Central bank independence: the orthodoxy's under attack

Have we handed the foxes the keys to the hen house?

Japan's central bank and treasury are discussing co-operating more on economic policy — news which has sent the Nikkei soaring, opening around 2 per cent higher than it closed yesterday, and rising further throughout today.

We've already had previews of this news. After all, new Prime Minister Shinzo Abe was elected on a promise (or threat?) to force the Bank of Japan to do more monetary easing, and has already made other unconventional moves like "nationalising" industrial stock to encourage private-sector investment.

Nonetheless, it was unclear that Abe would actually pull it off. Business Insider describes it as "one of the most taboo concepts in modern economics", noting that "the Treasury is supposed to do fiscal policy. The central bank is supposed to do monetary policy. And that's that".

But, as with so many orthodoxies of economics, the idea of central bank independence has come under attack since the global financial crisis.

Central banks are supposed to be independent to remove the risk that politicians will use monetary policy the same way they all-too-frequently use fiscal policy: to engineer temporary booms, gain brief popularity, and win elections. By removing control of policy from people who stand to gain if they favour the short- over the long-term, monetary policy ought to be "better run".

Monetary policy is worse for this sort of thing because it depends far more on ideas of credibility and restraint than fiscal does. Much of the job of a central bank involves saying the right things, rather than doing them. There's a thousand ways to hold interest rates low, but doing so while explicitly saying they will be low for the next two years (as with the Evans Rule) is very different from doing so while saying they may rise at any time.

But it's important to remember that an "independent" central bank may be no such thing. If principal-agent problems apply to banks run by democratically elected politicians, they apply just as effectively to banks run by technocratic ex-financiers. Frequently, this works well. As Tyler Cowen wrote in 2009:

The default selection mechanism favors bankers, i.e. lenders, people whose interests make them more favorable towards lower inflation.

Given the trend in monetary policy for most of the last thirty years was a desire to reduce then suppress inflation, that convergence of interests was beneficial. But there's no particular reason to expect the convergence of interests between the economy as a whole and one subsection of it to be a long-term thing.

If nothing else, we get the downsides of "independent" central banks when their policy turns to whether to backstop banks and bankers. As a lengthy Atlantic piece by Simon Johnson from May 2009 describes, too many of those decisions were actively favouring the interests of the finance industry when those interests were in direct opposition to the rest of the nation.

And as we've faced an increasing number of unprecedented situations, even the old truth has come under attack. As Joseph Stiglitz said in India earlier this year:

In the crisis, countries with less independent central banks-China, India, and Brazil-did far, far better than countries with more independent central banks, Europe and the United States. There is no such thing as truly independent institutions. All public institutions are accountable, and the only question is to whom.

Obviously the independence, or not, of the central banks is unlikely to have been the deciding factor between whether China or Europe came out of the crisis intact. But more and more people are starting to realise that concepts of independence need to be re-examined, as technocratic rulers are demonstrated to be just as beholden to their own interests as democratic ones, and as those interests continue to diverge from those of the nation as a whole.

So if Japan is about to break a taboo, maybe it has picked the right time to do it.

Pedestrians walk past a stock quotation board in Tokyo on January 11, 2013. Photograph: Getty Images

Alex Hern is a technology reporter for the Guardian. He was formerly staff writer at the New Statesman. You should follow Alex on Twitter.

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Leader: The unresolved Eurozone crisis

The continent that once aspired to be a rival superpower to the US is now a byword for decline, and ethnic nationalism and right-wing populism are thriving.

The eurozone crisis was never resolved. It was merely conveniently forgotten. The vote for Brexit, the terrible war in Syria and Donald Trump’s election as US president all distracted from the single currency’s woes. Yet its contradictions endure, a permanent threat to continental European stability and the future cohesion of the European Union.

The resignation of the Italian prime minister Matteo Renzi, following defeat in a constitutional referendum on 4 December, was the moment at which some believed that Europe would be overwhelmed. Among the champions of the No campaign were the anti-euro Five Star Movement (which has led in some recent opinion polls) and the separatist Lega Nord. Opponents of the EU, such as Nigel Farage, hailed the result as a rejection of the single currency.

An Italian exit, if not unthinkable, is far from inevitable, however. The No campaign comprised not only Eurosceptics but pro-Europeans such as the former prime minister Mario Monti and members of Mr Renzi’s liberal-centrist Democratic Party. Few voters treated the referendum as a judgement on the monetary union.

To achieve withdrawal from the euro, the populist Five Star Movement would need first to form a government (no easy task under Italy’s complex multiparty system), then amend the constitution to allow a public vote on Italy’s membership of the currency. Opinion polls continue to show a majority opposed to the return of the lira.

But Europe faces far more immediate dangers. Italy’s fragile banking system has been imperilled by the referendum result and the accompanying fall in investor confidence. In the absence of state aid, the Banca Monte dei Paschi di Siena, the world’s oldest bank, could soon face ruin. Italy’s national debt stands at 132 per cent of GDP, severely limiting its firepower, and its financial sector has amassed $360bn of bad loans. The risk is of a new financial crisis that spreads across the eurozone.

EU leaders’ record to date does not encourage optimism. Seven years after the Greek crisis began, the German government is continuing to advocate the failed path of austerity. On 4 December, Germany’s finance minister, Wolfgang Schäuble, declared that Greece must choose between unpopular “structural reforms” (a euphemism for austerity) or withdrawal from the euro. He insisted that debt relief “would not help” the immiserated country.

Yet the argument that austerity is unsustainable is now heard far beyond the Syriza government. The International Monetary Fund is among those that have demanded “unconditional” debt relief. Under the current bailout terms, Greece’s interest payments on its debt (roughly €330bn) will continually rise, consuming 60 per cent of its budget by 2060. The IMF has rightly proposed an extended repayment period and a fixed interest rate of 1.5 per cent. Faced with German intransigence, it is refusing to provide further funding.

Ever since the European Central Bank president, Mario Draghi, declared in 2012 that he was prepared to do “whatever it takes” to preserve the single currency, EU member states have relied on monetary policy to contain the crisis. This complacent approach could unravel. From the euro’s inception, economists have warned of the dangers of a monetary union that is unmatched by fiscal and political union. The UK, partly for these reasons, wisely rejected membership, but other states have been condemned to stagnation. As Felix Martin writes on page 15, “Italy today is worse off than it was not just in 2007, but in 1997. National output per head has stagnated for 20 years – an astonishing . . . statistic.”

Germany’s refusal to support demand (having benefited from a fixed exchange rate) undermined the principles of European solidarity and shared prosperity. German unemployment has fallen to 4.1 per cent, the lowest level since 1981, but joblessness is at 23.4 per cent in Greece, 19 per cent in Spain and 11.6 per cent in Italy. The youngest have suffered most. Youth unemployment is 46.5 per cent in Greece, 42.6 per cent in Spain and 36.4 per cent in Italy. No social model should tolerate such waste.

“If the euro fails, then Europe fails,” the German chancellor, Angela Merkel, has often asserted. Yet it does not follow that Europe will succeed if the euro survives. The continent that once aspired to be a rival superpower to the US is now a byword for decline, and ethnic nationalism and right-wing populism are thriving. In these circumstances, the surprise has been not voters’ intemperance, but their patience.

This article first appeared in the 08 December 2016 issue of the New Statesman, Brexit to Trump