HOW can Britain improve its monetary arrangements to avoid boom-bust credit cycles and inflation overshoots in future? The long time lags involved mean it is too late to improve this country’s not particularly rosy but by no means catastrophic prospects over the next year or so.

Britain has a small and trade-dependent economy. Its growth and inflation are more closely related to wider international trends than they are influenced by domestic fiscal and monetary policies, whose effects are weak and uncertain and operate with long and variable lags. The power and speed with which overseas developments impact on the British economy mean that the country is akin to a small vessel being tossed about on turbulent seas.

The ability of the chancellor of the exchequer and the monetary policy committee (MPC) to offset external disturbances is ameliorative at best. This does not mean the ship cannot be lost through incompetence, or that a soundly constructed policy framework does not have a better chance of survival than an ill-conceived one.

As regards fiscal policy, the best way is low taxes and light regulation, to strengthen the supply side while maintaining a tight grip on the cyclically adjusted budget deficit through spending discipline. However, these are not the policies pursued by Gordon Brown since his sham marriage to “Prudence” was annulled around 2000. The increased ratio of government spending to national output, and the rise in the regulatory burden, mean that Britain is acquiring the sluggish characteristics of a euro-sclerotic economy. There is a risk that Britain will also be afflicted by the high structural unemployment endemic in much of continental Europe, with all the attendant social tensions that can bring.

The granting of operational independence to the Bank of England means Britain’s fiscal and monetary policies have been institutionally separated since May 1997. This does not mean that there are no economic feedbacks between the pair, however. The large structural budget deficits require higher real interest rates than would otherwise be the case for any given inflation target.

Furthermore, the loss of political and Treasury credibility caused by debacles such as the 10p income- tax affair could easily contaminate the credibility of the MPC by association. All central banks have to be circumspect about cutting interest rates in high-tax economies with weak supply sides because any demand stimulus tends to induce higher prices rather than increased output.

In April 2007, I published a paper for the Economic Research Council on two monetary policy issues that remain of concern today (see Cracks in the Foundations? A Review of the Role and Functions of the Bank of England after Ten Years of Operational Independence on www.ercouncil.org ). The first, conceptual, worry is whether the simple three-equation model widely employed by theoretical economists — which regards the output gap as determining inflation, confines monetary policy to the setting of the official discount rate, and excludes credit and money — is intellectually valid.

This is important as this theory explains the present structure of the Bank, influences the analysis of MPC members, and is built into the Bank’s forecasting model. It also explains why the MPC has paid relatively little attention to the rapid growth of money and credit or the other symptoms of monetary excess in recent years, including balance-of-payments deficits and rising asset prices. If the three- equation framework is a dangerously oversimplified model of reality — as I believe it is — policy errors are inevitable.

At present, for example, the MPC appears to believe the inflationary consequences of the weaker pound will be outweighed by a modest widening of the output gap. But there is a good chance that the 11% fall in the sterling index since May 2007 will eventually induce a fully proportionate rise in the price level. This would make the inflation target equivalent to Monty Python’s “dead parrot” for some years ahead.

The second, institutional, concern is whether the tripartite dismemberment of the Bank in May 1997 was a serious error. My earlier paper decided that it was and predicted that problems would arise if the Bank had to act as a lender of last resort, as happened five months later with Northern Rock. This is history now, but several institutional conclusions can be drawn from these events.

One is that the management of the gilt-edged market should be returned to the Bank. This would permit it to operate on a wider front than at present, and help offset the lack of “pass through” from Bank rate to market rates.

Another conclusion is that the Bank should supervise all banks and building societies whose liabilities constitute M4 broad money — to improve its market intelligence in a crisis — while any future deposit-insurance scheme should probably be confined to Bank-supervised institutions.

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