What is central bank independence? (Updated)

Linking to Bennett McCallum with some puzzlement a while back, Brad DeLong asked why a higher inflation target could be seen as undermining central bank independence. I’m with McCallum on the analysis, but not on the policy conclusion. A higher inflation target would reduce central bank independence, and a good thing too.

The problem is that ‘central bank independence’ like the famous efficient markets hypothesis, comes in weak and strong forms. The weak form of central bank independence is the principle that the executive government should not direct the decisions of the central bank.

In this sense, central bank independence has always been the norm in developed countries. In Australia, for example, the government retained the power to override the central bank through a declaration in Parliament. This nuclear option was never used, but it created a strong incentive for agreement among what was then called the ‘offical family’.

Central bank independence as it operated from the 1990s was much stronger. The extreme form, unsurprisingly, emerged in New Zealand, then the darling of free market reformers. The Governor of the Reserve Bank of New Zealand, Don Brash was appointed on a contract (the Policy Targets Agreement) that required him to maintain inflation rates between 0 and 2 per cent, and otherwise gave him complete independence (a nuclear option allowing the government to scrapt the PTA altogether was retained).

The NZ approach to monetary policy was a disaster. Whereas Australia’s more flexible Reserve Bank steered the country through the Asian financial crisis, New Zealand was pushed into an unnecessary recession.

But less extreme versions of this approach were adopted throughout the world, and appeared, during the Great Moderation, to be successful. The key elements were

* Inflation targeting, typically with a range of 2 to 3 per cent

* Comprehensive financial deregulation

* The abandonment of active countercyclical fiscal policy

* Interest rate adjustments as the sole instrument of monetary policy

Taken together, these measures gave central banks almost complete independence from government.

If the policy responses adopted in the immediate aftermath of the crisis, including active fiscal policy and regulation of the financial system to maintain systemic stability are continued, this strong form of central bank independence would be at an end. Unsurprisingly, central banks have fought hard to return to the status quo ante, doing their best to promote fiscal austerity and resist any radical change in financial regulation.

A higher inflation target would be an even more direct repudiation of central bank independence. Not only would it facilitate active fiscal policy but it would underscore the point that the greatest financial disaster in history occurred during the era of strong central bank independence and as a result of the combination of central bank independence and financial deregulation, previously cheered on as the cause of the Great Moderation.

To paraphrase Clemenceau, monetary policy is too important to be left to central bankers. Governments will inevitably held responsible for the outcomes of macroeconomic policy, so they need to take a substantial share in shaping it.

Update To be clear, the link was to a discussion of US policy. I don’t think Australia needs a higher inflation target (as Chris Joye infers here), although, like Chris I think we need to re-examine our whole framework in the light of the GFC.

The case for a higher inflation target in the EU, US and UK is, in my view, overwhelming. It would make bondholders, as a group, pay something for the massive bailouts they have enjoyed, while reducing the need for default and/or restructuring, a process that is invariably costly and inequitable, but is certianly going to be necessary, at least for the peripheral EU countries, on current policy settings. More on this form Richard Tsukamasa Green at Troppo End update

25 thoughts on “What is central bank independence? (Updated)

  1. CSL Limited
    Origin Energy Limited
    Securency International Pty Ltd
    Woolworths Limited
    ALH Group Limited
    Fairfax Media Limited
    PrimeAg Australia Limited Wal-Mart Stores Inc
    BlueScope Steel Limited
    Brambles Limited
    Djerriwarrh Investments Limited
    BG Australia

    The list of companies above are some of those who have active directors/office bearers
    who are also members of the Board of the Reserve Bank, a majority of the Board actually.

  2. There is one thing that has become so terribly obvious with living with a lower inflation target and the hammering of higher interest rates every time it threatens to move outside the lowest of low bands. It rewards capital at the expense of labour. Central bank obsession with inflation is an oppression of a sorts. It sacrifices unemployment on the alter of capital security (capital laissez faire). It is, in itself the most obscene redistribution to the rich.

  3. Sounds like “Flashback to the Seventies”or Clement Atlee’s Britain sitting exhausted after two word wars broke its imperial hegemony in favour of the final definitive shift to the USA. I expect to see the Winter of Discontent and then Meggie Thatcher turning up in crinking black and white BBC footage followed by the Miners Strike. This went hard on many Brits, but Australians saw what was happening and they held to the hope that Hawke was the answer.

