Throughout the industrial democracies, economic internationalization has created potential conflicts over economic and monetary policy within the leading governing parties. Increased levels of economic openness have altered the policy preferences of key constituent groups, diversifying the demands made on these parties. At the same time, the ability of parties in office to deliver promised outcomes has also declined. These developments threaten the traditional parties’ ability to attain and retain office. Consequently, many parties have modified their electoral and policy strategies in order to reshape their electoral coalitions and maintain electoral viability. Central bank reform is one component of this change in party strategy. A more independent central bank can help prevent intraparty conflicts over monetary policy and enhance the government’s policy effectiveness, helping parties meet the political challenges of economic internationalization.
In this chapter, I illustrate this argument by discussing central bank reform in Italy and Britain. In both countries, the economic and political developments of the 1970s and 1980s created the potential for conflict within the governing parties. In Italy, divisions over economic policy within the ruling coalition and changes in the political strategy of the Communists endangered the dominant position of the Christian Democratic Party in the late 1970s. In Britain, both the Labour and Conservative parties suffered from intraparty conflicts brought about by economic change in the 1970s and 1980s.
As these internal divisions threatened the viability of the major parties, pressure to grant the central bank more independence increased in both countries. In Italy, the Christian Democrats initiated the “divorce” of the Bank of Italy in 1981, freeing it from some of its obligations to finance the government’s budget deficit. Italy’s politicians continued to grant the bank increased authority for monetary policy through the 1980s and 1990s, even as the Italian party system crumbled. In Britain, central bank reform was delayed. An independent central bank would have seemed to complement the Thatcher government’s monetarist policies in the early 1980s. Yet the Conservative government resisted demands for an independent Bank of England because, in part, Britain’s majoritarian institutions protected the cabinet’s position in office. Not until the election of a Labour government in 1997 was the central bank granted control over policy instruments.
In both countries, central bank independence was part of a larger process of policy and institutional reform—reforms designed to maintain and extend the social coalitions underpinning the main parties and protect their security in office. Around the time of the divorce, the Christian Democrats proposed reforms in a number of other issue areas, including regional, fiscal, and industrial policy. In Britain, the Labour government held referenda on the establishment of regional parliaments and studied electoral reform. The coincidence of monetary reform and other political reform supports the argument that changes to the party system conditioned the choice of central bank institutions in the 1990s.
This chapter examines the Italian and British cases in more detail. The first section discusses political and economic developments in Italy leading up to the divorce. The second section focuses on Britain and debates over central bank reform in the 1990s.
Since World War II, the Christian Democratic Party played a predominant role in the Italian party system. But the economic shocks of the 1970s exposed deep divisions within the party and the ruling coalition, leaving the Christian Democrats politically vulnerable. The Christian Democrats responded with a series of reforms, including the divorce of the Bank of Italy, designed to revitalize the party’s fortunes. The reforms, however, were not enough to rescue the party.
This section first discusses the position of the Christian Democratic Party in the Italian political system. It then examines the political response to the economic shocks of the 1970s, which left the Christian Democrats in a precarious position. Finally, it investigates the divorce of the Bank of Italy and its consequences.
In the postwar period, the Christian Democratic Party dominated Italian politics. Although the party never commanded a legislative majority, it consistently won the highest number of votes and seats in the system. And although cabinets changed with almost alarming frequency, Christian Democrats always held the most important ministries. As the major party in government, the Christian Democrats benefited from Italy’s strong export-led growth during the 1950s and 1960s, obtaining a reputation for competence and skill in economic-policy management.
Despite their reputation in economic matters, Christian Democratic politicians did not share similar economic-policy incentives. The Christian Democrats’ appeals of religion, anticommunism, and patronage attracted constituents with a wide range of interests over monetary policy, including Catholics, farmers, trade unionists, shopkeepers, artisans, small business, and big business (Sani 1987; Tarrow 1990; Wertmann 1987). During the 1960s and 1970s, the growing divide between the modern industrial north and the agrarian south also strained the Christian Democrats. As a result of these divisions, the Christian Democratic Party was notoriously factionalized (Spotts and Weiser 1986; Wertmann 1981).
The frequency of coalition governments created another potential source of conflict over economic policy. The Christian Democrats had to rely on smaller parties to form a government, including the Socialists, Liberals, Republicans, and Social Democrats. The Socialists possessed a policy program sympathetic to union demands. The other parties had economic-policy platforms generally closer to those of the Christian Democrats.
Bargaining between the Christian Democratic factions and the small parties, rather than expertise or merit, determined the distribution of cabinet portfolios. Because the prime minister could not choose or dismiss cabinet ministers, each minister possessed a high degree of autonomy (Laver and Hunt 1992; Tarrow 1990). As a result, factions and parties that were dissatisfied with policy were forced to withdraw their support from the entire government, contributing to the frequency of government turnover throughout the period. This high turnover also hurt government ministers’ policy credibility because few ministers served in office long enough to gain the expertise necessary to forecast policy outcomes.
As a consequence of the potential for policy conflict within the ruling coalition, most small parties and even some Christian Democratic Party members supported a central bank that was more independent of government control. For example, in 1975, the resignation of Bank of Italy governor Guido Carli sparked heated debate about an appropriate successor not only between parties but also within the Christian Democratic Party. The Christian Democratic candidate, Ferdinando Ventriglia, was opposed by the Communists, Socialists, Republicans, and some Christian Democrats (including Neno Andreatta, who, as Treasury minister, later initiated the divorce of the Bank of Italy). Eventually, the Christian Democrats decided to support the bank’s internal candidate, Paolo Baffi (Goodman 1992). Again in 1979, following Baffi’s resignation, the Christian Democratic–led government settled on the bank’s internal candidate, Carlo Ciampi, rejecting outside candidates because of their political affiliations.
Despite the diverse policy incentives faced by the Christian Democratic–led coalition, the Christian Democrats’ position as the dominant governing party was almost unassailable. Backbenchers and coalition partners could (and often did) withdraw their support from the cabinet, but the configuration of the Italian party system prevented an alternative coalition from forming without the Christian Democrats. Any alternative would have had to include the Communist Party, the Christian Democrats’ main rival But the Communists’ radical economic program prevented the smaller parties and dissatisfied voters from leaving the Christian Democratic camp. Because the Christian Democrats’ position in office was secure, party leaders had little incentive to open the policy process to scrutiny. Although the party faced constituents with a variety of interests over monetary policy, these constituents and their backbench representatives could not credibly threaten to punish the party by defecting—the Communists were simply too extreme. Party leaders therefore had no need to increase the transparency of their monetary-policy decisions with an independent central bank. As long as the Christian Democratic leadership was confident of the party’s predominant position, the bank would be dependent.
Developments in the late 1960s and 1970s, however, jeopardized the party’s dominance. First, Italy’s unions became radicalized in the late 1960s, particularly in the northern industrialized regions. The strong economic growth in those regions had lowered unemployment, creating a tight labor market. Workers began to organize unions and increase strike activity. This militancy exploded in the “Hot Autumn” of 1969, a series of strikes and demonstrations that paralyzed the Italian economy. As a consequence, labor not only attained higher real wages, but it also pressured the government for expanded public spending on social services and increased regulation of the labor market (Lange and Vannicelli 1982; Reyneri 1989).1
Second, the Communist Party, Italy’s second-largest party, moderated its economic position in an effort to get into office. In 1973, the Communists announced the “Historical Compromise,” changing the party’s goal from replacing the Christian Democrats to cooperating with them (D’Alimonte 1999; Lange 1980). The Communists hoped to emulate the German Social Democrats, who gained legitimacy by first serving in a grand coalition before leading their own coalition. The Communists thought the move would appeal to the growing number of centrist voters and demonstrate their coalition potential to other parties. As part of their strategy, the Communists espoused macroeconomic discipline, supporting austerity plans and negotiating with the unions to keep wages down. At the same time, they began to emphasize postmaterialist and left-libertarian issues (LaPalombara 1981).
