Posted by: Dirk | January 6, 2010

On Central Bank Independence

In today’s developed world there exists a consensus among orthodox and many non-orthodox economists that central banks should be independent. Government should not be allowed to control the ‘printing press’ since it would misuse its power by printing money, spending it and thereby causing inflation. This is why David Leonhardt at the NYT writes:

A once-marginal proposal — from Representative Ron Paul, the Texas Republican — that would give Congress the power to review interest rate decisions recently passed the House and will soon be considered by the Senate.

Economists are generally horrified by this idea. If Congress could force Fed officials to answer questions about every interest rate move, the process could easily become politicized. A politicized central bank is a first step toward runaway inflation.

So, are economists horrified? I don’t think so. I would guess that many economists would wonder why they are even considering that central banks might not be independent in the near future. What has changed?

Before we can tackle this question we must admit that stable inflation is not the holy grail of (macro)economics. What we really would like to have is growth of incomes, and the wider the benefits spread the better. The more income we hav the more utility we derive from our work. This is naive, but roughly right, so let’s just leave it there.

Stable inflation is just one issues among others then. Low unemployment would be nice as well. High wages would be nice for consumers, but probably bad for firms and capital owners. On the other hand, low wages would be good for capital owners and bad for workers. Speaking of which, low inflation is good for creditors and bad for debtors. It should be obvious here that some things are good for some groups of society while they are bad for others.

One more example. Low interest rates are generally thought to be good, but then again: people who want to save will not be happy with low interest rates. Therefore, they will not benefit from lower interest rates. Also, these might lead to overinvestment, maybe causing a stock market bubble. Since in the real economy there is no free lunch, keeping inflation stable is not the recipe for above average growth. At least so say Lawrence Summers and Alberto Alessina in an 1993 article named ‘Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence’:

This note investigates whether one can find a correlation between central bank independence and the level and variability of real economic variables such as growth, unemployment, and real interest rates. Our conclusion is that while central bank independence promotes price stability, it has no measurable impact on real economic performance.

So, price stability alone is not enough. In the economics literature this was recognized long ago. A lot of goals had to be achieved, but the number of instruments to achieve those goals was always short. Therefore, the profession concluded that there would be trade-offs to ponder. If a high level of employment can only be reached through high inflation and low inflation would bring with it high unemployment, where do we want to be? Questions like these (the famous Phillips curve) sometimes were the right ones to ask, sometimes not. Today there is certainly no Phillips curve trade-off available to the US authorities. More inflation and less unemployment would have been a good deal months ago already.

Coming back to central bank independence, macroeconomic theory has built theories that lead to the conclusion that central banks should act in a technocratic way and fix the level of inflation around some value, say 2 percent. Monetary policy would consist in inflation-targeting, reacting to deviations from inflation. A major assumption in the theory is that inflation gaps correspond to output gaps. That means that high (low) inflation is caused by excessive (sub-optimal) demand. If demand is too low, unemployment would result. However, using a lower interest rate to increase investment and therefore demand would lead to a fall of unemployment back to the old level.

Critical for this theory to work is the connection between output and inflation gaps. If an inflation rate of 1 percent would be compatible with 5% unemployment but also with 10%, then there would be multiple equilibria. It would not be possible to hold up the claim that inflation and output gaps are related, and that if one is closed the other is closed as well. Since 2007 we have seen that the inflation gap and the output gap are out of sync. Today we have an inflation rate which is close to the target of 2%. Does this mean that the output gap is closed and there is no additional unemployment left? Certainly not.

What can we learn from all this? First of all, talking about exit strategies is way too soon. Unemployment should be the priority really, since without employing all resources the economy will not find its way back to the growth path. In other words, there is no need to keep so many resources unemployed, especially workers which are suffering and don’t deserve to.

For central banks the threat to independence is connected to the monetary theory that failed. If keeping inflation at around 2 percent is not the goal of the central bank, then there is no reason to have it run by technocrats that are independent. After all, inflation is redistributing income from debtors to creditors and vice versa. So, today central bank independence has lost its main argument, and economists should think hard about the question how central banks should act in the future and in what kind of institutional form that should be embedded. Jan Tinbergen in his Nobel prize lecture said:

In several parts of our science, and I presume in other sciences as well, we must beware of following vogues too easily. Model building has become a vogue, just as, after that, linear programming or matrix algebra have become. Of course warnings against vogues are first of all coming from those who don’t command the techniques implied. This is why I am myself inclined to hesitate to apply one of the two latter methods mentioned. But a critical examination of the structure of the problem before we try to solve it remains useful.

This applies to central banks also. They should revisit the idea that the instrument of monetary policy is used exclusively for internal equilibrium (keeping inflation stable) while the external equilibrium (balanced trade account) is left to be determined by the financial market. Somehow the global (external) imbalances that build up have also affected the internal equilibrium. After wondering about the inflation puzzle, when a low interest rate only very slowly triggered rising inflation in the years after 2001, the financial market crash of 2007-8 drove inflation into negative territory and monetary policy useless for the first time since the 1930s.

Before thinking about central bank independence I would think about the future role of a central bank first. It has to be step by step. A quick&dirty fix is neither necessary nor useful. Perhaps a compromise would be better in this situation.

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