Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday, 5 March 2016

The strong case against independent central banks

I personally think giving central banks the power to decide when to change interest rates (independent central banks, or ICBs) is a sensible form of delegation, provided it is done right. I know a number of the people who read this blog disagree. Sometimes, however, arguments against ICBs seem to me pretty weak. This is a shame, because there is I believe quite a strong case against ICBs. Let me set it out here.

In the post war decades there was a consensus, at least in the US and UK, that achieving an adequate level of aggregate demand and controlling inflation were key priorities for governments. That meant governments had to be familiar with Keynesian economics, and a Keynesian framework was familiar and largely accepted in public discourse. Here I am using Keynesian in its wide sense, such that Milton Friedman was also a Keynesian (he used a Keynesian theoretical model).

A story some people tell is that this all fell apart in the 1970s with stagflation. In the sense I have defined it, that is wrong. The Keynesian framework had to be modified to deal with those events for sure, but it was modified successfully. Attempts by New Classical economists to supplant Keynesian thinking in policy circles failed, as I note here.

The more important change was the end of Bretton Woods and the move to floating exchange rates. That was critical in allowing the focus of demand management to shift away from fiscal policy to monetary policy. The moment that happened, it allowed the case for delegation to be made. Academics talked about time inconsistency and inflation bias, but the more persuasive arguments were also simpler. Anyone who had worked in finance ministries knew that politicians were often tempted and sometime succumbed to using monetary policy for political rather than economic ends, and the crude evidence that delegation reduced inflation seemed strong.

That allowed the creation of what I have called the consensus assignment. Demand management should be exclusively assigned to monetary policy, operated by ICBs pursuing inflation targets, and fiscal policy should focus on avoiding deficit bias. The Great Moderation appeared to vindicate this consensus.

However the consensus assignment had an Achilles Heel. It was not the global financial crisis (which was a failure of financial regulation) but the Zero Lower Bound (ZLB) for nominal interest rates. Although many macroeconomists were concerned about this, their concern was muted because fiscal action always remained as a backup. To most of them, the idea that governments would not use that backup was inconceivable: after all, Keynesian economics was familiar to anyone who had done Econ 101.

That turned out to be naive. What governments and the media remembered was that they had delegated the job of looking after the economy to the central bank, and that instead the focus of governments should be on the deficit. Macroeconomists should have seen the warning signs in 2000 with the creation of the Euro. There monetary policy was taken away from individual union governments, but still the Stability and Growth Pact was all about reducing deficits with no hint at any countercyclical role. When economists told politicians in 2009 that they needed to undertake fiscal stimulus to counteract the recession, to many it just felt wrong. To others growing deficits presented an opportunity to win elections and cut public spending.

Macroeconomists were also naive about central banks. They might have assumed that once interest rates hit the ZLB, these institutions would immediately and very publicly turn to governments and say we have done all we can and now it is your turn. But for various reasons they did not. Central banks had helped create the consensus assignment, and had become too attached to it to admit it had an Achilles Heel. In addition some economists had become so entranced by the power of Achilles that they tried to deny his vulnerability.

From 2010, as austerity began, the damage caused by ICBs became clear. One ICB, the ECB, refused to back its own governments and allowed a Greek debt financing crisis to become a Eurozone crisis. The subsequent obsession with austerity happened in part because governments no longer saw managing demand as their prime responsibility, and the agent they had contracted out that responsibility to failed to admit it could no longer do the job. But it was worse than that.

Economists knew that the government could always get the economy out of a demand deficient recession, even if it had a short term concern about debt. The fail safe tool to do this was a money financed fiscal expansion. This fiscal stimulus paid for by the creation of money was why the Great Depression could never happen again. But the existence of ICBs made money financed fiscal expansions impossible when you had debt obsessed governments, because neither the government nor the central bank could create money for governments to spend or give away. Central banks were happy to create money, but refused to destroy the government debt they bought with it, and so debt obsessed governments embarked on fiscal consolidation in the middle of a huge recession.

The slow and painful recovery from the Great Recession was the result. Economists did not get the economics wrong. Money financed fiscal expansion does get you out of a recession with no immediate increase in debt. But by encouraging the creation of ICBs, economists had helped create both the obsession with austerity and an institutional arrangement that made a recession busting policy impossible to enact.

I have tried to put the argument as strongly as I can. I think it is an argument that can be challenged, but that will only happen if macroeconomists first admit the problem it exposes.



39 comments:

  1. “The strong case against independent central banks”. So we have CBs controlled by politicians? The obvious problem there is the temptation to print just before elections.

