The desperation of independents
Stubbornly low interest rates may mean the end of central-bank autonomy
LIKE many articles of faith, central-bank independence requires some suspension of disbelief.
In most countries the central bank is a branch of government, which appoints its top officials and sets its goals. Yet in the decades after the 1980s, when governments began giving the institutions operational independence, that faith seemed to move mountains. The shift coincided with the “great moderation” era of low inflation and gentle business cycles. Indeed, central bankers came to be seen as near-omnipotent. The 2007-08 crisis reminded the public that the monetary titans are mortal. Yet for all the criticism they have faced since then, central bankers have less to fear from frustrated politicians and angry voters than from the cold logic of low interest rates.
What is so special, exactly, about an independent central bank? Support for their autonomy emerged as a result of the counter-revolution against Keynesianism of the 1970s, and is built on two related ideas. The first is that independence is necessary to preserve monetary restraint.
Robert Lucas, a Nobel-prize winning economist, argued that when elected leaders exercise influence over interest rates, they cannot resist the temptation to loosen monetary policy in election years, accepting higher inflation as the price of lower unemployment. As people learn to anticipate this behaviour, so their expectations of inflation change. Price rises accelerate even as unemployment holds steady or rises.
To rein in inflation, monetary policy had to be depoliticised and given to central bankers who stood alone.
Independence was also intended to impose discipline on fiscal policy. In 1981 Thomas Sargent (another Nobel laureate) and Neil Wallace pointed out that central banks and governments are locked in a battle for dominance. If a central bank is beholden to the government then spendthrift politicians might become emboldened and rack up enormous debts, knowing that should markets lose faith, a dutiful central bank will step in and print money to cover the fiscal shortfall.
If, on the other hand, a central bank can credibly assert independence and commit itself to a monetary-policy target, governments might be persuaded that money-printing is not available as a backstop, and that public debt must be kept under control. In the 1970s governments ran roughshod over their central banks, contributing to the high inflation of the period.
During the great moderation, in contrast, assertive central bankers hectored their governments about the need for fiscal restraint: Alan Greenspan, then chairman of the Federal Reserve, famously persuaded Bill Clinton to drop his plans for public spending and instead slash deficits. By successfully imposing discipline on governments, central bankers hoped to avoid being captured by them.
This model of the economy has been turned on its head by the steady downward march of interest rates that began in the 1980s as a result of financial globalisation, lower inflation and expectations of slower growth. In the years since the financial crisis rates have plumbed new and extraordinary depths. This striking trend, which once looked like a macroeconomic triumph, now threatens to marginalise central banks.
It has steadily eliminated the room central banks have to cut their benchmark interest rates in order to provide an economic boost in a slump. They look anything but all-powerful: unable to generate strong growth or to return rates to normal levels after years of recovery.
Negative interest rates relax budget constraints by reducing the cost of financing government debt. New policy tools (like the authority to buy a wider range of assets or a change in mandates) would in most cases require government permission. And as asset purchases lead to larger central-bank balance-sheets, so do the potential losses to those banks from higher interest rates (and corresponding declines in the prices of the bonds they hold). Such losses would not impair monetary policy, but would open the central banks to intense scrutiny and perhaps invite populist power grabs.
Although economists remain broadly in favour of central-bank independence, the amount of new research affirming the importance of stimulatory fiscal policy is growing. The continued economic doldrums are also creating a political opening for more aggressive fiscal action. On August 2nd the Japanese government announced new stimulus measures worth ¥4.6 trillion ($45 billion) this year. Both American presidential contenders have plans that will raise government deficits, and the British government has abandoned its target of balancing the budget by 2020. Low interest rates have emboldened politicians who might otherwise have ignored the calls of frustrated voters for fear of the bond-market vigilantes.
The loss of central-bank autonomy would create risks—serious ones in places with a history of fiscal incontinence. Governments are not the deftest of economic stewards. They are often slow to respond to slumping demand. Tax cuts and spending increases can play havoc with people’s incentives, undermining the efficiency of the economy.
Yet history also suggests that central-bank submission need not lead to disaster. The period from the 1940s to the 1970s, when governments took primary responsibility for keeping economies out of slumps, was more volatile and inflationary but it was hardly Armageddon.
Demand-starved recoveries with central-bank interest rates stuck perpetually at or below zero are corrosive in their own way. The independent central bank is an impressive technocratic institution. It may also prove to be a relatively short-lived one.