  4. @fred

    I assume the board would almost always accept the recommendation of the governor and assistant governors. Other members may raise concerns if the recommendation contradicts what they observe or believe, but for the most part, any decision on rates would be based upon the opinion of the RBA.

  5. trout
    If so, then there is no need or warrant for the Board to be so, may I use the word ‘stacked’ with persons whose ‘independence’ is so open to question?
    A key word in your second sentence is ‘believe’.

  6. @Alice

    There are specific (and well documented) reasons for a low, positive, and flexible target. Your suggestion is that the current target is too low, that the target is not flexible enough, or that they should not have any target at all. If your suggestion is that it’s too low or not flexible enough, what is your preferred target, and why is it better? If you’re suggesting there should be no target at all, I’m interested in how the high inflation environment of the pre/early nineties could be avoided? Or if it should be avoided at all.

    I know the current set-up is not ideal. But nothing is, and I fail to see how the flaws in the current system are any worse than the flaws in any other alternative system.

  7. Aren’t governments and central bankers converging in Europe? Both sides of the debate over there are being managed by the same bureaucracy, in the sense of a class of technocrats generating the thought bubbles and either side acting on them.

  8. The New Zealand approach was ridiculous but having Don Brash as Reserve Bank Governor was their greatest mistake. His ham fisted and dogmatic operation of inflation targeting must have cost NZ a significant accumulation of lost output and lost productivity. Apparently after being unsuccessful as leader of the National Party and failing to have been elected to Government against Helen Clarke and the Labour Party, he has now reappeared and is the new leader of the ACT Party – that is, the party of mostly former National Party loonies – Roger Douglas, Prebble, and so on.

  9. I do apologise for being mildly picky, but the latter named loonies (Douglas and Prebble) were members of NZ Labour, not National. Douglas started ACT in the early 90s and Prebble became one of the early leaders of the Abominably Callous Tag-team.

    I am constantly surprised at the “weird PTSD” that I’ve been left with after living through the Great New Zealand Experiment of the 80s and 90s. I find myself being strangely hypervgilant about the main players (hence my breaking from cover here) and also being strangely grateful to anyone who sees the GNZE for what it was. So, thanks Prof Quiggin for the comments above.

    The sad part is that the GNZE continues on, wafting along, in the current round of “political management”; the longevity of the “thing” apparently being maintained by a significant proportion of the electorate. I suppose that occurs because some have achieved the Economic Rapture promised in the 80s and the rest are standing in line…waiting and hoping…hoping. Sorry, this has been too much; I must go to therapy now. I really need to see my Cognitive Econopist.

  10. John,
    you are actually paraphrasing David Lloyd George.

    I see no need to change the target. It is OVER THE BUSINESS CYCLE and the target is not 2.5% both of which have escaped Christopher Joye’s notice perhaps he needs to talk to RBA officials. While I am at this no-one at the RBA has ever briefed any journalist of their intentions since Glenn Stevens has been Governor. He would understand this if again he just talked to RBA officials.

    The RBA have never had to worry about inflation going below the target only going above. They can easily deal with that by raising rates and cooling the economy.

    The only time activist fiscal policy is needed is when monetary policy is not working or is impaired as Keynes wrote of in other words in a liquidity trap.

    In most circumstances you merely let automatic stabilizers do their job.

    This of course did not apply in the GFC.

  11. @Freelander
    I agree re Brash and cut out some similar comments only to avoid thread derailment. But Prebble and Douglas are ex-Labour, and were never Nats. Still I hope Brash has the same success here as in his previous outings.

  12. What’s fascinating in the Australian context is we now have a central bank setting interest rates that are more appropriate for the Pilbara than the mortgage belts of our cities.

    If the RBA drives the wider economy into recession to “make room” for the mining boom, the political implications will be huge. Last time I looked, there were a lot more voters in east coast cities than Karratha.

