Why central bank independence is so important

Insulating monetary policy from day-to-day political interference has been key to financial prosperity, but with deflationary trends in a populist era, openness is the only remedy against populism.

Why central bank independence is so important

From the title of her article on the IMF blog, there could be no doubting her beliefs. Indeed, ‘Strengthen Central Bank Independence to Protect the World Economy’ is less of a headline than a mantra.

It was timely that Kristalina Georgieva, managing director of the International Monetary Fund, should publish her plea at the end of March. It highlighted what the Fund clearly sees as a major means of combating inflation and achieving long-term economic growth.

She pointed to how countries with independent monetary authorities had better withstood the financial storm caused by the COVID-19 pandemic and, in so doing, helped avert a global economic collapse.

A month before Georgieva’s article, the IMF published a research paper introducing a new framework to measure the independence of central banks.

Measuring it and enacting it are two very different things, however. Despite all the evidence that it works, political leaders will forever be tempted to interfere.

That interference can be particularly acute in the run-up to elections when central bankers are pressed to do things like reduce interest rates. The appointment of key banking officials can be politicians’ leverage.

Emerging independence

Central bank independence first emerged to shield monetary policy and the management of state funds from the day-to-day business of government. Ministers chase votes, whereas mandarins need only manage.

The concept of independence is far from new. When Napoleon Bonaparte established the Banque de France, he said its role in financing the Treasury should be limited to providing financial facilities rather than direct loans.

Following World War II, Germany’s Chancellor Konrad Adenauer took steps to make the Bundesbank independent to insulate it from pressures to finance military endeavours, such as had come from the Nazis.

When Napoleon established the Banque de France, he said its role in financing the Treasury should be limited to providing facilities, not loans.

After the gold standard was abandoned in the early 1970s, central bank independence became instrumental in combating soaring inflation rates.

Independence bolstered the credibility of central banks. It let them make tough decisions without fear of political interference.

Volcker's US rescue

Chair of the US Federal Reserve from 1979-87, Paul Volcker was so determined to tame inflation that he lifted interest rates until he provoked a recession in the 1980s.

He is widely credited with ending what some economists still refer to as the 'Great Inflation Era'.

More recent financial crises, especially the global crash of 2008 amid runaway debt, have created new challenges to the concept.

Keen to preserve their independence, central banks grew cautious in directly addressing issues. Instead, they favoured secondary interventions such as quantitative easing (printing money), negative interest rates, and other unconventional measures. Intended to stabilise markets, these measures often simply distorted them.

This drew criticism, in particular the delegation of decisions with big impacts (not least on incomes) to unelected officials.

Deflation conundrum

While central banks have the tools to bring down inflation, they lack tools to address its more stubborn sibling: deflation. Yet, it is harder to stimulate inflation than it is to tame it.

Therefore, there is a critical imbalance in abilities. It is this fundamental issue that lies at the heart of today's challenges, with entrenched deflationary trends across the world.

This has increased debt levels in both the public and private sectors, which in turn increases the risk of a new financial crisis, one in which central banks would find they could do little to help.

Central banks have the tools to bring down inflation but not to address deflation, yet it is harder to stimulate inflation than it is to tame it. 

Understandably, there is now a debate over whether the orthodox and unorthodox policies employed by central banks have reached their limits.

The move is towards closer cooperation between central banks and democratically elected governments to collaboratively formulate and implement policies.

Swiss watch

An example of this approach came in Switzerland last year in the immediate aftermath of the Credit Suisse collapse in mid-March.

This was the first such event affecting a global systemically important bank since that concept emerged in the early 2010s.

Despite being independent, the Swiss National Bank managed the crisis by collaborating with the Federal Council (a political authority) and the Financial Markets Supervisory Authority (the regulator).

The solution they came up with involved the government-mandated merger of Credit Suisse with its rival UBS. The central bank was able to provide guarantees over Credit Suisse during the merger and for future financial liabilities.

It spared the country from the kind of populist rhetoric that emerged during the euro crisis, when European governments backed away from intervening to solve the sovereign debt and banking crises.

They instead deferred to the European Central Bank, which responded by providing loans as the lender of last resort, buying government and corporate bonds, and implementing negative interest rates.

Politicians accused the ECB of overstepping its mandate. Some ECB policies were seen as financially redistributive, more akin to fiscal policy than monetary policy.

Helicopter money

One proposal to address shortcomings and inconsistencies in central bank independence is to increase governments' influence over monetary policy, especially when it comes to combatting deflation.

The idea has backing from some eminent figures in global central banking, including Ben Bernanke, a former chair of the US Federal Reserve.

Some eminent bankers support increasing governments' influence over monetary policy, especially in the face of deflation. 

It would involve the central bank independently determining the necessary amount of money to inject into the economy to combat deflation, then depositing this amount into the Treasury's account.

It would then be up to governments and parliaments to decide on an equitable way of distributing it, through mechanisms like tax refunds, public benefits, and other forms of fiscal policy interventions.

This approach is in-line with the idea of governments distributing economic stimulus funds, known in monetary policy circles as "helicopter money".

Communication is key

Central banks rely on effective, direct communication with the public to counter concerns about their lack of direct electoral accountability.

They are run by officials with significant influence over important matters in public life so they need to engage with citizens.

These strategies include explaining monetary policy and financial issues, as well as proposing solutions, with specific economic goals by specific deadlines.

Moreover, listening to citizens' opinions and concerns allows central banks to build support for their policies and initiatives.

Such engagement can help mitigate popular criticism of central bank measures and, consequently, reduce political doubts over central bank independence.

Transparent and inclusive communication fosters understanding, builds trust, and reinforces the perception that central banks are acting in the public interest, contributing to their legitimacy in a democratic society.

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