HOW CENTRAL BANKS JEOPARDIZED THEIR INDEPENDENCE / PROJECT SYNDICATE

How Central Banks Jeopardized Their Independence

The independent status that many central banks currently enjoy is a historical exception and could be reversed by a change in the political climate – as US President Donald Trump's attacks on Federal Reserve Chair Jerome Powell imply. But monetary authorities have also helped create this situation by expanding their mandate.

Otmar Issing

FRANKFURT – US President Donald Trump’s fierce attacks on Federal Reserve Chair Jerome Powell have attracted global attention, rattled markets, and, perhaps most importantly, sparked debate about the wisdom of central-bank independence – a complex issue with constitutional and economic implications.

Central-bank independence refers to monetary policymakers’ authority to make decisions free from political influence, albeit restricted to measures that fulfill the mandate established by the legislature. 

This independence would be called into question if political leaders could dismiss the central bank’s management at any time.

Some critics consider central-bank independence to be at odds with democracy, because it places monetary policy in the hands of “unelected bureaucrats,” underscoring the need for justification. 

But equating central-bank independence with judicial independence, as is sometimes done, is inappropriate. 

The legislative branch transfers authority for monetary policy to an independent institution, while the judicial branch determines, when necessary, whether this institution has adhered to its mandate.

The independent status that many central banks currently have is a historical exception. 

It was only around 1989-90 that independence came to be viewed as necessary to ensure monetary stability. Following the double-digit inflation of the 1970s and early 1980s, Western politicians began to recognize that when monetary policy is in the hands of the executive, higher and more volatile inflation is inevitable. 

The temptation to stimulate growth and employment, to the detriment of price stability, is too strong. 

Governments deliberately decided to disempower themselves.

In 1997, Gordon Brown, then the United Kingdom’s Chancellor of the Exchequer, spelled out this new consensus when granting independence to the Bank of England: “The previous arrangements for monetary policy were too short-termist, encouraging short but unsustainable booms … and higher inflation, which was inevitably followed by recession.” 

He went on to explain that reforming the Bank of England would “ensure that decision-making on monetary policy was more effective, open, accountable, and free from short-term political manipulation.”

But central-bank independence requires continued support from politicians: the legislature can revoke this authority just as it can grant it. 

And all it takes to tip the scales in this direction is a change in political opinion – brought about by a rise in populist parties, for example.

Trump’s repeated threats to remove Powell – which prevailing opinion holds is legally impossible – and appoint a successor who would conduct monetary policy according to his wishes demonstrates the system’s vulnerability. 

It is reminiscent of the early 1970s, when then-Fed Chair Arthur Burns yielded to pressure from President Richard Nixon to cut rates – one of the most inglorious eras in Fed history, culminating in the so-called Great Inflation of the 1970s. 

While one might think that this unequivocally grim outcome had settled the question of central-bank independence, Trump’s rhetoric shows otherwise.

The current debate over central-bank independence re-emerged when these institutions were at the height of their prestige. 

Tragically, monetary authorities fueled the fire by expanding their mandate into areas reserved for parliaments and governments.

After making a significant contribution to a decades-long period of low inflation and steady growth, monetary authorities were celebrated as saviors following their decisive actions in the wake of Lehman Brothers’ collapse and the global financial crisis of 2007-08. 

After all, they – together with fiscal policymakers – had prevented the world from sinking into a second Great Depression.

While the personality cult surrounding Alan Greenspan, who served as Fed Chair from 1987 to 2006, had already taken on grotesque proportions, this reverence spread across the entire central banking world. 

Global financial market players welcomed central banks’ expansionary monetary policies after the 2007-08 crisis and raised expectations about what they could accomplish, partly because of this hero worship, and partly because they were the primary beneficiaries of interest-rate cuts and bond purchases.

These excessively high expectations inevitably led to disappointment, and central banks took a serious reputational hit as a result. 

Both theory and experience have shown that expansionary monetary policy cannot increase employment and growth in the long term. 

What it can do is ensure monetary stability and low inflation – the foundations for steady growth and social justice.

By expanding their own understanding of their mandate, monetary authorities became caught up in fiscal policy and triggered inflation – precisely what central-bank independence is intended to avert. 

To be sure, the decision to implement drastic interest-rate cuts and make massive purchases of government bonds during the global financial crisis was instrumental in preventing an economic catastrophe. 

But the longer that quantitative easing continued after the acute crisis passed, and even with inflation above the 2% target, the less justifiable it became. 

Central bankers were suspected of trying to lower long-term interest rates, thereby facilitating government financing (and potentially supporting weak banks).

Around the same time, central banks were also given additional responsibilities in the areas of banking supervision and macroprudential policy, further blurring the lines between monetary and government policy. 

With their growing authority, monetary authorities become increasingly entangled in political debates.

For years, central-bank independence was taken for granted. 

But that era seems to be over, partly owing to monetary authorities’ own actions. 

The less central banks push the limits of their mandate, the less that they will put their independence at risk. 

Focusing solely on the mandate requires a certain degree of humility and constant reminders of what monetary policy can and cannot achieve.

Otmar Issing, former chief economist and member of the board of the European Central Bank, is Honorary President of the Center for Financial Studies at Goethe University Frankfurt.