Some expressions have a nice-sounding ring to them because they evoke certain values or historical events, but when applied as technical terms they sometimes carry more weight than they can bear and end up causing confusion.
The “independence” of central banks is a case in point. The expression seems to invite the presumption that it is self-explanatory and means that central banks are free to set their own goals and use whatever instruments they deem appropriate to attain them without any direct intervention on the part of the government.
Over the past two centuries, the relationship between central banks and government has seesawed between overbearing intervention on the part of the latter and extensive freedom on the part of the former. In the 19th century, when economic liberalism was in vogue, prices were stable and the gold standard prevailed, central banks could spread their wings. But when economic crisis struck after World War I, governments looked directly over the shoulders of the central banks.
They regained some of their independence when the economies stabilised again, only for interventionist approaches to reassert themselves in the aftermath of World War II. Then, the 1970s occasioned a shift in the opposite direction again towards the rule of the free market and a determination to restrict government powers to financing their expenditures by raising public deficits.
The central banks won back their immunity to automatic government borrowing with their potentially inflationary effects.
Traditionally, central banks have two functions. The first involves managing monetary policy with the aim of achieving stability and keeping inflation under control. The second entails supervising and regulating the banks with the aim of ensuring banking stability.
Some central banks are additionally charged with tasks related to driving economic growth. The theory goes that when they are allowed to operate independently, the central banks can perform such functions more effectively: monetary policy is better at controlling inflation, and the banking system enjoys greater credibility.
You would be hard put to find anyone who takes issue with the need for central bank independence in order to ensure the proper oversight of the commercial banks, even after the central banks’ regulatory functions expanded following the 2008 global financial crisis. However, you will find very differing opinions on matters related to monetary policy and whether central banks should be left to conduct monetary policy on their own.
Proponents of central bank independence point to successes in bringing down inflation in countries whose central banks enjoy considerable freedom to deploy such monetary tools as discount rates, the setting of reserve ratios, and money supply controls. They cite the experiences of the German Bundesbank before European monetary union and of the Bank of New Zealand and the Reserve Bank of Australia.
Some enthusiasts have invented a gauge according to which central banks can set “records” for independence. This relies on a number of indexes, such as legal powers (the authority that central banks have under domestic laws to set their aims and deploy fiscal instruments), the nature of the banks’ ownership, governance (i.e. how the governor and board of directors are elected and their terms of office and eligibility criteria), and transparency and accountability (who the central bank report to and the oversight mechanisms they are subjected to).
But is it true that the independence of central banks is the key to improving monetary policy, especially when it comes to developing nations? An answer to this question needs to address three main issues.
First, what is the purpose of central bank independence? If the aim is to keep down inflation on the premise that the bank’s legal independence will automatically achieve this goal, the logic is reductionist and empirically groundless. Inflation in developing countries is not just a monetary phenomenon, and giving a central bank the freedom to manage the money supply in order to rein it in, is unlikely to work on its own.
There are structural factors that contribute to driving up inflation, and these require close coordination between the government and the central bank in order to establish the appropriate monetary policy and the relationship between monetary policy and fiscal policy, even if the bank retains the prerogative of identifying the right tools to achieve monetary policy aims.
Second, is independence an end or a means? Reading some writings on the subject, one gets the impression that central bank independence is an aim in and of itself, as if the central bank is reeling under a tyrannical government and it is up to it to sunder the shackles and plant the flag of independence.
The fact is, however, that the main aim of central bank autonomy is to safeguard its decision-making, of an inherently technical nature, from political meddling. Short-term political ends must not be allowed to influence decisions whose primary aim is to achieve financial and monetary stability.
Governments should also not have the capacity to order unrestricted borrowing if inflationary deficit growth is to be kept in check. Central bank autonomy is also a means to strengthen credibility, which helps the central banks to achieve their ends.
