Central bank independence over monetary policy has been subjected to increased scrutiny over the past years. One of the main arguments against central bank independence is that monetary policy has become too politicised to be left in the hands of bureaucrats with essentially no accountability to the public. There are two key ideas behind this assertion. The first is that central bankers, being economists and not politicians, are beholden to the interests of capital and detached from the economic needs of the general public. Critics of central bank independence often contend that inflation-averse monetary policies can have unintended redistributive effects on the economy that increase income inequality, especially when inflation may raise wages at the cost of asset values. The second is that fiscal and monetary policy must be closely coordinated in order for either to be effective and that therefore the monetary policy should be subjugated to the same political discourse and influence as fiscal decisions. Following these arguments, it appears logical to return monetary policy decisions to the elected representatives of the public that determine fiscal policy. However, although the harmonisation of policy is important, the politicisation of monetary policy may not be the best way to ensure competent monetary policy or to achieve policy harmonisation. While the degrees and forms of central bank independence vary greatly between countries, there are enough common aspects of this important economic institution to allow for a thorough analysis.
To clarify, monetary policy is the field of economic policy that deals with the management of currency, namely relating to the price and quantity of money in the economy and to exchange rates. Over the past three decades, a general consensus has coalesced that this policy should be managed by central banks through the manipulation of interest rates on loans, which determine the price of money (in other words, the cost of ‘buying’ currency). For example, expansionary monetary policy is when central banks increase the money supply and lower the interest rate. This lowers the value of money and, thus, induces inflation. Fiscal policy, on the other hand, refers to a country’s budget, specifically how it is funded (tax policy or deficit spending) and how it is spent (budgetary policy).
Why Were Central Banks Let Off The Leash in the First Place?
It is unusual for policy, especially when so politically charged, to be determined by unelected technocrats. This makes central banks a unique case. Largely, these conditions can be summed up by the failure of the political echelon to effectively manage monetary policy, especially with regard to inflation and price stability. Politicians, especially in democratic countries, appear to have a difficult time managing the expectations of economic actors with the same prowess as autonomous bureaucrats. This is often due to short-term electoral interests such as quick boosts to output and the financing of government deficit spending. The advantage of central bank independence lies not only in the depoliticisation of monetary policy, but the ability of central banks to assert and follow through on specific monetary policy regimes. Central banks are generally considered to be very inflation-averse, a characteristic of conservative economic philosophy. This creates a level of stability and predictability that facilitates long-term planning of economic activity.
It is important to differentiate between operational independence, which allows central banks to make policy choices without political considerations, and political independence, a situation in which central banks would choose policy objectives without any input from representatives of the public. Central banks are operationally independent, in that they choose how and when to use different policy tools, but they are not politically independent because they do not set the monetary policy priorities. The political agenda of monetary policy is given to them by the political echelon through the mandate under which central banks operate. So, while central bank independence may seem counterintuitive from a political standpoint, especially in democratic societies, it is, in essence, a politically-mandated arrangement that reflects the interest of publicly-chosen representatives.
Moreover, there are in fact methods through which politicians can exert influence on central bank policy and hold central bankers accountable to the public. The mandate of central bank independence can always be rescinded if central banks do not live up to their official and unwritten mandates, meaning that they do in fact operate with an underlying accountability to the political echelon, and by extension, the public at large. Another form of political pressure that can affect monetary policy, if not, albeit, substitute for outright accountability, is fiscal dominance. This principle is based on the idea that governments can essentially force the hand of central banks through deficit spending, in which case central banks are compelled to fund the deficit through the purchase of government bonds. This leads to an expansionary monetary policy and can induce inflation. While this politically confrontational method may impose a threat to central bank independence, it can induce political accountability for monetary policy (even without a direct mechanism for political oversight of central banks). Further, it can offer a democratic counterweight for the conservative economic considerations of central banks when inflation-averse policies are opposed to the economic needs of the general public. Additionally, this form of fiscal intervention in monetary policy can also have a more collaborative character, one that allows for the oft-needed harmonisation of monetary and fiscal policy.
The Importance of Policy Harmonisation
Central bank independence has been argued to adversely impact harmonisation between monetary and fiscal policy. The fiscal theory of price level posits that price levels are determined not only by the volume of the money supply but by tax and expenditure policy as well. According to this theory, the tinkering of interest rates alone cannot affect the price level, but needs to be accompanied by complementary changes to the primary surplus of the government budget. This would seem to imply that keeping both monetary and fiscal policy under one authority would lead to more coherent economic policy regimes. Doing so would allow fiscal policymakers to adjust inflation rates according to fiscal needs.
However, this may not lead to the best outcomes. In all probability, it would lead to fiscal policy always prevailing over monetary policy considerations, meaning that the politics of government spending would become the primary consideration of the entire economic policy regime. By leaving central banks as independent bodies in this model, both monetary and fiscal policy authorities would be forced to work together to create effective economic policies. The underlying tension between monetary and fiscal dominance would allow for a more balanced economic approach that would account for both important economic and political interests. This equilibrium between politically-led fiscal policy considerations and conservative inflation-averse economic factors would induce both the harmonisation of monetary and fiscal policy while creating political pressure, if not outright accountability, for monetary policy.