These developments exacerbated tensions both within the Christian Democratic Party and between the Christian Democrats and their coalition partners, particularly the Socialists. Within the party, labor militancy increased the influence of the prolabor wing of the party as some party leaders feared that denying union demands would increase the power of the Communists. Within the governing coalition, the Socialist Party became more outspoken in defense of union interests. These policy divisions in the ruling coalition prevented a consistent and coherent government response to the economic shocks of the 1970s. Instead, the government’s stop-go policy choices plunged Italy into a prolonged economic crisis that tarnished the Christian Democratic Party’s reputation and set the political context for central bank reform.
In the early 1970s, Italy’s economy was not well positioned to weather the coming economic shocks. The combination of higher wages and government spending brought about by union militancy increased domestic demand, just as the Bretton Woods system collapsed. While the rest of Europe prepared to enter the European Exchange Arrangement (Snake), the lira was left alone to float and quickly depreciated. The Christian Democratic–led government, however, continued accommodative economic policies to appease the trade unions and the Socialists, creating an inflationary surge. In addition, the first oil shock in the fall of 1973 quadrupled oil prices, causing further deterioration of the current account.
Acting on the advice of the central bank, Ugo La Malfa, the Republican Treasury minister, requested a standby loan from the International Monetary Fund (IMF). The terms of the IMF program, although less restrictive than usual, provoked a government crisis. The Socialists complained that the terms were too harsh. The Christian Democrats, however, decided to accept the conditions after foreign banks announced that they would refuse loans to Italy unless the government adopted the package. The Socialists reluctantly went along because they did not want to jeopardize an upcoming referendum on marital divorce.
Under the IMF package, Italy received access to a credit line of over 1 billion dollars. In return, the Italian government agreed to restrict the growth of domestic credit and reduce its nonoil current account deficit. Additionally, loans from other sources, including the European Community and Germany, soon materialized, motivated in part by a desire to prevent the Communists from coming to power. The policies worked better than expected. Economic activity declined sharply in the last half of 1974, and the slowdown continued through 1975. The nonoil current account deficit was eliminated by the third quarter of 1974, well ahead of schedule.
Nevertheless, the government did not sustain economic and monetary discipline. Beginning with the May 1974 Divorce Referendum, the Christian Democrats suffered a string of defeats in local and regional elections. These electoral swings encouraged the Socialists, who called for expansionary economic policies and, anathema to the Christian Democrats, Communist participation in government. The fragile center-left coalition quickly disintegrated, and the Christian Democrats barely managed to find support for a minority government.
Consequently, the Christian Democrats decided to loosen economic and monetary policy in late 1974. Despite warnings from the Bank of Italy, the Christian Democrats lowered the discount rate, abolished limitations on imports, and created new facilities to finance exports.2 The government also negotiated an agreement with the Bank of Italy, giving the bank the right to tender Treasury bills at auction as long as the bank purchased all unsold bills. This agreement helped establish a private market in government securities, an institution that would facilitate control of the money supply (Goodman 1992; Padoa-Schioppa 1987). But the bank’s obligation to purchase all unsold bills left monetary policy vulnerable to the government’s fiscal profligacy. Additionally, the Treasury determined the floor price for each auction, implicitly setting a ceiling on interest rates.
As a consequence of this rapid monetary expansion, inflation took off and the lira depreciated. Two events turned these deteriorating economic conditions into a crisis. First, the U.S. government ruled that U.S. banks had to treat all loans to Italian state-owned companies as loans to the Italian government. Because U.S. banks were restricted in the amount of lending they could extend to a single customer, this decision blocked Italy’s access to new loans (Goodman 1992). Second, the Socialists withdrew their support from the Christian Democratic minority government in January 1976. The possibility of government instability raised serious questions about economic policy, both domestically and abroad. Pressure on the lira intensified. Because the Bank of Italy’s reserves were already low, the lira was allowed to float freely. In response, the caretaker government and the bank moved to tighten monetary policy. The government also began negotiations with the IMF for a second standby loan.
The crisis formed the backdrop for the 1976 elections. The Christian Democrats maintained their position as the top party in Italy, winning almost 39 percent of the vote, similar to their proportion in 1972. The Communists’ vote share, however, jumped seven percentage points, to over 34 percent of the vote. After the election, the Christian Democrats attempted to form a new government, based on the traditional center-left alliance with the Socialists. The Socialists, however, were not eager to serve in government. The Communists, on the other hand, called for a government of national emergency. Complicating the situation, the United States and Germany threatened to cut off financial assistance if the Communists participated in government.
After much negotiation, Christian Democrat Giulio Andreotti formed a minority government based on the cooperation of all the major parties, including the Communists. In return for consultation on policy decisions, the Republicans, Liberals, Social Democrats, Socialists, and Communists agreed to abstain from votes of no confidence. For both the Christian Democrats and the Communists, the strategy represented a gamble. In return for short-term cooperation, the Christian Democrats risked giving the Communists a new legitimacy with potential coalition partners and the public. For the Communists, implicit cooperation with the Christian Democratic government provided them with an opportunity to broaden their appeal by demonstrating a commitment to responsible economic policies, but the strategy risked alienating traditional constituents (Tarrow 1981).
The lira came under renewed attack in September 1976, forcing the government to turn again to the IMF. This time, however, the IMF placed strict requirements on any promise of assistance, demanding tight restriction of the money supply and limitations on domestic credit, including the level of the government deficit, in order to bring inflation and the current account deficit under control. Further, the IMF sought limits on increases in labor costs. Here, the Communists’ close relations with the trade unions helped the government negotiate these restrictions (see, for example, Goodman 1992, LaPalombara 1981). Although a second letter of intent was signed in April 1977, Italian authorities did not draw on the standby credit. Instead, an unexpected downturn erased the current account deficit. Further, inflation dropped to 12 percent in 1978. Consequently, the government never had to achieve the targets for domestic credit and the budget deficit that it had negotiated with the IMF.
The Communists’ support for the government, however, began to alienate their core supporters, especially workers and younger voters. Faced with declining membership and losses in regional elections in 1978, the Communists forced a showdown with the Christian Democrats by demanding formal participation in the government. Predictably, the Christian Democrats refused the request, ending the government of national unity and precipitating new elections in 1979 (Penniman 1981).
During the campaign, the Christian Democrats took a hard line against the Communists, reflecting the reassertion of the party’s right wing (Lange 1980; Tarrow 1981). In the elections, the Christian Democratic vote share remained steady, but the Communists’ vote share dropped to about 30 percent. The Christian Democrats were able to form a center-left coalition with the Socialists, leaving the Communists out of government.
Although the Christian Democratic Party had survived the 1970s, its position as Italy’s dominant party was not as secure. The economic shocks had revealed conflicts among the Christian Democrats’ main constituents over policy. Union supporters clashed with those who wanted a more disciplined policy. Firms and unions exposed to the international economy called for different policies than those insulated from international competition. The diversity of these constituent demands contributed to intraparty conflicts over the direction of economic policy.
The Christian Democrats’ reputation for competence also suffered. Voters became increasingly dissatisfied with the government’s management of economic policy and disillusioned with the political infighting, pervasive corruption, and incompetence of Italy’s traditional parties (Barnes 1984; Lange and Tarrow 1980; Sani 1981; Tarrow 1989). Moreover, much of the Christian Democrats’ continued electoral success depended on patronage, an appeal that did not help them attract support from young educated professionals or immigrants from rural and southern areas, two groups that grew rapidly during the 1960s and 1970s (Tarrow 1990).
