Friday, November 28, 2014

Independence Lost

TILBURG – Every major economic crisis has its victims. Some bounce back, while others experience long-lasting, even permanent, damage. When it comes to the global crisis that erupted in 2008, output growth has been a resilient victim. Central bank independence, by contrast, has been undermined severely – and possibly forever.

In the 1970’s, the Western world was confronted with a unique phenomenon: simultaneous recession and rising inflation. Germany’s success in maintaining low inflation in this environment was explained by the fact that the Bundesbank was de facto independent from the German government. This triggered a global movement, in which country after country adopted legislation to increase the independence of its monetary authority. Soon, inflation began to fall.

With rapid economic growth leading to lower-than-expected outlays and higher-than-expected income for Western governments, maintaining central banks’ independence from political pressure was easy. Governments did not need their central banks to print money.

But, in a less favorable economic climate, printing money becomes a handy alternative to difficult decisions and painful adjustments, such as tax hikes and deep cuts in government spending. Indeed, since the onset of the ongoing financial and sovereign-debt crisis, advanced-country governments and central banks have allowed fiscal policy to prevail over monetary policy.

The Bank of Japan is the most recent example of a major central bank bowing to its government’s wishes, which Prime Minister Shinzo Abe bluntly declared should be accommodated. The BOJ’s recent decision to buy an unlimited number of government bonds to meet its new inflation target of 2% has effectively ended the guise of autonomy.

Likewise, the Bank of England is effectively buying almost every new British government bond that is issued, even with annual inflation above the legally established ceiling of 3%.  Although British inflation has been higher than 4% in recent years, even rising above 5%, the Bank of England has continued to loosen monetary policy. Meanwhile, the US Federal Reserve is now buying more than 90% of newly issued US Treasury securities.

All three countries are violating the most important central-banking commandment: Thou shalt not engage in monetary financing of government spending. But this is not surprising, given that these countries’ central banks have never actually been independent.

For example, Article 4 of the Law on the Bank of Japan states that the bank “shall…always maintain close contact with the government and exchange views sufficiently, so that its currency and monetary control and the basic stance of the government’s economic policy shall be mutually compatible.” This means that the BOJ can pretend to be independent, but only for as long as the government permits.

Similarly, Article 19 of the Law on the Bank of England permits the Treasury to direct the Bank’s monetary policy, if it is “satisfied that the directions are required in the public interest and by extreme economic circumstances.” A favorite phrase among politicians, “public interest” is sufficiently vague to allow substantial room for maneuver, as is “extreme economic circumstances.” Indeed, these criteria have resulted in the Bank of England accommodating the UK Treasury’s wishes fully.

In the US, the Federal Reserve Act can be amended by a simple majority in Congress, a fact of which the Fed is acutely aware. Moreover, in the last few years, the system of checks and balances in place within the Fed’s Board of Governors has been severely hampered by the fact that, in his first term, President Barack Obama had the rare opportunity to appoint or re-appoint almost all of its members, enabling him to replace hawkish governors with doves.

By law, the European Central Bank is among the world’s most independent. And the cumbersome and difficult process of amending the ECB’s statutes – which, as part of the Treaty on the European Union, cannot be changed without agreement of all European Union member states – protects it from political pressure. But, rather than taking advantage of this, the ECB has accommodated European politicians, behaving less and less independently since the beginning of the crisis.

In southern Europe, central banks have traditionally been part of the government, which means that representatives from most EU member states consider central-bank subjugation natural. Given that they all have an equal say in ECB decisions – and that, since 2008, majority voting has replaced unanimity in ECB decision-making – the ECB has begun to resemble the Banca d’Italia far more than the fiercely independent Bundesbank. The ECB’s policy of purchasing large quantities of government bonds from ailing eurozone countries reflects this change, prompting two experienced German bankers, Axel Weber and Jürgen Stark, to resign from their respective posts as Bundesbank President and the ECB’s chief economist.

Independent central banks are becoming a relic of the past. The fact that inflation has increased in many Western countries, despite the severe recessions of recent years, could mean that financial markets have begun to account for this fundamental shift. If central bank independence is the key to maintaining long-term price stability, the era of low inflation may well be over.

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    1. CommentedMarinus Huizer

      I think these comments are unfair. Dr Eijffinger laments the erosion of CB independence. Of course when the BoE or de Fed (by now a giant hedge fund) buy gvt paper outright they monetize gvt debt. What he does not say is that just injecting money into the economy without this being part of an explicit policy to target an observable indicator (NDGP, private consumption, employment) is bad for CB credibility. A credible CB should be able to hit its target.

      I think the Japanese case is very different from the UK and the US (let alone the EU) Japan is presenting this uninhibitedly as a program to stimulate the economy through the FX channel. Doing this they are finally fighting back against Korea that has never allowed markets to set the KRW exchange rate. Japan, the US and to a certain extent, are complementary economies; FX mercantilism does not make sense there. However, Korea and Japan (rather their private sectors) are direct competitors and in that context, Japanese inaction did not make sense.

