Thursday, November 20, 2014

Central Banks’ Outdated Independence

BUENOS AIRES – The global financial crisis has raised fundamental questions regarding central banks’ mandates. Over the past few decades, most central banks have focused on price stability as their single and overriding objective. This focus supported the ascendancy of “inflation-targeting” as the favored monetary policy framework and, in turn, led to operational independence for central banks. The policy was a success: the discipline imposed by strict and rigorous concentration on a sole objective enabled policymakers to control – and then conquer – inflation.

But, as a consequence of this narrow approach, policymakers disregarded the formation of asset- and commodity-price bubbles, and overlooked the resulting banking-sector instability. This, by itself, calls for a review of the overall efficacy of inflation-targeting. Moreover, after the financial crisis erupted, central banks were increasingly compelled to depart from inflation targeting, and to implement myriad unconventional monetary policies in order to ameliorate the consequences of the crash and facilitate economic recovery.

With advanced economies struggling to avoid financial collapse, escape recession, reduce unemployment, and restore growth, central banks are being called upon to address, sometimes simultaneously, growing imbalances. This has triggered a search for a radical redefinition of central banks’ objectives – and has cast doubt on the appropriateness of maintaining their independence.

In particular, central banks’ behavior during the crisis has called into question whether inflation-targeting is an effective framework in the presence of systemic shocks, and, more broadly, whether it can be sustained throughout economic cycles. After all, a policy regime that sets aside its only goal during a crisis seems to lack the ability to cope with unexpected challenges. Critics identify this “crisis straitjacket syndrome” as the main problem with single-minded inflation targeting.

While theoretical arguments can be made to justify recent departures from policy, the reality is that in the post-crisis world, advanced-country central banks’ goals are no longer limited to price stability. In the United States, the Federal Reserve has essentially adopted a quantitative employment target, with nominal GDP targets and other variations under discussion in other countries. And financial stability is again a central-bank responsibility, including for the more conservative European Central Bank.

This shift toward multiple policy objectives inevitably reduces central-bank independence. Some analysts have recently claimed that this is because the pursuit of GDP growth, job creation, and financial stability, as well as the establishment of priorities when there are tradeoffs, clearly requires political decisions, which should not be made by unelected officials alone. Moreover, by pushing interest rates toward zero, the current policy of quantitative easing (increasing money supply by buying government securities) has strong, often regressive, income effects. Opponents of central-bank independence contend that, given the allocational and distributional consequences of current monetary-policy interventions, central banks’ decision-making should be subject to political control.

But this argument neglects an important point. While it is true that multiple policy targets tend to increase the political sensitivity of central banks’ decisions, concentrating only on price stability also has important distributional consequences and political implications. In fact, politicization is a matter of scale, not a substantive transformation of monetary policymaking.

The real reason why central-bank independence tends to create a democratic deficit under a multi-target monetary-policy regime, and why it has become increasingly vulnerable, is that the two main arguments in favor of it no longer apply.

The first argument in favor of central-bank independence is that, without it, politicians can exploit expansionary monetary policy’s positive short-run effects at election time, without regard for its long-run inflationary consequences. (By contrast, fiscal and exchange-rate policies rarely imply comparable temporal trade-offs, and thus are difficult to exploit for political gain.) But this argument becomes irrelevant when ensuring price stability is no longer monetary policymakers’ sole task.

The second argument for institutional independence is that central banks have a clear comparative advantage in dealing with monetary issues, and can therefore be trusted to pursue their targets independently. But this advantage does not extend to other policy areas.

Given that central banks are likely to continue to pursue multiple objectives for a long time, their independence will continue to erode. As long as governments do not encroach excessively on central-bank decision-making, this development will restore balance in policymaking and support policy coordination, particularly in times of stress.

To ensure a positive outcome, policymakers should develop a fully transparent framework with well-defined “rules of engagement.” A strict framework for allowing, and at the same time limiting, government’s involvement in central-bank decision-making is particularly crucial in emerging markets, given that, in most of them, central-bank independence has contributed not only to the eradication of inflation, but also to institution-building.