Combined with the moderation of the Communist Party, these developments increased the possibility that the Christian Democrats would lose office, due either to a coalition defection or to an electoral defeat. Confronted with that possibility, the Christian Democrats embarked on a new strategy in the late 1970s and early 1980s that entailed significant reforms in a variety of issue areas, including fiscal policy (Della Salla 1988), regional policy (Putnam 1993), and industrial policy (Ferrera 1989; Locke 1995). The Christian Democrats also pursued monetary reform by joining the EMS in 1979 and by making the Bank of Italy more independent in 1981.
Both monetary reforms were designed to help revitalize the Christian Democrats and maintain their dominance of the Italian party system. Reformers hoped that these commitments would enforce discipline on the party and provide a consistency to economic policy that would improve the macroeconomic environment. Moreover, these new institutions could verify that the Christian Democrats were pursuing coherent, responsible economic policies. Maintaining the value of the lira within the EMS would signal the government’s commitment to tighter monetary policy (Bernhard 1998). A more independent Bank of Italy would help the fiscal crisis and allow central bankers an increased freedom to provide information about consequences of the government’s policy decisions—a credible source of information that if handled properly, would benefit the Christian Democrats politically. Together, these reforms could help restore the Christian Democrats’ reputation among voters tired of the trade unions and the party’s vacillating response to the economic shocks of the 1970s.
Italy’s decision to join the EMS reflected both European and domestic concerns. At the European level, many Italian politicians recognized that non-participation would risk Italy’s position within the European Community. Domestically, the costs and benefits of participation were less clear. Whereas some Christian Democrats saw membership in the EMS as a way to enforce discipline on monetary policy, other Christian Democrats and the Communists opposed participation, arguing that the adjustment costs would be too high and that Italy would be unable to pursue its own economic policies (Ludlow 1982). Interestingly, the Bank of Italy echoed similar reservations about Italy’s participation in the EMS, fearing that influential trade unions and persistent budget deficits would make domestic adjustment difficult and that the weakness of the Italian economy would make the lira a target for speculation (Goodman 1992).
The Christian Democratic government’s commitment to the EMS was soon tested. In 1979, the economy faced two new shocks: a second oil crisis and a sudden restriction in U.S. monetary policy. The tightening of U.S. policy placed downward pressure on all European currencies, including the lira. Unlike past responses to exchange crises, however, the Christian Democratic-led government decided to tighten monetary policy to maintain the value of the currency.
The new monetary discipline, however, did not dampen inflation, which remained at about 20 percent in early 1980. The combination of high inflation and a fixed exchange rate hurt the competitiveness of Italian exports. Despite pressure from Italian firms, including Fiat, and from unions affected by restructuring, the government and the central bank refused to devalue the lira. The public, too, seemed exasperated by the trade unions. In response to union strikes at Fiat in September 1980, Fiat workers organized a massive counterdemonstration demanding their right to work. The so-called March of 40,000 marked a turning point in union influence over economic policy (Padoa-Schioppa 1987). Although the government eventually asked their EMS partners to devalue the lira in February 1981, they accompanied the devaluation with an increase in interest rates and limitations on imports, again reflecting the Christian Democrats’ support of tighter monetary policies. The Italian government devalued the lira several more times during the 1980s, but participation in the EMS provided a clear measure of the government’s commitment to macroeconomic discipline for markets, politicians, and the public. That policy transparency helped discipline monetary policy and bring inflation levels down.
The second reform, the divorce of the Bank of Italy, was precipitated by yet another change in government. In early 1981, a scandal led to the collapse of the Christian Democratic-led government, forcing the resignation of a number of prominent Christian Democratic ministers. Unlike other government collapses, however, the scandal emboldened the smaller parties to press for greater responsibility in the government. Bettino Craxi, leader of the Socialists, sought the prime minister’s position. Many Christian Democrats, however, found his candidacy unacceptable. Eventually, the ruling coalition settled on Giovanni Spadolini, leader of the tiny Republican Party, as a compromise; Spadolini and the Republicans had a reputation as the “conscience” of Italian politics. Spadolini became the first non-Christian Democratic prime minister in the postwar period. Nino Andreatta, a reform-minded Christian Democrat, became the Treasury minister.
With Spadolini’s approval, Andreatta issued an administrative decree freeing the bank from its obligation to purchase unsold government debt. Because Andreatta anticipated opposition from the Socialists, he used this method to avoid a parliamentary debate. Interestingly, the Communists supported the divorce, continuing their strategy of courting centrist voters and potential coalition partners. The trade unions and export manufacturers were largely silent on the measure (Goodman 1992). Only the Socialists opposed the divorce, arguing against the inevitability of higher interest rates. They were isolated, however, and did not press the issue. Nevertheless, bank officials discouraged the government from introducing a bill in parliament to guarantee central bank independence, not wanting to risk their status in an open debate (Goodman 1992). The divorce sparked other changes to the bank and monetary policy. In 1983–84, Italian monetary authorities decided to phase out the use of credit ceilings, enhancing the importance of the bank’s monetary targets as a guide to overall monetary policy. The Treasury also allowed the bank to have the primary responsibility for the determination of the monetary targets (Goodman 1992; Padoa-Schioppa 1987).
Despite the divorce, the government retained ways to finance deficit spending. It could still borrow up to 14 percent of total expenditures from the Bank of Italy. Beyond that limit, the government could ask parliament to authorize an “extraordinary advance” from the bank. It soon became apparent that monetary financing was to be a source of friction between the bank and the government, especially because the Treasury fixed the price of bonds on the primary market. In the fall of 1981, the Treasury lowered interest rates on short-term securities to ease the debt burden. The bank, however, feared inflation and raised interest rates for short-term securities on the secondary markets. With a higher interest rate on the secondary market, investors refused to purchase Treasury bills on the primary market, and the Treasury soon ran out of funds. To prevent a total collapse of the bond market, the bank agreed to purchase all the Treasury bills at auction (Goodman 1992). A few months later, a political dispute over how best to pay off Italy’s huge debt precipitated a cabinet dissolution, causing the demand for Treasury bills to fall dramatically. Again, the bank acted as a residual purchaser of the government’s securities to prevent a crisis.
The bank’s actions in the bond markets, however, fueled inflation. Additionally, the government’s borrowing had exceeded its statutory limit. Exasperated, the bank ceased all purchases of government securities in December 1982, forcing the government to appeal to the parliament for an extraordinary advance. The parliament easily and quickly passed the government’s request. The bank’s refusal to purchase more government securities therefore did not prevent the government from financing the deficit. But it did compel the government to acknowledge responsibility for its fiscal policy. Through an explicit vote, Italy’s politicians had to declare that their actions were contributing to the national debt.
The divorce did not solve Italy’s fiscal crisis. Indeed, government deficits increased throughout the 1980s. Italy’s public debt-to-GDP ratio exceeded 100 percent by the late 1980s. The percentage of the deficits financed by monetary creation, however, decreased (Goodman 1992). Without monetization of the deficit, Italy’s politicians were required to accept responsibility for the protracted fiscal crisis. Their inability to deal with this problem throughout the 1980s fueled voter discontent with the traditional ruling parties.
Changes to the Bank of Italy’s institutional status therefore mirrored long-term developments in Italy’s political system. The economic shocks of the 1970s, especially increased labor militancy, exacerbated tensions within the governing parties, creating potential conflicts between factions in the Christian Democratic Party and its coalition partners. At the same time, the Christian Democrats’ dominant position in the political system began to erode. The increasing vulnerability of the Christian Democrats led them to support a series of institutional reforms, including the divorce, as a way to reinvigorate their political fortunes. Reformers hoped that closer scrutiny of economic policy-making would help enforce discipline on the party and limit the policy conflicts that had dogged the party during the 1970s.
