Central Bank Independence and Price Stability

This article was initially prepared as the author’s introductory remarks to the Nicolai Rygg 2021 virtual panel debate on Central Bank Independence – Lessons from History, hosted by Norges Bank on Thursday 8 April 2021, 17:00-18:30. You can see a video of the event here.

by Harold James, Princeton University.

In the second half of the twentieth century, the arguments advanced in favor of central bank independence have been largely concerned with price stability, combatting inflationary legacies and breaking inflation expectations. These objectives have not always been over-arching social or political priorities. They were actually quite novel, in that discussions of the major functions of central banks had previously rested on either securing the funding of government debt or on maintaining the stability of the financial system.

The new motivation appeared in the aftermath of the Second World War, especially in the case of Germany: there the US military authorities identified a persistent deep-seated German historical tendency towards inflationism in the name of securing greater resources for a state that massively abused its powers. The answer was the imposition of a strict framework for the Bank Deutscher Länder, whose inheritance was then taken over by the Bundesbank, which would eventually export the philosophy to the whole of Europe. The same discussion also appeared in the United States, and formed the backdrop to the 1951 Fed-Treasury Accord, which allowed the central bank flexibility in the prices it paid for government debt, and hence allowed an effective control of interest rates by the Fed.

The modern version of the debate arose as a response to the Great Inflation of the 1970s, as well as to later recidivism, outbreaks of inflation, especially in the late 1980s in the UK and the US. During the 1980s a substantial academic literature developed concerning the inflation performance as well as macroeconomic stability and growth. So it was not just a preference for stable prices – or the protection of savers – that mattered. The new consensus suggested that in industrial countries, but also more generally, central bank independence was closely correlated not only with lower rates of inflation but also with better economic performance. It was already well known that monetary authorities were frequently subject to political pressures that produced higher levels of monetary growth, but that that had not improved long run growth rates.[1]

The literature initially developed on the basis of an appreciation that establishing firm commitment mechanisms was an essential element in the establishment of policy credibility.[2] This approach emphasized the contractual element of the position of central banks, and consequently focused on the explicitly defined terms of contracts or laws establishing central banks. The idea was backed by theoretical academic work that modelled the effect of a “conservative central banker.” It seems that the authors of this literature had in mind the behavior of a real-life figure, Paul Volcker. 

It was the move to CBI in Europe that represented the boldest, perhaps most foolhardy, instance of an institutional redesigning. The push for increased independence for Europe’s central bank started already before the intellectual revolution in economic thinking on the subject in the late 1980s, and before the political upheavals of 1989–1990 created a new framework for conceptualizing the relationship of political institutions and rules to political and social processes. In some notable cases, the debate was associated with the beginnings of the European Monetary System: in particular, the Bundesbank and the Banca d’Italia had used the negotiations over Europeanized money in the late 1970s to increase their own political autonomy. In Britain, the 1979 Conservative Party election manifesto had alluded to the desirability of central bank independence, but after the Conservative victory, the new government of Margaret Thatcher lost interest in the subject. Ten years later, the issue of the position of the central bank became acute again. Chancellor of the Exchequer Nigel Lawson in September 1988 asked Treasury officials to draw up a plan for greater Bank of England independence, in which the bank would be given some statutory duties, including the preservation of the value of the currency.[3] The step seemed congruent with Lawson’s wish to move into the EMS, which Prime Minister Thatcher opposed.

There were additional twists to the CBI doctrine as put into practice. First, there should be a different approach to a one-off challenge than to persistent or endemic inflationary pressures. At the Bank of England, Mervyn King saw inflation as determined by occasional shocks that needed to be accommodated, with the consequence that what was important was the distribution of inflation outcomes rather than occasional peaks. In this way, the central bank might deliver a better performance than that of an “inflation nutter,” as he characterized the “conservative” central banker (in a paper originally and provocatively given at the very conservative Swiss National Bank).[4]

Secondly, central banks often emphasized that they were acting in conformity with an international trend: this was the action of a coordinated “brotherhood of central banks.” Or, as Mervyn King put it, “It is, after all, easier to lose weight when one’s own family members are on the same diet.”[5]

Third, in the interwar debates, as set out for instance by the long-serving Governor of the Bank of England, Montagu Norman, advocacy for CBI involved a rejection of what is now known as fiscal dominance, but also of financial dominance. Norman put it simply in giving advice to German policy-makers at the end of the great hyperinflation, “A Central Bank should protect traders from the rapacity of other banks in his own country.”[6] As reinterpreted in the late twentieth century, this meant however that a central banks had its sole role in monetary policy and should not be involved in financial supervision and regulation, as such involvement might create illegitimate pressure to use expansive monetary policy to aid its client banks: this would be, as the Bundesbank liked to put it, a pollution or contamination of pure monetary policy.

The move to CBI involved a concept of delegation for a specific and narrowly defined purpose – monetary stability – that meant that central banks necessarily had to slough off their former multifunctionality: their long-standing and very traditional engagement in financial stability, but also in industrial policy, which had been a core concern of many traditional central banks as a legacy of the Great Depression era.

The logic should also have contained a parallel process of delegation for fiscal policy to independent groups of experts, fiscal councils, or – as in Norway – committed to following a fiscal rule that might (like the monetary target) be set through a political process.  

The converse side of the debate about CBI has not been given such an amount of theoretical attention. But the logic is perhaps appealingly, perhaps also unappealingly, obvious: if harmful levels of inflation require the remedy of CBI, do not dangerous deflationary tendencies require the reversal of CBI, more politely known as more fiscal-monetary coordination, and perhaps also a return to multifunctionality of central banks. Central banks need to experiment with pulling more and more levers to restart economic activity in the wake of a deflationary shock.

