Refuted economic doctrines #6: Central bank independence

by John Quiggin on March 19, 2009

Here’s the latest in my series on theoretical and policy doctrines in economics that have been refuted, or at least rendered highly problematic by the global financial crisis. Mainly of technical interest, I think, but I’m posting it here to keep numbering continuous.

The idea that central banks can and should act independently of governments is, fairly clearly, inoperative for the duration of the crisis in many countries. The combination of massively increased liquidity provision and large-scale bank bailouts requires close co-ordination between central banks and national treasuries, though the form of this co-ordination is inevitably different in different countries.

But the failure of central bank independence goes much deeper than this. The underlying idea was that monetary policy should be left to independent experts, and should be the main tool for macroeconomic stabilisation. Governments were expected to avoid active fiscal policy, focusing primarily on maintaining budget balance (there were some differences in view as to whether governments should target annual balance, or balance over the course of the macroeconomic cycle). The shift to independent central banking was closely associated with the adoption (implicit or explicit) of inflation targets as the primary focus of monetary policy, and with interest rates as the primary tool.

Not much of this appears sustainable in the light of the crisis. Inflation targeting failed to prevent unsustainable asset price booms, and it now seems clear that these could not have been prevented without much more direct control over unsound financial innovations. That’s a task where interaction between governments and central banks appears unavoidable. On the one hand, expertise is crucial. On the other hand, as with war, financial innovation is to important, and too dangerous, to be left to finance experts.

The idea that monetary policy alone is sufficient for macroeconomic stability might have looked appealing during the Great Moderation, but does not stand up when examined over a longer period. To put it bluntly, central bank independence appears to work well except when it is most needed.

A more difficult question relates to the separation between monetary policy and prudential regulation. The need to take systematic risk into account suggests that monetary policy must be closely integrated with prudential policy. On the other hand, Australia, with a clear separation between monetary and prudential regulators has done better than countries where central banks are more closely involved. My feeling is that the correct separation is between strategic issues, such as monitoring of systemic risk and the regulation of financial innovations, which belongs with the central bank, and institution-level supervision, which belongs with a specialist agency.

{ 14 comments }

1

Stuart 03.19.09 at 11:34 am

Was it the independence that was the problem, or the nature of the targets the independent central banks were assigned? If the banks were instead told to balance keeping inflation low and avoiding excessive growth in personal and business debt when they set rates, would the problems have been avoided? Or maybe we think the evidence shows us that trying to control inflation with interest rates will always lead to excessive debt growth?

2

Bunbury 03.19.09 at 1:19 pm

Wouldn’t the refuted doctrine here be better described as “The sufficiency of targetting personal consumption price stability through the medium of interest rate policy with some consideration given to GDP growth as a means of achieving economic stability”?

Independence doesn’t seem to have been the problem and moentary policy doesn’t seem to have been significantly better previously or in regimes that also explicitly considered other factors. Even inflation targetting doesn’t really seem to be the culprit.
There’s mileage in arguing that it is not independence but rather too narrow a scope that is the problem. The numerous initiatives to allow banks to operate with less capital and the prevention of effective oversight are largely political decisions to hamstring central banks and are much more obvious culprits.

It also seems wrong to divide financial innovations into sound and unsound. Paracetamol is a sound medicine even if you can OD on it. It’s absolutely possible to exaggerate the importance of the novelty at the expense of the consideration of similarity to well documented earlier problems with splitting cash flows (The great crash Goldman Sachs affair and the split capital trust scandal) and more mundane banking problems with property booms (S&L crises), inability to deal with cheap money from oil or export rich countries (Latin American debt banking crisis and the previous time monetary policy was bent to bail out Citi), the perennial attractions of undercapitalised banking (LTCM) and the even more prevalent difficulty of ensuring that accounts recognise income at the same time as costs. The failure of gaussian copula CDO pricing models to control all these repeat offenders and other banking staples is unsurprising and serves mostly as a distraction.

3

Anderson 03.19.09 at 3:03 pm

Great moniker, Bunbury — wish I’d thought of that.

4

Kathleen 03.19.09 at 3:23 pm

It seems to me this refutation makes the assumption that there are three autonomous actors — the private sector, the central bank, and the public sector / government — and that recent events have shown that the central bank should be, in many ways, less autonomous and more allied with the government than independent.

I’m not sure this describes recent events very accurately, at least in the United States. It looks to me as though after attempting — and failing — to capture public sources of revenue via privatizing social security (this method would have required — and did not achieve — some kind of democratic consent on the part of the people), the private sector has managed to seize outright sacks of public money by more or less holding a gun to the head of the public sector / government (and by having many of its operatives in key positions in the public sector/government).

I don’t think, then, a key problem is the lack of independence of the *central bank*, solvable by closer alliance to the government. Instead it seems to me that the real problem is the lack of genuine independence of the *public sector/government*. If the public sector/government were truly autonomous, conditions would be such that the the central bank could be, too.

