Is central bank independence all it is cracked up to be?

Regular readers will know that I am not a fan of combating the current economic ills purely via easier monetary policy and I do believe that both the Fed and BoE have been rather tardy in their monetary responses in recent years. Arguably, the Fed could have raised rates at a faster pace, and there was a window of opportunity for the BoE to have done so in 2014 as the unemployment rate breached the threshold levels which were seen as an obstacle to action. Indeed, a widespread belief is gaining ground that further monetary easing is likely to be counterproductive, given the distortionary effects this has on markets and the distributional impacts on savers. However, we have given central banks operational independence to focus on an inflation mandate and we have to leave them to get on with that job.

This makes the recent spat between UK politicians and the BoE Governor all the more remarkable. Prime Minister Theresa May noted a couple of weeks ago that, “there have been some bad side effects” from the current monetary policy “with super-low interest rates and quantitative easing” and that “a change has got to come.”  This prompted Governor Carney, who has already faced fierce criticism from pro-Brexit MPs regarding his impartiality during the referendum campaign, to respond that he would not “take instruction” from politicians about how to handle policy issues. Politicians have returned fire, and then some, with former Conservative leader William Hague writing yesterday that “eight years after the global financial crisis [central banks] are still pursuing emergency policies that are becoming steadily more unpopular and counterproductive. Unless they change course soon, they will find their independence increasingly under attack.” Whilst a good debate is healthy, that is tantamount to a threat. And one which most economists find unacceptable.

For one thing, central banks are not charged with distributional policy issues. That lies solely in the realm of government. If governments have not used the fiscal space created by the lowest interest rates in history, which after all were delivered by central banks, that is purely their own fault. Moreover, at a time when governments have been conducting an aggressively tight – and pretty regressive – fiscal stance it makes sense to keep monetary policy as lax as possible. It is called policy coordination and is what the Fed did during the first term of the Clinton Administration of 1992-96. We might not like the fact that interest rates remain at their emergency lows after eight years, but monetary policy prevented a much more dramatic collapse than might otherwise have occurred. With central banks having done the heavy lifting for all this time, what politicians should now be saying is, “thanks, we will take it from here."

Threats to central bank independence are not new, of course. The US Fed has been subject to Congressional badgering for years, as Alan Greenspan’s autobiography makes clear. The ECB’s unconventional policy measures have routinely been scrutinised by the German Constitutional Court, to ensure that they do not fall foul of the letter of the law. But is central bank independence all it is cracked up to be?

The independent central bank par excellence is the Bundesbank, which successfully delivered low inflation and stable growth for Germany for almost 50 years. Whilst the academic evidence suggests that they do deliver lower interest rates than non-independent central banks, this may be more to do with the trend towards more independence at a time of low inflation. Indeed, like many other aspects of monetary policy, they may simply be a fad which serves a purpose for a while but ultimately fall victim to a change in economic fashion, like monetary or exchange rate targeting. Indeed, there has been a tendency in the last 20 years to entrust the running of central banks to academic economists, not career bankers. Whilst they undoubtedly have a better understanding of monetary theory, which has allowed them to be more creative at finding solutions as interest rates hit the lower bound, I wonder whether the more restrained bankers of old would have been quite so tolerant of the liquidity build-up which contributed to the crash of 2008-09?

There is a school of thought which says that independent central banks were created to solve a problem which no longer exists – the reduction of inflation to tolerable levels – and that whilst they may be good at slowing the inflation process, they are not so good at reflating economies. There may be something in this, and we should not overlook the fact that the biggest financial crash in history took place on the watch of independent central banks. So there is nothing mystical or immutable about their independence. But the point of independence is to allow them to do things that politicians do not always like. Sometimes these things may be inconvenient, but if politicians want to change the landscape they need to have a grown-up discussion about the mandate, not issue threats.Political dialogue? There's a novelty!