Independent Central Banks and Inflation

by on July 20, 2009 at 7:39 am in Uncategorized | Permalink

A number of prominent economists have signed a petition calling for Congress and the Executive Branch to reaffirm their support for and defend the independence of the Federal Reserve System."  The petition is disingenuous. 

The petition argues that "central bank independence has been shown to be essential for controlling inflation."  "Essential," is a big exaggeration.  There is evidence that more independent central banks are better at controlling inflation (e.g. Alesina and Summers 1993).  Consider, however, New Zealand's central bank; it has been very successful at reducing inflation but in some ways it is one of the least independent central banks in the world precisely because (unlike in the U.S.) the governor can be fired if inflation moves outside of a target region.

Furthermore, the petition says that central bank decisions should not be "politicized."  Again,this is disingenuous.  Why are more independent central banks better at fighting inflation than less independent central banks?  There is nothing magical about independence that makes for low-inflation.  Suppose we pick someone at random and give them complete power over monetary policy.  Such a central banker would be very independent but I wouldn't count on this policy resulting in much in the way of systematically lower inflation.

The primary reason that independent central banks are better at controlling inflation is that absent direct political control the default selection mechanism favors bankers, i.e. lenders, people whose interests make them more favorable towards lower inflation.

Thus, independence is a political decision that favors lenders in the decisions of monetary policy.  Now, depending on the alternatives, there may be good reasons for making this choice but we should not fool ourselves into thinking that we have depoliticized money.  We should not be surprised, for example, that "independent" central banks tend to make lender of last resort decisions that protect banks and bankers.

Addendum: See also Robert Higgs on the petition and Arnold Kling offers cogent comments on the closely related issue of whether the Fed should be "audited," whatever that means.

Andrew July 20, 2009 at 8:13 am

In every current debate, it seems to me people are confusing sustenance of the current flawed yet viable system with the changes that require its gradual demise and may be improvements or disasters. It’s all the same problem. The only wrong way to go is to make many changes fast and all at once, which is of course what we are doing.

Doc Merlin July 20, 2009 at 9:23 am

Um… I thought the purpose of the central bank was to create inflation and prevent deflation?

Am I wrong here?

Jose July 20, 2009 at 10:04 am

The whole idea of independence as a good thing is based on the presumption that, without it, there would be political pressure for higher inflation. That is because there is a coordination problem: everybody wants higher spending in their specific area, but not higher taxes. Solution: monetize the deficit (and dilute the government debt), but everybody eventually looses due to uncertain inflation. Independence, the argument goes, solves in great part that coordination problem by eliminating that channel of funds.

You are saying here, it seems: “be careful, the independent body could still be captured by powerful players, big banks, that want their debts to be diluted”. But these same banks have also assets that would be diluted, so I do not see why they win so much by higher inflation.

It seems to me that the actions of the Fed of the last year reflect academic consensus (but not understanding) rather than capturing by big banks. That academic consensus rests in two a priori beliefs: 1. there are banks that are too big to fail (that is why we have to give them facilities), that is, they pose systemic risk; 2. deflation is disastrous for an economy.

The academic consensus on these issues come, as I say, not from theory, but from some intuition coupled with some scattered evidence.

Millian July 20, 2009 at 10:26 am

This post conflates goal independence and instrument independence. If RBNZ is not independent because the governor can be fired, then no central bank with a mandate is independent. Every major central bank has a mandate or goal set by the government. A goal-independent central bank would be a very anti-democratic institution, not to mention a sustained failure to implement monetary policy.

Gabe July 20, 2009 at 1:58 pm

“A central bank independent of political interference is desirable for the same reason that a supreme court independent of political interference is desirable.”

So to increase Supreme Court independence we need to make all rulings of the supreme court secret while also not allowing Congress to see who the judicial branch is making payments to?

daddysteve July 20, 2009 at 4:34 pm

I have yet to hear a believable reason for needing or wanting inflation. Of course, not being a banker…

mushr00m July 20, 2009 at 7:39 pm

“I have yet to hear a believable reason for needing or wanting inflation. Of course, not being a banker…”

Bankers don’t want inflation. Debtors do.

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Phil July 21, 2009 at 9:31 am

“Consider, however, New Zealand’s central bank; it has been very successful at reducing inflation but in some ways it is one of the least independent central banks in the world precisely because (unlike in the U.S.) the governor can be fired if inflation moves outside of a target region.”

