. If you're looking for a bolt hole outside the Dollar, be sure you avoid ruin on Threadneedle Street. Here's why.

A graduate of Cambridge and Harvard universities, Dr.King taught in Birmingham (UK) and the London School of Economics before becoming deputy governor at the BoE in 1998. Moving to the top job five years later, he learnt his chops as right-hand man to Sir Edward George, the much-respected old hand who steered the central bank on a 'steady' course for the second-longest tenure in history.

Dr.King, in other words, had a tough act to follow. Sound familiar so far?

'Steady' Eddie George ran the Bank of England for ten years, during which time the British economy enjoyed an historic run of unbroken growth. Its longest boom in the modern era came despite hiccups and risks including the Asian Crisis, the collapse of Barings, the Russian default, LTCM, the collapse of BCCI, the DotCom Crash, 9/11 and the Deflation Scare of 2003.

Sir Eddie led the Bank of England on its finest day, 6th May 1997, when the the incoming New Labour government finally gave the Old Lady her full independence in setting interest rates. Now the Bank of England would have free rein to manage the British currency without political meddling from Whitehall or Westminster. (His predecessor had been hand-picked by Margaret Thatcher; he suffered the indignity according to colleagues of being told by telephone that she'd changed the UK interest rate.)

The Bank's independence marked a 'spectacular beginning' for the New Labour government, Sir Eddie said. He gushed during an after-dinner speech in the City that 'it demonstrated, as clearly as anything could have done, [the government's] commitment to stability and long-termism in the British economy.'

Just like his Fed colleague, Sir Alan of Greenspan, Eddie George's stint in the frock of Pounds Sterling still looks great at first glance. Famed for his affable wit, he presided over average GDP growth of 2.8% and average inflation of just 2.5%...less than half the rate endured by his predecessor in the '80s.

But 'did George's hard-won stability in inflation and growth come at the expense of instability elsewhere?' asked Evan Davis, business editor at the BBC, when Sir Eddie left the Bank in June 2003.

'After all, Sir Edward's tenure has been associated with an overvalued exchange rate and soaring consumer spending. The high exchange rate kept import prices down; that in turn partly explained the low inflation. But that also created the conditions for consumers to import and spend.'

Yet more familiar again, right? Importing and spending by British consumers has taken the trade deficit to fresh all-time records. Household debt now towers above a whole year of gross domestic product. But it's here that the comparisons end.

We saw the new boy at the Fed revert to the script of his predecessor, Alan Greenspan, on Tuesday this week...slashing interest rates and fighting to 'forestall' the debt-led recession that's now long overdue. But Mervyn King? He's gone wildly off-message and is no doubt seeking a nice quiet professorship for the start of the new academic year in October.

After all, Dr.King is the guy who kept voting for tight money even as the Greenspan Fed slashed US rates to their emergency low in 2003. He stayed out of step with his Bank of England colleagues even after he became governor, as well, outvoted twice by his own team when he pushed for higher rates in Aug. 2005 and in June '07.

Yes, King failed to prevent the current soaring inflation of the UK money supply. Since he took over as the Old Lady's defender, annual growth in new lending to non-bank financial companies has risen at a double-digit rate. It hit 30% growth year-on-year in summer last year!

But with King gone and gone soon the Pound Sterling will be left with just political 'yes men' to defend it on the Monetary Policy Committee.

'The moral hazard inherent in the provision of ex-post insurance to institutions that have engaged in risky or reckless lending is no abstract concept,' Dr.King told the British Parliament in an open letter late last week. Pointing to the crisis caused in the banking sector by the need to refinance short-term debts amid the credit crunch, 'the risks of the potential maturity transformation undertaken by off-balance sheet vehicles were not fully priced,' Dr.King went on.

'If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalizes those financial institutions that sat out the dance, encourages herd behavior and increases the intensity of future crises.'

Smack of sound thinking to you, a level-headed response? Mervyn King's walked the walk of strong moral policy, too refusing at first to lend emergency funds to the money markets. He also refused, for a while, to accept mortgage-backed bonds as collateral from struggling borrowers.

But the crisis at Northern Rock, one of Britain's most successful and aggressive mortgage lenders during the Housing Bubble of 2002-2007, has finally forced a series of dramatic U-turns. Delaying a bail out of London's most profligate bankers will cost Dr.King dear.

First, the big banks in London side-stepped the Old Lady's refusal to inject emergency funds, simply bidding instead for cheap money from the European Central Bank in Frankfurt. Last week the ECB lent a record weekly sum of €75 billion in extra three-month funds. Around 140 banks bid for the cash and the Financial Times Deutschland reported on Friday that a good chunk of those emergency loans went to British banks bidding via their European subsidiaries.

Next, the Old Lady blocked an offer from Lloyds TSB, the only AAA-rated bank in the United Kingdom and a rock-solid institution, to buy Northern Rock mortgage book, short-term debts and all. Why stymie a market solution to the problem? The details have yet to emerge, but the Bank of England itself then offered on Thursday to step in as 'lender of last resort'. That only caused savers to start a run on the bank, queuing out on the sidewalk!

It took the government, led by finance minister Alistair Darling, to calm the panic on Monday. In a truly historic move, Darling gave an absolute guarantee to Northern's depositors that their money would be insured by the taxpayer a move that one London hedge-fund manager says signals the 'death of capitalism' in Britain.

So by the start of this week, Mervyn King was beginning to look both detached and impotent. But ahead of speaking to a government committee on Thursday, things only grew worse.

'Allowing this situation to develop openly and publicly has been a disaster and lessons have to be learnt,' warned one member of parliament. 'I want to know more about the sequence of events at Northern Rock,' said another. 'King has got some explaining to do,' added a third.

Then, on Wednesday this week, the European Commission in Brussels said that the government's support for Northern Rock may be illegal under EC competition law. That will only make Dr.King's position more precarious still. Because if he'd fixed this mess with cheap cash in the first place, the thinking will run, then nationalizing Northern Rock's balance sheet wouldn't have become necessary.

And then, finally and also on Wednesday Dr.King's vow to only lend emergency cash for short periods, and to only accept government bonds as collateral, was reversed in a humiliating reversal of policy. The Bank of England announced 'that it plans to conduct an auction in which it will provide funds at a 3-month maturity against a wider range of collateral, including mortgage collateral, than in the Bank's weekly open market operations.'

The first auction will be held next week. Three further auctions will be held over the three weeks following, with £10 billion up for grabs ($20bn) each time.

In short, moral hazard has hit London at last and it's being funded by the Old Lady herself.

'This is exactly what it said it would rather not do in the letter to the Treasury Select Committee,' notes Alan Clarke, an analyst at BNP Paribas. 'Clearly the financial market situation has deteriorated to the point that the slowdown implied for the economy is more severe than the Bank had seen as desirable.'

'Looks like the Bank is now being run from Whitehall,' adds Charles Pretzlik for the Financial Times. 'Can the governor stay in these circumstances? Does he want to? Surely this is one U-turn too many...unless the governor knows something new that we don't.'

Ben Bernanke always said he would slash interest rates to forestall recession. He's not known as Helicopter Ben without good reason! Now Dr.Ben has made good on his promise, and set about destroying the Dollar to try and prolong the Great Greenspan Inflation. Mervyn King, on the other hand, forgot what central bankers are for.

An independent Old Lady is no use at all if she won't do what she's told.

Adrian Ash is editor of Gold News and head of research at www.BullionVault.com