    2. CommentedJaroslaw Przybyl

      90% of new treasury bonds are expected to be purchased by FED in 2013, Bank of Japan is already holding 30% of treasuries in Japan. How Japan or US would be able to finance its debt in the absence of central banks’ help? On one hand they keep the treasury yields low facilitating debt issuing and servicing on the other they are the main buyer. I would call it monetizing after all.

    3. CommentedLee Scharich

      There are a number of very serious issues with your characterization of central banks in this article. Most outrageous is your assertion that central banks in the US, UK, ECB, and Japan have "engaged in monetary financing of government spending." You are either being intentionally obtuse or you simply do not understand what is implied by this. Mrs. De Kirchner's Agentina or Orbán's Hungary could be accused of this, but hardly the Federal Reserve. You fail to distinguish between two obviously distinctive practices: monetary easing and monetary financing fiscal shortfalls, the differences are obvious. Unlike Argentina or Hungary, where inflation has risen above 30% and access to sovereign debt markets is limited, the aforementioned developed countries are not locked out of borrowing. In fact the opposite is true! Borrowing costs in America, Japan, and the UK are at historic lows, while inflation is mostly absent. Regarding inflation, your thesis is at odds with reality. Excluding the brief oil-driven spike in 2011, there has been consistently low inflation the countries you mention. for more see:

      Lastly, you border on intellectual dishonesty when you bemoan the loss of "independence" of central banks and then criticize the ECB's policy of accommodation while admitting that this has nothing to do with the bank's lack of independence. If anything the aggressive stance taken by Mario Draghi and the ECB has been an EXAMPLE of the bank's independence... from Angela Merkel and the Bundebank in this case.

      You essentially conflate "independence" with "monetary rigidity" and argue for an increase in both. You justify this absurd stance by pointing to the threat of higher inflation in "many Western countries" (without specifying which). You fail to demonstrate the latter and completely misrepresent the former.

    4. Commentedsrinivasan gopalan

      Going by the example of the US, UK, Japan and some European countries post-crisis a la 2008 alone is not a sufficient ground to state that central banks the world over are becoming a relic of the past. In emerging economies like India the central bank stood its ground firmly and against the dictates of the political masters lest the raging inflation should be a runaway one if its primary responsibility to leash in price rise and usher in price stability is not to be thwarted. It would be jejune to argue that central bankers are not being backed tacitly or openly by the political dispensation. What is being experimented by way of unconventional monetary policy cannot be an alibi to state that the central banks the world over are losing their credibility or credo! It is time academic community got its act together before being unduly critical of the central banks which in many parts of the world including in advanced countries are doing a wonderful work in sticking to their basic remit of reining in inflation. If the remits become unwieldy then the problem begins to surface, much to the embarrassment of all. Let us all back the central banks in their thankless task of bringing some relief to us all as consumers since escalating price of essential consumption items is too grave a burden to get adjusted to by millions of people whose income is not indexed to inflation. That said, let us be more responsible in our assessment of ground realities! G.Srinivasan, Journalist, New Delhi, Inde

    5. CommentedFrank O'Callaghan

      Economics seems so childish from any intelligent standpoint. Of course an increase in the money supply by printing money will result in inflation -all other things being equal! A more interesting question is why this has not happened?

      Huge QE and no inflation! Why? Because the QE is not real of course! The 'printed money' has been locked in the vaults of the banking system that caused the mess. This money has been credited to the accounts of reckless gamblers who have lost amounts equivalent to years of real economy production.

      An economic system that does not reflect reality or the needs of the population is ultimately doomed.

    6. CommentedGreg A

      Very poor article. Inflation is not the issue in western countries and central banks can easily control it if needed. A higher inflation is in fact an arguably good thing given the high levels of public debt. But apparently the "central bank commandment"is more important, what a joke.

    7. CommentedZsolt Hermann

      The most important missing element from the article, and from most comments about the crisis is the underlying root cause.
      These articles are based on the notion that humans are floating in free air, independent of any system, independent of evolutionary changes, independent of natural laws.
      Thus we think everything is in our hands we just have to tweak here and there, adjust finances, or markets, or politics and soon we will return to where we want to be.
      This illusion is driving us ever deeper into crisis.
      We are not independent, we are part of a vast natural system that has strict, unbending natural laws.
      Through evolutionary changes we entered a global, interconnected human system, where independence as we thought before simply does not exist.
      In a fully interdependent network we live in today, each action invites a global reaction that rebounds to the initiator with multiple force. Before any action we would need to take the whole system and its optimal state into consideration.
      Constant quantitative growth is not possible in such an interconnected system, which is embedded into a closed, finite natural environment, only through harmful, destructive competition.
      These facts are always left out of commentaries or decisions, thus people keep on suggesting, implementing superficial, local, partial solutions completely ignoring a systemic point of view.
      We will not understand let alone solve the crisis until we view the whole picture in its entirety.