  13. @trout
    Trout – you ask me the following question

    “There are specific (and well documented) reasons for a low, positive, and flexible target. Your suggestion is that the current target is too low, that the target is not flexible enough, or that they should not have any target at all. If your suggestion is that it’s too low or not flexible enough, what is your preferred target, and why is it better? ”

    What exactly are the specific, and well documented reasons for a low, positive and felxible inflation target? Could it be that lenders benefit more than borrowers? Could it be that capital benfits more than labour? Could it be that we are still operating on the premise of “trickle down” ? ie keep the lenders happy and they will invest more in businesses and job creation?
    Could it also be that the central banks have a preference for their own so called power to control the economy and deny absolutely the power of fiscal policy? How many statements have you read where central bankers say “we dont need fiscal policy” (meaning we have sole control?)
    No I dont think they can control the economy adequantely when unemployment is so largely understated, given people OLF or underemployed and lots of youth in training for want of a real job. I am not fooled by the unemployment statistics.

    I am not fooled by the RBA contu=inuing to tell us we are “close to full employment”, “inflation is a threat”, “interest rate rises are on the horizon”.

    Lets see? what would really happen in inflation rose to 5% or 8% without the RBA’ s intervention? People might get a wage rise? Labour might do better and capital (lenders?) do worse?. Let them put the interest rate up then to a decent amount so that old people can get some decent interest on their life savings?

    No, it wouldnt be the end of the world and maybe businesses would put a bit more money in workers’s pockets so they could actually spend more and maybe they would do so on inflationary expectations, so that workers real wages rose for a change.

    Make no mistake, central banks and their obsession with monetary poslicy and their aversion to the use of fiscal policy( this is ideology at its worst – they dont want to share economic policy power – they think Central banks are all we need) are a party to growing inequality.

  14. Central bank independence simply means they are working for the bankers and not for the ruling party. The election year boom of older times wasn’t the worst thing in the world. At least you knew it was coming. All aspects of institutional norms show the central bank working for banker enrichment.

  15. “The NZ approach to monetary policy was a disaster. ”

    “Disaster” understates it. Strict monetary targets combined with the elimination of the reserve asset ratio created a situation where whole towns, perfectly viable like my one, were on the verge of closing down. This was an anti-market outcome since my town had vast forestry resources and what ought to have been very viable farming outfits. New money was basically fed into the system via land bubbles in places like Auckland and Hamilton, and since the interest rate was the only limiting factor to cause monetary growth to stick at around 4% and price inflation to stay 0-2%, the interest rate was always like some sort of ever present punishment.

    The pre-Oil-Shock New Zealand banking system had been almost idyllic. There was strict separation between trading and savings banks. Trading banks created new money really only through the use of peoples cheque-books. Savings banks invested locally on the basis largely of local savings. So you would never have these local monetary droughts of the Douglas era (I like Douglas but these are technical matters). By and large the savings banks had very little basis upon which to pyramid money. At least this definitely was not their core business. There were truly excellent “building societies” which helped you get it together to buy a house. These did not create money either so did not distort real estate investment or the release of new money in specific areas like in the current and Douglas era.

    The building societies were ruined by Muldoons policies of forcing them to have government people sit on their boards and making them buy up Muldoons various bond offerings. But they would have gone under in the Douglas era in any case since they would not have been able to compete with money-creators.

    Milton Friedman was right to bring the focus back to money. But the rule-based approach could only mean soaring and crashing business revenues, which is the real metric to focus on. Worst of all was the elimination of the reserve asset ratio. This changed the entire nature of the relationship between the banks and the community. Savings bankers used to show up at primary school teaching small children the importance of saving. Now they would offload credit cards onto them if they could.

    Had the focus been shifted to money, but the politicians kept control of policy, we could have gone with the flow, knowing that there would be faster monetary growth on an election year. That would be not such a bad thing. Tight conditions for two years, knowing that light was at the end of the tunnel leading up to an election. A time to pay down debts and get out of trouble. Whats wrong with that? Part of my decision to stop being abusive of leftists comes with the understanding that cronyism and banking dysfunction are the real enemy. There is greater chance to have a lot more bipartisan agreement if we can grab these people and clip their wings like we used to do to the chooks.

  16. “What exactly are the specific, and well documented reasons for a low, positive and felxible inflation target?”

    There are none. Targeting low consumer price inflation is wagging-the-dog of business revenues. To keep the tail stable you have to take the dog (ie business revenues) and bash that dogs head against the concrete. There can never be any chance for stable growth under that formula.