    2nd alternative is the existing one, namely having stimulus decided by two separate bodies, treasury and CB. That makes as much sense as a car with two steering wheels controlled by a quarrelling couple going thru a divorce.

    3rd alternative (nirvana): some sort of independent committee of economists, perhaps based at the central bank, which decides the size of the deficit, i.e. how much stimulus is suitable and how much of that is monetary as compared to fiscal. Meanwhile strictly POLITICAL matters, like the % of GDP allocated to the public sector and how much goes to health / education / roads etc is left with politicians.

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    1. Print just before elections? Fine. No problem.

      If the economy is depressed, that's a good move.

      If the economy is overheated, this causes inflation, and the opposition candidate wins.

      Delete
  2. That does it. No one will ever be able to take Wren-Lewis seriously again.

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    1. this was an excellent article and if you believe that then you have with not read it , or did not understand it

      the main point is not against independent central banks

      it is against government abdicating their role in fiscal response to inadequate aggregate demand

      for this i clearly DO BLAME FRIEDMAN! who consistent alleged that fiscal policy is at most temporary and effects are ultimately reversed

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    2. Daniel,

      You've overlooked my retractation of 5 March 2016 at 03:12, sent before my comment was published.

      I agree the post is against governments. But that means that its title is misleading.

      Not only because of that, the post is not excellent, but needlessly complicated.

      As for the view that fiscal policy only has temporary effects, that is entirely mainstream, cf. the criticism of the Romers against the other Friedman, namely Gerald, whichPaul Krugman fully approves of:

      https://evaluationoffriedman.files.wordpress.com/2016/02/romer-and-romer-evaluation-of-friedman1.pdf

      http://krugman.blogs.nytimes.com/2016/02/26/romer-and-romer-on-friedman/


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    3. that's the issue. By comparison, in the US the ICB knew that they could only do so much (QE) and they did plenty. But they couldn't independently force substantive investment in necessary infrastructure projects--both rehabilitation as well as new projects (e.g., the attempt to create a High Speed Rail system in the US on the part of the federal govt. fell apart in response to organized opposition by Republicans in Congress and Republican Governors).

      I don't know how much of the US's subsequent economic success in the post war period was based on all the "make work" infrastructure projects during the New Deal but it was considerable, from dormitories at universities to hydroelectric dam projects, the TVA, etc.

      So the issue is what to do when the ICBs and the national governments are beholden to policies that make no sense economically.

      I don't know what we can do.

      Prof. Wren-Lewis's argument in a recent entry about how austerity (and by extension deficit reduction) has little to do with thoughtful policy as much as it is taking advantage of any and every opportunity to execute the ideology of small government and neoliberalism. Depriving the government of money is the best way to prove the belief that government is ineffective and of course it shrinks govt. impact as agency budgets decrease and the span of activity decreases in response.

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  3. Sorry, I retract my comment "That does it..."

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    1. Interesting. But are you the 'Anonymous' who actually made the comment ?

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  4. In the U.S. context wages have been stagnant for 15 years and inequality has been rising for 40 years. This has been a failure of macro policy (monetary, fiscal, currency) and the regulation/taxation of the financial sector. Also labor unions have been neutralized. "Independent" central banks have been overly concerned with inflation. Leading up to the financial crisis, the Fed was passively tightening when it should have been loosening and asking for fiscal help. The recovery wasn't quick because the Fed tightened prematurely, again overly afraid that inflation would break out and they would be forced to raise rates quickly.

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  5. Simon, it´s not a strong case against ICB´s but a strong case against "IT" by ICB´s!
    https://thefaintofheart.wordpress.com/2013/03/29/dont-wrap-your-product-in-inflation-paper/

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  6. I think you're being too generous. Since the "revolution" of the 80s, the "consensus view" has been to restrict the scope of government action as much as possible. What was it that was said at the time - the Tory chancellor was accused of having a set of golf clubs but only allowed to use one (the base rate)? This has been organised and concerted. CB independence was just one aspect of this.

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  7. There is no logic to SWL's post. If anything it is an argument against democratically elected governments with democratic legitimacy to enforce economic policies of which he disapproves. What would abolishing central banks' independence change? To think there is a strong case cannot be deduced from this post. On its basis, there is no case.

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  8. I think it is hard to determine the relative importance of central bank independence and of the myth that stagflation proved that Keynesian economics was invalid.