The reforms did help improve Italy’s inflation performance: inflation rates dropped from over 18 percent in 1981 to less than 5 percent in 1986. But instead of restoring the Christian Democrats’ reputation for effective economic management, the reforms called attention to the Christian Democrats’ inability to solve Italy’s tough economic questions, particularly the national debt problem. Reformers had figured that the divorce would compel the party to deal with the fiscal crisis. By the late 1970s, however, the Christian Democrats had come to depend on patronage to hold together their core constituencies—an appeal that directly contradicted the need for fiscal discipline. Many party politicians were reluctant to risk their seats and the party’s fortunes by abandoning a source of certain votes to achieve deficit reduction, an objective with a nebulous political payoff. Instead of demonstrating the Christian Democrat’s commitment to macroeconomic responsibility, therefore, the divorce actually exposed the party’s futile response to the fiscal crisis.
The continued failure of the Christian Democrats to address Italy’s fundamental economic problems contributed to voters’ dissatisfaction and disillusionment with Italy’s traditional parties. Throughout the 1980s, the vote share of the Christian Democrats declined (Barnes 1984; Leonardi 1987). New single-issue and regional political parties emerged, giving voters other outlets for their frustration. Under the weight of corruption scandals, increasing regional disparities, and voter dissatisfaction, the political system disintegrated in the late 1980s and early 1990s. In a series of referenda in the early 1990s, voters approved a new mixed proportional representation-majoritarian electoral system. Designers of the system hoped to promote the establishment of two broad-based party blocs, preventing the type of one-party dominance that had marked Italian politics since the end of World War II.
The popular demand for reform demonstrated that Italy’s party system had not adjusted to the new political and economic environment. The old parties, particularly the Christian Democrats, simply could not accommodate the diversity of interests created by economic modernization and internationalization. Instead of modifying their appeals to attract new constituents, the Christian Democrats relied on their traditional patronage appeal and pursued an inconsistent policy program. Increased levels of economic openness during this period simply magnified the consequences of the government’s weak and vacillating policies. As result, the Christian Democrats and Italy’s postwar party system simply dissolved in the face of popular discontent.
The Bank of Italy’s reputation, however, made it a symbol of national unity during the political crises of the 1990s. The bank remained one of the few institutions in Italy untouched by scandal. Indeed, its governor, Carlo Ciampi, was called upon to form a government in May 1993 in the midst of the political upheaval. Ciampi’s government implemented electoral reform and attempted to bring the public deficit under control. After the collapse of the Berlusconi government in December 1994, another former central bank official, Lamberto Dini, formed an emergency government of nonelected technocrats. (Dini had also served as Treasury minister in the Berlusconi government.) Although many did not expect the Dini government to last, Dini successfully shepherded a new budget, pension reform, and modification of regional electoral laws through parliament (The Economist, 12 August 1995).
In Britain, as in Italy, the economic shocks of the 1970s and 1980s created sharp divisions within the Labour and Conservative parties over economic policy. Britain’s majoritarian institutions, however, ensured that these conflicts did not threaten the cabinet’s position in office, making reform less urgent than in Italy. Indeed, the Conservative government blocked a bill to increase the independence of the Bank of England in 1993–94. Nevertheless, growing tensions within the Conservative Party and the fiasco of being forced from the EMS in 1992 created pressure for a more transparent monetary policy. After winning election in 1997, the incoming Labour government moved quickly to grant the central bank authority over interest rates. The reform was designed to solidify Labour’s diverse social coalition and enhance its reputation as a responsible moderate party.
This section first explains the divisions within both the Labour and Conservative parties. It then discusses the conflict over British participation in the EMS and the consequent bill to increase the Bank of England’s independence. Finally, it examines the response to the Labour government’s proposal of a more independent central bank.
Throughout the 1950s and 1960s, British economic policy reflected cross-party support of Keynesian demand management (Alt 1979; Britton 1991; Hall 1986; Kavanaugh 1987; Scharpf 1987). In return for wage restraint, the government would strive to lower unemployment, increase social spending, and strengthen the unions’ bargaining position with employers. At the same time, however, sterling’s position as a reserve currency made the balance of payments vulnerable to international speculation. The government would pursue expansionary policies to increase employment levels but then quickly slam on the brakes due to balance of payments pressures. This stop-go pattern to macroeconomic policy deterred investment and confidence, hurting long-term economic growth. Indeed, since World War II, Britain’s economic competitors have outperformed it in almost every category.
The economic shocks of the 1970s shattered this cross-party consensus and exposed deep divisions within each party over economic policy. For the Labour Party, these divisions centered on the relationship between the party and the trade unions. In 1975, following the first oil crisis, the Trade Unions Congress (TUC) voluntarily restrained wage increases to help the Labour government (Scharpf 1987). In return, the Labour government initiated pro-labor legislation, repealing the Conservatives’ Industrial Relations Act, expanding safety, health, and pension benefits, and freezing rents in council housing. The balance-of-payments situation, however, continued to deteriorate as British inflation remained high. To counter the growing crisis, the government demanded more wage restraint in 1976. Although unemployment had increased, the TUC again agreed to moderate its wage demands.
In early 1976, however, the pound came under heavy attack in international financial markets. The Bank of England quickly used up all its reserves and exhausted its access to international credit in defending the pound. Import prices increased dramatically, contributing to an inflationary surge. As in Italy, the government turned to the IMF for access to a special longer-term loan. The IMF agreed to the loan on the condition that the government tighten its fiscal and monetary policies.
Following the 1976 pound crisis, James Callaghan, the new leader of the Labour government, was determined to bring inflation under control.3 The government tightened fiscal policy and requested that the TUC limit wage increases again in 1977. The TUC, however, argued that the working class had already borne enough costs. Unemployment was still increasing. And although inflation had begun to fall in 1977–78, the government had rescinded some regulations designed to insulate the working class from inflation, including food subsidies and price controls. Consequently, the TUC leadership did not push the guideline on the rank and file.
The following year, the Callaghan government demanded that unions limit their demands to a 5-percent wage increase. By this time, however, union membership had become dissatisfied with the government and with wage restraint. Skilled workers in particular felt that they had accepted a disproportionate share of the adjustment burden. The government’s request also divided the party, the increasingly radical left wing arguing against the government’s orthodox economic policies. The TUC decisively rejected the government’s plan and opted for free collective bargaining. Private-sector unions concluded agreements for large wage increases, making up for the years of restraint. The government, however, held firm against the public-sector unions. This conflict exploded in 1978–79’s “Winter of Discontent” as the unions staged a series of strikes that crippled public services throughout Britain.
The widespread dissatisfaction with the Labour government’s macroeconomic performance and its conflicts with the unions swept the Conservatives into office in May 1979. Labour responded to its defeat by moving leftward, calling for more radical Socialist programs, including nationalization of key industries and disarmament (Kavanaugh 1987; Kitschelt 1994). As a result, centrists exited the party to form the Social Democratic Party in 1981, a party that eventually merged with the Liberals. Interestingly, Labour’s middle-class constituents supported the Socialist agenda more than did the working class; an exodus of working-class voters contributed to Labour’s crushing defeat in 1983 (Crewe 1985).