But I am not an economist; perhaps I misunderstand.

5

spencer 03.19.09 at 5:08 pm

The Federal Reserve is not independent of the government.

It is independent within the government.

6

jim 03.19.09 at 5:26 pm

Spencer’s _mot_ deserves some unwrapping.

At least in the US, the Federal Reserve has a great deal of formal power, but it doesn’t have much money. The Treasury has a great deal of money, but very little formal power. If the two cooperate (in practice, if the Chairman of the Fed and the Treasury Secretary agree that an action needs to be taken) then the Treasury can supply the money (it makes a “special deposit” with the Fed) and the Fed take the action.

But if the two disagree, then action is prevented — or the Treasury tries an end-run around the Fed by asking Congress to give it the powers that the Fed refuses to use on its behalf, which us what gave us the TARP.

7

Tracy W 03.19.09 at 5:37 pm

The main argument for central bank independence in NZ at least is that the Government (as in the political party in power, not the government which is the continuous operation that does things like hiring the police) has an incentive to use monetary policy to try to make the economy look good to voters (as inflation increases monetary incomes), leading to a general rise in inflation over the decades.

Nothing in the crisis so far refutes that worry.

8

Ed 03.20.09 at 1:15 am

The the US, a cooperative Federal Reserve has used monetary policy to make the economy look good to voters (as inflation increased asset prices), leading a general rise in inflation (not called that because it mostly affected assets that were left out of the CPI calculation) over the decade.

From here, I’m not sure what central bank independence has accomplished in practice other than further diffusing accountability, politicians have another person to blame when things go wrong. There are actually quite a few examples of central bank policies creating inflation.

Suppose an elected government directly set monetary policy, and elected governments consistently pursued inflationary policies for short term electoral gains. Wouldn’t the voters catch on eventually? Political parties have won elections on anti-inflationary platforms, notably the Conservatives in the UK.

Also we have parts of the government bureaucracy that are supposedly independent enough to not constantly make wrong-headed decisions to keep the ruling party in power, some examples include various park services, weather bureaux, the military in some countries. But these are not structured around independent boards only partially appointed by politicians, serving lengthy terms. There are lots of parts of the government where a senior bureaucrat can be removed by an elected politician, but manage to act in a non-partisan manner.

9

Tracy W 03.20.09 at 9:17 am

Ed – I was not aware that the US Fed was formally independent in say the way that the NZ central bank is. Yep, independent central bank policies might create inflation, figuring out the proper method of inflation targetting is a problem. In NZ the central bank and the Government of the day agree a target for monetary policy, so it is flexible in that sense. The Government of the day could set a target for monetary policy that allowed for considerable inflation, the idea behind central bank independence is that the Government however would have to be explicit that that’s what it is doing, and it’s hoped that that would be enough to prevent the Government from manipulating the monetary supply secretively. (When I say “Government” I mean the politicians in power at the moment, “government” means the whole institution, including the poor constable plodding the beat in some remote part of the country).

Wouldn’t the voters catch on eventually? Political parties have won elections on anti-inflationary platforms, notably the Conservatives in the UK.

Yep, that’s part of why in NZ we have an independent central bank – as a reaction to continual and generally rising inflation from the 1960s through to the 1980s. The fear of the policy advisors and politicians at the time was that once memories of high inflation had died down amongst voters future governments would be tempted to return to inflation as a tool for getting out of trouble, and an independent central bank is an attempt to reduce the chances of that happening.

Also we have parts of the government bureaucracy that are supposedly independent enough to not constantly make wrong-headed decisions to keep the ruling party in power … But these are not structured around independent boards only partially appointed by politicians, serving lengthy terms.

How are judges appointed? From memory, in NZ, judges are appointed by politicians with the advice of the Law Commission but they serve lengthy terms (basically until they retire I think), and cannot be removed by the Government of the day.

There are lots of parts of the government where a senior bureaucrat can be removed by an elected politician, but manage to act in a non-partisan manner.

I think this depends on the government in question. I do not understand the details of the USA system, but in NZ there is a variety of responsibilities by bureaucrats. The core public sector is required to implement what the Government of the day wants, independently of their own opinion (the logic is that the Government is elected by the people of NZ), but the judiciary is far more independent, for example Ministers can’t make day-to-day orders to the police about who the police investigate, and the judiciary even has a role in reviewing the policies of the Government of the day (they can’t overrule Parliament however, which is distinct to the Government), the Electoral Commission which runs the general elections is very independent, and so forth. Perhaps the Americans do get along better without any formal independence, though the mess of the vote counting in the 2000 US Presidential election, compared to the relative lack of fuss in the 1993 election in NZ does make me think that there’s something to formal independence.

Central bank independence may not work in the long run – in NZ we have been through relatively few electoral cycles since it started, and a lot of voters still remember the high inflation of the 1980s, including most politicians in power. Perhaps when those memories fade a Government that wishes to inflate its way to an election will be able to just change the policy targets agreement to do so. But judicial independence has a long history politically, so I don’t think that central bank independence is doomed to failure.