I’m afraid that statement confuses INDEPENDENCE with ACCOUNTABILITY. Only in the ivory tower would
freedom from evaluation of results being confused with political interference.

johnleemk July 21, 2009 at 1:09 pm

“The hardships related to adding zeros to a fiat currency script are no less than the difficulty of adding zeros to the right of the decimal point on hard currency promisary notes.”

The result is precisely the same: inflation (i.e. the devaluation of existing money). Is this really that hard to see?

Gabe July 21, 2009 at 2:07 pm

“A number of prominent economists have signed a petition …”The petition is disingenuous”

Is Tyler becoming a conspiracy theorist? He thinks this group of economist is being “disingenuous”? I don’t disagree, but I’d love to here Tyler’s insight on the nature of these disingenuous economist. Why are they disingenuous? what is there goal? what philosophy leads them to be such phonies?

sideways July 22, 2009 at 5:02 am

Also Alex Tabarrok’s opinion as well of course.

Gabe July 22, 2009 at 10:53 am

Johnleemk,
Sticky wages is also a illogical excuse for wanting inflation. If people are reluctant to accept nominal wage cuts how does it make sense to solve this “problem” by seeking to deceive wage earners by gradually devaluing their wages?!

As much as I do advocate economic literacy, individual responsibility and think people should learn math. I do not think it is moral to set the system up to continually punish constant wage earners(uneducated people) through deception. I do not think this makes our economy more productive.

If people are not happy with wage cuts then perhaps they SHOULD reevaluate the services they provide and search out opportunities to add more value to the economy.

Are people also sticky about paying more for goods and services? Do they gladly accept paying more each year for various goods and services? no!, they pay the minimum needed to acquire the goods and services they need. Why shouldn’t this “problem” need to be solved just as badly as the “sticky wages problem”? wages are no more special a price than any other price. The superstition with which the “sticky wage theorist” treat this special class of prices called wages is primitive at best.

johnleemk July 22, 2009 at 2:14 pm

“I’m saying that a stable currency(free-market money) would lead to deflation.”

Why? As there are more people in the world and more things to buy, it is common sense that prices must either fall or more money must come into existence. Prices are difficult to adjust downwards because wages must also adjust downwards for this to work. (That’s what’s special about wages — labour is the service which almost everything hinges on. Since the price of labour rarely, if ever, falls in nominal terms, it’s hard for other prices to adjust similarly, barring other changes.) Therefore, inflation is the usual result if someone with good sense controls the money supply (this need not be the central bank; it could be a bunch of different banks charged with issuing money).

If inflation is prevented by the enforcement of a strict gold standard, then you will get slow deflation — much slower than necessary. Simultaneously you will see the economy slow down, because deflation decreases the incentive to spend or invest. Just as inflation is a tax on saving, deflation is a tax on spending and investment.

That is why *price stability* is the chief objective of most central banks. The main reason we see inflation is that they prefer to err on the side of caution and thus inflation whenever possible. If we can’t have an inflation rate of 0%, the next best alternative is 1 or 2%.

Under a commodity standard, there is no guarantee of either inflation or deflation. If the economy grows faster than the rate of extraction of the commodity, then we will see deflation; if it grows slower, then we will see inflation. An obvious example of the latter is what happened when the Spaniards began shipping gold back to Europe from the New World.

I’m sympathetic to free banking because I suspect it would get us closer to real price stability than either central banking or a commodity standard. And as for your diatribe against the notion of wage stickiness, you can tell people what to do, but they’re not necessarily going to do it. The thing about macroeconomics is that a lot of it hinges on funny sorts of market failure, from coordination failures (like bank runs) to irrational bias against taking pay cuts. These market failures aren’t necessarily remediable by government intervention, but they are a great deal of what makes macroeconomics and finance complicated.

Graeme Bird July 24, 2009 at 5:46 pm

“The primary reason that independent central banks are better at controlling inflation is that absent direct political control the default selection mechanism favors bankers, i.e. lenders, people whose interests make them more favorable towards lower inflation.”

This is half right. In that its true that an independent central bank will favour the bankers. But it does not follow that the bankers want low inflation. High inflation enriches the bankers. When they make loans without creating new money they can only ever get a cut of the interest. Not the interest itself but only a cut. When they create make loans that create new money they get almost the entirety of the value of the principal and the interest.

This is why there ought never be a central bank. Its part of a cartelisation of the financial sector run for the benefit of the bankers. What laughably passes for monetary policy usually consists of a bunch of subsidies for the banks.

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