The Thatcher government entered office in 1979 intent on not just controlling inflation but also reshaping the entire relationship between state and economy. The government’s program consisted of three interrelated initiatives: monetarist management of macroeconomic policy, labor-market deregulation, and privatization. First, in macroeconomic policy, the government rejected the Keynesian consensus in favor of a monetarist approach, tightening fiscal policy and raising interest rates. In the 1980 budget, the government announced the Medium Term Financial Strategy (MTFS), a plan to target monetary aggregates over a four-year period. Interestingly, the Bank of England provided only reluctant support for the government’s macroeconomic policies, fearing the real economic consequences of dogmatic overreliance on a single indicator (Britton 1991; Hall 1986). Additionally, the Bank of England had to dissuade the government from pursuing wholesale reform of the banking system, arguing that reform would make the relationship between monetary policy and the money supply impossible to predict (Britton 1991).
Second, the Thatcher government sought to break the power of the trade unions. The government favored free collective bargaining, whereby firms and unions could coordinate their expectations around the monetary target. Wage agreements out of line with economic conditions would simply result in unemployment. Not content with eroding the unions’ market power, the government also passed legislation weakening unions’ bargaining position with employers and increasing members’ influence over their leadership. It also challenged public-sector unions, successfully closing a number of labor disputes, including a violent conflict with the mine workers in 1984–85. Both economic and political reasons motivated the government’s anti-union strategy; the strategy not only opened up the labor market, but it also injured the Labour Party’s main constituency.
Third, the Thatcher government rolled back the state’s role in the economy, privatizing nationalized industries and reducing government regulation. The government also made nationalized firms more efficient, laying off thousands of workers and closing plants. Again, the government’s motivation reflected both economic and political concerns. Selling council flats to their occupants attracted working-class constituents to the Conservative Party (Garrett 1992). Additionally, the government’s method of privatization encouraged small new investors to purchase shares on the theory that shareholders were more likely to vote Conservative. Finally, the windfalls from privatization and North Sea oil raised substantial revenues, limiting the tax burden.
The immediate consequence of the Thatcher program was a deep recession. Between 1979 and 1981, unemployment doubled, quickly climbing above 9 percent. In 1980, the GDP declined by more than 2 percent. Inflation began to fall, but not nearly as quickly as the Thatcherites had hoped. Despite the fact that the British inflation rate was well above the OECD average, the pound appreciated on international currency markets, reflecting high interest rates, North Sea oil revenues, and investor confidence in the government’s monetarist resolve. The high exchange rate, however, had devastating consequences for British manufacturers, who were priced out of international markets. Manufacturing output fell by over 15 percent (Britton 1991).
The deep recession exposed divisions within the Conservative Party between the radical free-market Thatcherites and Tory “wets.” Whereas the Thatcherites preferred the efficiency of the market to state intervention, the “wets” supported the traditional Keynesian consensus surrounding economic policy and the welfare state and felt an obligation to provide a social safety net to all classes of British society. Indeed, the government’s MTFS received harsh criticism from the Treasury and Civil Service Committee in Parliament, despite its Conservative majority. Their report argued that the MTFS “was not soundly based,” and it proposed a less dogmatic approach to economic and monetary policy (Britton 1991). Within the cabinet, some ministers disputed the government’s tight fiscal policies, pressing for more expansionary policies. In spring 1981, however, Thatcher asserted her dominance of the party organization. After she failed to secure her preferred spending cuts in the budget, Thatcher responded by dismissing her moderate or “wet” ministers, replacing them with more loyal monetarists (Hall 1986).
By mid-1981, the economic recovery had begun, helping Thatcher solidify her position. Increases in domestic demand provided a spark for the economy, benefiting the construction and service sectors. In contrast, manufacturing and export sectors remained mired in a slump due to the weakness of the world economy. Unemployment also remained stubbornly high because productivity growth led the recovery. Nevertheless, the Conservative government capitalized on the economy, the Falklands victory, and the disarray of the Labour Party to win the 1983 elections decisively.
During the next few years, the economy continued to grow while inflation fell. With inflation seemingly under control, the government loosened both fiscal and monetary policy. From 1986 to 1988, Chancellor Nigel Lawson produced a series of expansionary budgets. In monetary policy, Lawson ceased to rely on monetary targets and instead shadowed the D-mark. To maintain the parity, the government actually had to lower interest rates. These policies helped ensure another Conservative victory at the 1987 elections.
The government’s confidence in its ability to manage the economy, however, dulled them to the possibility of renewed inflation. The combination of increased consumer spending, expansionary budgets, and lower interest rates increased inflationary pressures in the economy. Between 1987 and 1990, the inflation rate more than doubled, increasing from 3.7 percent to 9.3 percent. The subsequent debate about how best to regain control over inflation further divided the Conservative Party and led to Thatcher’s downfall.
During the 1980s, the foreign-policy cleavage surrounding Britain’s relationship with Europe reemerged, creating tensions within the major parties, especially the Conservatives. With the disinflationary success of EMS member states and Britain’s poor inflation performance in the late 1980s, discussions soon centered on the question of British participation in the EMS. Advocates of participation, including Lawson and most other party leaders, argued that joining the exchange-rate mechanism (ERM) would provide the macroeconomic discipline necessary to regain control over inflation and enhance the government’s anti-inflation credibility with markets and the public. Additionally, participation would allow Britain to influence any negotiations over economic and monetary union. Thatcher and her allies, however, remained opposed, arguing that participation in the ERM would sacrifice policy-making autonomy to Germany. Thatcher turned increasingly to her personal economic advisor, Sir Alan Walters, for advice, ignoring Lawson’s policy judgments and party sentiment.
The conflict between the prime minister and the chancellor climaxed in October 1989 with Lawson’s resignation. His resignation speech to the House of Commons noted his disagreements with Thatcher and advocated entry into the EMS. Surprisingly, Lawson also stated that he had proposed a “fully worked-out” plan for an independent Bank of England to Thatcher in 1988, when inflation had begun to rise (Financial Times, 2 November 1989; The Economist, 4 November 1989; Elgie and Thompson 1998; Lawson 1992).4 Thatcher had rejected the proposal, arguing that it would appear to indicate “failure” in the battle against inflation (Thatcher 1993, 706).
Under increasing pressure from her party, Thatcher finally agreed to join the ERM in October 1990. Thatcher’s belated acceptance of EMS entry, however, was not enough to maintain the party’s support. The inflationary surge of the late 1980s, her imperious nature, and a number of other missteps, including the poll tax, made Conservative MPs wary of fighting the next election under her leadership. In November 1990, party MPs did not give her their full support during a leadership challenge, and she resigned. The party settled on John Major as their next leader.
British entry into the EMS, however, had come at an inopportune time. In an effort to enhance the anti-inflation credibility of its exchange-rate commitment, the government entered the system at a parity higher than what many economists argued was justified by economic fundamentals. Moreover, with the tightening of German monetary policy after unification, the government had to maintain high interest rates to sustain the pound’s value in the system, prolonging the economic slowdown long after inflation had been controlled. Both Major and his chancellor, Norman Lamont, pressed the Germans to cut rates, but their demands were ignored. Despite the economy, however, the Conservatives won a surprising electoral victory in April 1992, giving Major a small working majority in Parliament.
The Conservatives’ good fortune did not last long. Amid concerns about the disparity of economic fundamentals across Europe and ratification of the Maastricht Treaty, currency traders attacked the EMS in September 1992. Both the British pound and the Italian lira were forced to leave the ERM (Bernhard 1998; Cameron 1993; Cobham 1994; Gros and Thygesen 1998). The Major government, which had issued public assurances about the pound’s value prior to the crisis, had to backtrack on its statements, losing credibility not only with markets but also with the public and its own backbenchers.
