The last thirty years of debate regarding the function of central banks has reached a point where it is widely accepted that given the inherent inability of governments to always generate desired outcomes and prevent adverse effects regarding macroeconomic stability, monetary policy operation would be optimally serviced by an independent institution that places greater focus on inflation stability than output (Rogoff, 1985). Nonetheless, the degree of autonomy varies depending on incumbent governments and how they envision their objectives for macroeconomic stability, thus they can utilise the political apparatus (e.g., introducing legislation) to determine the degree of independence. However, since the establishment of the first central bank, the Sveriges Riksbank, in 1668, historically, central banks have undergone various modifications to their mandates and functions (Goodhart, 1988; Lastra, 1996); and in times of relative peace, central banks have enjoyed a significant level of autonomy. The topic of central bank independence (CBI) is a contested field, and the debate isn’t new. In fact, it’s almost as old as the institution itself, prominently, demonstrated by David Ricardo’s assertion that the absence of independence hindered the Bank of England’s duties after accusing it of operating at the behest of the government. He proposed three principles of CBI: “institutional separation of the power to create money from the power to spend it; a ban on the monetary funding of the State budget; and the central bank’s obligation to give an account of its monetary policy” (Rossi, 2014, pp.4), which has since been an influential contribution to both the debate and the operation of central banks independence.
Less than a hundred years later, by 1900, there were 18 central banks — and almost all were in Europe; they were either privately owned or contained a mix of private and public capital; and “were granted the right to issue private notes in exchange for committing themselves to buy limited amounts of government debt” (Mas et al., 2020, pp4.). And until 1971, these banks operated under the Gold Standard which meant they mainly carried out government policy (Parkin and Bade, 1978), focusing “on maintaining the convertibility of their notes by adjusting interest rates to maintain adequate levels of gold reserves. This monetary policy regime indirectly contributed to maintaining price stability” (Mas et al., pp.4). During the 1970s, the world was subjected to an inflationary period caused by a contested group of factors — one of them being the collapse of the Gold Standard by Richard Nixon and the transformation of the US dollar (i.e., the global reserve currency) into a fiat currency; another being oil price shocks — which several major economies were unable to curb. Consequently, by the late-70s, there was a reshuffle of economic theory with the development of the New Classical school of thought rendering New Keynesian economics insufficient (Masciandaro and Romelli, 2015), this caused a shift in the CBI debate resulting in an emphasis on the importance of central bank ‘governance determining macroeconomic performance.’ Simultaneously, this period influenced the development of arguments regarding the relationship between inflation and growth. The effects of the period gave rise to the belief that an independent central bank that was accountable could optimally shape the economy by generating a compromise between inflation and output. Consequently, this reshaped monetary policy operation, thus, by the late-1990s, in many countries (advanced and emerging economies alike) the focus of central banks was exclusively on inflation-targeting monetary policy. And has since been understood as fulfilling the following objectives, in summary: sustainable economic growth, inflation control, and price stability through a monetary policy framework that utilises interest rate control as its primary tool.
Nonetheless, while the case for central bank independence has theoretical and empirical legacy of two decades, naturally, like any prominent economic field, it contains shortcomings rendering it contestable. Among criticisms of central bank independence is the undemocratic existence of central banks, the fact many central banks, especially in the West, have expanded their roles and policies since the Global Financial Crisis, and the claim it cannot be divorced from the political economy context within which it will undoubtedly be influenced by regardless of the degree of autonomy a central bank may enjoy. Therefore, this essay will discuss the contested debate on central bank independence drawing on evidence from multiple countries.
2. CASES FOR AND AGAINST CBI
For clarity’s sake, the meaning of independence must be established to clarify the nature of functionality. There is ‘operational’ independence, which signifies the bank’s freedom to utilise the necessary tools in whatever capacity to achieve its objectives, and there is ‘objective’ independence, which allows the bank to set the inflation target (Howells, 2009; Mas et al, 2020). Moving on, independence rests on the conceit that independent monetary policy is best served by specific features, thus understanding the characteristics of central bank independence that underpin the task undertaken by external economic agents offers a practical starting point for contextualising the arguments in favour. Such constitutive features include functional, operational, financial, and personal independence.