Politicians Failed Monetary Policy, and Central Banks Bailed Them Out
The world has, for the past decade, been facing a problem of slow growth and under-target inflation. In a world of allegedly depoliticised monetary policy, this is a problem that is easy to pin on central banks. However, before rushing to judgement, the role of politicians in creating this reality should also be assessed. Perhaps the question that needs to be asked is how well central banks perform according to the goals set out in their politically-originated mandates. If they are achieving targets, or at least earnestly working towards their mandated objectives, then it would seem that the problem is not the extent to which monetary policy is politicised, but rather the mandate itself. Indeed, one of the defences put forward by central bank institutions in the aftermath of the 2008 financial crisis was that they had, in fact, achieved their inflationary targets and that they had neither the mandate nor the tools to aim for financial stability. This would suggest that monetary policy was never really depoliticised. Rather, the political failure of monetary policy was that the politicians charged with creating policy guidelines did not produce a pertinent mandate to translate the political goals of monetary policy into an effective administrative apparatus. In this case, the problem with central bank independence is neither a lack of accountability nor divergent monetary and fiscal policies, but an incoherent economic policy regime arising from dissonance within the political echelon. While central banks have indeed struggled to achieve inflation targets in the years following the financial crisis, this could be partially caused by a lack of harmonisation between monetary and fiscal policy. In any case, there is certainly no evidence that it is the result of central bankers reneging on their goals of price stability. Although this further supports the need for more harmonisation between monetary and fiscal policy, it does not indict central bank independence as the cause of policy discord, nor endorse the politicisation of monetary policy as the appropriate solution.
One argument against the central bank independence might be found in the reason politicians created this principle of monetary policy to begin with. Leaving inflation targeting to central banks was considered to be a politically advantageous framework as it delegated the responsibility for important monetary policy decisions that are often accompanied by painful but supposedly necessary repercussions. There is extensive research on why politicians are incentivised to hand over these decisions to independent central banks. In light of this reality, it seems somewhat disingenuous to heap blame on central banks for monetary stability, especially coming from the politicians who outsourced this undesirable task to avoid becoming scapegoats of monetary responsibility themselves. This, thus, may be a reason to rescind the independence of central banks. If the choices and consequences surrounding monetary policy are indeed highly politicised, and if the tools and goals of monetary policy need to be responsive to political discourse, then it would, in fact, be more logical for politicians to take the burden of monetary stability upon themselves.
The problem, of course, is that politicians have a bad track record of achieving price stability, with often dire consequences for the entire economy. There may be sound economic, political, and even moral prerogatives for prioritising employment over monetary stability or slowing growth to maintain price stability or lowering interest rates to keep credit accessible instead of raising interest rates to prevent undercapitalisation of banks. However, the fact remains that the consequences of a populist monetary policy may be just as bad, if not worse, for the same citizens who often feel that their economic needs run counter to conservative monetary considerations. This problem is exacerbated by the fact monetary and fiscal policy need to account for the kinds of long-term considerations that contemporary democratic political systems often have difficulty in properly managing. The election cycle, which often drives cycles of policy decisions, economic policy among them, is in no way synced with a given market’s business cycle, which should be the metronome of monetary policy.
While historically, politicians have not been trustworthy stewards of monetary policy, that is not to say monetary policy under independent central banks has not been without any controversy either. There is a strong case that central banks either underestimate or overlook the redistributive consequences of their monetary policies. However, this is not necessarily a problem arising from central bank independence. These considerations could be included in a multipronged mandate for monetary policy that allows for missing inflation targets in order to balance price stability with income inequality considerations, or it could be solved through fiscal policy measures, without changing the monetary policy regime. In either case, monetary stability ultimately makes the implementation of economic growth policies easier and more effective, but it requires the kind of policy discipline that central banks have historically proven to be capable of, and that politicians seem to almost intrinsically lack.
While certain central banks may still lack proper mandates and tools to address political considerations of monetary policy, it bears noting that, in the aftermath of the financial crisis, new policies were introduced, which allowed for a wide degree of accommodation to fiscal policy, even if not explicitly implemented with policy harmonisation in mind. These new policies included the lowering of interest rates to near or below zero, along with quantitative easing policies that aimed to further keep interest rates down by essentially buying unlimited amounts of government debt at any price to keep a cap on interest rates. Although many central bankers preached austerity during this period due to a renewed interest in credit and liability balances as central macroprudential indicators, monetary policy in the years following the crisis could have facilitated almost unprecedented levels of government deficit spending, especially in peacetime. Ultimately, central banks were doing their part in the neo-Keynesian revival to boost the economy by increasing demand through government deficit spending. The stimulation of demand through fiscal policy was left to the politicians. The ensuing dissonance could, again, be construed as evidence for the need for more harmonisation between monetary and fiscal policy. However, it would be difficult to argue that monetary policy in the wake of the crisis was either ill-conceived or unhelpful on its own, nor that by giving politicians more influence over monetary policy, there would have been better overall economic outcomes.
Why We Still Need Independent Central Banks
It, therefore, seems that central bank independence is indeed crucial for expansionary fiscal policies. The response of governments around the world to the economic fallout of the COVID-19 pandemic substantiates this. One of the reasons governments have been able to swell relief packages to the extent that they have is because of the confidence investors have in central banks. They know that there is an independent central bank behind such measures that is committed to ensuring that increases in government debt will not lead to untethered inflation in the economy. Just in the US, the Fed dropped interest rates, pumped cash into the economy and committed to buying essentially unlimited debt issued by the Treasury before the government had even cobbled its $2 trillion relief package together. These measures have bolstered confidence in the global financial system that unprecedented amounts of US government debt are still viable, and that the dollar is still stable.
The independence of central banks continues to be something of an anomaly in a world of liberal political economy. However, the institution of central bank independence has proven itself to be a more effective incentive structure for producing desirable monetary policy outcomes than the over-politicisation of monetary policy instruments. While it may not be a perfect device, it still seems preferable to interest rates being chosen by legislative committees, or any other actionable proposition. To ensure further monetary policy efficiency, the political echelon needs to proactively take steps to ensure that the mandates of central banks reflect desirable political objectives, and should increase collaboration with central banks to better synchronise monetary and fiscal policy. However, simultaneously, they should respect the independence of the central bank to make monetary policy decisions, both for their own sake and that of the public.