The Bank of England

The Bank of England pervades the very fabric of our everyday lives. Barely noticeable to many, evidence of its activities confronts us dozens of times a day, every time we see a banknote or log on to our account. This venerable institution – the “Old Lady” of Threadneedle Street – has been with us for over three hundred years, and has provided a model for central banks around the globe. Its function has evolved from its original role of banker to the English government to its current, wide-ranging responsibility for the monetary and financial stability of the entire United Kingdom.

Banker to the government

The Bank of England (BoE) was established in 1694, six years after the accession of William and Mary. At the time they took the throne, James II had been overthrown, England was at war and the country’s finances were in chaos.
The Amsterdam Wisselbank, founded in 1609, had evolved into a successful and stable model of a central bank that had made a significant contribution to the success and stability of the Dutch economy. Scottish entrepreneur William Paterson began to argue the need for a similar institution in England, proposing a loan of £1,200,000 to the government. His scheme was approved, and a group of subscribers put up the money that became the initial capital stock of the BoE, to be lent on to the government to finance spending projects. In return, the government granted the bank’s Royal Charter, and the subscribers were incorporated as “The Governor and Company of the Bank of England”, with Sir John Houblon as the first governor.

Banker to the banks, and the birth of monetarism

At the beginning of its life, the BoE’s only role was banker to the government but, during the eighteenth century, the BoE became the banker to other banks. However, the BoE ran the risk of collapse if depositors tried to withdraw all their money at once, so the BoE had to ensure that it maintained enough gold in reserve to cover this contingency. The depredations of the Napoleonic Wars sapped the BoE’s gold reserves, so the government forbade the bank from converting its notes into gold, a move that led to a surge in inflation that was blamed primarily on the BoE having printed too much paper. An investigating Parliamentary Select Committee concluded that paper currency that could not be converted into gold or silver could only retain its value by limiting the amount of paper issued and, with this decree, the concept of monetarism was created.

Taking control of Britain’s finances
Banking crises during the nineteenth century spurred the BoE to assume responsibility for the stability of the entire UK banking system, taking on its role as “lender of last resort”. The nineteenth century saw the BoE become the primary issuer of banknotes in England and Wales through the Bank Charter Act of 1844, which prohibited the issuance of new notes by banks. Many small banks had printed notes, undermining monetary discipline in the UK. However, the new Act stated that the issuance of banknotes by the BoE would be tied to the bank’s gold reserves, a move that led to the establishment of the Gold Standard. Moreover, the BoE had to separate the accounts of its banknote issuance from those of its banking operations, and to provide weekly summaries of both accounts. This “Bank Return” is still published every week.

During the eighteenth century, the government borrowed an increasing amount of money, which became known as the National Debt. During the First World War, the UK’s National Debt soared to £7 billion, and the BoE assisted in the management of government borrowing and the fight against inflation.

An independent Bank of England?

In 1931, the UK left the Gold Standard and its gold and foreign exchange reserves were handed to the UK Treasury, although the BoE continued to carry out their administration. The BoE was nationalised in 1946, following the end of the Second World War. Almost fifty years later, in 1997, it was given responsibility for setting UK interest rates, independent of any operational interference from the government. The BoE’s Monetary Policy Committee’s (MPC’s) task is to ensure that UK inflation meets a government-set target (currently 2%). If inflation falls more than one percentage point outside this target, the BoE’s governor has to write an open letter to the Chancellor of the Exchequer, outlining the reasons for the failure to meet the target, and explaining how he intends to resolve the problem. Interest rates are reviewed by the MPC at a monthly meeting.

However, the BoE’s independence does not necessarily equate to autonomy. The MPC’s relatively narrow brief – focusing on inflation – is likely to become increasingly problematic in coming months. The UK has lurched from concerns about soaring prices to worries about deflation in the space of a few months; however, an environment of deflation cannot be averted purely through monetary policy, so the BoE and the government might well be obliged to work together more closely. Any hint that the MPC’s interest-rate decisions are being influenced by the government would not only compromise the BoE’s much-vaunted independence, but could also raise the prospect of interest-rate policy being harnessed for short-term political gain rather than for the long-term monetary strength for the UK. Only time will tell the outcome; however, it seems likely that the Old Lady’s role will continue to evolve.