In the wake of the crisis, Lamont sought to reestablish the cabinet’s trustworthiness. In October 1992, he announced that the government would establish a public medium-term inflation target. If the government missed the target, it would have “to explain how this had arisen, how quickly it intended to get back within the range, and the means by which it could achieve this” (Financial Times, 9 October 1992). Further, he proposed a new role for the Bank of England: monitoring the government’s pursuit of the inflation target. The bank would publish an Inflation Report, a critique of and prescription for monetary policy. Although the Treasury would see the report prior to publication, the Treasury would not be able to modify it. By making monetary policy more transparent, Lamont “could hope to convince the electorate and the markets that decisions, even if ultimately wrong, were being made for good, rather than bad, reasons” (Elgie and Thompson 1998, 78).
Lamont and Major, however, disagreed about how to handle monetary policy in the short term. Lamont favored maintaining interest rates in order to meet the new inflationary target. Major, on the other hand, saw interest-rate reductions as a way to shore up his dwindling support within the electorate and within his own party. Against the chancellor’s wishes, Major ordered a series of interest-rate cuts in late 1992 and early 1993. Over the spring, it became evident that the two men had very different ideas about monetary policy, and in May 1993, Major fired Lamont and replaced him with Kenneth Clarke. In his resignation speech to the House of Commons, Lamont, echoing Lawson, voiced his support for a more independent central bank.
The resignations of Lawson and Lamont placed the Bank of England’s institutional status on the public agenda. As a result, the Commons Select Committee on the Treasury began hearings on the institutional status of the Bank of England (Guardian, 5 May 1993). The select committee, including MPs from all three major parties, sought information not only on the bank’s independence but also on its supervisory role in the Bank of Commerce and Credit International (BCCI) scandal and the bank’s actions during Britain’s exit from the EMS in September 1992.
During the hearings, the committee heard testimony from Lawson (pro-independence) and Lord Healey, the ex-Chancellor of the Labour government in the late 1970s (anti-independence) (Financial Times, 8 July 1993). A number of prominent economists also issued a report, sponsored by the Centre for Economic Policy Research, calling for independence (Guardian, 18 November 1993). The new governor of the Bank of England, Eddie George, argued for increased autonomy.
The committee’s final report, published in December 1993, argued for an independent Bank of England, proposing institutions similar to the newly reformed Reserve Bank of New Zealand (Guardian, 17 December 1993). Under the proposal, the government would determine inflation targets, and the bank would be obliged to set interest rates to meet those targets. Bank policy would be determined by a Monetary Policy Committee, whose members could not hold positions outside the bank. The proposal also included institutional safeguards designed to enhance the bank’s accountability to Parliament. First, the bank’s governor would have to appear regularly before the select committee to answer questions about the conduct of monetary policy. Additionally, the government would have the authority to override the bank’s price-stability objective “temporarily and in exceptional circumstances.” Finally, unlike in New Zealand, the House of Commons would have to approve the government’s inflation target.
The proposal met with opposition from both the Conservative and Labour frontbenches and from the extremes of both parties.5 Prime Minister Major made it clear that the report was a “dead” issue. Opponents argued that monetary policy entailed distributive questions best determined by the voters through their representatives. Consequently, elected politicians, not central bankers, should control interest rates. Opponents also doubted the effectiveness of the institutions designed to hold the Bank of England accountable for its actions. They did not trust the bank to be truthful during its testimony nor did they believe that the Commons was capable of effective oversight. Finally, critics of the proposal noted that, “of the 30 memorandums submitted to the [Treasury] committee, 21 were from central banks—so it was hardly likely they would contest the idea that price stability does not conflict with employment and growth, or that independent central banks are the best means to achieve that end” (Guardian, 17 December 1993).
Nevertheless, Conservative MP Nicholas Blugden, a member of the Select Committee, attempted to place the committee’s report on the legislative agenda, proposing “The Bank of England (Amendment) Bill.” His arguments in favor of the bill emphasized the informational role of an independent central bank: “The whole object of these proposals is to achieve openness and to ensure that when a Government says it is doing one thing, it cannot give directives to the Bank which may do something quite different. My proposal does not prevent the Government giving instructions to the Bank to let inflation rip, but merely means that, if they do that, it has to be done openly and everybody has to understand the consequences.… We want a bit of openness between the House and the Government” (Guardian, 29 January 1994).
Both Conservative and Labour leaders opposed the proposal and prevented it from further consideration. Only the Liberal Democrats formally supported the reform. Opposition to the bill, I contend, reflected the government’s incentives over the central bank. Although the Conservative Party possessed constituents with a growing variety of preferences over monetary policy and increasing conflict within the party, Britain’s majoritarian political institutions still encouraged MPs to toe the party line and support their frontbench leaders. In other words, the institutions of the Westminster system insulated the governing party’s tenure from the political consequences of economic internationalization.6 Because the governing party had little reason to fear that its supporters would withdraw their support, they had no reason to support a more independent bank.
The growing pressure for an independent bank, however, contributed to changes in the relationship between the government and the Bank of England. Already, people had noticed that the bank’s governor had become more outspoken in his criticism of government (Guardian, 20 May 1991, 1 November 1991, 17 December 1993). With the increasing divergence of policy views within the governing parties, the governor could be sure to find a supportive audience. The appointment of Eddie George as governor in January 1993, one of the bank’s inflation hawks, helped ensure that the bank would continue to espouse restrictive policies.
In fall 1993, Chancellor Kenneth Clarke proposed several more institutional changes to increase the transparency of policy while keeping the ultimate authority for interest-rate decisions with the chancellor. First, the bank would cease to submit its Inflation Report to the Treasury prior to publication. Consequently, differences between the bank’s policy analysis and the government’s own evaluations would become more public. Second, Clarke allowed the bank to determine the exact timing of interest-rate changes he requested. Finally, in spring 1994, after negotiations with the bank, Clarke decided to publish the minutes of the monthly meetings between the Treasury and the bank after a six-week delay. In these meetings, the bank advised the chancellor about monetary policy before the chancellor took any action on interest rates. The publication of the minutes would help provide transparency to monetary policy and hold the bank accountable for its policy information (Guardian, 11 April 1997).
Coming out of the recession of the early 1990s, both the Bank of England and the government advocated relatively accommodative policies. In September 1994, however, the bank issued warnings about the inflationary pressures of an overheating economy and called for an interest-rate hike. Clarke reluctantly acquiesced and supported interest-rate increases in December 1994 and February 1995 as well. But as the Conservative Party’s approval ratings continued to decline, Clarke felt that he could not afford to continue to raise interest rates, touching off a series of public disagreements between the Treasury and the bank—a melodrama dubbed the “The Ken and Eddie Show” by the popular press. Beginning in May 1995 and continuing through the summer, Clarke ignored the bank’s warnings of higher inflation and refused to raise interest rates (Business Week, 5 June 1995, 7 August 1995). Most Conservative MPs agreed with the chancellor’s actions, fearing the political fallout of dampening the economic upturn. Currency markets did not punish the chancellor either. Although the pound depreciated soon after Clarke began to chart his own course, it soon restabilized due to changes in the position of the U.S. dollar.
In December 1995 and January 1996, Clarke cut interest rates further, hoping to maintain a robust economy in the run-up to the next election. In spring 1996, however, the bank forecast an inflationary surge on the horizon. But the chancellor continued to cut interest rates. Finally, by October, it was apparent that inflation was accelerating. Clarke and George agreed to raise interest rates by 0.25 percent. At the same time, however, the pound began to appreciate on international currency markets. Arguing that the appreciation would dampen any potential inflation, Clarke resisted the bank’s advice to raise rates from December 1996 through March 1997, the six months preceding the next general election, helping to preserve the economic recovery.
