Central bank independence is widely regarded as a prerequisite for successful monetary policy. However, with economies having struggled over the past decade and inflation no longer seen as a problem, that view is being contested, argues Stewart Robertson, chief economist at Aviva Investors.
4 minute read
In the 1980s governments around the world handed central banks greater control over monetary policy as they searched for a cure for rampant inflation that had plagued their economies the previous decade. Politicians’ failure to maintain monetary discipline was considered a major cause of inflation getting out of control.
For the next 30 years, the reputation of central banks in policymaking circles grew steadily around the world as greater independence was widely followed by low and stable inflation, and satisfactory growth and employment, a period that became known as The Great Moderation. Belief in their omnipotence peaked with the start of the financial crisis, when they were initially praised for preventing a depression of a similar magnitude to that seen in the 1930s.
However, it was not long before the criticism began: first of their failure to spot the crisis in advance and then of their role in bailing out banks at the expense of taxpayers. With their policies widely seen as having failed to ignite strong economic growth in the past decade, the criticism has continued to grow.
Kicking the can
For some critics, central banks’ adoption of ‘quantitative easing’ (QE) was a flawed response to the problems of recent years for two reasons. Firstly, because it is only an indirect method of pumping money into the economy and acts with a time lag. And secondly, due to its wealth-distorting consequences.
This has opened central banks up to the complaint they were not only pursuing a sub-optimal policy but one with huge societal consequences. With electorates increasingly questioning the integrity of public officials and professionals, their belief in the power of central banks appears to be crumbling.
Germany, the UK, Turkey, Russia, South Africa and Thailand are among an ever-expanding group of countries where politicians, facing voter disaffection, have attacked central banks in recent times. Last October, US President Donald Trump added his name to the list when he complained the Federal Reserve (Fed) was “crazy” to hike rates.1
Even former central bankers, such as Otmar Issing (ex-European Central Bank) and Charles Goodhart (ex-Bank of England), are openly questioning whether institutions, faced with an ever-louder political assault, can retain their independence.2, 3
From inflation to deflation
Part of the explanation for the criticism being levelled at central banks is the main economic issue confronting them has changed. Whereas in the 1970s inflation was the primary enemy, today it is the opposite: deflation, or at least too little inflation, excessive debt and weak economic growth.
Independent central banks tend to be good at fighting inflation so long as they are credible. Workers, trade unions, retailers and other economic agents soon get to learn bankers, unlike governments which are answerable to their electorates, are willing to pursue unpopular policies.
However, monetary policy has proved far less effective in fighting deflation. That is partly because of the problem of the so-called zero lower bound. Whereas central banks can raise rates without limit, monetary policy becomes far less effective as rates fall to zero, particularly if it is not accompanied by expansive fiscal policy, as the experience of many countries over the past decade demonstrates.
QE, but not as we know it
Although the warnings from Issing and Goodhart may be overly alarmist, it nonetheless seems the tide could be turning towards greater political involvement in the activities of central banks. Calls for governments to step in seem likely to intensify during the next downturn.
With interest rates unlikely to be too far from recent record lows when that happens, it could be that central banks will initially resort to deploying fresh QE. That could mean the likes of the Fed and ECB take a leaf out of the Bank of Japan (BOJ)’s book by purchasing equities for the first time. [The BOJ has an annual policy goal of purchasing ¥5.7 trillion ($52 billion) of exchange-traded equity funds]
However, given the criticism of QE, it is valid to wonder whether politicians will not view it as having reached the limits of its usefulness and, equally importantly, its democratic legitimacy. One way of addressing these criticisms would be for central banks to co-ordinate policy more closely with the government of the day. An extreme example of this could be the creation of so-called helicopter money. Perhaps more realistically, it could simply involve greater co-ordination between politicians and central bankers over fiscal and monetary policy.
Although economist Milton Friedman’s original parable envisaged central banks dropping money to individuals from a helicopter as a means of avoiding a liquidity trap, economists have subsequently used the term to refer to a wide range of different policy ideas, including the permanent monetization of budget deficits.
As with the other types of ‘unconventional’ monetary policy measures introduced in recent years, it is not without its critics. In a scathing article published in 2016, Issing warned a central bank that was “throwing out money for free, will hardly be able to regain control of the printing press”.4 One only has to think of the experience of Weimar Germany, or more recently Venezuela and Zimbabwe, to see that while inflation may have been yesterday’s problem, it could conceivably become tomorrow’s too.
While there is a risk policymakers become addicted to issuing paper money, helicopter money has potential advantages over QE. Firstly, the effects would be more direct and faster acting since it bypasses financial middle-men. Secondly, and most importantly, governments would be able to ensure its benefits were distributed in a more equitable fashion, according to their electorates’ wishes. That could either be in the form of increased spending, tax cuts, or a combination of the two.
More than credibility at stake
It is worth remembering the trend towards independence began with the appointment of Paul Volcker to head the Fed in 1979 and followed sharp contrasts in the inflation records of Germany and other leading industrial nations in the preceding years. Whereas in Germany, with the Bundesbank operating independently, annual inflation averaged five per cent in the 1970s, in the US, France and the UK – where central banks were not independent – it averaged 7.4, 9.1 and 13.1 per cent respectively.5
Under Volcker’s stewardship, the Fed raised its key lending rate, which had averaged 11.2 per cent in 1979, to a peak of 20 per cent in June 1981.6 Although the policy drew sharp criticism from the Reagan administration as it plunged the economy into recession, Volcker stood firm and ultimately succeeded in choking off inflation.
Given that history, it seems improbable – for now – that any major nation would remove a central bank’s ability to set interest rates independently of government. To do so would not only set a dangerous precedent, it would risk undermining the hard-won credibility of the central bank. And by unsettling financial markets, it could have the opposite effect to the one intended. In the present economic environment such a move might not lead to a rapid return of inflation, but in the longer run higher inflation would almost certainly ensue.
As for other aspects of monetary policy, more government involvement might be a good thing in the next downturn. While not without its risks, it is possible greater co-ordination of monetary and fiscal policy would be the most effective way to respond. If so, far from undermining the credibility of central banks, it could even restore the public’s faith in them by shielding policymakers from some of the criticism they have been hit by in recent years.
1. Trump says the Federal Reserve has 'gone crazy' by continuing to raise interest rates. CNBC 10 October 2018.
2. The uncertain future of central bank independence. Otmar Issing. VOX CEPR Policy Portal. 2 April 2018
3. Potential threats to central bank independence. Charles Goodhart & Rosa Lastra. VOX CEPR Policy Portal. 11 March 2018.
4. Former ECB Chief Economist: Helicopter Money Means Bankruptcy. Frankfurter Allgemeine Zeitung. 23 March 2018.
5. Source: Macrobond.
6. Source: US Federal Reserve.