In defence of central bank independence
The Prime Minister took aim at the Bank of England’s prolonged monetary easing in her party conference speech in October. U.S. President-elect Donald Trump, for his part, has accused the Federal Reserve of seeking to prop up the current administration and creating “a fake economy” through QE and low interest rates. Never one to dance around the issues, Ed Balls – who helped to make the BoE independent in the late 1990s – this week called for “a more nuanced approach” to central bank autonomy in a paper for the Harvard School of Government.
Gone are the days when the doyen of 20th-century central bankers, Alan Greenspan, could claim rock star status, his pronouncements as earth-shattering as colliding tectonic plates. Electorates across the West are these days more receptive to arguments about control of economic policy-making, and less susceptible to admonitions about the importance of political independence for macroeconomic stability.
What explains the shift? It is tempting to ascribe it to the wider mood of discontent and anti-establishment sentiment claimed to have been behind the Brexit vote and Donald Trump’s victory. Indeed, as prominent members of the ‘ruling class’, central bankers were bound to feel the backlash. But the recent performance of monetary authorities is likely also a factor. In the 1980s and 1990s, central banks were widely perceived to have successfully vanquished inflation and enabled an extended period of growth and macroeconomic stability.
There is, by contrast, little of the heroic in their record immediately before and after the 2008 crash. Central banks largely failed to see the downturn coming, they failed to adhere to the Taylor rule for monetary stability, and they failed as regulators, whether by commission or omission. After 2008, central bank activism has depressed yield curves to an unprecedented extent, with negative consequences for savers and a potentially destabilising impact on asset prices. Yet, growth has been sluggish. It is no wonder that the public is losing faith in the wisdom of technocrats.
A measure of distrust in the power of public officials to shape our lives for the better is certainly healthy. Hayek taught us that, more often than not, the knowledge ascribed to economic planners is mere pretence, a “fatal conceit” which not only made people less free, but also poorer in the long run. The failure of central bankers to measure up to the demands made on them by the 2008 crash is just a demonstration of the quite adverse effects of placing excessive trust – and power – in government officials.
But one should be careful not to draw extreme conclusions from the experience of 2008. It is convenient for politicians to call for a curtailment of, or even an end to, central bank independence. This would both help them to eschew blame for poor economic outcomes – despite their role in drafting and passing the legislation and regulations which often cause them – and likely increase their own future power over economic policy.
However, central bank independence was arrived at after recurrent episodes of high and rising inflation, followed by recessionary periods, confirmed the unsuitability of elected officials for interest rate management. The heart of the matter is what economists call the time-consistency problem, namely that it is optimal for politicians to promise one thing – to do whatever it takes to keep inflation low – and later do another – to ease rates in order to foster a short-term boom that will make them more popular. What is good for the economy in the long term – price stability – can be in conflict with what is best for politicians’ own prospects in the short term – reelection. But economic agents are rational, and they can see through politicians’ elusive promises – so they raise their inflation expectations. Thus, the monetary conundrum is really as much about principal-agent conflicts as it is about time consistency.
Granting central banks political independence is an attempt to resolve this problem. The hope is that the combination of a clear mandate – usually for price stability and, in some cases, low unemployment and financial stability as well – and policy autonomy will both anchor the central bank’s commitment and restore its credibility with agents. That has by and large been the experience since the principle was introduced. Over the last thirty years, inflation rates across Europe and North America have tended to settle around low values of the vertical Phillips curve.
So, what have we learnt about the optimal institutional setup of central banks since 2008? Balls and his co-authors make an interesting distinction between operational independence – defined as central bankers’ ability to choose how to meet their targets – and political independence – which would include control over policy objectives and personnel. They argue in favour of the former but question the latter, for which they can glean no empirical support, at least in developed economies.
For free-marketeers, the issue poses more of a dilemma than might be apparent at first sight. It is clear that the power of politicians should be constrained, especially on matters with as many ramifications as monetary policy. But entrusting a small unelected set of relatively homogeneous technocrats raises troubling prospects of its own. For one, unelected bodies with a great deal of power are prone to inertia and impervious to change, no matter the evidence against existing practices. The U.S. Food and Drug Administration is a salient example of such tyranny of the status quo. It may be argued that, in certain instances, democratic bodies can be more responsive to changing circumstances and demands.
Secondly, unelected institutions are open to capture by the industries they are supposed to regulate, whether as a result of the prospect of future private-sector occupations for regulators, or due to a political equivalent of the Stockholm syndrome, whereby regulators identify more with the goals of the regulated than with their own mandate. Thirdly, institutional autonomy can breed isolation and groupthink, weakening the institution’s grasp of the outside world and perpetuating erroneous interpretations of events.
But the recent experience of central banking does suggest a number of conclusions:
- Independent central banks, once given a mandate for price stability, are better able to meet it than time-inconsistent politicians.
- The further removed a target – such as full employment or financial stability – from a central bank’s immediate power, the harder it is for the central bank to achieve it with any degree of consistency and accuracy.
- The separation of legislative from regulatory functions, and monetary from fiscal policy, may be desirable for political and constitutional reasons, but it raises potential problems such as incoherent policies, perverse incentives and accountability gaps.
These plausible lessons raise more questions than they answer about what central banks should be charged with in the future, and to what extent they ought to be autonomous from elected government. Nonetheless, there should be no mistake that central bank independence, as far as the price level – the main responsibility of monetary authorities – is concerned, has been an unambiguously positive development.