Despite the bank’s warnings of impending inflation, Clarke’s position enjoyed solid support within the Conservative party. This support reflected the similarity of policy incentives for party politicians created by the institutions of the Westminster system. In Britain’s centralized unicameral system, party politicians run for office all at once. Consequently, only the economic conditions at the general election matter for the party’s success. Any medium-term negative consequences of the chancellor’s strategy—for example, higher inflation or tighter monetary policy after the election—would not hurt the party because party candidates would not stand until the next general election, and by that time the government would have had an opportunity to reinvigorate the economy. Because Conservative Party members had similar electoral incentives, they supported Clarke rather than the bank’s policy position.
The economy’s performance, nonetheless, was not enough to save the Major government at the May 1997 election. Tired and divided over the question of Europe, the Conservatives lost badly to the Labour Party. But it was a new Labour Party that took office under Tony Blair—one that had responded to the changes in the electorate by becoming more centrist, inclusive, and moderate while still attempting to retain its working-class constituents.
The political and economic environment had changed considerably since Labour had last held office. The size of the manufacturing sector, shrinking through the 1970s, decreased drastically during the 1979–81 recession. Instead, the service sector replaced heavy industry as the dynamic engine of economic growth, creating regional disparities between the declining industrial north and the booming service-oriented south. Consequently, new sectoral conflicts replaced the union-management division, pitting service against manufacturing, profitable sectors against declining industry, and sectors exposed to international competition against sectors producing for the domestic market.
These developments challenged the long-term viability of the Labour Party’s traditional emphasis on unions and the working class. After sharply moving to the left in the early 1980s and losing badly to the Conservatives, Labour Party leaders began to pull the party toward the center—a slow and difficult process. Centrist leaders and entrenched party interests clashed repeatedly over policy changes and reforms to internal party organization that limited trade-union influence. These divisions between radicals and moderates prolonged Labour’s reputation as a party of special interests and contributed to electoral losses in 1987 and surprisingly, in 1992. Finally, with the ascent of Tony Blair as party leader, the moderates were solidly in command. Nevertheless, the leaders of “New Labour” faced a difficult balancing act. With the socioeconomic developments of the 1970s and 1980s, the Labour Party had to build and maintain a very different social coalition than its predecessors—a coalition that included not only the remainder of the traditional working-class base but also the middle class, new sectoral interests, business, and centrist voters.
New Labour’s party program was clearly designed to appeal to that coalition. The policy agenda emphasized middle-class concerns such as education and improvements to the National Health Service. The Labour government also advocated substantial institutional reforms. It supported referenda in Scotland and Wales on whether to establish regional parliaments. Devolution would not only enhance Labour’s support in those regions, but it would also allow the national party to pass responsibility for potentially divisive policy issues to regional governments. Additionally, the Labour government formed a commission to explore electoral reform. The commission proposed an alternative vote system combined with additional member constituencies, a compromise between the traditional first-past-the-post system and proportional representation (The Economist, 31 October 1998). The government promised action on the proposal after the next election. These policies and reforms were designed to help the Labour Party build a viable electoral coalition among constituents with heterogeneous economic policy preferences.
I argue that Labour’s reform of the central bank fits with this strategy of party building. The Labour Party manifesto promised monetary reform, although it fell short of calling for complete independence: “We will reform the Bank of England to ensure that decision-making on monetary policy is more effective, open, accountable and free from short-term political manipulation.” In particular, party leaders proposed the establishment of a monetary-policy committee to advise the governor, who, in turn would advise the chancellor. This committee, they contended, would help make monetary policy more representative of Britain’s economy.
But in a surprise move just after the election, new Chancellor Gordon Brown announced that he was giving “operational responsibility” for setting interest rates to the Bank of England. While the government would determine the inflation target, the central bank would control day-to-day management of interest rates to achieve that target.7 Further, decisions about interest-rate changes would be taken by a new nine-member monetary-policy committee, consisting of the governor, two deputy governors, and six other members. Four of the six nonexecutive members were to be appointed by the chancellor for three-year terms. A reformed Court of the Bank of England, composed of individuals from industry, commerce, and finance, would supervise the committee to determine whether it “was collecting proper regional and sectoral information for the purposes of monetary policy formation.” The bank would also give reports to the House of Commons through the Treasury select committee (Financial Times, 7 May 1997; Guardian, 7 May 1997; Parl. Deb., Commons, 5s, 295:508). Later in May, Brown stripped the bank of its responsibility to supervise the banking sector, transferring those duties to the Securities and Investments Board (Financial Times, 21 May 1997; Guardian, 21 May 1997).
The reform reflected the Labour Party’s desire to solidify its potentially fragile social coalition. In announcing the reform, Brown explained, “We must remove the suspicion that short-term party political considerations are influencing the setting of interest rates” (Financial Times, 7 May 1997). In parliamentary debates, he emphasized that the reforms would make monetary policy more representative of Britain’s diverse economy: “The [Monetary Policy] Committee will be responsible for taking full account of regional and sectoral information in its monetary policy decisions.… The Court [of the Bank] will be substantially reformed, so that it is able to take account of the full range of industrial and business views in this country, and for the first time it will be fully representative of the whole of the United Kingdom” (Parl. Deb., Commons, 5s, 294:508). These institutional changes were clearly designed to enhance the bank’s credibility not only with markets, but also with the public. By moving to grant the Bank of England more independence, the Labour Party’s leadership sought to prevent potential conflicts over monetary policy from dividing the party and also to reassure constituents about its commitment to moderate economic policies.
Labour’s announcement enjoyed a largely positive reception from a variety of actors. Predictably, the major financial press, The Financial Times and The Economist, praised the decision, as did The Guardian. Financial markets, which might have been expected to be hostile to a Labour government (Herron 2000), also reacted favorably. In the wake of the chancellor’s decision, the pound appreciated and the stock market rose. Most dramatically, British government bond prices made their biggest one-day gains in more than five years, indicating that market actors expected a reduction in long-term inflationary pressures (Financial Times, 7 May 1997). Consequently, the Labour government would enjoy lower long-term interest rates, freeing up some public money for new spending projects.
Business, another group not traditionally associated with the Labour Party, also welcomed the announcement. The Confederation of British Industry (CBI) and the Institute of Directors issued statements applauding the reform. Adair Turner, director general of the CBI, stated, “We very much welcome this move. We would like to see macro-economic policy become independent of politics and we see this as a step in the right direction” (Financial Times, 7 May 1997). During parliamentary debates, several Labour MPs reported that businesses in their constituencies approved as well. MP Lawrence Cunliffe (Leigh) stated, “In my part of the world, the largest industrial region in the north-west, the bosses are backing Labour: in the latest poll of industrialists, 88 per cent, responded in support of the Chancellor.… That is an independent response to an independent bank system” (Parl. Deb., Commons, 295:1059). Similarly, first-time Labour MP Ivor Caplin (Hove) said, “I know from my postbag that many businesses in my constituency are solidly behind his [the Chancellor’s] decision” to make the Bank more independent (Parl. Deb., Commons, 5s, 295:1067).
Financial and business interests were not the only ones to endorse the reform. Many citizens also approved the decision. Helen Liddell, economic secretary to the Treasury, stated, “it was not just universal acclaim from the City and the financial institutions, but universal acclaim from the people. As recently as Saturday, at Shotts highland games—hardly the usual scenario for talking about monetary policy—I was assailed by people wanting to congratulate the Government on their decision on the Bank of England” (Parl. Deb., Commons, 5s, 295:1076).
But not everyone was pleased with the chancellor’s decision, particularly the traditional elements of the Labour Party (Financial Times, 7 May 1997). These left-of-center MPs complained that they had been surprised and betrayed by the announcement. Diane Abbott (Hackney, North and Stoke Newington), who emerged as one of the most reasoned opponents of independence, quipped, “Why do not we simply sub-contract the entire economy to Goldman Sachs?” (Parl. Deb., Commons, 5s, 295:1059).8 Dennis Skinner (Bolsover) complained, “I cannot understand, however, in a world economy that offers very few financial levers to any incoming Government, why … the first thing a Labour Government do—without a manifesto commitment in precise terms—is hand over one of the most important financial levers to the enemy” (Parl. Deb., Commons, 5s, 294:518).