Central-bank independence is a peculiar institutional innovation. Seemingly irrefutable theoretical models underlie a paradigm that has changed in significant ways, and that, if preserved, is bound to cause serious political problems. Like it or not, policymakers must accept that central-bank independence will continue to weaken, and they should prepare to cope with the consequences.

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    1. CommentedCarol Maczinsky

      The systems which work have independence, listen to the Sirens as you like but not when you are in control of a ship.

    2. CommentedRobert Pringle

      Mario offers an excellent account of what is happening; but the enormity of what is involved in effectively abandoning the inflation targeting framework needs to be fully taken on board. If we do reject it, please let us go into this new world with eyes open! We are abandoning a monetary rule, the only one we have - the one big lesson of the 1970s and all that. What is going to replace it? Don't let us pretend we can have our cake and eat it.

    3. CommentedProcyon Mukherjee

      The IMF note "Rethinking Macro-policy-2" by Blanchard et al prescribes almost nothing very concrete and the vagueness in these discourses is mounting that the inter-connectedness of the monetary policy with fiscal policy and the looseness of the former with the consequential tightening of the latter has no definitive outcome on which policy could be broad-based. Out of the plethora of targets from financial stability to exchange rate moderation to inflation targeting, the only leftover seems to be the addition of jobs and a departure from the wage rigidity that the zero lower bound has permanently impaired; the last dollars released by the Fed leaves the marginal efficiency question hanging in the air as only a fraction is moving to investments in the physical and human capital building. All this leaves a sobering thought how much control central banks have over the affairs of a recovery when so much fragility is in evidence.

    4. CommentedC. Jayant Praharaj

      While prolonged low-interest rate policies by the central bank along with reckless behavior by economic agents in the economy may give rise to asset bubbles, attempts to use monetary tightening to deflate existing asset bubbles can be dangerous. So the point about central banks disregarding asset bubbles needs to be examined very carefully. The central bank is traditionally in the business of tracking and influencing ( or trying to influence ) prices, unemployment levels and economic output. Trying to affect existing asset bubbles may very well mean compromising on one or more of these other goals.

      The question of what a particular central bank targets and the question of whether it is independent are two separate questions. Non-independence of the central bank may imply undesirable aspects like unbridled seigniorage financing of an irresponsible and incompetent government. Clearly, this kind of feature associated with non-independence of central banks needs to be avoided. This is not to say that a central bank should not try to use seigniorage at all, but it should not follow the whims of a government. Instead, to the extent possible, it should use the best methods available to help with maintaining a good balance of inflation, employment and output.

      During recent economic crises, the US Fed, for example, has often tried to help employment and output to the extent that it can, and based on the best understanding it has ( instead of just targeting inflation ). This does not make it non-independent from the US Federal government. It tries to help output and employment while still being an independent body.

    5. Portrait of Pingfan Hong

      CommentedPingfan Hong

      The argument of "because the pursuit of GDP growth, job creation, and financial stability, as well as the establishment of priorities when there are tradeoffs, clearly requires political decisions, which should not be made by unelected officials alone" is strange: as both the central bank governor and the finance minister are appointed by the President (though in different terms, at least that is the case in the US), why these two positions have different political implications?

    6. CommentedRalph Musgrave

      Thoughtful article by Mario Blejer but he doesn’t quite take his ideas to their logical conclusion, which I think is as follows.
      1. Decisions on stimulus should not be in the hands of politicians because the latter will simply boost stimulus prior to elections. Ergo the decision should be in the hands of an independent committee of economists. And whether that committee is part of the central bank doesn’t matter.
      2. That in turn means that the whole concept of “central bank” becomes near irrelevant: it might as well be merged with the Treasury, though there may be minor technical reasons for keeping it separate.
      3. As distinct from stimulus decisions, the decision as to what proportion of GDP to allocate to public spending, and how that is split as between education, law enforcement and so on, that’s an obviously political decision which should stay in the hands of the electorate and politicians.

