Why central bank independence is a bad idea

Why are central banks independent? If you stop to think about it, it’s really very odd.

Central banks are the only entities in the world that have the power to control money supplies – to move interest rates around the place as and when they fancy, and to create unlimited money. This gives them astonishing power. Yet they are completely – in theory at least – independent of outside, and in particular elected government, control.

As David Blake points out in a newsletter from Montrose Associates: “once appointed, no central bank head can be sacked for having the wrong policy or being incompetent”.

At the same time, while governments can’t tell central bankers what to do (that’s considered political interference in monetary policy), central bankers get to amuse themselves at great length by releasing statements telling governments what to do.
All this might (just might) be OK if the banks were any good at using their extraordinary powers. But recent history tells us that they are really worse than useless.

In the years before the great financial crisis of 2007, they lounged around in something of a golden age. “Not only had governments transferred effective control of demand management to them by giving up discretionary fiscal policy”, says Blake, but “they were able to bask in the glow of praise” that came their way as the economy appeared to flourish with low inflation. They were able to set short-term interest rates low with seeming impunity, while dismissing ‘minor issues’ such as unemployment and stagnant real wages as supply-side problems that were really nothing to do with them.

They actually deserved none of this praise. They might have looked like they were creating a great moderation, but they were actually creating one of history’s great credit bubble and busts – based on the idea that targeting one particular level of inflation alone is not just “necessary for good economic performance, but also sufficient” – when it clearly isn’t.

In fact, the more you look at the independence of central banks, the odder it looks. Not only does it “set itself firmly against the kind of holistic joined up approach which is fashionable in other areas”, as well as against the democratic process, says Blake, but even before it was introduced it was already known in some circles that it probably wasn’t going to work.

Anyone who has studied economics will remember being taught about the Moniac, a series of glass tanks and pipes built by economist Bill Phillips back in 1949 to model the workings of the UK economy. It was designed to be used as a teaching aid, but provided a variety of interesting predictive information as well.

Here’s Blake on one of them: “one student pretended to be chancellor … and the other governor of the central bank. When they coordinated tax and interest rate policy, all went smoothly. But when they were told not to talk to each other, but just do what seemed right in their own field, everyone got very wet as water splashed around.” Reason to doubt, then, whether “this idea of complete separation of monetary and fiscal policy, which lies at the heart of central bank independence, is a good idea.”

There’s no point in pretending that economies were immaculately run in the days before central banks grabbed all the power. But there do, nonetheless, seem to be more than enough good arguments for reversing the policy. That way, we at least won’t find that our elected governments can’t control our own money supplies – that the political choice between inflation and employment is out of their hands. Nor will we find ourselves in the situation we saw last year, when the then president of the European Central Bank, Claude Trichet, surveyed the wreckage of the global economy as he stepped down, and pronounced the ECB’s performance on his watch as “impeccable”.

Before the crisis the general view was that monetary policy was too important and too technical an issue to be left to politicians. It seems to me now that it is too important and too political an issue to be left to unaccountable technocrats. More on all this from Blake here and from Businessinsider.com here.