15 Days of Economics — Day 6: The Bank of England
The Bank of England is an integral part of the United Kingdom’s financial system. It promotes financial stability and security throughout the entire economy. It regulates banks, the Great British Pound, and monetary policy. It is incredibly important in preserving the way of life in the UK
History
Banks have a long history beginning in the ancient era. Banks, initially, where firms to store people’s gold(the principal currency at the time). Banks would then lend the gold out for a profit. This created an issue of trust. If trust in the bank fell and citizens wanted their gold back all at once(a run on the banks), the bank may not be able to deliver. In the 17th century, banks in England began to issue banknotes as a transferable token of gold stored in the bank. This gave additional value to banks as they enabled transactions to be carried out much more easily. Banks then realized that as long as there was trust in the bank, they could issue more notes(in the form of loans) than they had gold to redeem. This massively increased the supply of credit to the economy and was beneficial for society. However, this greatly increased the risk of a fatal run on the bank. In the case of a run on the banks, citizens would lose the money they had there and their notes would be worthless. This created the unfortunate effect that fear of a bank collapse could cause a bank collapse.
To solve this problem The Bank of England was created in 1694. Part of its purpose was to ensure the banks of England so that if they failed citizens could get their money back. This enabled unprecedented trust in the banking system as the government of England was backing the banks. This enabled more credit to be supplied to the economy, increasing economic growth.
Later, the Bank of England standardized banknotes by banning new banks from issuing their own banknotes, instead, issuing a new currency, the pound, that could be traded for gold. This enabled greater ease of transactions across the economy which increased spending.
The Bank of England also regulated the amount of surplus currency issued. In place of independent banks lending surplus of their own currency, the Bank of England would lend to the banks which the banks can then pass on to businesses and people. The interest rates of these loans have wide effects across the economy and are referred to as the Offical Intrest Rate. Changing this can change the level of risk in lending and also encourage economic growth.
Up until 1931 the Great British pound was on the Gold Standard. This meant that any banknote could be exchanged for a certain amount of gold. However, following the extensive debts of the British Government after the First World War, the currency was taken off the gold standard and instead fixed to the United States Dollar which was still on the gold standard. This meant that the price of the pound was fixed to the price of the dollar. This changed in 1971 when the pound became a free-floating currency.
The Bank of England initially controlled the value of the pound by printing when the price got too high and selling foreign currency reserves when the price was too low. In 1979 the European Exchange Rate Mechanism(ERM) was established of which the UK was a part of. This meant that the Bank of England was fixing the price of the pound to other European currencies. However, this was unsustainable as the Bank of England only had finite foreign currency reserves to increase the value of the currency.
In 1992 George Soros capitalized on this unsustainability by selling more than £10 billion. This large of a sale encouraged other entities to also sell pounds in anticipation of the bank running out of reserves. Eventually, The Bank of England ran out of reserves and ceased buying back the pounds. This caused the price to fall dramatically and undermined the stability sought by the ERM. This event, known as Black Wednesday, threw the UK into a recession. In the wake of this, the UK left the ERM and The Bank of England permanently stopped regulating the price of the currency.
Current Activities
Currently, the Bank of England has many important regulatory activities. These are meant to promote the stability and economic progress of the UK.
The Bank of England still lends to banks in order to regulate the lending habits of the country. If interest rates are lowered lending will increase speeding up economic growth. However, this can lead to risky lending increasing the risk of worse recession. This is usually done at times of slow economic growth and is referred to as a “monetary stimulus”. If interest rates are increased lending will decrease but lending will be less risky. This can mitigate the magnitude of a future recession.
Inflation targeting has been commonplace among central banks ever since New Zeland’s success with it in the 1990s. This is where the central bank will encourage wages and prices to increase by a certain amount per year. The Bank of England does this too and sets target inflation to 2%. The mear target of 2% inflation is a major cause of inflation nearing 2% every year. This inflation is useful for encouraging economic growth and stability.
The Bank of England also conducts quantitative easing where money is printed(or more often created digitally) and used to purchase bonds in the private sector. This increases the capital supply in the economy increasing the potential for production in the economy.
Independent banks are also regulated by the Bank of England. They control how much capital a bank has to hold and how much they can lend out. This limits the risk of a bank collapse. In the event of a bank collapse, the Bank of England sometimes bails out banks. Otherwise, the Bank of England insures people’s bank savings up to £85,000 per person. This enables a high level of trust in the banking system.
