Whither Central Banking?

Politicians are not known for behaving unpredictably. When they do, it is usually for a reason. Thus when Germany’s Chancellor, Angela Merkel, publicly criticized three of the world’s leading central banks—the U.S. Federal Reserve, the European Central Bank (ECB), and the Bank of England—in a June 2 speech in Berlin, journalists and policy-makers around the world looked up and took notice.

It was not just that Merkel decided not to speak in the hushed, polite tones that politicians usually reserve for any discussion touching upon central banks’ conduct of monetary policy. Merkel’s Berlin speech drew attention for two reasons: first, her forthright criticism of the policies currently being pursued by the Federal Reserve and the Bank of England; second, her claim that the independence of some central banks, including the ECB, has been compromised as a result of political pressures.

Merkel’s first set of criticisms echo the deeply anti-inflationist approach to monetary policy consistently pursued by Germany’s central bank, the Deutsche Bundesbank, since its foundation in 1957. Even today, Germans remember that rampant inflation twice wiped out the savings of Germany’s middle-classes after World War I, thereby helping to open the path to power to Adolf Hitler’s National Socialists. It is no coincidence that two German members of the ECB board, including Axel Weber, the present Bundesbank president, have publicly warned in recent weeks about the potential for loose monetary policy to create future inflationary problems and asset-price bubbles.

In political terms, Merkel’s comments also reflect her determination to restrain European Union member-states from adopting neo-Keynesian deficit-spending programs on the scale presently being pursued by the Obama Administration. As Federal Reserve Chairman Ben Bernanke recently noted, the overall effect of these and other measures will be to raise America’s debt-to-GDP ratio to 70% by 2011. This represents an increase from 40% in 2008. This may explain why Merkel was perhaps the most forthright dissenter at the recent G-20 meeting when President Obama urged the world’s leading economic powers to adopt policies similar to his own in response to the global recession.

But it was, however, Merkel’s concerns about possible compromises to the independence of central banks that drew the most attention. “We must”, Merkel insisted, “return together to an independent central-bank policy and to a policy of reason, otherwise we will be in exactly the same situation in 10 years’ time”. Her position contrasts with that of other European centre-right leaders such as France’s Nicholas Sarkozy who, not long after being elected president in 2007, expressed the desire to diminish the ECB’s independence.

Such remarks may simply reflect France’s ingrained dirigiste instincts. Over the past 15 years, the trend has actually been toward increasing central banks’ independence. One of the Blair Labor government’s first decisions following its election in 1997 was to grant the Bank of England operational control over monetary policy. This trend, however, should not blind us to the fact that politicians have many reasons for wanting to exercise strong influence over central banks. It is hard for governments to resist the temptation to try to manipulate interest rates in order to maximize their re-election chances. It also gives governments the option of letting the inflation genie out of the bottle in order to boost short-to-medium-term employment at the expense of devaluing savings, shattering price stability, and undermining long-term employment growth.

One of the financial crisis’ long-term effects will be to raise questions about central banks’ ability to maintain an independent monetary policy during periods of economic stress: that is, precisely when such independence is most important. Of course, no institution can be rendered completely immune from political and public pressures. But over forthcoming months, central banks are going to be faced with making decisions unlikely to please governments and legislatures worried about being reelected.

Though the Obama Administration has tried to avoid creating any public perception that the Federal Reserve is merely doing the Treasury’s bidding, it is unclear how the Administration and Congress will react when the Federal Reserve chooses to reduce the chance of future inflation by winding back some of the measures it has taken since the onset of the financial crisis last year. As David Wessel remarked recently in the Wall Street Journal (06/04/09), Chairman Bernanke “may find Fed lending so intertwined with the Treasury’s bailouts that the Fed lacks the flexibility and independence it needs. Or he may find tightening tough while Congress is contemplating changes to the Fed’s governance and powers.”

The bigger political question, however, is the place of central banks in democratic political orders. Insulating central banks from excessive political influence reflects recognition of the truth that even in a democracy there are many public-policy decisions that should not be made by legislative or popular votes. Most democracies, for example, embody constitutional limits on the ability of governments and legislatures to interfere with the judiciary’s operations. This is usually derived from awareness that the common good normally requires some separation of powers in order to prevent excessive centralization of power.

The problem is that when it comes to the economy, governments have legitimate reasons for being concerned about and involved in the development of economic policy. This inevitably raises questions about how to maintain the autonomy of central banks and what ought to constitute the content of that autonomy. Governments committed to pursuing populist and socialist policies have no qualms about dramatically limiting or even abolishing such autonomy. This is why Venezuela’s Hugo Chavez has steadily eroded the independence of his country’s central bank, describing its autonomy in a 2007 address as a “neo-liberal idea” obstructing his long march towards “new socialism.”

A more traditional way for governments to resolve these questions has been to charter the central bank’s specific responsibilities, and then generally limit the government’s formal involvement in monetary policy to periodical meetings between the government and central bank governors, appointing members of the central bank’s board at legislatively-specified intervals and arriving at memoranda of agreements with the central bank about inflation targets. The intended effect is to create a situation of “independence within government.” Thus, according to European Union law, the ECB’s prime objective is “to maintain price stability.” It also has the responsibility —“without prejudice to the objective of price stability”— to “support the general economic policies” of the European Union, these being specified by Article 2 of the Treaty on European Union as “a high level of employment and sustainable and non-inflationary growth.” The ECB therefore has the luxury of having a prime objective to which the other goals are subordinate.

By contrast, the Federal Reserve has the responsibility of “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” It is thus legislatively charged with realizing goals that are not only ascribed equal importance but which may be incompatible in some circumstances. As the experience of the early 1980s illustrated, the Federal Reserve’s pursuit of stable prices (i.e., fighting inflation) could only be achieved by accepting high unemployment for three years. In retrospect, this was surely the right decision, but whether it reflected the Federal Reserve adhering to all its legislatively-mandated responsibilities is another matter.

In the end, it may be that the only way to protect central banks’ ability to conduct monetary policy in ways that truly insulate them from excessive political pressures and the distorting effects of internally incoherent legislation is to cut the links between them and governments. This is the argument contained in Professor Tim Congdon’s recent thought-provoking monograph, Central Banking in a Free Society (2009), published by the Institute of Economic Affairs.

Among other things, Congdon reminds us that the Bank of England was a private bank from its foundation in 1694 until its effective nationalization by the Attlee Labour Government in 1946. Looking at the present, Congdon maintains that central banks should be “privatised and owned by the banking system, not by the state,” primarily because he holds that “central banks in private ownership would be subject to a better pattern of incentives, with checks and balances that would be more likely to keep them on the right course, than if they remain in the state’s hands.” In this scenario, the capital for central banks would be directly provided by commercial banks rather than governments.

One advantage of this approach is that the central bank would acquire a primary objective—monetary stability—uncomplicated by secondary goals or other state-mandated primary purposes. Another benefit is that the task of maintaining monetary stability would be even further insulated from direct and indirect political influences—if only to the extent that all other private businesses enjoy some protection from government pressures.

In the present political and economic climate, proposals for radically rethinking central banking are unlikely to achieve either popular or elite acceptance. Governments’ natural survival instinct during recessions is to try to augment their influence over monetary policy. This is especially true when governments are anxious to prove to economically-battered and politically-angry electorates that they are doing something, even if they themselves know that what they are doing is more than likely to have deleterious long-term economic consequences. But if we take seriously the advice of President Obama’s Chief of Staff Rahm Emanuel to “never let a serious crisis go to waste,” then now is as good a time as any to rethink the practices and institution of central banking.