EFFECTIVENESS OF CBI
Studies suggest CBI has managed to generate macroeconomic stability, especially before the Crisis, by establishing a negative correlation between inflation (Issing, 2006). Even in low-and-middle-income countries that may have looser constraints on the legislative, legal independence is associated with lower inflation. And the same can be suggested for non-democratic countries where “de jure protections to central bankers are effective in non-democratic regimes because they reflect other kinds of power-sharing agreements among authoritarian elites” (Garriga and Rodriguez, 2020).
However, although there are two decades worth of evidence to support central bank independence in relation to successful inflation control (Alesina, 1988; Cukierman, Webb, and Neyapti, 1992; Alesina and Summers, 1993), the argument that CBI ensures such success and is better at promoting price stability is countered, for one, by the fact the Great Inflation of the 70s was under control by the 90s — before CBI was widely accepted and adopted. In addition, the fuelling of exogenous disinflationary consequences caused by globalisation and technological advancements that skew the achievement of price stability maintenance. “Even more serious is […] that independent central banks spectacularly failed to achieve and preserve financial stability” (Wachtel and Blejer, 2020, pp.3). Moreover, some authors argue that the empirical evidence in favour of CBI is questionable (Parkin, 2013; de Haan, Bodea, Hicks, Eijffinger, 2018). The studies constructed to measure CBI contain degrees of arbitrariness in the weightings of the relative importance of independence, meaning there is a lack of consistency in evidence (Howells, 2009). Additionally, evidence of operational independence is underwhelming given the measurements use variables such turnover rate of bank governors and survey data to measure functionality (Wachtel and Blejer, 2020, pp.7). Furthermore, after the Financial Crisis, some even claim that central banks (in advanced economies) were to blame for the Crisis for their role in credit expansion during the 2000s, but more importantly, the Crisis made it clear that they had not focused on price and financial stability (Balls, Howat and Stansbury, 2018; IMF, 2010). Failure to anticipate future inflation is costly (Mishkin, 2006) because it causes the redistribution of income and wealth because wages and assets, respectively, are not uniform, thus will increase beyond the price level; and from creditors to debtors, who benefit from the reduced purchasing power of the currency. Additionally, this causes a misallocation of resources because relative prices are distorted due to the fact markets adjust prices differently.
The volatile nature of politics is an obvious argument in favour of CBI because, for example, aspirations of winning re-election could be used by the incumbent head of state as a reason to manipulate monetary policy (like exploiting inflation targets), contrasting what is needed to maintain inflation and generate optimal outcomes, which is a short-term ploy that risks negatively impacting the long-term goal of inflation and price stability. Rogoff (2019) says that politicised monetary policy will be hard to control and protect from further politicisation once it happens. Subsequently, this results in a reduction of macroeconomic instability, which will be exemplified within the relationship between inflation and growth demonstrated by Mas et al. (2020), who help clarify how the consensus on this relationship has evolved since the late 1960s. In essence, there is the, now commonly acknowledged, belief that the adverse relationship between inflation and unemployment is short-term; (informed by models developed by Phelps (1967) and Friedman (1968)) they showed that monetary expansions attempt to artificially dictate the unemployment rate would induce an “inflation bias: higher inflation with no improvement in economic or employment growth in the long run” (Mas et al., pp.12, 2020).
