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.

39 thoughts on “Refuted economic doctrines #6: Central bank independence

  1. What will be the anchor for monetary policy now if inflation targetting has failed? Do central banks return to focusing on monetary aggregates? Or do they extend their inflation-watching mandate to asset prices?

    As to the relative stability and soundness of Australian banks, that would appear to be more an unintended consequence of the Four Pillars policy (as Ian Macfarlane observed) than to any particular prudential judgment by APRA.

  2. The biggest asset boom was obviously in the US and the Fed didn’t have inflation targeting.

    Considering the fact that inflation usually increases before a recession, and considering the fact that this occurred this time around as well, I would argue that inflation targeting is more essential than ever.

    I would, however, argue that if the goal of monetary policy is price stability, then prices should be kept stable. ie “zeroflation” (neither inflation nor deflation over the course of the business cycle).

    Had interest rates been higher in the US after 2001, there is a chance that the housing bubble might never have formed. After all, interest rates were lower than inflation rates between 2003 and 2005, and that was the period when the housing bubble blew up the most.

    Negative real interest rates should never be practised by central banks.

  3. Here are a few epigrams that if applied might help central bankers create a stable monetary system.

    Do not lend money if you do not have it.

    Create assets first then create money

    Measure wealth by what we have not by what we consume

  4. Re 3


    Perhaps the first two are better directed to private banks…

    I’m not sure that anyone says that consumption is wealth. Consumption might encourage firms to increase capacity, and it is the latter that constitutes wealth. Consumption might reactivate idle resources. Idleness reduces the value of productive wealth. The effect of consumption is indirect and not generalisable.

  5. PS to 4

    Of course consumption may increase income, as distinct from wealth. And consumption can erode wealth (partying away your life savings, or chopping down trees to make confetti). As measured in the national accounts, consumption raises GDP if output rises. But sometimes we in effect consume our capital(our stock of wealth) and mis-define this as higher income.

    There is a forgotten definition from Sir John Hicks: income is defined as the maximum amount you can consume without reducing your wealth. It seems clumsy at first but it is useful.

  6. I haven’t forgotten it, though I (and Wikipedia, FWTW) would call it Haig-Simons. But Hicks would have been saying it about the same time.

  7. If the independent or arms-length monetary policy system fails when fiscal action is required, shouldn’t the obvious response be to add fiscal policy to it’s repertoire? My understanding of the rationale of RB setting interest rates is that a voter driven process will be seriously suboptimal because voters are too short-sighted to increase interest rates when it’s required. By similar reasoning, voters are equally silly when setting tax levels. Witness the current tax cuts situation. I’d prefer to assign responsibility for tax levels and fiscal policy to the central bank – or central bank like entity, I guess – rather revert to a political process for monetary policy. In fact, it can’t be too long before an AI could do a better job of managing the economy, if it hasn’t happened already. It might upset the SIGs, and close a few Canberra eateries, but there you go.

    If the next questions are why not hand more stuff over, and, what do we really need a government for at all, so be it.

  8. Coogee Resources Limited
    CSL Limited
    Securency International Pty Ltd
    Coca-Cola Amatil
    PrimeAg Australia
    ALH Group
    Fairfax Holdings
    BlueScope Steel
    James Hardie

    This is an incomplete list of active directorships currently held by a majority of the Board of the Reserve Bank of Oz.


  9. Bruce I was referring to the measure we use to measure “progress” or the GDP. This I believe is a measure of the total amount of money spent not the total amount of assets we have at our disposal. Thus if I buy a pack of cigarettes it counts as much as if I buy a machine to make cigarettes. Hence the third epigram.

    The first two refer to the way we as a society increase the money supply by creating debt and money first before some of it turns into assets.

  10. #8 Hmmmm…interesting Fred. It was always the same. Protecting money in banks, over jobs and unemployment, always came first with the money men in a crisis….way back to Rothschilds. Lets see if they block financing of deficits this time around..? Nothing would surprise.

  11. Fred can you explain how those companies incentives aren’t aligned with the economy as a whole? Fred and Alice, John has raised some good points regarding whther central banks should be independent but i don’t think there is any reason for google video type paranoia.

