Central Bank Independence

(Bloomberg) -- After inflation ran amok in the 1960s and 1970s, many central bankers fought for, and won, more freedom to control interest rates and set other monetary policy decisions without political interference. Their shields began to crack after the 2008 financial crisis. In the years since the bankers deployed trillions of dollars to save the global financial system, the public’s faith in their work has been fading. Critics say independent central banks are too secretive and put commercial banks’ interests before taxpayers’, so it’s time for more public control. Central bank officials counter that they need to be free from political pressures to do their job of containing inflation, promoting full employment and maintaining financial stability. But the “trust us” mantra is increasingly a tough sell.

The Situation

Central banks everywhere are struggling to stay above politics. Turkish President Recep Tayyip Erdogan, who claimed the power to appoint rate-setters and put his son-in-law in charge of economic policy after winning re-election in 2018, fired the head of the central bank in July after pressuring the bank to restrain borrowing costs. (Erdogan holds the unorthodox belief that high interest rates cause rather than curb inflation.) U.S. President Donald Trump has repeatedly criticized the Federal Reserve’s interest-rate increases, breaking with more than two decades of White House tradition of avoiding comments on monetary policy out of respect for the independence of the central bank. Trump has labeled the Fed “our most difficult problem,” blamed it for stock market declines and said that he was “not even a little bit happy” with his choice of Jerome Powell to head the bank. The governor of the Reserve Bank of India resigned in December just weeks after the government moved to exert more control over the RBI’s regulatory powers and how to use its excess capital. Central banks in Pakistan, Russia, Nigeria, South Africa and Thailand have also been pressured by politicians in recent years.

The Background

The modern notion of central bank independence evolved over time. Following the Great Depression, the U.S. Congress gave the Fed more power to set monetary policy. Still, it wasn’t free from political arm-twisting: Both Presidents Lyndon Johnson and Richard Nixon pressured Fed chairs to keep interest rates low. In the 1970s, Congress clarified the Fed’s mandate — to strive for maximum employment, stable prices and moderate long-term interest rates. Fed Chairman Paul Volcker’s drastic efforts to curb high inflation helped cause the recession of 1981-82 and attracted fierce criticism and even, as he reveals in his 2018 book, an order from Ronald Reagan’s chief of staff not to raise rates ahead of the 1984 election. (Volcker left that meeting without saying a word.) Volcker’s efforts were ultimately credited with bringing prices under control and setting the scene for steady economic growth. As a result, the case for central-bank independence gained ground elsewhere. The Bank of England was granted operational independence in 1997. And the European Central Bank, which oversees interest rates for all countries sharing the common euro currency, was independent starting from its creation in 1998. But in recent years there’s been movement in the opposite direction. In the U.S., the Fed has been blamed for failing to foresee and prevent the 2008 financial crisis and for bailing out some of the very financial institutions that contributed to the disaster. The Bank of Japan agreed in 2013 to coordinate policy with the government, a move some called an alarming attack on its independence.

The Argument

A widely cited 1993 paper by Alberto Alesina and former U.S. Treasury Secretary Lawrence Summers concluded that independent central banks are better at controlling inflation than central banks under political control. Shielded from pressures of day-to-day politics, the paper noted, they can take a longer view and make unpopular decisions to get there. Supporters of the current arrangements add that the Fed’s reports to Congress and financial audits by the U.S. Government Accountability Office provide oversight. Nobel laureate Joseph Stiglitz has argued that economies with independent central banks don’t always do better in financial crises. As central banks have turned to new tools such as bond-buying to juice economies, they’ve arguably wandered into the territory of fiscal policy, normally the reserve of lawmakers and other officials who make government spending decisions. At the same time, central banks are being forced to reexamine the tools they use to effect policy — and indeed to rethink their very identities. The broader their tasks and the wider the effects, the more politics is bound to intrude.

The Reference Shelf

• A global rundown of central banks under political pressure.
• The Federal Reserve Bank of Kansas City published a history: “The Balance of Power: The Political Fight for an Independent Central Bank, 1790-Present.”
• The European Central Bank explains its political independence and its practical implications. 
• A 2014 study in the International Journal of Central Banking of more than 100 central banks found that there’d been a general trend toward greater independence over time. 
• An excerpt from Paul Volcker’s book,“ Keeping at It: The Quest for Sound Money and Good Government,” written with Bloomberg Markets Editor Christine Harper. 
• Bloomberg News on the many times President Donald Trump has attacked Fed chairman Jerome Powell. 
• Bloomberg QuickTakes on how Trump can — and can’t — influence the Fed, why South Africa’s central bank came under fire and why the governor of the Reserve Bank of India quit.

To contact the editor responsible for this QuickTake: Laurence Arnold at larnold4@bloomberg.net

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