Why central banks will just keep getting weaker

Mario I. Blejer, former governor of the Central Bank of Argentina, on independence.

The global financial crisis has raised fundamental questions regarding central banks’ mandates. Over the past few decades, most central banks have focused on price stability as their single and overriding objective. This focus supported the ascendancy of “inflation-targeting” as the favoured monetary policy framework and, in turn, led to operational independence for central banks. The policy was a success: the discipline imposed by strict and rigorous concentration on a sole objective enabled policymakers to control – and then conquer – inflation.

But, as a consequence of this narrow approach, policymakers disregarded the formation of asset- and commodity-price bubbles, and overlooked the resulting banking-sector instability. This, by itself, calls for a review of the overall efficacy of inflation-targeting. Moreover, after the financial crisis erupted, central banks were increasingly compelled to depart from inflation targeting, and to implement myriad unconventional monetary policies in order to ameliorate the consequences of the crash and facilitate economic recovery.

With advanced economies struggling to avoid financial collapse, escape recession, reduce unemployment, and restore growth, central banks are being called upon to address, sometimes simultaneously, growing imbalances. This has triggered a search for a radical redefinition of central banks’ objectives – and has cast doubt on the appropriateness of maintaining their independence.

In particular, central banks’ behavior during the crisis has called into question whether inflation-targeting is an effective framework in the presence of systemic shocks, and, more broadly, whether it can be sustained throughout economic cycles. After all, a policy regime that sets aside its only goal during a crisis seems to lack the ability to cope with unexpected challenges. Critics identify this “crisis straitjacket syndrome” as the main problem with single-minded inflation targeting.

While theoretical arguments can be made to justify recent departures from policy, the reality is that in the post-crisis world, advanced-country central banks’ goals are no longer limited to price stability. In the United States, the Federal Reserve has essentially adopted a quantitative employment target, with nominal GDP targets and other variations under discussion in other countries. And financial stability is again a central-bank responsibility, including for the more conservative European Central Bank.

This shift toward multiple policy objectives inevitably reduces central-bank independence. Some analysts have recently claimed that this is because the pursuit of GDP growth, job creation, and financial stability, as well as the establishment of priorities when there are tradeoffs, clearly requires political decisions, which should not be made by unelected officials alone. Moreover, by pushing interest rates toward zero, the current policy of quantitative easing (increasing money supply by buying government securities) has strong, often regressive, income effects. Opponents of central-bank independence contend that, given the allocational and distributional consequences of current monetary-policy interventions, central banks’ decision-making should be subject to political control.

But this argument neglects an important point. While it is true that multiple policy targets tend to increase the political sensitivity of central banks’ decisions, concentrating only on price stability also has important distributional consequences and political implications. In fact, politicisation is a matter of scale, not a substantive transformation of monetary policymaking.

The real reason why central-bank independence tends to create a democratic deficit under a multi-target monetary-policy regime, and why it has become increasingly vulnerable, is that the two main arguments in favor of it no longer apply.

The first argument in favor of central-bank independence is that, without it, politicians can exploit expansionary monetary policy’s positive short-run effects at election time, without regard for its long-run inflationary consequences. (By contrast, fiscal and exchange-rate policies rarely imply comparable temporal trade-offs, and thus are difficult to exploit for political gain.) But this argument becomes irrelevant when ensuring price stability is no longer monetary policymakers’ sole task.

The second argument for institutional independence is that central banks have a clear comparative advantage in dealing with monetary issues, and can therefore be trusted to pursue their targets independently. But this advantage does not extend to other policy areas.

Given that central banks are likely to continue to pursue multiple objectives for a long time, their independence will continue to erode. As long as governments do not encroach excessively on central-bank decision-making, this development will restore balance in policymaking and support policy coordination, particularly in times of stress.

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Leader: Theresa May and the resurgence of the state

More than any of her recent predecessors, the Prime Minister seems willing to challenge the economic and political orthodoxies of the past 35 years.

Theresa May entered office in more tumultuous circumstances than any other prime minister since 1945. The UK’s vote to leave the European Union was a remarkable rebuke to the political and business establishment and an outcome for which few had prepared. Mrs May recognised that the result was more than a revolt against Brussels. It reflected a deeper alienation and discontent. Britain’s inequalities of wealth and opportunity, its regional imbalances and its distrusted political class all contributed to the Remain campaign’s ­defeat. As she said in her speech in Birmingham on 11 July: “Make no mistake, the referendum was a vote to leave the European Union, but it was also a vote for serious change.”

When the financial crisis struck in 2007-2008, David Cameron, then leader of the opposition, was caught out. His optimistic, liberal Conservative vision, predicated on permanent economic growth, was ill-suited to recession and his embrace of austerity tainted his “modernising” project. From that moment, the purpose of his premiership was never clear. At times, austerity was presented as an act of pragmatic bookkeeping; at others, as a quest to shrink the state permanently.

By contrast, although Mrs May cautiously supported Remain, the Leave vote reinforced, rather than contradicted, her world-view. As long ago as March 2013, in the speech that signalled her leadership ambitions, she spoke of the need to confront “vested interests in the private sector” and embrace “a more strategic role” for the state. Mrs May has long insisted on the need to limit free movement of people within the ­European Union, and anticipated the causes of the Leave vote. The referendum result made the national reckoning that she had desired inevitable.

More than any of her recent predecessors, the Prime Minister seems willing to challenge the economic and political orthodoxies of the past 35 years. She has promised worker representation on company boards, binding shareholder votes on executive pay, improved corporate governance and stricter controls on foreign takeovers.

The shadow chancellor, John McDonnell, has set the ­Labour Party on a similar course, stating in his conference speech that the “winds of globalisation” are “blowing against the belief in the free market and in favour of intervention”. He pointedly criticised governments which did not try to save their domestic steel industries as China dumped cheap steel on to global markets.

We welcome this new mood in politics. As John Gray wrote in our “New Times” special issue last week, by reasserting the role of the state as the final guarantor of social ­cohesion, Mrs May “has broken with the neoliberal model that has ruled British politics since the 1980s”.

The Prime Minister has avoided the hyperactive style of many new leaders, but she has deviated from David Cameron’s agenda in several crucial respects. The target of a national Budget surplus by 2020 was rightly jettisoned (although Mrs May has emphasised her commitment to “living within our means”). Chancellor Philip Hammond’s Autumn Statement on 23 November will be the first test of the government’s ­fiscal boldness. Historically low borrowing costs have strengthened the pre-existing case for infrastructure investment to support growth and spread prosperity.

The greatest political ­challenge facing Mrs May is to manage the divisions within her party. She and her government must maintain adequate access to the European single market, while also gaining meaningful control of immigration. Her statist economic leanings are already being resisted by the free-market fundamentalists on her benches. Like all prime ministers, Mrs May must balance the desire for clarity with the need for unity.

“Brexit means Brexit,” she has repeatedly stated, underlining her commitment to end the UK’s 43-year European
affair. If Mrs May is to be a successful and even transformative prime minister, she must also prove that “serious change” means serious change and a determination to create a society that does not only benefit the fortunate few. 

This article first appeared in the 29 September 2016 issue of the New Statesman, May’s new Tories