Wednesday, December 26, 2018

Central banks and independence from politics and Wall Street

The year may have initiated a decisive debate on the issue of central bank autonomy. And if it ends up upending the conventional wisdom, then the central bankers and their supporters in the financial media have none but themselves to blame. 

In the aftermath of the taper-tantrum I had cautioned about the dangers of central banks' hankering for technocratic independence from the political economy. More recently, after the RBI Deputy Governor's speech, I had questioned the empirical basis for the claims of the superiority of pure technocracy over democratic political economy in macroeconomic decision-making. 

Robert Skidelsky hits the nail on its head and makes a clarion call, 
Monetary policy is neither particularly effective nor politically neutral. Since governments, not central banks, are accountable for the results of policy, macroeconomic management cannot be outsourced to central banks. The two arms of policy, fiscal and monetary, need to be integrated. The experiment of independent central banks has to be brought to an end.
Let's examine the balance sheet of central banks from two dimensions - macroeconomic stability and financial market stability. The first demands independence from politics and the second independence from financial markets. 

It is impossible to credibly assert that central bankers and their actions have been major contributors to the Great Moderation with its low inflation basis. It's just that there have been too many structural things going on - trade liberalisation, globalisation, wage restraints, technology, EMs and China etc - which undoubtedly kept inflation down and helped the world economy chugging along. The only thing that we can definitively say is that they did not screw up things or played along. 

At no point during the quarter century did they face the sort of political economy trade-offs that Paul Volcker undoubtedly faced in early eighties. Central banks played along to keep the party going - invariably being behind the curve in deflating bubbles (and engendering bubbles) and tightening late, and rarely being behind the curve during recessions to loosen the strings. Why would therefore the political masters have had any problem with central bank policy stances? What did the rockstar central bank governors actually do to enjoy their current reputations, beyond being actors in a narrative that has limited empirical basis? It also begs the question whether central bankers' aura of importance is just a legacy of the memory of Volcker's rate hikes to slay inflation?

So the central bankers did little to earn independence from politics. In fact, there was nothing in their actions for politicians to demur. 

On financial market stability, it cannot be denied that they have to take a good share of the blame for the financial instability engendered by both erring on the side of caution to keep credit taps loose at all times and in offering the monetary policy 'put' to backstop equity markets. Sample this from John Mauldin,
The last three Federal Reserve Chairs have acted like the Fed has three mandates: the two official ones (low inflation and full employment) and an unofficial third one: making sure asset prices rise as the market wants. Not just the stock market, but real estate and all other investment assets. It started with the Greenspan “Put” which morphed into the Bernanke Put (remember the taper tantrum?) and reached its apex with the Yellen Put. And what did we get? A series of bubbles. As Stan Druckenmiller says, the really big Fed mistake was when Greenspan kept rates too low for too long in 2003–2004, setting up the housing bubble and Great Recession. He clearly helped the massive bubble in 1999–2000. Then Bernanke’s reluctance to raise rates above zero in 2012–2013, when the economy was manifestly recovering, refueled the asset price bubble. Yellen continued that course. Her reluctance to raise rates until Trump won the election, the economy was booming, and unemployment clearly falling was inexcusable. The Federal Reserve should be just as concerned about Main Street as it is about Wall Street.The serial bubbles of the last 30 years all had serious negative consequences.
So, in terms of independence from financial markets, the central bankers have shown a remarkable consistency in responding to its concerns even at the cost of all others. As Mauldin highlights, they have had their opportunities to break-free and squeeze the credit taps to pre-empt the build-up of bubbles. That would have a demonstration of true independence, from both the politicians and the financial market. But nothing of that sort happened.

If their role in the Great Moderation was neutral and in engendering financial bubbles was negative, then on the net, how do we explain the superiority of technocratic wisdom which has had a free-run over the past quarter century in the developed economies? They have exhibited independence from neither politics nor financial markets.

