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Here’s why economists favour central bank independence

Here’s why economists favour central bank independence

By T T Ram Mohan

Central bank independence is an idea that came out of the stagflation in advanced economies of the 1970s. High inflation did not lead to reduced unemployment – the world discovered the truth that the Philipps curve trade-off exists only in the short-run. If you keep boosting money supply for too long, you get only inflation without the associated benefits of reduced unemployment.

Central Bank

Central Banks were made independent in order to tackle post war stagnation in the 1970s. | Source: Khan Academy

So politicians decided they would leave it to central banks to decide monetary policy as a means of imposing overall macroeconomic discipline. Central banks would then no longer underwrite unlimited government borrowings and this was good for the economy.

Now central bank independence is under threat and it’s not on account of politicians, the Economist points out. The problem is the steady decline in interest rates in recent years, culminating in negative interest rates in many countries. Monetary policy no longer appears effective and this undermines the authority of central banks.

Moreover, the tool that some banks have resorted to, Quantitative Easing, which involves massive purchases of government bonds, amounts to the purchase of government debt using newly printed money – precisely what central bank independence was intended to avoid!

At the same time, there’s a general sense that fiscal stimulus has a key role to play in the present situation:

Although economists remain broadly in favour of central-bank independence, the amount of new research affirming the importance of stimulatory fiscal policy is growing. The continued economic doldrums are also creating a political opening for more aggressive fiscal action. On August 2nd the Japanese government announced new stimulus measures worth ¥4.6 trillion ($45 billion) this year. Both American presidential contenders have plans that will raise government deficits, and the British government has abandoned its target of balancing the budget by 2020. Low interest rates have emboldened politicians who might otherwise have ignored the calls of frustrated voters for fear of the bond-market vigilantes.

As monetary policy wanes in influence relative to fiscal policy, so will the importance of central banks.

Here in India, we have seen a movement away from the commitment to a 4 per cent inflation target on the part of the RBI. This has at least partly to do with the perception of the political authority that rigidity in respect of the inflation target of 4 per cent was coming in the way of higher economic growth.

Central Bank

The policies made by most Central Banks presently have been unable to tackle the economic problems. | Source: Market Watch

Central bank independence is not ordained by the gods. It was a mechanism devised by politicians in response to a particular economic situation. You can count on politicians to reduce its importance in a different economic situation.

Prof. T T Ram Mohan is a professor of finance at the Indian Institute of Management, Ahmedabad.

This article was first published on The Big Picture.

Featured Image Credits: Flickr

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