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Independence of Central Banks

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Utsari makes a case for why Central Banks should remain independent.

Without Central Bank independence, monetary policy is bound to go to astray. An economy is like an automatic operation, which when goes worse, should be corrected by individuals who excel in economics and have no conflict of interest. Hence, the government of that economy must have no to very subtle influence on monetary policymaking. Central Banks are responsible for monetary policy while the government is responsible for the fiscal policy of a country. At least, that’s how it is on the papers. 

The fact that central banks perform better independently was established when Bundesbank was given autonomous status in 1957 after which it effectively bailed Germany from hyperinflation (more than 30,000% per month)- which witnessed massive minting of cash, to an extent that households started burning it to keep warm. 

Eventually, Central banks all over the world started gaining autonomy in the 1980s. 

Monetary Policy ensures general trust in the currency by controlling the volume of money in an economy. Targeting an inflation rate and an interest rate, the central bank expands or contracts the flow of money.

Political cycle vs business cycle

The natural business cycle, when tampered to act in favour of the government, witnesses short-run gains. However, in the long run, it faces unfavourable pressure at large. To get re-elected a government is ready to face this long-run cost by pressing the central bank to decrease interest rates. Low interest rates boost disposable income, increase economic growth and reduce unemployment- everything working in its favour. 

 US President Richard Nixon’s influence on The Fed should be a cautionary tale. Throughout the 1960s, most policymakers believed you could permanently lower unemployment by accepting higher inflation. This concept is known as the Phillips Curve. 

Conventional wisdom was that the central banks could increase the money supply, push the inflation a bit, and more people would have jobs. It was a mantra for politicians. Behind closed doors, he pressured the Fed Chairman to decrease the interest rates, even though the Fed is supposed to be independent of the government, the central banker appeared to comply. The economy got its boost, and Nixon got reelected.

But the Great Inflation followed with annual rates exceeding 10% across OECD countries. What’s worse? The Phillips curve didn’t hold true over the long term. Inflation was high and so was unemployment. It was a lose-lose, a phenomenon is known as stagflation.

Anthony Barber, a chancellor of British Government who led the Ministry of the treasury in 1972, delivered a budget which was designed to return the Conservatives to power in an election expected in 1974 or 1975. This budget led to a period known as “The Barber Boom”. The measures in the budget led to high inflation and wage demands from public sector workers.

It took another lesson for England to make its bank independent as the Lawson boom followed in 1988.  They felt that the last recession had removed a lot of inefficient firms. They also felt that supply-side policies had been effective in increasing the productivity of the economy and therefore had increased the long-run trend rate of growth. This belief encouraged the chancellor Nigel Lawson, to believe the economy could grow at a much faster rate than previously. Therefore, when growth increased above 4%, they did little to slow down an overheating economy. 

It is clear that political interests tend to jeopardize the economy in the long run. The public loses its trust on the central bank which is supposed to act independently. And hence, it leads to economic speculations which cumulate to a multiplier effect e.g. If the government has a track record of allowing inflation, then inflation expectations start to creep up making inflation more likely. An independent Central Bank may have more credibility. If people have more confidence in the Central Bank, this helps to reduce inflationary expectations. In turn, this makes inflation easier to keep low.

Concerns over the independent central bank –

Lately, central banks have been criticized for sticking too rigidly to the target of low inflation when a country has much bigger problems with unemployment and low economic growth. Since Central Banks were made independent there has been a change in economic climate. Inflation and booms are no longer a major issue. Instead, the issue is one of secular stagnation and the prolonged liquidity trap. In a single generation, the world has grown used to low and stable inflation and to the idea that the interest rates on their bank deposits and mortgages are under control. 

Though the focus now shifts to managing low inflation rates, the independence remains under a modern threat of populism. Populism is a political stance that presents “the people” as a morally good force and contrasts them against “the elite”, who are portrayed as corrupt and self-serving. Hence, as this can work in their favour, governments tend to make populist decisions be it out of good faith or its political interests. For instance, governments may decide to provide free health care and retirement benefits even though they don’t have the financial wherewithal to implement such decisions. 

The confluence of populism, nationalism and economic forces are making monetary policy political again. President Donald Trump has demanded that interest rates should be slashed, speculated about firing the boss of the Fed and said he will nominate Stephen Moore and Herman Cain, two unqualified cronies, to its board. Brexiteers rubbish the competence and motives of the Bank of England, while in Turkey President Recep Tayyip Erdogan has been in a tug-of-war with the central bank when it showed an unwillingness to lower interest rates. India’s government has replaced a capable central-bank chief with a pliant insider who has cut rates ahead of an election. There is a genuine need for reflection on central banks’ objectives and tools. But dangerous forces are afoot that could have alarming consequences for economic stability. 

Deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit or budget deficit. Government deficit spending is a central point of controversy in economics. Running deficit spending is the last thing a Central bank would allow. Governments all over the world are fond of undertaking populist projects even though such projects are not supported by economic fundamentals. Consider the case of sports stadiums built for the Olympics in Greece and for FIFA World Cup in Brazil. In both cases, the government should not have indulged in deficit spending, but it did. These instances would become more common if the government had full control of monetary policy. Hence, it is important to keep the monetary policy separate from the government in order to maintain the financial health of the state.

Conclusion-

The bottom line is that if the government is given control of the economy, they might resort to indiscriminate money printing which will ultimately lead to economic collapse. This is what has happened in many ancient civilizations including Rome. Hence, to prevent this, central banks have been made independent of government authority. 

There are valid concerns about the equity effects of monetary policy, but there are ways for the government to deal with these – other than taking back control of monetary policy. Although Central Banks are independent, it is important to bear in mind, that the targets can be reset. Arguably, all the central banks should be given a wider brief than just focusing on inflation. Restrictions on the central bank’s direct monetary financing of the government make it possible to separate monetary and fiscal policy, leaving more authority to the central bank. While a target for monetary policy implicitly sets limits for monetary financing of the budget, it is the experience, particularly in developing countries, that without explicit limits for credit to the government, the central bank will face difficulties in achieving price stability.

 

– Utsari Gupta Bhaya,

Writer, Bharat Bhagya Vidhata

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