Tuesday, 21 February 2017

Central Bank Independence Cannot Survive a Crisis

For once my university curriculum was enough in-sync with world events around us to provide some relevant and interesting readings. The essay I just finished dealt with central bank independence, a fairly modern invention to these rather old institutions: most of them used to be another sub-departments under direct control of a Treasury. The idea behind an independent central bank, one that makes its decisions about monetary policy and target rates underlying most interest rates in the economy without influence by politicians or current policy-makers is as follows: since the result of monetary policy operates with a certain lag, a sitting government in direct control of the central bank can lower the target rate before an election – an action that will spur investments and increase economic activity in the short run – which lowers unemployment, and may help the sitting government to victory. This action has longer-term consequences in higher price inflation, which will not be apparent until later; to bring that price inflation down, rates have to be increased again, often causing (slight) recessions.
Now clearly, politically savvy governments used this to get themselves re-elected in tight elections (lower unemployment tends to favour the sitting government), but had long-term damages to the economy and the very voters who benefitted. It may not be entirely clear how, but one effect was permanently higher real interest rates for the entire economy because of the extra inflation-uncertainty this behaviour created – in a sense, that extra interest rate we all paid acted as a tax on everyone else. Not to mention the unnecessary fluctuations in the macroeconomy and financial markets this led to.

This is the big insight in William Nordhaus’ 1975 article ‘The Political Business Cycle’. Since then, economists came up with a whole range of solutions to prevent governments from behaving in this opportunistic way. In the early 1990s a consensus had developed: if we pre-commit governments to certain inflation targets, and we make monetary authorities (= Central Banks) independent with no direct control by the sitting government, this opportunistic behaviour would no longer be possible.

The strategy was quickly adopted around the world and very effective. Many now-famous economists such as Alberto Alesina and Lawrence Summers as well as Guy Debelle and Stanley Fischer found that average inflation and average inflation variability was almost perfectly aligned with how independent various central banks were – with no cost to employment. Ed Balls, the then advisor to the Chancellor of the Exchequer described Britain’s immediate experience after making the Bank of England independent in 1997 in the following way (Bernanke more recently described the same thing)
long-term interest rates, measured by the 10 year benchmark government bond, have fallen from 7.4% to 6.6% since the day before the election and the spread over German 10 year government bonds has narrowed from 191 basis points to 87 points over the same period. (p. 117)
Until quite recently, central bank independence was one of these few things almost every economist agreed on: giving direct control over monetary policy to politicians will make things worse for everyone (but politicians?)  let's not do it! (To mention a few other such positions that basically every single economist agrees on: free trade opposition to tariffs  they are basically part of what it means to be an economist  check out the IGM Panel survey of economists' beliefs for more interesting details)

Following the GFC and Trump’s vocal criticism of the Fed, this consensus have been seriously attacked. Last weekend, Wolfgang Münchau in the Financial Times followed up on his post-Trump declaration that this was the end of central bank independence. His argument in November was fairly straight-forward: 
Central bank independence is premised on two conditions. The first, and more important, is that there is a broad consensus on the goals of monetary policy. The second is that an independent central bank board, usually staffed by professional economists, can deliver those goals. The first of these conditions is broken. The second is under a cloud.
In his column Sunday last, he was much more balanced, though he was still convinced about the end of an era. Here is his take-home point:
[Central banks] became independent after a period of price instability in the 1970s and 1980s produced a consensus in many countries about what a central bank should do. If almost everyone agrees on the goal of a technically complex policy, then, so the argument in favour of central bank independence goes, we are better off in leaving the implementation of the policy to experts.
If we no longer broadly agree on what central banks should do – as is evident by Trump’s criticism or McHenry’s letter to Chairwoman JanetYellen shows – defending independent central banks becomes much harder. It is in cases like this that economic history can provide an almost invaluable lesson, which banking historians Forrest Capie and Geoffrey Wood of course took advantage of in an essay (and book chapter) in which they argue the following case: 
We maintain that central bank independence never has survived a crisis and never can. We make this point by use of economic analysis, and support it by evidence drawn mainly from Britain (because of the length of its central bank’s history) but not exclusively from there. Indeed, we suggest that there cannot really be such a thing as a truly independent central bank. (p. 379)
It is impossible to design a contract so complete that nothing ever happens to require its being rewritten, thereby letting the government of the day tame or at the least reshape the central bank. [...] Reactions to the recent crisis may turn out to be an example of that; but whether they do or not, they certainly exemplify how a crisis can thrust a central bank into the arms of its government. (p. 381, p. 384)
To support their case the draw on various episodes in history, including my dissertation crisis (the banking crisis of 1847) where post-crises governments have tended to retract the leach on which central banks have operated. I guess we will find out if the same thing happens this time. Capie & Wood's declaration that central bank independence has never survived a crisis is clearly an appealing reason to believe that this time won't be any different. 

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