After the Global Financial Crisis, central bankers saw the institutional dangers and frequently expressed their frustration at being at the center of the effort to shore up against economic collapse. There was more fiscal effort required. Nowhere was the demand articulated more insistently than in Europe, where the Maastricht Treaty had constructed the world’s most independent (or in the eyes of its critics least accountable) central bank. Mario Draghi in particular pushed insistently for more fiscal coordination, but his predecessor, Jean-Claude Trichet, had made the same kind of argument though less emphatically. Leaving the ECB, Draghi concluded: “Monetary policy can still achieve its objective, but it can do so faster and with fewer side effects if fiscal policies are aligned with it.”[7] Europe is again the guinea pig for the development of a theory of central banking that fits with current policy concerns. The ECB standpoint is not however singular: Fed Chair Ben Bernanke made very similar arguments to those of Draghi.

The logic of eroding CBI was also pushed as the role of central banks became again more complex and varied. The background to the extraordinary range of criticism of central banks in the 2010s was that policy had become more complicated, and that many of the practical steps to combat the crisis involved elements where distributive spillover effects were much clearer than in the case of monetary policy. Rescuing banks obviously involved a fiscal element, and the major initiatives came from the government, from treasuries and particularly from the prime ministers and presidents. Policies that required buying certain classes of assets on the central bank balance sheet also changed relative prices. As central banks moved back more into financial regulation, and made judgments about what sorts of lending might be desirable, their actions were clearly also favouring and disadvantaging specific sectors of the economy. When distribution is at stake, the choice looks political, and the logic of delegation weak.

By the end of the 2010s, and on the eve of the Covid pandemic, this view had become a practical policy-consensus. In response to Covid, there is more uncertainty about a future inflation trajectory: the forecast range has increased. Are there inflation dangers, that would lead us to push for more CBI, or deflation risks in a crisis, which would indicate a need to continue the post-2008 course?

In this uncertainty, and especially as the inflation risks may appear greater, some of the old arguments against CBI will appear again. In the aftermath of the First World War, central banks that continued a monetary accommodation of fiscal dominance had justified their policy as a patriotic necessity. Central banks fundamentally controlled the cost of government debt, and hence they were subject to irresistible pressure. The language of patriotism was also enunciated as the Truman administration sought to persuade the Fed in the midst of the Korean war. When Truman received the entire FOMC he started with an amazingly explicit explanation of US foreign policy. He “emphasised that we must combat Communist influence on many fronts. He said one way to do this is to maintain confidence in the Governments credit and in Government securities. He felt that if people lose confidence in Government securities all we hope to gain from our military mobilization, and war if need be, might be jeopardized.”[8] It is striking that former chairman of the Fed Marriner Eccles, the major dissident who was now very hawkish on inflation, also laid out an alternative view of foreign policy: he did not like the Korean war, and worried that the US “was stumbling into and uncharted Asian morass without reckoning the costs.”[9]

What is the modern equivalent of that argument about national security? In some countries the language of Rudolf von Havenstein or of Truman about defense and national interest appears. That is dramatically evident in the statements of Turkey’s President Erdogan about the high interest rates as “the mother of all evil,” orchestrated by “Turkey’s enemies, who are hiding behind currency rate speculators, the interest rate lobby, or credit rating agencies.”[10] The push to control interest rates – the motivation of Havenstein or Truman – is evident in the recent dismissal of central bank governor Naci Agbal, after he put interest rates up by 2 percent.

European countries and European politicians would not argue in Erdogan (or Orban) terminology about national needs. But they do point to a further set of policy desiderata – the twenty-first century equivalent to overriding national interest – in making the case that the existential threat of climate change requires a new orientation of the central banking framework, and a new element of fiscal-monetary interaction. The ECB has been especially innovative in this regard, but also runs into the difficulty that some of the bonds taken in the asset purchasing program (from airlines and other carbon producers) do not look climate neutral. On the other side of the Atlantic, the Fed is increasingly thinking about policy measures that can counteract racial inequalities. In both cases, the priorities of central banks in tackling pressing policy questions cannot be isolated from more general orientations of government policy.

[1] James Buchanan and Robert Wagner, Democracy in Deficit (Amsterdam: Academic Press, 1977).

[2] Especially Finn E. Kydland and Edward C. Prescott, “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy 85/3 (1977), 473–491; Robert J. Barro and David B. Gordon, “Rules, Discretion and Reputation in a Model of Monetary Policy,” Journal of Monetary Economics 12 (1983), 101–121.

[3] Nigel Lawson, The View from No. 11: Memoirs of a Tory Radical (London: Bantam, 1992), pp. 867–868, 1059–61.

[4] Mervyn King, “Changes in UL Monetary Policy: Rules and Discretion in Practice,” Journal of Monetary Economics vol. 39 (1997): 96.

[5] BoE, King memoranda, vol. 11, Whither the ERM?

[6]  Harold James, The End of Globalization (Cambridge: Harvard University Press, 2001), p. 36.

[7]  https://www.reuters.com/article/us-ecb-policy-draghi/ecb-policy-losing-some-potency-needs-fiscal-help-draghi-idUSKBN1X71LV (October 28, 2019)

[8]  Marriner S. Eccles Papers : Summary of Meeting of President Truman and the Federal Open Market Committee on January 31, 1951, Box 62, Folder 1, Item 1.

[9]  See Sidney Hyman, Marriner S. Eccles: Private Entrepreneur and Public Servant (New York: Alfred A. Knopf, 1976), p. 339; also Thorvald Grung Moe, Marriner S. Eccles and the 1951 Treasury – Federal Reserve Accord: Lessons for Central Bank Independence, Levy Economics Institute of Bard College, Working Paper No. 747, January 2013.

[10]  https://www.ft.com/content/d1fe4bf2-551b-11e8-b24e-cad6aa67e23e

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