From the start of his second administration, American President Donald Trump sent shockwaves through global financial markets and the community of economists by taking a specific interest in the central bank of the US, the Federal Reserve. Central banks mostly make the headlines in times of economic crisis, when the guardians of monetary policy are called upon to stabilise the economy. However, in this instance, that was not the case. Instead, Donald Trump tried to fire Lisa Cook, a governor of the Federal Reserve. Putting aside the ongoing legal battle, Trump’s intervention attacked the highest value of a central bank: independence.
Why Independence?
The attempted firing of a Fed governor is not without precedent. Throughout history, politics has often interfered in monetary policy, with various consequences. Yet many worry about the potential outcomes of Trump’s interventions specifically. But why is central bank independence so important?
The positive effects of central bank independence have long been established in literature. Primary among them are higher credibility of a central bank’s policy announcements and a solution to the time-inconsistency problem. The latter refers to the competition between a potential short-term economic boost, preferred by politicians who stand for election, and long-term stability. An independent central bank usually has the long-term in mind when making decisions about the economy. A prime example of this would be the stern commitment to high interest rates under Fed Chair Paul Volcker. In the 1980s, during a time of stagflation (high inflation combined with stagnant economic growth), Volcker raised and kept the interest rates purposefully high to control inflation and ease investors. This policy was criticised at the time for its harshness towards workers and the recession it brought on, but has retroactively been regarded as necessary by mainstream economists.
Central bank independence has become a self-evident principle. The importance of stability is so fundamental that any interference in the Fed, the most influential central bank in the world, would throw the global monetary system out of balance. This self-evident truth, however, may not be as self-evident.
How Independent?
While politicians might prefer the short-term economic boost and the accompanying votes, investors act as a counterweight. They prefer independence and long-term policies. They are deterred from putting up capital if they detect political interference. Politicians are discouraged from interfering due to the necessity of private investment for a functioning economy. Theoretically, this tension leads to an equilibrium, where the most independent central banks draw in the most amounts of capital. As with many theories, however, it only holds to a certain extent.
Many different indices have ranked the independence of central banks worldwide. Unsurprisingly, the European Central Bank (ECB) ranks near the top in all studies. The Federal Reserve, lauded for its abilities to attract direct investment due to its high level of credibility, often ranks towards the middle, right next to the People’s Bank of China (PBoC). Given the stark difference in political systems, this violates established theories. If the US government exercises as much control over its central bank as the one-party state of China, investors should flee the United States. There is, however, a relatively simple explanation for this seemingly contradictory ranking.
These indices are composites, meaning they take into account several different measures of independence. Crucially, these measures are equally weighted, whereas investors may value some elements more than others. The PBoC scores poorly on policy independence and limits on lending to the government. The Fed excels in these categories, but suffers from the duality of its mandate with the focus on price stability and employment, two conflicting objectives. While the evidence for the trade-off between inflation and unemployment has been harshly criticised, on a theoretical level, the interaction holds. Ideological differences of Fed governors, that is a preference for higher employment or lower inflation, influences its independence. The ECB in contrast, scores very highly on all indicators. Being endowed only with a mandate of price stability, it does not have large conflicts in its policy conduct. The question then remains, who benefits from which central bank strengths?
Whose Independence?
Decisions on monetary policy, particularly in the case of the Federal Reserve and its mandate to balance inflation and unemployment, have heterogeneous effects on a population. Critiques of current central banking practices reinforce the push for democratisation. While the mandate of central banks always includes price stability, distributional consequences are rarely addressed. Central banks, therefore, are not completely apolitical. Receiving the mandate of price stability which is most important for private investors, central banks provide stability by ensuring that bondholders keep receiving returns.
A more democratic approach, benefitting not only bondholders, has been brought forward multiple times, especially after big financial crises. Central banks, during the 2008 Global Financial Crisis, the Eurocrisis, as well as the COVID-19 shock, were trying to keep prices stable and calm investors. Though, democratisation by including the public in decisions on monetary policy may not be the answer. Shocks to the economy, such as COVID-19, need to be dealt with quickly. Holders of government debt should not be
alienated, as the constraints on state budgets become tougher to obey in every crisis. The mandate of the central bank, keeping asset-rich investors calm, has important implications and acknowledging this may improve some aspects of central banking. The public may have preferred different policies if consulted, which may have brought different distributional consequences, but would also have sacrificed speed, which is crucial in crises. This trade-off stands at the centre of central bank independence.
After more than a decade of financial crises, from “whatever it takes” in Europe to COVID-19, central banking has turned from stewards of monetary policy, distinct from politics, to active negotiators in day-to-day politics. This cemented their commitment to sustaining the status quo.
Democratic deliberation may be too slow, delaying crucial decisions. Moreover, public opinion is easily swayed, depending on the crisis. This leaves two options, both of which are rather unrealistic. First, true independence from politics can likely never be achieved, at least not while central banks play such a crucial role for the lives of every citizen. Second, making the political mandate of the central bank explicit risks antagonism. Hence, both options are unlikely to be realised as their downsides are too great. However, a new approach to central banking is needed, should monetary sovereignty be restored to its proper place.
Central banking in response to shocks will always be a difficult task. During times of economic stability, the job of a central banker is relatively uneventful. This should also remain the same. Without crises and experimental monetary policies, both investors and the public tend to be satisfied. Nevertheless, political instability and economic volatility have become commonplace around the globe. While a return to boring central banking might look attractive, it is unlikely given the faultlines in the global economy. A new equilibrium between democratisation, efficiency, and boredom has to be found.
Written by Konstantin Philip, Edited by Myrddin Snoeck
Photo Credit: Etienne Martin (Uploaded on 27 July, 2017) on Unsplash