  12. Certainly El Mono, lets run down some of the list briefly.
    CSL used to be a public body did it not? Then was privatised.
    That’s an issue which straddles ideology.
    Coke is an international company I understand and we must take the interests of transnationals into account when looking at how to run our economy mustn’t we?
    Fairfax are having one or two financial problems at the moment aren’t they?
    That would qualify them for a seat at the board that decides fiscal policy.
    James Hardie??? Iv’e heard of them for some reason. Why is that company famous?
    Wal Mart, who are they?
    Telstra, weren’t they once known as Telecom? What is the difference?

    El its bleeding obvious all these companies are involved in the economy.
    Who isn’t?

    But is no one else? Are the only groups ‘aligned’ with the economy big business groups, are they the only source, well 5 out of 6 non bureaucrats, for expertise on the board?
    Is there not a prima facie case for ‘conflict of interest’?
    How does a person, well 5 of them, go from a meeting of directors of any one, actually all, of the companies above with their agendas and issues directly relevant to that subset of the Australian economy [not ALL the Aust, economy consists of big business only El] but nowhere near representative of the interests of ALL Australians, and then take off one hat “Director of …” and put on another “RBA Board Member”?
    You seem to subscribe to Henry’s little saying [paraphrased]:”The business of Australia is business” or did he say “What’s good for business is good for Australia”? I forget.

    The point I make above is very simple, the RBA Board is not an independent group.

  13. Fred #12 may be understating the problem. I recall back in the 1970s Ted Wheelright’s team producing an analysis of interlocking directorships in Australia; i.e., the somewhat cartelised economy, protected by tariffs, was run by relatively few people each on many boards. Google points to updated research such as this.
    Re Interlocking directorships as a small-world network:

  14. Fred, i should have been more specific, can you name where the interest of those board memebers aren’t aligned with the economy in regards to monetary policy which the reserve bank controls.

  15. El why don’t you explore the possibilty that there may be other personnel from other groups who can have a say in RBA policy?
    Try figuring out who else, other than big business, may be appropriate to board membership.
    Because currently, 5 out of 6 non bureacratic members, a majority of the total Board, is just a trifle overkill.
    Or do you consider that nobody, no group, that is not big business, is qualified to sit on the board?
    Only big business need apply.

  16. I would not really have an issue with a more diverse range of board members, but at the same time I can not see what those companies would want from monetary policy that any Australian wouldn’t. I think that treasurers would be of the logic when he makes these appointments.

  17. “..I can not see what those companies would want from monetary policy that any Australian wouldn’t ..”
    With all due respect El, that is a ridiculous statement.
    You are equating what all big business [not just business but specifically ‘big’] would want with the interests of all Australians.
    You are agreeing with these statements [before it was implicit in your words but now its explicit]:
    -“The business of Australia is business”
    -“What’s good for business is good for Australia”.
    Not everybody buys the conservative capitalist ideolgy you know.

    Look check out the current membership, check out the history of membership of the Board, see if you can see other groups and members who may have brought a different perspective, ideology, set of values, to the Board other than the Fordism you think is the only relevant POV.

    At the moment we have a highly blinkered group.

  18. Fred, i am being specific, regarding Monetary policy. This is not big business on the board of the Treasury or the ACCC this is a very specific policy arm. Why would big business want a tightening of monetary policy when the rest of australia want a loosening and vice versa what am missing here?

  19. Monetary policy has ramifications for much of the economy in a variety of ways, it impacts on the prices of goods and services, including labour that is, wages and salaries, it impacts on housing and other costs, on inflation and on employment.
    Thats just to name a few areas.
    OK so far?
    Right, well big business does not have the same wishes and hopes as the rest of Australians in toto in respect to any one of those issues.

    One of the RBA members was CEO of a company that had a subsidiary that was convicted of price collusion [something like that] and fined millions.
    The companies involved and ‘all Australians’ do not share a perspective on that.

    One of the members was associated with the union breaking crisis on the waterfront.
    Unionists, and maybe others, do not share the same perspective as big business on the value of unionism.

    Look through the role of the RBA and you will see many areas where decisions are made that various sectors of the Oz community have a range of opinions that do not directly agree with that of big business.
    Employment for example.
    Yet it is from that perspective that the majority of the board approaches the monetary issues it considers.
    Unless you believe a lifetime of experience and ideology can be shucked off at the doorway to one boardroom, another tried on for the occasion and then swapped back when heading for Telstra or Brambles or Coke whoever.
    Leopards and spots.
    This post is mainly about the ideology, the dogma of economic doctrine.
    Not all groups in our society share the same dogma.
    I for one do not see why one small, but powerful, group of vested interests should be allowed to dominate the decision making process on a set of policy that has considerable impact on other sectors, those not big business, and effects the lives of millions.

