Bank Of England, Take A Bow

Britain's weak, inconsistent growth in the decades after World War II was due in part to erratic fiscal and monetary policy. Overly expansive government policies would raise inflation and cause a balance-of-payments deficit, which put downward pressure on the pound. To defend the currency, the government would boost interest rates, raise taxes, and restrain spending, sending the economy back down. The cycle repeated so often it even had a name: "stop-go."

Those days are over. In the 1980s, Prime Minister Margaret Thatcher freed the British economy to grow through deregulation and privatization. And in the 1990s, the British started getting monetary policy right, too.

Under Governor Eddie George and his successor Mervyn King, the Bank of England has become one of the world's most admired central banks. The economy has steadily grown since the bank gained interest-rate-setting authority from the Chancellor of the Exchequer in 1997.

The Bank of England's success proves that the U.S. Federal Reserve, as good as it is, doesn't have a monopoly on central-banking wisdom. The BOE offers lessons for less successful central banks such as the Bank of Japan and the European Central Bank. And it could be a role model as fast-developing countries such as China and India try to strengthen their central banks and financial systems.

The Bank of England's approach to rate-setting is more transparent and less ad hoc than that of any other major central bank. It simply tries to steer the country toward an ideal level of inflation -- the current target is 2% -- by raising and lowering interest rates. It has the flexibility to drift above or below the target for a while if necessary. The Federal Reserve has no explicit inflation target, nor does the Bank of Japan, so outsiders are never quite sure what's going into their rate-making decisions.

The BOE also quickly publishes the minutes of its rate-setting meetings so the public can see inside the box. The Fed and the Bank of Japan minutes appear considerably later, and the European Central Bank not at all.

The boldest aspect of the British design is that the inflation target is set not by the Bank of England, but by the Chancellor of the Exchequer, a member of the elected government. This brings more democracy to the management of the economy. (The European Central Bank has more leeway in setting its inflation target.) A danger in the British approach, of course, is that the government will raise the inflation target to get rates down at election time and win votes, regardless of the long-term harm. So far no politician has dared try that.

The true mettle of the new British system won't be apparent until it's tested in a crisis. Right now the Bank of England is coping with tight labor markets, high capacity utilization, rising government spending, and an overheated real estate market. Still, the bank has done much to move the economy from stop-go to steady cruising speed. Britain deserves applause for getting a better handle on central banking.

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