However, independence does not ensure complete insulation from political interference. We can see the shortcomings of CBI in relation to overbearing political economic influences in the case of Argentina which has independence stipulated in its central bank constitution. Yet, it was not independent operationally and this became evident in 2010 when then-president Cristina Kirchner used an executive decree to dismiss the bank president Martín Redrado for refusing to lend the government $6 billion. Additionally, in 1995, Zimbabwe — under Robert Mugabe — underwent various forms of financial liberalisation, one of which increased the independence of its central bank (Reserve Bank of Zimbabwe). Acemoglu et al. (2008) illustrate that the impact of this attempt at improving monetary policy was constitutive of political equilibrium that was the cause for policy reform, meaning — within a political economy context — the dysfunctional nature of governance in the country would hinder independence because the central bank would still be susceptible to bad governance due to the absence of constraints on the political elite, thus unable to achieve its objectives. Walle (2001) suggests that this was a common occurrence in the region subjected to politicians for whom “restoring economic stability and growth has often taken a back seat in government motivations to preserving political power” (pp.13). Acemoglu et al. (2008) test this using cross-national panel data. Subsequently, results show that CBI has an insignificant effect on inflation in countries with either high or low levels of constraint on the legislative, but it does significantly reduce inflation in countries with “medium-constraints.” They go on to hypothesise whether the failure of policy reform on political equilibrium means policy reform — within the context of CBI — has contradicting effects in a different dimension, thus they measure the impact of CBI on fiscal policy. Consequently, in essence, a See-Saw Effect becomes apparent. CBI, in a country with either strong or weak constraints on the legislative, does not impact the size of the government relative to GDP; however, in countries with intermediate constraints, CBI reduced inflation concurrent to an increase in government expenditure. Essentially, this means that CBI cannot be divorced from, or is contingent on, the political context within which it exists in, and thus will nonetheless be impacted by and likewise impact political outcomes.
In fact, this method of central bank governance, which isolates the bank from the electorate, is a major argument against the central banking system itself because it is undemocratic because central bankers are unelected — deliberately so. CBI’s conception can be traced back to Milton Freidman’s 1962 essay “Should There Be An Independent Central Bank?” which offers a definition of what an independent central bank should entail; however, he ultimately disagrees with his theoretical exercise, stating “in a democracy to have so much power concentrated in a body free from any kind of direct, effective political control” (p. 227). Concluding that an independent central bank with “wide discretion to independent experts” (p.239) is wrong. It also creates a contradiction, as Issing (2006, pp.67) argues, “The decision on the ultimate goal of monetary policy must be left to citizens and set by their democratically elected representatives via legislative procedure”, but “Keeping the goal setting within the ongoing political process would expose the mandate for monetary policy to exactly those influences which are intended to be excluded by making the central bank independent.”
Proponents contend that independence can be legitimised by coupling it with accountability grounded in legislation, thus the central bank would legally operate similar to the judiciary. This is an alternative structure that (Freidman prefers too) imposes a constraint that dictates the function of independence, in the process increasing transparency, which appeases the inherent democratic deficit. Moreover, there is evidence to suggest that the absence of a rules-based, legislative approach decreases the effectiveness of independence to generate optimal monetary outcomes (Taylor, 2013; Buol and Vaughn, 2003).
GLOBAL FINANCIAL CRISIS
Relatedly, we can see the impacts of unelected technocracy in the distortion of financial markets since the Global Financial Crisis. Central banks have been conceptualised as the stabilising force to a “polymorphous crystallization” (Mann, 1993, pp.75) of social power that the state is, and thus isolated from elected officials who vie for power and the accompanying pressures from the electorate (similarly, markets do not trust democratically elected banks because they are presumably prone to cause inflationary traps). However, the legitimacy of this argument rests on the wide-ranging impacts of central bank actions, as Best (2018) states, “Central banks play a paradoxical role in today’s liberal democracies. Their work is highly technical, yet the consequences of their actions are inevitably political, producing big winners and losers.” The calamity of the Global Financial Crisis of 2007–09 forced several governments to expand the scope of their central banks because the scale of the Crash warranted an unprecedented policy response to control and overcome the damage, which, concurrently, revitalised the debate around the scope of central banks; ushering in a wave of reforms increasing central bank independence and a particular focus on central banks’ role of supervision. Following the Financial Crisis, in 2010, the US legislature passed the Dodd-Frank Act, which actually increased the power of the Federal Reserve (or the “Fed”) as macroprudential regulator (Komai and Richardson, 2011; Gorton and Metrick, 2013); in Europe, the European Union Bank was assigned supervision of the Single Supervisory Mechanism (banking supervision) alongside the respective supervisory authorities of member states; Germany introduced the Banking Act in 2011 which saw the Bundesbank replace the existing financial supervisor BaFin; and globally, the Basel Capital Accord increased the responsibilities of central banks by assigning them the task of countercyclical macroprudential supervision (Masciandaro and Romelli, 2015).
