Do we need Central Bank independence?
“[Should Bank of England] get behind Britain instead of deprecating our nation and continuously weakening our bargaining stance?”- This is the question that a member of the BBC audience asked Jacob Rees-Mogg, a Conservative MP. Such complains about the Bank are hardly new- Mr Rees-Mogg himself complained about the Bank’s decision to publish a report that contained unpleasant predictions about Brexit last year. His main point was that the Bank is no longer independent and apolitical. Consequently, there have been doubts about the technocratic nature of central bank’s (CB) decisions.
This is hardly new when someone looks at the history of central banks. On the other side of the ocean, there is the libertarian wing of the Republicans who have been uneasy with the Fed for a long time. Ron Paul — one of the chief libertarians in the party — has long called for limiting Fed’s power, partly by returning to the old gold standard. This skepticism is not limited to professional politicians: Alan Greenspan, the most famous central banker of his time, wrote a PhD thesis arguing against central banks.
And there are good reasons why bank’s actions should be under constant scrutiny from both the Parliament and from the Public. The efficiency of its monetary policy has been questioned: Philips curve- the model that describes the inverse relationship between unemployment and inflation- is gradually losing its empirical character. In essence, the curve shows that by controlling inflation one can credibly control the effect of monetary policy on unemployment. This was one of the reasons for establishing central banks, and as Philips curve becomes less accurate, the necessity in banks disappears with it.
At the same time, CBs are reaching the lowest possible levels of interest rates. This bound, called zero lower bound, makes traditional instruments of central banks inefficient and forces them to shift into more unconventional ones like quantitative easing- buying government bonds, typically on the secondary market- and direct asset buying. This leads to another problem- the redistributive nature of many of banks’ decision, especially quantitative easing. Indeed, some economists have expressed doubts whether CBs work is as technical and apolitical as they claim. Their decisions regarding interest rates have an impact on asset prices; it has been argued that the extended period of low-interest rates has hurt the young people disproportionately by incentivising others to invest in housing markets and drive up the housing prices.
Meanwhile, the Bank of England faces an additional challenge — Brexiteers complain that Bank’s negative reports about Brexit weakens the UK’s position and creates unnecessary fearmongering. In an LBC piece, Nigel Farage echoed Rees-Mogg’s criticism. Highlighting Gove’s “enough of experts,” he alluded that Bank of England’s mistakes in post-Brexit predictions is especially irksome.
However, so far, the ball has been on central banks’ field. One of the key reasons for establishing central banks was to prevent governments from increasing the money supply. This is especially the case in democratic states where the government would want to boost the economy temporarily to gain electoral advantage. So far, CBs have been able to control inflation successfully despite the occasional attempts by governments to pressure them into laxer monetary policy. Studies show that independent and risk-averse central banks are able to reduce average inflation and decrease political business cycle. In fact, so much so that they might have become the victims of their own success- part of the reason why Philips curve relation has become so much weaker is that central banks have been able to persuade markets that they would be able to control inflation. The following graph, taken from Alesina and Summers’ paper, shows the relation between inflation and central bank independence in several developed economies. It can be seen that, indeed, as central bank becomes more independent the average inflation decreases.
Controlling inflation is crucial since it provides an anchor for investors and government may not be able to do that when it is necessary for some political reason. In the 1980s during rampant inflation, the Chairman of the Federal Reserve Paul Volcker was able to tame it by tough and unpopular monetary policy. Similar to Brexit it provided a political backlash against the central Bank. The heat reached the point where Reagan declared “Do we really need the Fed?”. Sometimes hard choices are necessary, and governments may not be able to implement them.
Anchoring is essential, but it relies on the central bank’s ability to analyse markets independently of government influence and provide an island of sanity and consistency in a quickly changing political environment. And here is where Brexiteers misrepresent the Bank of England’s intentions. To be able to control inflation the Bank has to speak up on factors that are the most likely to have significant effects on macroeconomic variables. While Mr Mogg’s comment that the Bank should not have commented on Brexit might seem plausible, within the broader economic community, many have argued that Brexit would have an enormous impact on the economy. It would be an equivalent of ignoring the elephant in the room.
When questioned by Rees-Mogg to explain why Bank of England did not comment on Corbyn’s policies Mark Carney, the Governor of the Bank of England, just said, “I don’t think it’s worth a reply”. Central bankers need to be careful — while the intellectual argument is still in their favour, in the new age of feelings political victory might be more critical than an economic one.