Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 30 July 2018

Should Eurozone central bankers keep quiet about fiscal policy?

The Governor of the Irish Central Bank, Philip Lane, has called for higher taxes on savings and investment (property taxes). Frances Coppola, in a very clearly argued and well informed article, says this “attempt to dictate to the Government is a serious threat to Irish democracy.” Is it?

The conventional view is that there is an implicit quid pro quo between independent central banks (ICBs) and governments. Governments do not interfere with monetary policy and in exchange central banks do not suggest to governments what fiscal policy, or any other non-monetary policy, should be. It is important to note that this implicit quid pro quo has never seemed to extend to central bankers in the Eurozone, who have frequently pontificated on matters outside monetary policy, so in that context Lane’s comments are not out of the ordinary. But that does not make it right or wrong.

I have argued in the past that the situation where interest rates are at their lower bound requires ICBs to tell governments what to do, or at least say they can no longer do an effective job unless the government undertakes fiscal expansion. In that context I rather like the suggestion in a paper by Ed Balls and colleagues [1] that at the ‘Zero Lower Bound’ (ZLB) central banks should be mandated to write every three months to the government suggesting how much stimulus they think is required for the economy to get of the ZLB.

The situation for central banks in Eurozone countries is similar in the sense that cannot change interest rates (which are set by the ECB). They do, however, as Frances points out,  have responsibility for the health of the financial system in their own economies which requires macroeconomic expertise. So it seems reasonable to apply the quid pro quo to financial supervision by an ICB in a Eurozone country in much the same way it is applied to a ICB that is not in a currency union or fixed exchange rate regime.

But is the quid pro quo sensible in the first place? There is a real concern that an independent central bank might be intimidated by government politicians telling them what to do. That is understandable, as part of the whole rationale for ICBs in the first place is that their independence from politicians gives them additional credibility that they are not acting for political reasons.

The argument for a quid pro quo is that independent central banks should not abuse their authority to interfere with political decisions that have nothing to do with monetary or financial (macroprudential) policy. Let me put a counterargument that I sketched out in a different (UK) context here. While it is obvious no central banker should give advice on who should win the next General Election, that is not what we are talking about here. We are talking about issues were the central bank has some expertise.

Given that, it would be strange indeed if the central bank was prohibited from telling the government what its expertise suggested. You could see the outcry if the ICB guessed a recession was on its way, but kept that knowledge to itself and it subsequently turned out it was right. So in this case Lane would undoubtedly tell the government his views. What we are therefore talking about is secrecy. Is it best that this expertise is kept from the public so as not to embarass politicians when they ignore it? That does not sound so clever. More generally, the lesson of the last ten years is not one where governments would have made good macropolicy if only they hadn't been intimidated by central banks, but rather than in Europe central banks gave bad advice.  

I wanted to talk about this particular case because it perfectly illustrates this dilemma. Back in the early 2000s, while he was still a lowly academic, Philip Lane was one of the few public voices suggesting that the Irish Republic needed to use fiscal policy to cool down its economic boom. He was ignored, and the result was a financial and economic crash. He therefore not only has expertise but a reputation for being right on the very issue he is giving his advice about. Is it really better for Irish democracy that this advice is kept secret from the public?

[1] Balls, E, Howat, J and A Stansbury (2016) 'Central Bank Independence Revisited: After the financial crisis, what should a model central bank look like?' M-RCBG Associate Working Paper No. 67


  1. Your point is well made but there is a problem. Clearly the ECB manages monetary policy for the whole of the EZ but that does not apply to fiscal policy which, as you say, is the preserve of national banks. It seems to me that in operation you would end up with a partial attempt by some countries to play by the rules but not by others; it might well end up showing the dysfunctionalities of the EZ rather than providing useful information initially and better policy generally.

    This is an attempt to overcome one of the main problems of the EZ: the fact that there is no fiscal union. It may be a sensible step forward but it may end up emphasising the problems rather than be a partial solution.

  2. A non-economist here. Can you explain why ZLB is a problem?

  3. The paper:
    delivered at the McGill Summer School is a good bit more nuanced than the newspaper report suggests.

    Although some progress is being made in adjusting key macro metrics to reflect the wonderful Leprechaun economics idiosyncrasies of the Irish economy so as to have public economic policies that might have some tenuous relationship with reality, there is a long way to go. Using GNI* (the asterisk reflects the exclusion of depreciation of MNEs' IP assets) rather than GDP when assessing the domestic economy is a big improvement, but there is no interest in quantifying the extent of the pervasive and endemic capture of economic rents by the sheltered private, public and parastatal sectors, of the failure of competition policy and economic regulation, of the resulting excessively high cost of living and of the great fiscal redistribution required to ameliorate the impact of this rent capture on those on low and fixed incomes and of the lack of universal public provision particularly in health services.

    Like all well-behaved Irish academics and senior officials, Prof Lane has to tip-toe around these issues. He can only talk about the risks to the taxation revenues required to fund politically expedient holding solutions to the problems these issues generate - and hint at measures that might make these revenues more resilient while seeking to dampen the increasing frenzy of rent-seeking in some sectors that again threatens economic prosperity.

    In my view he's doing an excellent job. But I would counsel against drawing any inferences from a speech to a very specific, self-selecting Irish audience about the relationship between ICBs and governing politicians at the EU level or wider.

  4. By way of clarification, this article references Governor Philip R. Lane's comments on the economy as going ‘far beyond his remit’. ‘But the Governor's comments nevertheless go far beyond his remit. Tax and spending decisions are the responsibility of elected politicians, not central banks - and for very good reasons. “Taxation without representation is tyranny," as James Otis famously said.’

    It is important to note that the legislation governing the Central Bank of Ireland specifically includes the provision of economic analysis and commentary in relation to national policy development as part of our mandate. The Central Bank Act 2010 states:

    The Bank also has the following objectives:
    section 6A
    (a) the stability of the financial system overall;
    (b) the proper and effective regulation of financial
    service providers and markets, while ensuring
    that the best interests of consumers of financial
    services are protected;
    (c) the efficient and effective operation of payment
    and settlement systems;
    (d) the provision of analysis and comment to support
    national economic policy development;
    (e) the discharge of such other functions and powers
    as are conferred on it by law.

    Nicola Faulkner
    Media Relations Manager
    Media Relations │ Communications Division
    Central Bank of Ireland

  5. "Philip Lane was one of the few public voices suggesting that the Irish Republic needed to use fiscal policy to cool down its economic boom. He was ignored, and the result was a financial and economic crash."

    Cause and effect logic working overtime here. Hard to see how Ireland could have avoided being caught up in the GFC no matter what policies it implemented.

  6. When ST interest rates are at their lower bound central bankers should write to ask for permission to buy some other asset class in order to provide the needed monetary stimulus. if such permission is needed. If not needed they should just buy whatever is necessary in whatever amount is necessary to do their job. They might however include a short obiter dictum explaining to fiscal authorities that when interest rates are low is generally a good time to make expenditures on things with current costs and future benefits, that "deficits" are not reason to reduce expenditures, and not to be afraid that following this advice will look like "Keynesian" stimulus.


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