Refuted economic doctrines #6: Central bank independence
The idea that central banks can and should act independently of governments is, fairly clearly, inoperative for the duration of the crisis in many countries. The combination of massively increased liquidity provision and large-scale bank bailouts requires close co-ordination between central banks and national treasuries, though the form of this co-ordination is inevitably different in different countries.
But the failure of central bank independence goes much deeper than this. The underlying idea was that monetary policy should be left to independent experts, and should be the main tool for macroeconomic stabilisation. Governments were expected to avoid active fiscal policy, focusing primarily on maintaining budget balance (there were some differences in view as to whether governments should target annual balance, or balance over the course of the macroeconomic cycle). The shift to independent central banking was closely associated with the adoption (implicit or explicit) of inflation targets as the primary focus of monetary policy, and with interest rates as the primary tool.
Not much of this appears sustainable in the light of the crisis. Inflation targeting failed to prevent unsustainable asset price booms, and it now seems clear that these could not have been prevented without much more direct control over unsound financial innovations. That’s a task where interaction between governments and central banks appears unavoidable. On the one hand, expertise is crucial. On the other hand, as with war, financial innovation is to important, and too dangerous, to be left to finance experts.
The idea that monetary policy alone is sufficient for macroeconomic stability might have looked appealing during the Great Moderation, but does not stand up when examined over a longer period. To put it bluntly, central bank independence appears to work well except when it is most needed.
A more difficult question relates to the separation between monetary policy and prudential regulation. The need to take systematic risk into account suggests that monetary policy must be closely integrated with prudential policy. On the other hand, Australia, with a clear separation between monetary and prudential regulators has done better than countries where central banks are more closely involved. My feeling is that the correct separation is between strategic issues, such as monitoring of systemic risk and the regulation of financial innovations, which belongs with the central bank, and institution-level supervision, which belongs with a specialist agency.