In addition, to their role in the Crisis as mentioned earlier, these policy shifts demonstrate an evolution in central bank governance given that historically — before the crisis — changes have resulted in an increased separation between central banks and supervision (Orphanides, 2011; Eichengreen and Dincer, 2011). Focusing on the Federal Reserve, there have been some notable negative effects over the decade since the Crisis, like the persistent use of quantitative easing (QE) and negative interest rate policy (NIRP). Understandably, during the Crisis the Fed provided liquidity, but the decision to continue supplementing credit and asset markets, respectively, has distorted financial markets resulting in a misallocation of capital and exacerbating bubbles. Thus, the argument here is that central banks, especially the Fed, have reached a stage in their existence that is beyond the narrow mandate that had been developed for them in the 90s; beyond the primary objective of inflation control and price stability, they are now fuelling asset and credit bubbles and conduct massive bailouts and quantitative easing procedures. For example, the past decade has seen the Fed cross into fiscal policy via large-scale lending to banks and corporations “against low-quality collateral and the purchases of non-traditional assets (e.g. mortgage-backed securities or corporate assets) under the quantitative easing programmes can pose credit risk to the states’ consolidated balance sheets” (Mas et al., pp.23).
This reality has also raised concerns that what has been demonstrated during the Crisis could jeopardise CBI. For example, Brunnermeier & Gersbach (2012) argue that the ECB’s independence has been undermined because “governments expect the ECB to continue providing cheap funding” to distressed banks in order to stimulate lending, which it has done so over the past decade before the COVID-19 pandemic called for unprecedented actions. The concern this raises the question of whether central banks can be ‘too independent?’ — that allowing central banks to carry on as they have since the Crisis has distracted them from their primary focus because their responsibilities are now overloaded. And as Fischer (1995) recognised the limits, the answer is ‘yes’. However, to reiterate, pre-Crisis CBI performance was relatively good and it was the operational and goal independence that central banks developed before it that allowed them to quickly adapt and combat the fallout with unconventional instruments. We have seen the same actions repeated again during the ongoing pandemic to support economies, and, in some cases, banks have reacted before governments’ fiscal policies.
To conclude, central bank independence has been a staple of modern economics, or ‘new macroeconomic consensus’, for two decades now, and for good reason — in general, central banks have carried out their duties appropriately. However, the inherent existence of a central bank is at odds with the fundamental principles of democracy and contradictory to the rule of law that is constitutive to its optimal operation, but the argument that independence is contingent on legislative accountability and transparency (like the judiciary) is a reasonable argument supporting its existence.
Theoretically, a central bank that exists within a functional political economy, that is autonomous with a narrow mandate and follows a rules-based approach is less susceptible to government interference and nor do its responsibilities increase the potentiality of a conflict of interests or negatively impacting macro-and-microeconomic stability. However, central banks are now a lot more complex today; their duties having evolved drastically, especially, since the GFC from the narrow mandate of strict monetary policy, focused on inflation and price stability, to include fiscal and expenditure responsibilities, which has had consequences on the economy at large — bringing their autonomy into question. Therefore, it can be argued that if they wish to act like the government, why not simply work at the behest of the government?