    A fraction of a percent increase in housing interest rates can have a major impact on the lives of millions of Aussies [that may be a bit of an exaggeration but you get my drift]. How on earth can a bunch of men [one exception] whose average income in their recent/current working lives is measured in several millions of dollars per year each, understand or have the slightest concept of what that means to ordinary folk in real terms?
    They live in a different world.

  20. The way monetary policy effects inflation and emplyment areactually far more aligned than you would make them out to be. Issues regarding union bashing and price fixing are irrlevant to decisions on monetary policy. A counter example is sortof pointless because it can not be witnessed, but of the board was all Union leaders Monetary policy would not have been done any differently.

  21. 1. I believe that the board of the RBA has no real power or influence over the bank’s decisions. I understand that the board has always accepted the Governor’s recommendations. The minutes released over the past few months show this.
    2. Even if independent central banks are partly responsible for the bubble by keeping interest rates too low, does anyone seriously believe that if such decisions were made by politicians interest rates would have been increased sooner? I vote for independent central banks, perhaps with tighter goals.

  22. Why not have fiscal policy set by rule (or pre-announcement) independently of politicians too?

    In a boom, raise taxes by x%.
    In an asset boom, raise capital gains taxes by y%.
    In a crisis, move projects X, Y and Z forwards.

    Is parliament really the place for the untutored to “debate” the effects of once-off payments vs “permanent” tax cuts?

  23. El Mono – if the makeup of the board has no impact on the decisions reached then surely there is no need for the board at all.

  24. Ken N has picked up a reasonable point. The main post goes too far too soon on the (lack of) value of Central Bank independence, and the circumstances in which it is desirable. Yes, collaboration with the government on monetary policy is necessary in a crisis – what else would you expect? And yes, central bank’s performance in managing damaging asset bubbles over the last 15 years hasn’t been good – but that was outside all banks’ specified area of control.
    The key questions are:
    1. Would government control of interest rates resulted in better inflation and asset price outcomes over the past 10 years?
    2. Can we improve the performance of central banks by explicitly including targeted control of asset price inflation in their brief?
    3. Are we committing the fallacy of expecting engineering-standard central banking performance when all we can really expect is less damage than if politicians were at the helm?

    I suggest No to the first and Yes to the remaining questions.

    Re:Bruce, on independent fiscal authorities, there has been a lot of talk about this for some time. The UK has taken some steps with their Fiscal Council cabinet paper (, and Barry Eichengreen has been writing about the concept for years. But the practicalities for budgetary rules are more difficult than monetary ones, and in all honesty would probably require things like target banding for clearly defined underlying, structural, headline budget balances and much stronger control over line item definitions.
    It was hard enough to move people to central bank independence. In a recession ceding this sort of control just ain’t gonna get there.

  25. If you want glowing proof that the RBA should not be independent just read this nonsense from them in Dec 2006:

    Some Juicy quotes:

    “Old rules of thumb about individual mortgages have likewise been rendered
    obsolete. As lenders have used a wider range of information to ascertain different
    borrowers’ credit risk more precisely, the amounts they are willing to lend are no
    longer linked to repayment-income ratios or loan-to-valuation ratios in a simple
    way. Particularly in North American markets, simple ratios have given way to
    credit scoring and risk-based pricing, so that loan sizes and pricing are more
    closely tailored to individual borrowers’ circumstances.”

    “The most important lesson to draw from recent international experience is that a
    run-up in housing prices and debt need not be dangerous for the macroeconomy,
    was probably inevitable, and might even be desirable”
    “If a macroeconomic downturn were to occur, it could be exacerbated by a
    correction of an extended housing boom. However, the experience of Australia and
    the UK seems to suggest that booms in housing price growth can subside without
    themselves bringing about a macroeconomic downturn.”
    “These relatively benign outcomes point to the underlying robustness of the
    financial systems in these economies”
    “Although there have been anecdotal reports of home buyers experiencing
    negative equity, it seems that much of this can be attributed to the normal
    idiosyncratic risk inherent in a heterogeneous product like residential housing.”

    “….it might provide some comfort that an economy-wide contraction is not
    the inevitable outcome of a substantial increase in property prices.”

    And so on … and so on….. and so totally, completely wrongly on.

    Fire them all {and bring out the pitchforks, tar and feathers I say}.

