Central bank independence

The attacks on central bank independence are wrong and potentially damaging

Since the beginning of the 2007-2008 crisis, central banks have played a major role in reviving the economies and stabilising financial markets. They first took action with conventional measures, such as interest rate cuts, and then - given the depth and length of the crisis - they moved to unconventional ones, mainly launching QE programs and pushing interest rates into negative territory.

Such monetary policies proved quite effective, especially considering the absence of stimulating fiscal policies which left central banks as the only authorities acting to spur the economic growth. Nonetheless, their conducts eventually came into question. German officials criticised the ECB for keeping interest rates too low for too long, at the expense of risk-averse German savers; Mr. Trump personally attacked Ms. Yellen (even though for the very wrong reasons, see previous article "2. Trumponomics"); the Bank of England was disputed for its assessment of Brexit. Basically, critics of central bank independence argue that, since their actions have economic and thus political consequences, they should report to democratically elected political institutions. Even if such an argument might sound reasonable, the reasons that brought central banks to be independent should no be forgotten.

After the Second World War, in many countries finance ministers played the dominant role in setting monetary policies. At that time, the international financial system was based on the Bretton Woods regime, which established fixed exchange rates. Such a system could work only if governments subordinated other (domestic) issues to the exchange rate. In 1971, the Bretton Woods system collapsed: currencies floated and inflation soared; moreover, many countries experienced high unemployment at the same time, entering a phase of stagflation. Politicians had proved once again that they were not able to provide monetary stability, since in the trade-off between inflation and unemployment they were biased toward the latter (more sensible to voters). Indeed, history is full of periods of high inflation, and even hyperinflation, sparked by monetary indiscipline. The Bretton Woods collapse provided the ultimate push toward central bank independence.

The 1990s and early 2000s, under the influx of the "monetarist approach", were characterized by low inflation and stable economic growth, marking the success of central banks acting in full autonomy and focused on reaching specific targets of inflation. The modern monetary policies are mainly based on such concepts: in the long run, inflation is a monetary phenomenon depending on central banks’ behaviours; central banks can affect economic growth and unemployment only in the short term (they can help an economy to escape from a recession, but cannot sustain it over the medium and long run); in order to reach their objectives, central banks need to be credible in the eyes of the system, which means being independent from the political institutions that are only focused on the short term (on the next elections).

Moreover, in recent years, many other tasks have been assigned to central banks: in addition to the traditional monetary policies, they revive economies, act as banking supervisor, safeguard the financial system and play a big role in the financial assistance programmes. Firstly, it is clear that these goals are not always easy to reconcile: for instance, as banking supervisor central banks want banks to have more capital, but in the attempt to revive the economy they would like to see more lending. Secondly, the reasoning about the right level of central bank independence should refer to such extra-tasks and not to the traditional monetary policy management.

The principle to follow should be a multi-level independence. Central banks should act under clear limits for tasks like micro and macroprudential supervision, for which political control is fairly due. Instead, for the traditional tasks of setting interest rates, controlling the money supply and the other operations strictly related to the core monetary policy, both the economic theory and history have shown how full independence must be granted. The quite popular concern of having not-coordinated monetary and fiscal policies because of central bank autonomy is misleading, for the simple reason that central bankers always pursue counter-cyclical policies while that's government policies that often go in the wrong direction. In an ideal world of governments led by forward looking statesmen, monetary policy could be assigned to them. But until governments are composed by short-termism politicians, this would be a very bad idea.

2017.05.29