10

Martin Bento 03.20.09 at 9:30 am

I proposed this as another refuted theory in the original thread. (see comment #73). Would be nice to get a shout out.

Jim, as I understand it, the Fed has all the money in the world, as it issues money. That’s how it came up with 4 trillion or so in loans with no major cooperation from treasury. What it doesn’t have are tax revenues, so it is really “just printing money” when it acts independently of the treasury: refuted doctrine #7 “Just printing money” is always and everywhere a disaster.

11

Tracy W 03.20.09 at 1:23 pm

refuted doctrine #7 “Just printing money” is always and everywhere a disaster.

Whose doctrine was this in the first place? About the only group I know who adopt this as a doctrine is the “gold standard” advocates, who whatever the merits of their arguments, are not exactly the economic or policy mainstream. And are any countries in the world still on a commodity currency, rather than a fiat currency?
Now, the idea that “hyperinflation is always and everywhere a disaster” would be a more plausible doctrine. But that’s an argument you haven’t even tried to refute.

12

Barry 03.20.09 at 1:35 pm

“Just printing money” is always and everywhere a disaster.”

The ‘always and everywhere’ is a steal from Milton (doesn’t look so good now) Friedman’s comment about inflation, isn’t it?

13

Tracy W 03.20.09 at 9:58 pm

I have failed to memorise Milton Friedman’s entire works, but his famous quote was “Inflation is always and everywhere a monetary phenomenonn, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.”.

I do not know whether this hypothesis has been disproven, but regardless of its truth or falsity it’s a rather different statement to ““Just printing money” is always and everywhere a disaster.” (Hint for the hard-of-thinking, the word “disaster” and the phrase “just printing” don’t occur in Milton Friedman’s comment).

14

Martin Bento 03.21.09 at 11:01 am

Tracy, by “just printing money”, I did not mean simply having a fiat currency; I meant monetizing government debt. Given that my context specifically said that the Fed is just printing money when it acts independently of the Treasury and its tax revenues, I don’t see how you can think I’m talking about metalism – the currency is backed by a metal or it is not, but whichever it is remains the case whether the Fed acts independently of the Treasury or not. If you’re going to spew snark about the “hard of thinking”, at least try to keep up. Let me spell this out: there are three basic ways the government can pay for its spending: 1) it can pay out of revenues – in modern days, mostly taxes, but also tariffs and whatnot. 2) it can borrow the money by issuing bonds, and 3) it can “just print” the money, meaning to expand the monetary base and pay with the newly-minted money. The last option in the US system is achieved somewhat circuitously, by having the Treasury issue bonds and then having the Fed purchase and retire them. Or it would be so achieved if this were ever done. The Fed has an official policy of never, ever doing this, which supports my contention that there is an economic doctrine against it. After all, it would be awfully strange for the Fed to forswear such a thing if all the economists thought it was just a dandy thing to do. Now, the Fed has just announced that it will be buying a huge amount of US Treasuries, but the assumption is that it will eventually, in keeping with its stated policies, sell them again (see the recent Krugman on this), so there will still be no permanent monetization.

Then there’s this exchange:

… But these are not structured around independent boards only partially appointed by politicians, serving lengthy terms.

How are judges appointed? From memory, in NZ, judges are appointed by politicians with the advice of the Law Commission but they serve lengthy terms (basically until they retire I think), and cannot be removed by the Government of the day.

Apparently, you didn’t understand Ed’s comment either. When he said boards “only partially appointed by politicians”, he was referring, I take it, to the FOMC, the governing board of the Fed. “Central Bank Independence” in the US entails somewhat more than in NZ, judging from your account of the latter. There are a set of regional Federal Reserve Banks, and these are private institutions in which the member banks own stock. The Federal Open Market Committee (FOMC) calls the shots at the main (government) Fed, and its membership consists partly (slight majority) of government appointees and partly of representatives of the (private) regional Feds. It would be like Big Pharma appointing people to board of the FDA, or Big Media to the FCC.

For such a system to be even arguably justified in a democracy, one has to assume that the banking interests are very committed to serving the public interest over their own, and not willing to use their power to influence political matters. The first would seem to contradict the premise of Capitalism, and the latter is refuted by the actual history of the Fed. Greenspan constrained Clinton’s spending plans in the name of fiscal restraint, but he did this to none of the 3 Republican Presidents he served under before and after Clinton, though he did criticize Bush 1. Burns stimulated the hell out of the economy to get Nixon re-elected, setting off the inflationary problems of the 70s a year later. To be fair, Burns is often cited as a case in point against politicians pushing Fed chairman around but 1) obviously, if Burns was pushed, central bank independence does not prevent pushing 2) Burns was a longterm Nixon friend and appointee, so it’s not clear he actually needed pushing, and 3) No one seems to think Greenspan was pushed, so pushing does not seem a necessary element.

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