The Central Bank Independence

Central bank independence is a hot topic right now.  Two obvious themes are in play.  First, should central banks always be independent?  Second, are the supposed threats to independence widespread?

On the first topic, Izabella Kaminska offers this:

Nowadays, the idea of not having an independent central bank is seen as being a bit backward. One could even say that central bank independence is widely accepted as the optimum set-up for any country’s monetary system, a reflection of its developmental status.

“Independent central bank? Check.”

“This country must be civilised. ”

Yet, can we really be so absolute about the matter?

In Raiders of the QE surplus — a post that challenged the controversy regarding the UK Treasury’s so-called raid of Bank of England surpluses — David and myself proposed that central bank independence must not be treated so resolutely. We argued, in fact, that any central bank’s status should be determined by the economic context it finds itself in.

I tend to agree.  I don’t recall there being an Eleventh Commandment to the effect of “Thou shalt always grant independence to the monetary authority.”  Ultimately, the central bank serves the public, and the latter only grants independence if the former is adequately meeting the needs of the public.  In other words, central bank independence is ultimately tied to job performance.

With this in mind, note this Reuters piece by Leika Kihara:

Abe had run his campaign with a relentless focus on economic policy and had called on the Bank of Japan (BOJ) to take drastic steps to end the nation’s long bout of deflation, or else face a radical makeover at the hands of parliament.

The vote had become an unexpected referendum on the BOJ itself, and the bank had lost.

Senior officials concluded that to preserve the BOJ’s scope to act in a future crisis, it needed to move quickly to show it recognized reality, according to people familiar with the hurried deliberations. Abe had won a mandate for more forceful monetary easing, and Japanese taxpayers were frustrated with an economy slipping back into its third recession in five years.

Kihara suggests that what many perceive as the loss of independence is the Bank of Japan’s response to the will of the people:

“The LDP’s win was just too big, and it won an election calling for a 2 percent inflation target. If that’s the will of the people, the BOJ must respect that,” said a source familiar with the central bank’s thinking. “Otherwise, the BOJ could lose everything, including its independence.”

The counterargument is that the Bank of Japan is fooling itself; a response to political pressure, by the fiscal authority or the electorate, is simply a loss of independence.  More accurate, in my opinion, is that the Bank of Japan is choosing the avenue of least restraint – either willingly acquiesce to political pressure and retain some modicum of self-respect, or suffer the humiliation of have their independence seized from them by legal decree.  Can’t blame them for taking the first option.

Gavyn Davies responds to charges that other central banks are losing their independence, coming to the opposite conclusion:

It seems to me that this is a very premature conclusion. While there is no denying that this is indeed the objective in Japan, the direct opposite seems to be happening in the rest of the developed world.

Davies’ first point is:

First, it is argued that the central banks are now operating far outside the realms of traditional monetary policy, and have crossed the border into territory that has always been deemed to be clearly “political” in western democracies….I would point out that none of the recent actions of the central banks, including the 2008 bank rescues and the subsequent credit easing, have been contrary to the wishes of elected officials, such as the US Treasury secretary, the UK chancellor, or a clear majority in Congress. As a result, there are very few signs that the political process sees any urgent need to re-assert any control over central bankers in these areas. Obviously, this could change if central bankers were to become more hawkish in ways that could prove politically unpopular, but to date there is little sign of that happening either.

Indeed, one can argue that, aside from the Bank of Japan, the last few years have strengthened the notion of an independent central bank (I made an argument to that effect here regarding the European Central Bank).  And notice were Davies ends up – in the current environment, the lose of independence is most likely to come from being excessively hawkish.  With inflation low, some elements of Congress might publicly lament about runaway monetary policy, but few would actually take the chance of derailing what recovery we have by undercutting the central bank in the pursuit of tighter policy.

Davies’ second point:

The second reason given for the inevitability of political control over the central banks concerns the relationship between fiscal and monetary policy….politicians will “order” the central bank to expand the monetary base to finance the budget deficits. This will hold down the public debt ratio, and if it causes inflation to rise, that might be a welcome side effect….This has now happened in Japan, but it has taken a full two decades of failing economic activity to get there. And while the outcome in Japan will presumably have powerful effects on opinion elsewhere in the world, the current situation is a long way from fiscal dominance over the central bankers.

Again, the key is “failing economic activity.”  If central bankers can’t or won’t due their jobs, they will lose their independence, period.  Davies then points out something that is often missed:

In the US, for example, the Fed has, entirely voluntarily, announced an open-ended programme of bond purchases, which will be continued until unemployment falls substantially. Furthermore, the Fed chairman has hinted that he thinks that, for a while, fiscal policy should be more supportive of economic activity.

