Concerns are rising that central-bank independence is at risk, already curtailed by governments eager to control all other levers of growth. The Japanese government’s none-too-subtle strong-arming of the Bank of Japan is one of the most blatant examples (e.g. King 2013).
But the current debate on the risks to central-bank independence misses the point.
Central-bank independence has already been compromised by the financial crisis and by recession. The issue is not independence de jure (there has been little change there); the issue is independence de facto. Central banks do not act in a vacuum. The financial crisis has caused ‘mission creep’, forcing a number of advanced country central banks to venture into uncharted territory: they have massively expanded their balance sheets, accepted collateral of longer maturity and increasingly dubious quality, backstopped government bonds, and tried to direct liquidity into specific markets. The Fed has underwritten both the mortgage market and the government-bonds market; the ECB has stepped in to both protect and discipline high-debt countries; and the Bank of England has a launched a ‘funding for lending’ scheme to boost credit.
Victims of their own success
Yet, even as they have done a lot more than ever before, central banks have acted consistently with their mandate – that is, to avoid an economic collapse that would have sent both employment and inflation well below target. Their contribution has been invaluable, and in a way central banks are now victims of their own success: monetary policy is increasingly seen as the easy solution to all problems. And if monetary easing alone can boost GDP growth back to higher levels, why should governments take tough measures now if they can simply wait for the return of better times?
Central bankers are well aware that monetary policy alone is not enough. Monetary policy cushions real adjustment and helps spread it over time, but the real adjustment does need to happen. The ECB has been explicit about this, making purchases of government bonds subject to policy conditionality. The Fed has been softer but has never stopped reminding us that fiscal and structural policies need to do their part.
No room to manoeuvre
The problem is not that central banks are losing their independence, it is that their room for manoeuvre is being eroded by lack of progress on structural reforms and fiscal adjustment. After trying every trick in the book – and then writing some new chapters – the Fed still faces unemployment at nearly 8%. At the January Federal Open Market Committee meeting, Fed officials put on a brave face, noting that the fourth-quarter GDP contraction was due to temporary factors and that the underlying economy continues to gradually improve. This is all true, but for all that improvement they could only restate their commitment to keeping a long term ultra-loose monetary policy stance. The longer this goes on, the greater the risks of economic and financial imbalances and the harder it will eventually be to unwind extraordinary stimulus, the raising of interest rates and stepping out of mortgage and government bond markets (Taylor 2013). But unless fiscal policy helps, the Fed’s options are limited.
A game of chess
Central banks and governments are constantly sparring in a policy chess game – analysed by a long-standing game-theoretic literature. It’s a game where both players employ threats, signals and commitments. It is also a game where one or both players can turn out to be less than fully rational, at least in the strict economic sense.
Central bankers are subject to pressures from governments. But even if they were not, even if central banks where run by benevolent dictators who could refuse to pick up the phone when the government calls, they would still have to factor the government’s policies in to their own decisions.
It is hard to point to a move by one of the major central banks over the last few years as determined by government interference. Central banks' decisions have been driven first by a desperate desire to avert catastrophe. Then they’ve been aimed at fostering an economic recovery while desperately hoping that governments will do their part. I do have concerns on whether some central banks are pushing loose monetary policy beyond the point of rapidly diminishing returns, understating the risks. The Fed is a case in point. But similar concerns are voiced within the Federal Open Market Committee, and in the end the Fed is following its own assessment of risks and benefits, not following orders.
In the case of Japan, the weak growth performance and the previous strong appreciation of the exchange rate in real effective terms should suffice to justify monetary stimulus – at least when benchmarked against the Bank of Japan’s peers. In this light, the Bank of Japan’s announcement that it will target inflation at 2% (in line with other major central banks) and that it will start outright purchases of government bonds only one year from now could actually be seen as passive resistance to political pressure.
Pressures on central banks
Where central banks may find their hands tied is in the unwinding of this massive monetary stimulus if governments have not made progress in their own backyard. The Fed will eventually need to offload gigantic holdings of Treasuries and mortgage-backed securities, after having been the dominant buyer in the market for a long time. We all hope it will be able to do so smoothly, but it would certainly help if the reduction in the Fed’s demand is accompanied by a reduction in debt supply thanks to greater fiscal prudence. If the fiscal position remains on an unsustainable long-term path, the Fed will be forced to choose between two evils: tighten policy and cause a recession, or accommodate and allow higher inflation. Similarly in Europe, unless momentum on reforms at the national and EU level accelerates, the ECB will eventually have to choose between bailing out undeserving governments and risking another surge in Eurozone disintegration risks. Both banks may end up being accommodating, but this would be choosing the lesser evil in response to government inaction, not following orders.
I am not arguing that central-bank independence is irrelevant. On the contrary, the fact that in normal times central banks can pursue prudent monetary policy rather than serving as daily lenders of last resort is extremely beneficial. The fact that central banks, armed with deep professional expertise, can publicly advise and criticise governments contributes to a more informed debate and better policymaking. Having qualified professionals directly in charge of a key area of economic policy is reassuring, just as you would want doctors in the hospitals even if it’s politicians who design the national healthcare system. Central-bank independence should be preserved.
But central-bank independence is powerless against fiscal dominance, and this is the true problem we face today. Instead of fretting about whether central-bank independence is on the way out, perhaps we should discuss whether any part of fiscal policy could similarly be delegated to a qualified independent agency.
King, S (2013) “Era of independent central banks is over”, Financial Times, January 10.
Taylor, J (2013) “The Fed policy is a drag on the economy”, The Wall Street Journal, January 28.