  26. Sorry OldSkeptic (#26), but pointing out RBA statements that are wrong in hindsight, or even were likely to be wrong given a good application of economic principles, doesn’t address the key issue:

    Would things have been any better with closer control of monetary policy by politicans, or by public servants answerable to politicians?

    The fact the RBA got it wrong is to be expected. If they got it right it would only be a fluke. Expecting monetary authorities to get it right – rather than less wrong than politicians – is to give to central banking a degree of certainty and knowledge that isn’t there, despite the claims of academics and central bankers.

    Again, the monetary policy frame for independent central banking is about getting it less wrong, not exactly right. And as your quotes show, individual research economists in central banks are (sadly) just as susceptible to herding errors as others are. Which is why the institutional framework and charter has to be clear and enforced.

  27. “….it might provide some comfort that an economy-wide contraction is not
    the inevitable outcome of a substantial increase in property prices.”

    I agree Oldskeptic, its just so much rubbish isnt it?….and if banks old methods used as lending criteria (like repayment income ratios) were giving them danger signals, well they made new measures that didnt and they could turn their back on risk while ever the party was in full swing and they were making money from a dangerous bubble in housing and shares. Statements proliferated in media such as “we have the underlying fundmantals right, housing corrections dont affect the economy……. They may as well have added “and when I count to three you will be wide awake and remember nothing!”

  28. Oldskeptic #26 Today we have Obama trying to think of a way to stop AIG disbursing taxpayers bailout monies as huge employee bonuses. Should have let it fail. The infallible market fundamentals imploded, and they got addicted to their lavish lifestyles and now want the taxpayers to fund it. Time to escalate the problem from tar and feathers to the public gallows Oldskeptic.

  29. At what point were the Central banks totally independent ? It must be the shades of grey kind of independence.

    The Central banks came about by the political will of the bureaucrats not the civilians. That implicates the bureaucrats as major exploiters of the central banks power.

    We are simply better off without Central banking, because it clealry has been exploited at either end of the scale of independence, by the government and/ or by those private individuals in charge of it.

  30. Ubiquity #32 What makes your suggestion of an “orderly liquidation of Iceland” any less attractive than an “orderly liquidation of AIG”. AIG is trading whilst insolvent with a large injection of government help. Or is that type of fiscal injection OK Ubiquity (when it goes to insolvent private sector organisations?)
    You argue for no government interventions, no government and no central bank, and then you support AIG coming for a big government intervention with its begging bowl in hand for taxpayers money.

    Your argument is completely, profoundly and wildly hypocritical.

  31. I think you missed my point or I wasn’t very clear. I think AIG should be liquidated. I just didn’t expect you take the same position. I was a little suprised at your response.

  32. When AIG are taking taxpayer support and continuing to pay themselves huge salaries and bonuses, in my opinion, the corporate executive of AIG is decadent, rotten to the core, and undeserving of federal tax money assistance. Evil is a better word, and you dont provide evil a lifeline.

  33. Nanks, the makeup should be made up on the basis of Economic competence (which i understand everyone thinks is a crontradiction in terms now)as the basis of sound monetary policy aligns with the incentives of all the broad classes (big business, small business, workers , consumers).

  34. I agree with Milton Friedman that central bank independance is bad because it gives the central banker too much discretion in setting monetary policy. As One Salient Oversight points out the Fed doesn’t have an formal inflation target.

    The great moderation lasted so long in the US because between 1983 and 2002 Volker and Greenspan set interest rates in a rule like way most of the time and adopted a defacto inflation target.

    Later Greenspan didn’t obey the Taylor rule at all, and Taylors recent research strongly implicates this in the asset price boom and subsquent bust.

    Having said that central bank discretion beats treasury discretion. More credibility, which means that smaller movements in interest rates are required to move inflationary expectations back to target, and no less (but I wouldn’t say zero – it depends on the central banker) temptation to run an electorally synchronized business cycle.

    I propose that monetary policy should be set according to the following rule. This is a standard forward looking Taylor rule in normal times, but if interest rates fall below a certain threshold (say 0.5%), a McCallum rule (monetary target that gets adjusted based on the output gap) is employed, eg quantatiative easing is automatically switched on.

    The RBA board would oversee the operation of the rule and monitor its performance, with the option of switching it off if actual or projected performance deteriorated too much.

    Of course, this would do nothing to deal with asset price bubbles. If Quiggin is right that the best response is regulatory, that is best left to the Government.

    – Tim

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