    A remarkably large number of economists thought that Ricardian equivalence implies that temporary increases in public consumption and investment don't cause increased nominal aggregate demand. The fact that Milton Friedman was basically a Keynesian was not (and is not) widely accepted.

    Also, I expected you to argue again (as you have before) that a problem with central bank independence is that almost all economic expertise was reallocated from Treasuries to central banks. I thought that was a very good point and it strongly supports your current argument.

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    1. Thanks. You are right, I could have added that last point as well.

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    2. Simon, I commented on one of your blogs a couple of weeks ago: “Of still greater importance is the role central bank independence plays as a shield behind which politicians can hide. … It would be harder to justify austerity if politicians were fully accountable for making both fiscal and monetary decisions to achieve and sustain recovery.” I agree with the observation that “the existence of ICBs made money financed fiscal expansions impossible when you had debt obsessed governments, because neither the government nor the central bank could create money for governments to spend or give away”.

      The essence of the problem is the reluctance of governments to undertake fiscal expansion. Monetary expansion alongside this would alleviate associated issues of public debt but unless governments are prepared to spend (either directly or by giving money to consumers to do so) any stimulus would be muted, as we have seen with orthodox QE. As you say, “governments no longer saw managing demand as their prime responsibility” and this abdication - through incompetence, ideology or malice – delayed and hampered recovery. It also leaves us exposed to the next downturn.

      On institutional arrangements, the worries about government money printing will not go away. Perhaps the simplest proposal would be a temporary suspension of central bank independence in defined circumstances (such as a sustained fall in inflation or NGDP below a defined level). This would force governments to take back responsibility for demand management until the desired target had been attained, at which point monetary policy would return to the central bank.

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    3. Nobody should complain about government money printing. Money printing is the *job* of the government.

      If the government prints too much money, this causes inflation. This gets the government thrown out of office. Simple, effective, easy, does not require any form of "independence".

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  9. Three points:
    Central Bank Independence is actually a figleaf. The government appoints the Monetary Committee (or equivalent) and sets the parameters under which it should operate. This is quite right in a democracy. One thing we've surely learnt is that economics has not yet reached the status of engineering or dentistry in that it is sufficient to define the problem to be assured of consensus on how to deal with it.

    Second: All central banks are primarily concerned with. possibly obsessed by, inflation. Even the Federal Reserve which has (I think still) the dual mandate of inflation and (un)employment has always, until recently, prioritised inflation. This made sense in the context in which they were given independence but is completely disfunctional in today's world.

    A third point. Central Bank governors do not drop from the sky. They are mostly bound in to the finsncial structures of their countries and see themselves, often quite explicitly, as representing the financial sector. This was fine when central banks acted as an agent of the government but is very dangerous when they are given some form of independence. It will be a long time before I forgive Lord King for his call for more austerity in the run-up to the 2010 election.

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    1. On your second point, I agree to some extent, but to be fair the MPC in 2011 must be at least a partial counterexample, and the Fed also did not raise rates in 2011.

      I think your third point raises a danger, but both Bernanke and King were academics, and King was no friend of the financial sector.

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  10. Case dismissed. Costs to be borne by the author for wasting his readers' time.

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    1. I'm afraid 'magisterial' and 'entirely anonymous' isn't really a viable combination.

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    2. With due respect Your Honour, it may help if you had even a meagre understanding of the details of the argument presented by SWL, would it not?
      (See other commenters above, who actually do understand and add to the discussion with insightful points, unlike Your Honour who insists on continuously embarrassing himself).

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    3. Simon,

      The judgement is based on the merits of the case and the comments in its defence.

      Since you deny that, you will be remanded for contempt of court with the obligation to read SWL's entire blog since 2011 with all comments and then to register with the mental institution of your choice.

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  11. What's the thought on Forder (2005), which argues that CBI is objectionable simply because it's anti democratic for no clear reason other that a lack of commitment to democracy - is there a good answer to 'what makes monetary policy and any other type of policy different cases'?

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  12. China's case?
    "China NPC targets 2016 GDP growth bet
    ween 6.5 percent and 7 percent" - http://www.reuters.com/article/idUSKCN0W706Y

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  13. This a tough question. The tradition of CB independence was certainly strongly tied up with the Bank of England, which was a private institution (though dependent on the crown for its monopoly rights) until 1946. A system like the Fed in the U.S. has plenty of checks and balances that allow for control by the Congress over what the Fed does, but give monetary policy plenty of wiggle room in the short run. It seems to me that this works tolerably well - it's not like the people in charge of fiscal policy are doing a great job of it.

