The Illusion of Central Bank Independence

by on January 8, 2013 at 7:30 am in Economics, Law, Political Science | Permalink

In 2009 a number of prominent economists signed a petition arguing for central bank independence. I was less enthusiastic writing:

There is nothing magical about independence that makes for low-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.

Joseph Stiglitz recently made similar remarks

“[The crisis] has shown that one of the central principles advocated by Western central bankers- the desirability of central bank independence-was questionable at best…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.”

From Business Insider, which adds:

[Stiglitz] believes that in the run-up to the financial crisis, the Federal Reserve was accountable only to Wall Street, and singles out New York Fed President William Dudley for some especially harsh criticism. He claims Dudley was “a model of bad governance” because of his inherent conflict of interest: he bailed out the very banks he was supposed to regulate – the very same banks that enabled him to gain his position.

1 mw January 8, 2013 at 7:44 am

It’s true it’s a stupid word. But of course what they meant historically was that it not be subject to *popular* political forces, as an elected official would have an incentive to ramp up inflation in run up to an election. Maybe the idea made more sense before we let banking become 8% of GDP.

2 Bill January 8, 2013 at 8:23 am

Agree. You don’t want the central banker to be subject to pressure from the Chair of the House Banking Committee or the Wall Street Journal editorial board every month.

In fact, I think you see degrees of freedom, and steps taken by central bankers to be free even of those influences. You can create your own independence depending on the circumstances. Or, if there is a crisis, you can make it clear that you are part of the team.

Take Bernanke’s committment to keep interest rates low until 2014. This means that we do not have to read WSJ articles or editorials about what the Fed should do to raise interest rates. He is creating his own independence.

Odysseus assured his independence by having his crew tie him to the mast.

3 oh yeah January 8, 2013 at 8:16 am

that awesome chinese central bank that flodded the market with nonperforming loans of which a substantial portion ended up in the wallets of the leading class and caused inflation which to this day angers many chinese. what a great example

4 Ashok Rao January 8, 2013 at 8:22 am

I don’t even think in China’s case we would call it a central bank. More like a National bank.

5 scott linthorst January 8, 2013 at 8:54 am

1. I believe there is an argument to be made for consistently low interest rates. I’ve never seen anyone come out in favor of hyper inflation. Consistency is good because it is predictable – people can count on it.

2. The policies of those more centralized banks have not been tested in the long run yet. not to mention they started from different baselines. What a broad sweeping and non.metric based comment

6 mo lo January 8, 2013 at 8:57 am

This is an awesome book about how the political decision of CBI works out.
Bankers, Bureaucrats, and Central Bank Politics: The Myth of Neutrality (Cambridge Studies in Comparative Politics)
Christopher Adolph

7 Millian January 8, 2013 at 9:16 am

Aren’t there significant differences between the economies of China/India/Brazil on the one hand, and Europe/USA on the other?

Maybe extremely rapid technological convergence matters more than central bank governance for GDP growth. Just a guess.

8 UnlearningEcon January 8, 2013 at 9:18 am

Great post!

I’d extend this to say I don’t think anything can truly be outside politics, despite economist’s desires to the contrary.

9 Eric falkenstein January 8, 2013 at 9:24 am

I don’t think China, India, and Brazil are fully developed, so their ‘catch up growth’ is dominating. You might add that Paraguay and Liberia were unaffected by the 2008 crash–they aren’t in the same league. Economists aren’t (weren’t?) against central bank’s being part of the legislature because they like bankers, but rather, as Weimar showed, and as the 1970’s showed, there’s a populist incentive towards higher inflation that ultimately is very costly.

10 Peter Schaeffer January 8, 2013 at 9:48 am

Stiglitz criticizes Dudley, but not Geithner? Dudley took over the New York Fed in January of 2009. Geithner ran the New York Fed from November, 2003 until he left to join the Obama administration. Geithner had absolute responsibility for regulating Wall Street as Wall Street went crazy. There is not evidence that he did anything substantive to restrain the recklessness, greed, irresponsibility, cupidity, etc. that crashed Wall Street and the U.S. economy. Obama make him the Secretary of the Treasury.

Denouncing Dudley while ignoring Geithner is political pandering at its worst. No doubt Stiglitz supports Obama and is loathe to do anything (even utter a few honest words) that would undermine the anointed one. Of course, it’s long been rumored that what Stiglitz really wants is an appointment.

11 Philip W January 8, 2013 at 9:53 am

What a weird post. “BREAKING: Joe Stiglitz does not like the regulatory conduct of U.S. bank regulators.”

12 Andrew' January 8, 2013 at 10:09 am

Why would banks put themselves in a position to require the beneficence of government to bail them out? In other words, where’s Joe been? Is he just playing his proper historical role as a credit dove when the money is flying around and then blaming banks for predatory lending when the sketchy borrowers bust the banks?

13 Andrew' January 8, 2013 at 10:10 am

And who is The Fed supposed to bail out, shrimp boat fishermen?

14 Delhem January 8, 2013 at 10:20 am

The primary purpose of central-banks is monetary inflation.

Supposed “independence” is nonsense. Central-Banks are fundamentally government entities, everywhere & always.