Third, how does central bank autonomy and credibility achieve the aim of keeping inflation under control? The answer is contingent on the actual application of the extensive powers vested in the bank. It goes without saying that one of the foremost prerequisites is that the bank must be staffed with people with the highest qualifications relevant to the nature of the vital and meticulous work required of them. It should also be borne in mind that it takes considerable time, effort, and investment to develop qualifications of this sort, which are also difficult to replace if lost.
In terms of practice, central banks have become overly dependent on various evaluative and forecasting models that have not been updated. Monetary authorities in the industrialised nations have also encountered formidable problems in steering monetary policy through the available alternatives, with this casting a shadow over their credibility.
This reached embarrassing proportions in the US recently, where officials swung back and forth over whether post-Covid-19 inflation was a temporary phenomenon or a more enduring one that required prompt and decisive intervention to contain it. Unfortunately, when the intervention did come, it came too late and only after huge amounts of cheap money had been poured into the economy to help people cope with the economic impacts of the pandemic.
One of the most commonly cited justifications for granting central banks independence is that this is a way to relieve governments of pressures that might cause them to yield to demands to print more money despite the inflationary effects. Ironically, however, when the last economic crisis struck, the central banks stepped in in ways that exceeded their role as “the lender of last resort” and ended up becoming the first resort for direct and facilitated and non-facilitated credit, short-term instruments to attract hard currency, and long-term loans.
An important book came out a few weeks ago by the UK economist Stephen King called We Need to Talk About Inflation. It addresses concerns over the expansion of the work of central banks beyond their customary functions of ensuring monetary stability and a sound banking system into realms such as financial stability in general, full employment, green financing and, in the case of the European Central Bank, protecting the Euro as a political project as opposed to a purely economic one.
As King points out, as important as such aims are, there is no guarantee that they can all be achieved at the same time by a single agency.
Moreover, given that the scope of central banks’ activities now overlaps with that of governments, is this not cause to reconsider the rules relating to the banks’ governance? Can we say they are still truly independent in terms of their actions to combat inflation, for example?
This was the subject of a voluminous work by former deputy governor of the Bank of England Paul Tucker called Unelected Power, and it prompts us to ask whether the major central banks’ interventions in the global financial crisis were actually intended to serve the public, or whether they were swayed by value judgements of their own. This led them to rescue banks from going under during the crisis using “whatever it takes,” as then President of the European Central Bank Mario Draghi famously said at the time. As it turned out, it took even more than had been envisioned of sacrifices.
Former governor of the Reserve Bank of India Raghuram Rajan raises another issue with regard to US monetary policy, which has long been inclined to keep interest rates down, but then suddenly notched them up after a period of quantitative easing. One result of this was that four US banks crashed one after the other due to long-term investments in low-yield bonds funded by short-term deposits most of which were uninsured.
Rajan lays the burden for this on what he terms the “separatists” in the central banks, referring to those who separate monetary policy from its effects. Examples of this include ignoring the political effects of monetary easing or the effects of restricting liquidity and credit in order to fight inflation or how the central banks’ swings between open-handedness and close-fistedness have often wreaked havoc that has spread from the money markets to the economy as a whole and has affected people’s standards of living.
Clearly, there is a need to review central bank governance in view of the considerable powers granted to the officials of these banks, all of whom are unelected. Tucker’s recommendation regarding prudent delegation should be seriously considered. One way of doing this involves agreeing on a specific area of delegated responsibility and ways to gauge efficacy and credibility in fulfilling it. Another suggestion is to create a team of experts delegated to ensure that a central bank performs its duties in the framework of its powers and the practical and institutional independence granted to it.
Measures of this sort would prevent central banks from acting in ways that exceed their remit, thereby affecting areas that should be the subject of public choices, as would be the case with decisions that create obligations that end up skewing the distribution of wealth, hampering rights, or affecting the political balance of power in society.
* This article appeared in Arabic in Wednesday’s edition of Asharq Al-Awsat.
* A version of this article appears in print in the 1 June, 2023 edition of Al-Ahram Weekly