Why central bank independence is a bad idea

Aug 15, 2012, 02:50

Merryn Somerset Webb

Posted byMerryn Somerset Webb

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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.

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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.

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  • 1. CoolerD

    (15 August 2012, 03:36PM)  Complain about this comment

    As much as central bankers can be seen as having more room to be incompetent possibly due to the lower level of public scrutiny relative to the politicians, we must not forget that scrapping this independence of the central bank from government would most likely increase uncertainty in the economy and the financial markets... Look at the US fiscal cliff for example and imagine how bad things could be in terms of uncertainty if both fiscal and monetary policies are left to the whims of politicians come a major election

  • 2. Colin

    (15 August 2012, 03:38PM)  Complain about this comment

    Central Banks are not the only entities allowed to create money. Commercial banks do it all the time, out of thin air, and in astonishing quantities, as I'm sure you know. 97% of the money in the economy was created in this way. The stupid thing is if it is repaid it is destroyed, so David Cameron and the rest of those in charge wants both economic growth (more money in the economy) and us to repay our debts (less money in the economy) at the same time!

    See www.positivemoney.org

  • 3. crazy tony

    (15 August 2012, 05:23PM)  Complain about this comment

    Its a good piece.

    The counter argument would be that the Chancellor controls the BoE remit, so only needs to change that to effectively control things like the money supply and interest rates.

    This world "independent" makes me laugh. It gets banded around all the time. I doubt the BoE prints money without consulting the chancellor.

  • 4. Colin Selig-Smith

    (15 August 2012, 07:36PM)  Complain about this comment

    Giving bankers... Any bankers control of the monetary system and monetary policy is putting the fox in charge of hen house. It is possibly the stupidest thing we could ever do as a nation. Of course they are going to think and say it is a wooonderfull idea that our money is debt based and that we must grow, grow, grow that debt decade after decade.

    I have a feeling that future generations are going to look at the post war period and end of the Bretton Woods system following Nixon's shock and wonder what on earth we were smoking.

  • 5. Nick

    (15 August 2012, 08:15PM)  Complain about this comment

    Surely the BoE example has demonstrated how bad the CB performance can be.
    In a democracy it is unthinkable that a non-elected person can have such power to do as they please and ignore their main remit.

    Hope in the next election this issue gets addressed and the BoE independence is removed.

    Would be also nice to see the MPC commitee members charged for failure of duty since they have ignored their main remit for 70+ months.

  • 6. Roberto Birquet

    (15 August 2012, 08:24PM)  Complain about this comment

    Remember well how the last government was lauded for the decision to grant the Bank independence. Just taking our own experience as a guide: an independent central bank, disastrous.

    And the governor? A knighthood for what exactly? Because he mirros the government so well: primarily in blame shifting.

  • 7. Chester

    (16 August 2012, 12:43PM)  Complain about this comment

    I have long gone on about the need to make central bankers an extinct species, but have yet to find a way of doing it without ending up in jail - which is where these incompetent fools need to end up. Will it happen? Not likely

    The reality of deflation, and their inadequate and foolish responses to a financial crisis they have largely caused, will probably do the job for us. Once people start to understand the failures of our debt based the money system, social mood will doubtless drive the change nescessary to restore "sound money" principles through suitably regulated democratic institutions. When that day comes, I doubt banks will be lending out money they do not have, and "debt" will become a dirty word again

  • 8. yorrrick

    (16 August 2012, 05:45PM)  Complain about this comment

    As Colin points out above the attempts by central banks to control the money supply are somewhat compromised because commercial banks actually create the vast majority of the money supply when they extend credit (make loans). The main control that a central bank has over commercial bank lending is to play with the interest rate but this doesn't stimulate more money to be created in bad times and fails to stop rampant money creation in good times.

    Ideally the power to create the money supply should be returned to central banks so that commercial banks can go back to doing the job that everyone thought they were supposed to be doing - intermediating between savers and borrowers.

    Astonishingly the IMF has just published a research paper 'The Chicago Plan revisited', which proposes exactly that!
    http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf

    I had to pinch myself to be sure I was not dreaming. Clever of them to publish it while all the bankers are on holiday...

  • 9. Ellen

    (18 August 2012, 04:17PM)  Complain about this comment

    I remember the argument in favour of allowing central bank set base rates, without the monthly discussions with the chancellor, was so government couldn't use reductions in interest rates as sweeteners to the electorate just before an election.

    The behavior of various members of the MPC is that of supreme rulers who feel entitled to make decisions that effects all our lives in a most fundamental way without needing to justify their themselves, apart from in the most vague of ways to newspaper journalists. There are no consequence to any failures to policies they oversee.

    Rather than their function being 'independant', much better than the decisions they are charged with should be arrived at through cross party consensus.

  • 10. Critic Al Rick

    (18 August 2012, 05:29PM)  Complain about this comment

    As I see things, insofar as the economy is concerned the BoE is no more independent than the Govt; both are puppets to the Banksters.

    Democracy has degenerated to govt. by the Banksters for the Banksters.

    We'd do a lot better with a Truly Benign & Patriotic Dictator. Trouble is, (s)he wouldn't survive long as many people don't appreciate how bad the economy really is and how drastic the required remedy.

    So we'll end up with something far worse; anarchy and/or no freedom at all.

  • 11. Andrew H

    (20 August 2012, 10:38AM)  Complain about this comment

    What this article and the commenters seem to miss is that Central Banks are also the lenders of last resort to the commecial banks, which in my opinion makes them a bad thing regardless of their "independence" or otherwise i.e. record low interest rates and QE (money printing) are their current methods of propping up bankrupt banks, and which are also disorting prices and generally ruining the economy for anyone else trying to do business.

    Try to imagine the BOE doing similar things for other businesses e.g. printing money to buy up every bread roll that the supermarkets weren't able to sell, and it's clear that their role is absurd, anti-competitive, and fraudulent.

    See "Denationalisation of Money" by F.A. Hayek for an alernative.

  • 12. robin

    (20 August 2012, 02:41PM)  Complain about this comment

    Clearly the BoE isn't independent, since they have kept interest rates very low even though their mandate clearly indicates that they should increase interest rates if inflation is above 3%.

    If they are not independent, then we might as well get rid of them. If monetary policy is controlled by politicians, at least we can vote them out next election.

    What would be expected from an independent BoE would be for them to pop the credit bubble when it first got going. This would be to the benefit of us all as it would have curtailed false growth. That would have depressed the economy and they would have received a great deal of blame for doing so. Surely this is why they are independent? But, being pragmatic, it could never have worked. Mervyn King would have been slaughtered at the time. He is an actor in a play where the part is already written.

    The only realistic solution is to better educate the voters.

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