15 Millian January 8, 2013 at 10:22 am

So are courts, but they are often independent.

16 chuck martel January 8, 2013 at 10:36 am

Yes, the independent judiciary, which is composed of members of the legal profession. There might be the possibility of independence in central banking if the central bankers themselves were drawn from a pool of circus jugglers, gunsmiths and pole dancers but since the central bankers are bankers it doesn’t seem very likely.

17 Steven Kopits January 8, 2013 at 10:41 am

Have you read Gorton, Alex? In a systemic crisis, the purpose of the central bank is to protect the system as a whole. The weakness of the system, as I comment extensively in “The Bankers’ New Clothes” below, results from the mismatch in durations of the asset and liability side of the banking system.

If you disagree with Gorton in “Misunderstanding Financial Crises”, then say so explicity and explain why. But no modern society has elected to liquidate its financial system during times of panic. Gorton takes us through the history in nice, plain terms.

As for the performance of the OECD versus the non-OECD during the Great Recession, no one (other than myself) has proposed a plausible reason. Suppose it were 2005, and you were at the IMF with a staff economist. You said to him, “I will give you a two lists of countries, tell me which list is experiencing fiscal crisis. List 1 is Argentina, Egypt and Indonesia. List 2 is Iceland, the United States and France.” Without hesitation, the economist would have picked List 1. And yet, in 2008, it was List 2–and specifically excluded List 1. No one has explained why. You are arguing that it was, what, the independence of the banks, or the lack thereof?

That’s not even remotely plausible as a narrative, unless you are arguing that bank independence is a bad thing and actually caused or exacerbated the Great Recession in the OECD. If that’s your case, get your guns, because there’s going to be some shooting.

18 mark January 10, 2013 at 1:04 pm

I haven’t read that book but the point is exactly right. One of the three main purposes of the Fed IS to bail out banks. Stiglitz has a capacity for ridiculousness that is infintely baffling.

19 Eliezer Yudkowsky January 8, 2013 at 10:47 am

I thought at first I was reading a Scott Sumner post (seriously, that’s what I thought, I often read this and Money Illusion in the same window) because of the obvious mechanism – if you’re Scott Sumner, you believe that of course Boards favoring more inflation did better during the crisis.

20 o. nate January 8, 2013 at 11:30 am

One of the benefits of NGDPLT as proposed by Sumner is that it would make the question of central bank independence largely moot, since central bankers would be for the most part following a deterministic formula.

21 mulp January 8, 2013 at 11:59 am

The view that the Fed was the central bank from 2000 to 2007 is the problem. The shadow banking created monetization equal to the Fed in the US economy, and perhaps 50% of the ECB and Eurozone banks.

The run on the shadow banks in 2008 return the power to the Fed and ECB, and if they had not acted in the past four years to offset the destruction of money in the shadow banks, we would have seen a depression, and the losses would have been felt by hundreds of millions of individuals in loss of their “cash savings”.

Was the Fed and ECB acting independently when it prevented hundreds of millions of people from pulling all their cash (if they could) out of all the banks and Wall Street? Or was the Fed catering to the demands of the bankers and Wall Street? Or was the Fed catering to the demands of the politicians who did not want a depression caused by a pure cash economy?

The Fed and ECB independence is the ability to implement a technical solution without explaining to voters and policy makers why the technical solution will prevent a depression, and without having to explain who is being saved from suffering the consequences of the failure of the non-central shadow banking failure.

22 Daniel January 8, 2013 at 12:23 pm

I´m not sure Stiglitz’s remarks about the developing economies should be seen as denoting causality. At the very least, it’s a highly selective subsample. Besides, in the specific case of Brazil, the Central Bank was highly regarded as independent until circa the first half of 2010, after the crisis. Now, after a significant policy shift, the country is underperfoming all of its latin-american peers.

23 mark January 10, 2013 at 1:09 pm

This is true. Brazil’s CB has cut the SELIC almost in half over the past year, the real has debased over 10% and the economy is still underperforming. Real GDP growth of about 1% was less than population growth last year meaning the people got poorer individually. Consumer debt has exploded upward. The government has basically maintained price controls over everything energy related. Its hyper inflation era is only a generation away. It’s hard to see anyone endorsing its economic model for a developed country.

I have found the website pretty interesting.

24 MorganWarstler January 8, 2013 at 12:42 pm

one can conjure up a system where Local Virtual Mutual Banks easily get FDIC protection…. and later we ONLY give them FDIC protection.

Using an online model like COVESTORdotCOM – anyone with decent credit could cough up a deposit of $5K+ get it matched by outside investors, and be able to make Local loans around town with their entire book exposed.

Profits yearly would be split with his depositors (the Mutual bit). Best bankers would run quite a book. Losers would be drummed out and ruined. Conservative lending would reign, but loans would be competing A LOT. The very rich would have to pt $250K into lots of different bankers to get that FDIC coverage.

The point is that online data sharing and home offices obliterates the costs of lending and TBTF efficiencies that Big Banks. And the profits / prod gains flow to SMB borrowers.

Lesson: We can easily make banking a tool for distributism, which alters the playing field of borrowers / creditors – and changes our perceptions of inflation on the whole.

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