Why central banks should remain independent

By Suranjana Roy

We’ve always come across our school textbooks teaching us the imperative independence of the central banks, the apex body of a financial system in an economy. This independence essentially relates to non-interference of a third party, that is the incumbent government and/or political leaders, even though in most countries the executive heads of the central banks are chosen by their governments. This gives rise to a concept pragmatists would call ‘relative independence’, the categorization and exploitation of which still remains ambiguous.

While some governments leave the central banks to do their tasks with the narrow objective to gain a stable economy, rather than meeting political aspirations, recent trends haven’t been very ideal. Recently, American President Donald Trump and Japanese Prime Minister Shinzo Abe have been accused of interfering with the monetary policy of their respective central banks (The Federal Reserve and The Bank of Japan). Economic findings across United Kingdome (UK) and the Eurozone correspond to a significant portion of the populace believing in a steady decline in the central banks’ independence over the next 4 years. This fiscalisation of monetary policy is subjected to much debate and criticism, across the world.

Background

To understand the roots of this issue, we need to go back to the United States of America (USA) circa 1970. The US had been seeing a period of economic boom, which could lead to an inflationary pressure on the economy. To control this, the Fed ideally had to raise interest rates to reduce the money supply by discouraging investments. However, President Nixon was also eyeing a re-election in 1972, and the Republican (and industrialist) voter base had to be withheld.

Enter Arthur Burns as the President of the Fed. Nixon did not keep the political alignment of Burns a secret. As a result, the Fed cut down the interest rates further. Richard Nixon got re-elected as the years of boom succeeded but eventually this lead to increased inflationary pressure combined with stagnant economic growth (stagflation), a crisis the US kept on dealing with in the forthcoming decades. This is where the era of ‘Relative Independence’ of central banks begins, even though until very recently, there was broad consensus that the banks’ decisions should be seen to be impartial.

Recent Trends

However, since the 2008 financial meltdown, there has been a drastic change of trends, with more and more political leaders attacking independent monetary policy. President Donald Trump criticised the Fed for having created a ‘false economy’ with its not-so-stringent policies post the financial crisis and called Janet Yellen (Chair, Federal Reserve) to be as big a political contender as his Democrat Presidential Candidate and Opponent, Hillary Clinton. While the Fed has maintained its need to retain autonomous, President Trump has also picked Mr Jeremy Powell to become the next Chairman of the Federal Reserve, who also happens to be a Republican. Powell does not openly admit to all Trumpian policies though he does stand up to strengthening the American Central Bank’s Policy by raising interest rates, an issue which became a part of the Trumpian political campaign for the 2016 Presidential Elections.

Europe

The Eurozone hasn’t been performing well since the 2008 financial meltdown. In fact, its performance is much worse than the United States which was the epicentre of the crisis. Think of Greece, who’s worse off than most affected economies during the Great Depression or of Finland, whose GDP was 5.5% less than its 2008 peak. An explanation for the arising economic north and south divide in the EU comes from the flawed nature of the Euro. The eurozone’s structure imposes strict rigidity on the common currency against its gold standards. As a result, there isn’t any adjustment mechanism that countries like Finland or Greece can take in terms of their real exchange rates, while other countries like Germany remain adamant on its inflationary boom. This dismal scenario has also given rise to immense political tensions and fragmentation among member states of the EU.

Now let’s relate this situation to the role of the European Central Bank, its primary objective being price stability and controlling inflation, like all other central banks. Recently, it took the responsibility to ‘save the euro’ as a second to its primary role. Given the political reverence of the same, we do not know the priority the ECB sets, if it has to choose between rescuing the euro or maintain price stability. It would be fair to assume that it would choose the former to build confidence among investors, something which paradoxically reduces the institutional independence of the ECB. We could only wait to see the course of this body, which was also the one which went loggerheads with the Hungarian Government when they threatened the dismissal of the central banks if they failed to submit a wealth declaration, thus endangering the independence of policymakers.

Japan

This brings us to the Japanese economy which has been struggling against deflationary forces for a decade now. Prime Minister Shinzo Abe has implemented various sets of economic policies (known as Abenomics) to bring Japan back to its economic glory. In the heart of Abenomics lies its unorthodox monetary policy which makes the BOJ inject liquidity in the economy through an instrument called Quantitative Easing which has for the first time, pushed the interest rate to negative territories. BOJ is one amongst the ECB, Denmark, Sweden and Switzerland to introduce negative interest rates. While critiques have criticized this to be a political influence over the banking system, supporters of the same claim this to be an affirmative action against the inefficiency of the BOJ over the past decade. However, these policies have still not risen to the targeted inflation rate at 2%, having stagnated at 1%. Economists also fear the risks to financial stability with excessive monetary easing, citing the distortions caused in the financial asset markets and market mechanisms with increased asset purchases, a strategy used under Abenomics. In all essence, Shinzo Abe has been accused of risking BOJ’s independence, in the pursuit of revitalizing the economy.

As for emerging and developing economies, we do not have strong literature to provide evidence for how independent central banks are, but it could be fair to assume that a weak political apparatus may lead to increased political interference in monetary matters. If so, the conclusions of advanced economies hold true for emerging economies as well.

Perils of reducing central banks’ independence

We’ve seen examples from history and in the contemporary world, where the third party interference in the institutional autonomy of the central banks, has either lead to inflation or has posed questions of uncertainty over a stable economy. In no concrete proof, could we say that the politicization of monetary policy would provide us with controlled levels of inflation and price. However, in a famous article released in 1993, Alesina and Summers found out the negative relationship between independent central banks and inflation rates (though specifically in developed countries). The GMT index focuses on the political and economic independence of the central banks; defining political independence as the ‘capacity of the monetary authority to choose the final goal of policy’ and the economic independence as the ‘capacity to choose the instruments of monetary policy. ’In the regression analysis, they found a ‘negative relationship between average inflation and CBI, as well as between inflation variability and CBI measured by GMT index.’

Even if we do not base our conclusions on empirical research but on the mere behaviour of politicians; we would come across similar findings. As we have noted earlier, in pursuit of controlling the money supply in the economy, the central banks purchase/sell government bonds (quantitative easing), which accordingly increase or decrease the short-term rates of interests. The government may differ in policy with the central banks: While the CB anticipates an inflation and wants to raise interest rates, the government might just want to see an extended period of economic boom, like it happened for President Nixon.

The government doesn’t necessarily run with the economic or legal reasoning for that matter, and therefore, the independence of the Supreme Court stands as an important example of the need for an independent central bank.


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