I made similar comments to Pedro DaCosta at Reuters, although I think more forcefully.  Congress and the President are remarkably tone deaf with regards to the message from the Federal Reserve, which is essentially “issue as much debt as you want; we won’t stand in the way as long as inflation is under control.”  Federal Reserve Chairman Ben Bernanke has opened the door to implicit cooperation, but fiscal authorities remain afraid to enter.

Which brings me to Greg Ip, who argues against the platinum coin because it would infringe upon the Fed’s independence (and I thought I was going to make it through the year without writing something on the platnium coin).  How he gets there is interesting.  Ip first argues that the platinum coin and the subsequent (although not immediate) increase in the monetary base need not lead to an increase in inflation as long as the Fed has the ability to control interest rates:

…in 2008, Congress gave the Fed authority to pay interest on reserves.  Because banks should not lend reserves to each other for less than they can get from the Fed, this restores the Fed’s control over interest rates regardless of the size of its balance sheet, and thus over inflation…What this means is that while the platinum coin option expands the Fed’s balance sheet and, ultimately, the monetary base, it has no implications for inflation, even if the Treasury never buys back the coin.

So the platinum coin does not cause inflation because the Fed has a tool to control interest rates.  Ip continues:

But while the economic consequences for the Fed are benign, the political consequences are not. As I noted earlier, the Fed buys coins in response to demand from commercial banks (the process is explained here). Banks won’t want a $1 trillion platinum coin, so the Fed will only buy the coin if Treasury forces it to. The Treasury, in “depositing” its coin at the Fed, is in reality ordering the Fed to print money. And if Treasury doesn’t take the coin back, the money stays printed.

The economics may be the same as QE; as Mr Krugman notes, coins, like bonds, are liabilities of the central government. But the politics are utterly different. We have a central bank to separate fiscal from monetary policy. The Fed implements QE when it has decided that’s the best way to carry out its monetary policy objectives. Buying a coin solely to finance the deficit is monetizing the debt, precisely the sort of thing central bank independence was meant to prevent. How could any Federal Reserve chairman justify cooperating in such a scheme, in particular since the Fed would be taking the White House’s side in a fight with Congress over a matter of dubious legality?

Ip initially claims that the platinum coin does not cause inflation, which is good, but it is monetizing the debt, which is bad.  But how can both of these things be true?  I think there is a logical error here.  Because if, as Ip claims, the platinum coin does not lead to inflation, why should the Fed care about how government spending is financed?  In Ip’s analysis, whether government spending is financed by debt or platinum coins is irrelevant.  Indeed, it is strongly irrelevant in Ip’s analysis – he doesn’t just say that there is no difference at the zero bound, he says there is always no difference (…”no implications for inflation”) as long as the Fed can pay interest on reserves (…”regardless of the size of the balance sheet”).

If the Fed has control over interest rates, and thus control over inflation, then how can the platinum coin infringe on the Fed’s independence?  The Fed is not charged with stopping monetization.  It is charged with price stability.  We don’t care about monetization itself; we care about monetization because it has the potential to generate hyperinflation, which Ip says we don’t have to worry about because the Fed can control interest rates.  Thus there is no threat to Fed independence.  In short, no one is ordering the Fed to raise the inflation target; it remains free to conduct monetary policy with the objective of 2% inflation.

Furthermore, turn the situation on its head and say that what if push came to shove and the Administration was forced to choose between issuing the platinum coin or defaulting on the debt?  What would be the consequences of the Fed asserting its independence by not accepting the coin?  Financial chaos as the world’s safest asset becomes unsafe leading to a massive deflationary shock?  For this the Fed would lay claim to its independence?  Indeed, this is exactly the sort of thing that gets a central bank stripped of its independence.  See Davies above.  Either retain its independence by willingly accepting the coin, or be complicit in triggering a global recession which, in the process, would cost it its independence eventually.  Ultimately, the Fed would have no choice to accept the coin.

Simply put, at some level lofty ideas about strict central bank independence are like those of moral hazard, largely talk around the water cooler.  When the economy is on the line, moral hazard concerns will pale in comparison to the need to saving the financial system, as too would the idea of independent central banks.  The old adage is true:  There are no atheists in foxholes.

Bottom Line:   The idea of central bank independence has always been more of an illusion than reality.  Ultimately, the monetary authority is a creation of the electorate.  It retains the illusion of independence so long as its actions are consistent with the conventional wisdom of the public.  At this point, only the Bank of Japan is threatened with such a loss of independence.  Otherwise, fears are as of yet unfounded.