  17. @Graeme Bird
    These two points you make resonate GB for they have come to pass
    1.Savings bankers used to show up at primary school teaching small children the importance of saving. Now they would offload credit cards onto them if they could.

    My son used one of my accounts for years to save his pocket money in (sure I paid the interest but it was better than him getting no interest AND fees as a schoolkid).
    Come year twelve leaving – he was absolutely inundated with credit card offers from banks when he didnt even have a job.

    2. the understanding that cronyism and banking dysfunction are the real enemy.

    I agree. Complete banking dysfunction aided and abetted by central banks.

  18. @Alice

    The reasons can be found in almost any macro textbook. In short, low positive inflation creates greater certainty with regards to the real value of assets, while actually targeting inflation helps us avoid dynamic inconsistency problems. With regards to targeting, assume the usual short-run tradeoff between inflation and unemployment given by the Phillips curve. The policymaker chooses and announces its inflation policy, and the public observes this choice and determines its inflation expectations. Nonetheless, once inflation expectations are set, the policy-maker has an incentive to “cheat” and not implement their previous announcement. But with repeated interactions the public will know this and set their inflation expectations higher regardless of the announcement. Inflation targeting acts to, somewhat, tie the hands of policy-makers. This is of course a simplification, but it demonstrates the point.

    @Graeme Bird

    I disagree. That may be the case for NZ, but they did not have a ‘flexible’ target. If a severe shock did hit the economy, keeping short-term inflation close to the target could be very costly in terms of lost output. Nonetheless, a well implemented inflation targeting program should make room for short-run output stabilization. I guess the question is, “how much room should be made?”. But that will (and should) always be a grey area. The major benefit of inflation targeting is it still allows appropriate responses to various kinds of shocks, but the scope for irrational policies or political mischief is much smaller than under pure discretion.

  19. trout,

    Asset price inflation (financial and physical) features in the GFC (as well as in previous financial crises). Thus, ‘inflation targeting’ as understood in textook macro-models (ie consumer price changes) misses the point.

    The macro-economic (Y = C + I + G + External net trade) equivalent of the accounting balance sheet (Asset = Liability+ Owners’ Equity) identity is inadequate to represent reality.

  20. @trout
    Says “assume the usual short-run tradeoff between inflation and unemployment given by the Phillips curve.”

    I am assuming that the rise in real unemployment over the past three decades (and by that I mean including underemployment, and disenchanted jobs seekers who have given up, and the appalling long run shift to profits of the gains from productivity Trout,
    that central bank obsession with keeping inflation unnaturally low across the globe is costing us jobs. Worse, for Central Banks to deliberately pursue the false idea, that Central banks and Central banks alone can manage all aspects if the economy, with interest rate adjustments alone, is akin to religion and making economies worse in many nations.

    The Central bank does not have sufficient control of the real economy and their persistent dogged one eyed focus on low inflation and interest rate manipulation is helping to turn the “alleged” short run tradeoff of the Phillips curve into an unnaturally longer term increasingly less flexible and mired in the mud trade off.

  21. @trout
    Also says “Inflation targeting acts to, somewhat, tie the hands of policy-makers”

    That is part of the problem caused by central banks, not part of the solution.

  22. Supposing you’ve got three eyes. And with two of them you eyeball gross business revenues. With only one you eye nominal GDP. If nominal GDP is falling you grow gross business revenues a little faster than usual. If nominal GDP is growing you hold gross business revenues steady at 0 growth but erring on the positive side, since you never want gross business revenues to drop. In practice you might err in such a way as to be growing at 2% and 8% in the contrary case. I only talk about having one eye on nominal GDP because nominal incomes aren’t flexible enough downwards.

    It is the above targeting principles that would bring stability. Sometimes, and particularly at first, consumer prices would rise. More often they would fall. But asset prices would be far more stable. And thats what you want for good investment decisions.

    Note that fractional reserve not only robs the public purse of resources that could be theirs. But it makes such fine-edged targeting difficult. In fact all current institutional arrangements are not just bad because they lead to banker enrichment. They are also bad because they make spending targeting difficult. But under a fiat system you can hit any spending target you want, so long as your only levers are new cash creation, and raising the reserve asset ratio.

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