    7. CommentedMargaret Bowker

      A good article on an interesting subject. When a country's economy is satisfactory, then a Central Bank 's remit is usually narrower and its independence high, often focusing on price stability in order to be a brake on any fiscal exuberance. However, a different ethos comes into effect when growth is very low, or negative, and debt is very high. As Mario Blejer says, crisis situations encourage flexibility in monetary policy and the working together of fiscal and monetary policy. Issuing indications of monetary policy timescales seems a valid measure and offers a greater degree of certainty; and targeting QE and basing monetary flexibilty on growth figures also has merit. Central Bank remits can be adjusted when a Governor's term ends, if the economic situation has improved and it is safe to reintroduce more independence and narrower targeting, although it seems likely a degree of flexibility will be always be retained now.

    8. CommentedStamatis Kavvadias

      Definitely the wrong take on a crucial issue. The perspective of the author is focused on how we *engineer* a balanced institutional framework. Intentionally, attention is destructed from the facts that led to the crisis, and focuses on the post-crisis situation and what it gestates. The truth is that *occurrence of the crisis proves inflation targeting wrong*!
      (not post-crisis central bank policy effectiveness, trying to offload some of the well deserved decrial!!!!)

      In fact, the crisis has eventually revealed to many (even central bankers who do not want to acknowledge it), the fallacy of indirect central bank control to the "money supply": a system with *no reserve requirements* (or next to zero), that allows no limit to private bank money *creation and lending*!

      This renders "inflation targeting" tantamount to lying with models, inflation indices, and numbers. It should be clear by now, setting policy rates only *seams to work*, because private banks are allowed to inflate long term assets, like government debt and property-backed loans, and because these assets are not accounted for by central banks "measuring" inflation!

      This is the real thing that renders central bank independence an insult, and a clear threat to democracy, as has become apparent. Most of all because, lack of accountability and this crew of hypocrites that hide their responsibility for the crisis under the carpet, only exploiting our ignorance, is a recipe for disaster!!!

      P.S.: By the way, private banks inflate long term assets using derivatives and speculation, which are supposed to reduce risk with increased complexity, and which is tantamount to *nonsense*, if complex derivatives are supposed to be products someone will buy! This is a fairytale, regulating authorities *allowed* to become our present nightmare.
      *This is not "systemic risk"* --the new fairytale they are feeding us!

    9. Portrait of Michael Heller

      CommentedMichael Heller

      A quick response, with apologies if I am not giving due credit to the subtlety of your argument. I agree that if it is already an irreversible fact that central banks have outreached beyond their original monetary remit then it is probably inconceivable and perhaps undesirable that they retain the old degrees of independence from government.
      I can see you are talking mainly about Europe and the US but still find it ironic that an Argentine, and you of all people, should give this advice, since Argentina (during administrations prior to yours) tried so desperately hard to design institutional mechanisms to restraint the irresponsible propensities of high-spending (inflation-inducing) politicians.
      If one accepts your argument, then, as you say, one way to go is clear new “rules of engagement” in the relationship of government to the central bank (John B Taylor might like that). Another or parallel way, I might prefer, is to design and enforce alternative constitutional constraints on government, i.e. new rules to limit the scope of the prevailing un-restraint of government in regard to the areas (employment targets, fiscal policy, etc.) where central banks have begun increasingly to trespass. This might permit central banks to *go back* to, and be limited to, price stability (Weidmann is perhaps the central banker who would like to put himself back in that box). I just have this uncomfortable feeling that by focusing on and accepting the expansion of central bank functions you are forgetting to deal with the more important core issue of addressing the maldevelopment and over-expansion of (unneeded/duplicated) government functions (which seems to me to be the problem of our times). John Cochrane is an example of someone who it appears to me has an intelligent critique of central bank over-expansion, when what is really needed is a rethink of government. Government is doing too much nowadays, but that’s no excuse for subcontracting superfluous roles to central banks. The answer might be to think of institutional mechanisms able to accommodate the perpetual redefinition of what is essential (natural monopoly) and what is superfluous. Again, I’m sure there are ways of fitting this ambition with John B Taylor’s emphasis on simple predictable policy rules.