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  14. Another good post, which appears to me to make the case for more automatic fiscal stabilizers. For example, I would like to see unemployment insurance directly cover mortgage and rent payments (in addition to living expenses).

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  15. this is my first time reading your blog (got the link from naked capitalism - http://www.nakedcapitalism.com/2016/03/links-3616.html)

    very interesting piece, thank you for writing. i don't agree that cbs should act in tandem with governments, but i think you've got to be insane to be pushing central banks to fix everything wrong with the economy to the point where negative interest rates are becoming "normal." there is nothing normal about bleeding out your banking system. i know it's the cool thing to do to hate on banks but every country needs a banking system and it's only x-amount of time before they pass their costs onto consumers.

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  16. The question of the propriety of independence for what we call the central bank should include consideration of something perhaps taken for granted, through institutional tradition.

    If we are indeed talking about what is actually a central 'bank', then why would it need any independence from the people making monetary policy .... the monetary authority?
    It would not.
    A central bank, operating as paymaster, settlement maker and banking supervisor, should not be independent from the governmental monetary authority and the Department of Treasury, who should be making monetary policy in a coordinated and transparent public activity.
    Central bankers should not be independent from the monetary policy apparatus, and they should also never be in charge of that monetary policy apparatus.
    Let them be bankers. Let the government be responsible and accountable for monetary policy.

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  17. while I'm not convinced that making ICBs less independent would be great, one area that does concern me is that ICBs have engaged in policies that create winners & losers without any democratic control.

    10 years of ZIRP have had significant redistributional effects. Borrowers gained and savers lost out. Asset owners have benefited and as most assets are owned by the wealthy this has widened significantly wealth inequality. It has also created huge inter-generational inequality since anyone starting work now has little chance of buying a house in a major city.

    Also I have my doubts that the answer is as simple as doing more infrastructure projects. In practice almost any major project will be resisted by some people. Here in the UK how many projects can you do that won't cause major protests? HS2, Heathrow Terminal 4, Hinkley Point.

    JM

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    1. Agreed. One of the problems with the CBI debate is that proponents present a case that is reduced to macroeconomic aggregates, forgetting that any use of monetary or fiscal instruments also has distribution and other effects.

      On infrastructure, it's not just major projects that are contentious. Most people agree more housing is needed but every current proposal or project in my ward is contended: the proportion of social housing, alternative land use, parking contention, skyline, etc.

      We cannot take democratic politics out of policy decisions and just hand them over to all-seeing, all-knowing technocrats.

      Delete
  18. Tom in MN-interesting comment on automatic fiscal stabilizers and employment insurance. Robert Shiller has been talking about this recently, including insurance which would maintain wages at a similar level if a lower-paying job is taken. However, in the current "full employment" environment, will this be as effective as other forms of fiscal stimulus including sorely-needed infrastructure projects which would create more and higher-paying jobs in the first place?

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  19. The main reason for central bank independence is that if central bank decisions are politicized, the economically ignorant public will demand things which are in fact contrary to their long-term interests.

    Also, the fact that econ 101 teaches about Keynesian theory does not mean that it is broadly accepted in the field. Indeed, there are quite a lot of economists who are skeptical of the ability of Keynesian aggregate demand stimulus to have desirable effects in the long run (however, I think there are times where it is useful).

    The opposition to austerity relates to right wing dogmas about balanced budgets, and this is essentially unrelated to the role of central banks.

    Respectfully, I disagree with virtually every premise presented in this note.

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    1. "The main reason for central bank independence is that if central bank decisions are politicized, the economically ignorant public will demand things which are in fact contrary to their long-term interests. "

      Such as? Go on.

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  20. My question is: bankers are criminals because the economists are stupid or the other way around ?

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  21. That's a different way of putting the description of the CB's role. I do agree with the premise that separating fiscal and monetary policies has led to an economic schizophrenia where one side wants one thing another wants the opposite.
    I'm from Bangladesh and the CB here is not that independent, result is the government engages in a lot of print-and-spend that really fuels inflation.
    Setting the limits of CB independence will be really important to the economy if this approach is taken seriously.

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  22. What we need is a central bank for central banks, a BIS on steroids if you will.

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  23. To say that central banks think they can do the job is, think, a stretch. The EU's 3% deficit limit seems to be a factor, as has the general conservative bias against government activity in general. A certain German Finance Minister has been at the head of the austerity movement. And I seem to recall both Bernanke and Yellen noting in public that fiscal policy needs to help out to boost the recovery.

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