These complaints, however, represented “old” Labour and did not fit with the party’s new emphasis on moderation and inclusion. Indeed, supporters of central bank independence attacked the complaints of Labour extremists as antithetical to the party’s interests. Stephen Timms (East Ham) argued:
An article … written by one of my hon. Friends describes the decision as “delivering policy to the enemy” and “a gesture which … conciliates only our enemies.” The decision also conciliates many people who are not our enemies; many who wanted a new Labour government who would be radical and trustworthy, and who feel that this is what they have got. The new Government will not play fast and loose with people’s money, and it would be a fatal error to believe that only our enemies would be anxious if it were otherwise. To be successful, do not the new Government have to consign to the dustbin the idea that large parts of the economy constitute our enemy? Such an idea can only be recipe for the disastrous and debilitating strife that has so damaged Labour Governments in the past. We would fail if we went down that road again. We are on a different road now, and we shall succeed. We want partnership, not warfare. (Parl. Deb., Commons, 5s, 295:1064)
Clearly, reformers hoped that making the central bank more independent would cement Labour’s electoral coalition and prevent monetary policy from dividing the party.
Parliamentary debates about the Bank of England Bill centered on three issues: the Bank of England’s accountability, the policy consequences of such a move, and Britain’s participation in the single currency. Unlike debates over nationalizing the bank in 1946, a considerable portion of the debate in 1997 focused on the bank’s governance structure. Even MPs who supported making the bank more independent questioned whether the government’s proposal gave the chancellor too much influence over the bank—an unsurprising concern in a party with diverse constituents and backbenchers who did not necessarily share the chancellor’s policy preferences. MPs pressed the government to allow the Treasury Select Committee to hold confirmatory hearings for appointments to the monetary-policy committee. Labour MP Giles Radice (North Durham), a supporter of the bill, asserted that the select committee would hold such hearings: “The fact we can and shall do it [hold hearings]—even without formal powers being written into the Bill—could influence the Chancellor were he thinking of putting his granny or whoever on to the Monetary Policy Committee” (Parl. Deb., Commons, 5s, 300:747). MPs further complained that the three-year term for committee members was too short, giving the “perception that they could be put under pressure” by the Chancellor (Malcolm Bruce, Gordon, Liberal Democrat [Par1. Deb., Commons, 5s, 300:752]). Finally, MPs did not believe that the Treasury Select Committee had enough resources to hold the bank responsible. Diane Abbott, speaking against the bill, stated, “We cannot seriously believe that the Treasury Committee, with two and a half special advisers, can hold to account the Monetary Policy Committee and the battalions of economists behind Eddie George” (Par1. Deb., Commons, 5s, 300:765)—a view that was echoed by many of the bill’s supporters. The government, however, contended that the bill already contained enough measures to ensure the accountability of both the bank and the chancellor, including reporting requirements and increased transparency.
The second issue centered on the policy consequences of the bank’s independence. Critics on both sides of the aisle expressed concern that the bank would impose a deflationary bias on the economy, hurting growth and employment unnecessarily. Former Chancellor Kenneth Clarke argued, “In recent years, the Bank of England has not been very good at forecasting inflation. The Bank has always overestimated the likely upside inflation risk. . . . The Bank always fears the worst and reacts accordingly, which is what will cause damage” to the real economy (Par1. Deb., Commons, 5s, 300:738). The bill’s supporters repeatedly countered that lower and more stable levels of inflation would foster investment and growth, helping to restore Britain’s competitiveness.
The third topic of debate focused on Britain’s participation in the single currency. Euro-skeptics in both the Conservative and Labour parties complained that making the central bank more independent was a covert step toward entry into the single currency. Conservative MP Sir Peter Tapsell (Louth and Horncastle) stated, “The Bill is intended as a halfway house towards our economy being managed by a European central bank. . . . It is a further constitutional retreat along the road to a single European currency and the sacrifice of British parliamentary self-government to the bureaucracies of a federal Europe” (Par1. Deb., Commons, 5s, 300:758). The Chancellor, however, emphasized that the reform was not a stepping stone to the single currency: “The Government’s decision to give the Bank operational responsibility for setting interest rates is a British solution, designed to meet British domestic needs for stability. Decisions on EMU will be taken if and when required, and will have to be agreed by Cabinet, Parliament, and the people” (Par1. Deb., Commons, 5s, 295:87). He added that his reforms did not entirely meet the requirements for central bank independence in the Maastricht Treaty.
The bill passed, but it generated internal dissension for both the Labour and Conservative parties. In the Labour Party, many old-guard MPs were clearly hostile to the bill, although they were not numerous enough to block it. On the other side, the Conservatives officially opposed the bill, although some privately approved of the measure. (Former chancellor Norman Lamont openly endorsed the proposal.) Only the Liberal Democrats supported making the bank more independent with little intraparty conflict.
In the first year of the Labour government, therefore, party leaders successfully launched a series of institutional reforms, including a more independent central bank and regional devolution. These reforms helped the party balance new interests with their traditional core constituencies and establish a reputation for good governance, a reputation that was reflected in the high approval ratings given to the Blair government during the early part of its term.
The economic shocks of the 1970s and 1980s changed constituent preferences over economic and monetary policies, contributing to electoral dealignment in many industrial countries. The erosion of the traditional social coalitions underpinning the governing party(ies) diversified the policy demands placed on politicians, creating distrust among party politicians. At the same time, governments became less able to deliver promised economic outcomes. Faced with changing constituent bases, less-committed electoral support, and new political challengers, the major parties had to adjust their strategies to maintain their viability. They needed to build new social coalitions that embraced the diversity of economic interests yet continued to appeal to their core constituents.
Central bank reform represents a response to such political pressures. A more independent central bank can help prevent intraparty conflicts over monetary policy from threatening the party’s ability to win and retain office. It also demonstrates a commitment to a variety of constituents, helping the party hold together a diverse social coalition. In both Italy and Britain, political parties made the central banks more independent as part of a strategic calculation to help them compete in a changed economic and political environment. Further, in both cases, central bank independence was adopted amid other major reforms—devolution, legislative reform, and even electoral reform.9 With these institutional changes, party leaders were seeking ways to ensure the party’s political survival.10
The combination of central bank independence and political reform in Italy and Britain is not a mere coincidence.11 The same factors underlying central bank reform—changes in constituent demands and increases in intraparty conflict—also increase the possibility of political reform. In fact, monetary reform and political reform are linked in other countries as well. In New Zealand, the adoption of an independent central bank in 1989–90 nearly coincided with the popular rejection of the majoritarian electoral system in 1992–93. Prior to the 1990s, New Zealand had possessed a typical “Westminster” system, with two-party competition between the Labour Party and the National Party. When the National Party won the 1990 election,12 it honored a pledge it had made in opposition to hold a referendum on the electoral system (The Economist, 26 September 1992). In 1992, voters rejected the first-past-the-post electoral system, supporting mixed majoritarian–proportional-representation system.13
The coincidence of central bank reform and electoral reform suggests a similar underlying cause: politicians are seeking to insulate themselves from the political consequences of economic internationalization. Established political parties are using these institutional reforms to balance conflicting interests, rebuild social coalitions, and maintain electoral viability. Central bank independence, therefore, is more than just a “technical” solution to an economic problem. Rather, the institutional status of the central bank reflects how political parties choose to aggregate citizen demands and in turn, how those demands shape public-policy choices—fundamental questions about the nature of democracy in a capitalist society.