In fact, the true test of the mettle of a critical decision-maker like a central bank Governor is how they respond in difficult times. To follow the models and conventional wisdom in good and bad times (and generally, or always, in terms of expanding) is perhaps the easiest thing to do, especially for an academician or a technocrat. Further, it is unlikely to trigger opposition from politicians. The difficult thing is to constructively engage with the government in responding to difficult situations, where there are trade-offs to be made. Sadly the last two Governors of RBI have fallen short in this regard, in stark contrast to their predecessors.

In contrast, and especially in light of what their rockstar counterparts in the West did, in India, the RBI, manned by mere bureaucrat Governors, did a remarkably good job in the lead-up to and in the management of the global financial crisis. Their scepticism about excessive financialisation, caution with capital flow liberalisation, and application of a heterodox toolkit to address financial market stability has now come to be applauded

Then too the poor bureaucrats were criticised for their conservatism. Many leading economists, including Raghuram Rajan, and organisations like the IMF have long called for India to allow capital account convertibility in varying degrees. The financial media opinion makers had been assailing the government for dragging its feet. As an aside, when I wrote urging caution with capital account liberalisation, one worthy among India's opinion makers showered ad hominem on bureaucrats,
When some Indian bureaucrats have argued in favour of a closed capital account at international forums, they have faced amusement from the audience. No country has taken this idea seriously.
As a perfectly plausible counterfactual, it would have been very easy for Dr YV Reddy to have accepted the superior wisdom and ease capital flows. Given the prevailing global market trends and the domestic growth momentum, capital would have rushed in. The markets would have doubtless cheered. The politicians too would have been happier.

And we would have been picking up the pieces from an even bigger banking crisis. But thank God, these bureaucrats did what they do best and did not fall into the thrall of the supposedly superior wisdom of academic scholars. 

Given all this, ironically, doesn't it make sense to say that one of the signatures of a good monetary policy action during boom times is the "wrath of markets"? Then it is more likely that the central bank is actually doing its job. 

Mauldin applauds Jerome Powell and writes that his words and actions are a reminder to everyone that the Federal Reserve is regaining its independence from Wall Street. Powell's determination to put sand on the wheels of financial markets and stabilise market activity comes out looking like a breath of fresh air. If he survives and continues with what he would be doing, this would perhaps become a neo-Volckerian moment in central bank history. But it is not a good reflection on central bank independence that it has a taken almost three decades of rockstar Fed Governors to have someone actually indulge in a substantially high-stakes trade-off monetary policy stand-off (with both the politicians and the markets). 

This by TT Rammohan is a very balanced commentary on the debate in India about RBI's autonomy.

I feel that the Indian financial media commentators and academic researchers (especially the foreign-based ones), the former feeding from the latter, have completely lost their objectivity in assessing the issue of RBI autonomy. Captured (to varying degrees) by the hegemony around the superior wisdom of central banking technocracy, they appear blind to the empirical evidence.

It is perhaps not incorrect to say that they have become a self-serving clique which feed on each other. Once someone who fits the narrative becomes the Governor, the hosannas begin, the 'confidence fairy' rises, stocks boom, the Governor is praised even more, and central bankers start behaving like infallible rockstars. In this environment, anything that government disagrees with the central bank, irrespective of the merits, is scorned on. Governments are criticised. The central bank    plays along conveniently. Some of the articles in Indian media in recent days disparaging the appointment of bureaucrats and endowing some other-worldly wisdom on economists are downright pathetic.

Forget this government in Delhi, the opinion makers would be shrill with anything seen (and actually pretty much anything can get projected so in today's world) as an attempt to encroach on the so-called central bank independence. This government only makes the noise shriller.

In conclusion. There is nothing superior about the technocracy of central bankers compared to the rough-and-tumble of democratic politics. There is also nothing superior about the wisdom of academic researchers that endow them to be better central bankers. These are narratives that have no empirical basis. 

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