Some thoughts on central bank "independence"

Viral Acharya, the Deputy Governor of the Reserve Bank of India (RBI) has this speech where he makes a very strong case for central bank independence. He argues that it is in the government's self-interest to allow autonomy to central banks since refusal to do so would be catastrophic in terms of market reactions and its impact on the economy.

One can appreciate the underlying larger point about the need for central bank autonomy. Also, especially in the context of recent history of disputes between the government and the Reserve Bank of India, the need for governments to exercise restraint is undoubtedly greater.

But there is a tendency to take such arguments about central bank independence to excessive extremes. It only amplifies the narrative about dispassionate and wise central bankers trying to protect the economy from the capriciousness and corruption of governments. Viral Acharya's speech is not immune from playing to this tune. But global experience shows that this is far from true.

In this context, it is worth stepping back and placing his claims in some perspective. This is also the subject of my forthcoming book with V Ananthanageswaran.

Some observations in this regard.

1. The point about markets punishing governments which threaten central bank autonomy has its origins in one of the most dominant narratives of our times - markets are an efficient aggregator of information and therefore know what is best for the economy, and therefore policy should follow market signals. While this may be right on some occasions, it is also wildly off-mark on several others.  The events leading up to the sub-prime mortgage meltdown and in its aftermath are only the latest manifestation of the reality that markets are not only not efficient and self-correcting but also engenders deeply destabilising distortions. This, this, this, this, this and this are only the latest posts in this blog alone on the issue. 

Unfortunately, this has become an article of faith among opinion makers, financial market participants, and central bankers, thereby limiting their ability to appreciate pervasive market failures.  In fact, central banks have taken "following market signals" to its extremes. The market's "confidence fairy" rules the roost. A growing body of research appears to indicate (see this and this) that monetary policy decisions, especially in developed economies, have become captives of financial market dynamics. Talk about putting the cart before the horse!

2. The recent ring-side accounts by insiders like Yanis Varoufakis and Paul Tucker gives the lie to the conventional wisdom about central bankers as independent and objective technocrats selflessly pursuing public interest and broader macroeconomic concerns. While the former indicates how the European Central Bank (ECB) was a captive of political interests, the latter exposes the belief about the superior wisdom and expertise of central bankers and experts in general. 

There have also been numerous recent instances of practices ranging from border-line compromised accommodation to wholesale information leaks involving central bankers and preferred financial market participants. In fact, just in the last five years, there have been high profile examples of culpability and corruption from US (Jeffrey Lacker, President of Federal Reserve Bank of Richmond) UK (Charlotte Hogg, Deputy Governor of Bank of England), Switzerland (Philip Hildebrand, Governor of Swiss Central Bank) and ECB (Benoit Coeure, ECB Board member). The first three were forced to quit once the scandals surfaced. 

With great power comes great responsibility and accountability as well as the need to exercise restraint. In democracies, despite all its flaws, political leaders face checks and balances which significantly limits the degrees of freedom available for excesses. Unfortunately, the experts in central banks neither have anything similar in terms of the accountability nor the restraints. Like with executives who have reached the C-suite of the largest financial institutions, central bank leaders are largely impervious to reputational considerations. A revolving door with financial institutions and high-paid speech circuits raises serious concerns about objectivity and fairness, not to speak of malafide actions. 

3. Since the nineties, aided by the Goldilocks global macroeconomic conditions, central banks have assumed an aura of competence and credibility. These conditions have had their origins in several factors,  of which central bank actions are but just one. But given the amorphous and diffuse nature of the other factors (globalisation, liberalisation and deregulation, technology revolutions, financialisation, emergence of China etc) and the growing omnipresence of a few individual central bankers, a narrative around the superior wisdom of central banks has taken hold. It can also be argued that the conditions too allowed governments leave central banks to their domain and ignore the emerging narratives. In any case, when the going is good, the policy challenges for all concerned are that less demanding. 

Once the global financial crisis struck, faced with their own limited fiscal space as well as the difficulty of mobilising political consensus, governments in the developed world left their central banks to do the heavy lifting. Central banks went the full hog into uncharted territories with quantitative easing and extraordinary monetary accommodation. It gave the impression of central banks being the only game in the town. In the guise of transparency and central bank communication, some central bank governors merrily assumed the status of populist media darlings. 

While it may have perhaps helped avert another Great Depression, nearly a decade of such policies has not succeeded in restoring balanced growth and macroeconomic stability. In fact, it is now certain it has engendered several distortions. And, in the thrall of their theoretical frameworks and captives of market confidence fairies, central banks appear to have lost sight of the emergent distortions. 

Consequently, it is no surprise that governments have sought to wrest back control. In recent years, governments have not shied away from taking on central banks. The actions of Presidents Trump and Erdogan in the US and Turkey respectively are only high profile examples of such actions. And such trends are likely to become more frequent going forward. 

4. Unfortunately the issue of central bank independence gets framed on an absolute basis, whereby any policy action by a government that intersect with the domain of central banking is viewed as a threat to its autonomy. In fact, central banks react sensitively to even perfectly legitimate public statements by governments indicating their preference for particular monetary policy actions, say lowering of rates or exchange rate interventions. 

There is nothing absolute about the issue of central bank independence. Its separation from the government cannot be absolute. Instead, a more appropriate question should be about what is the right level of independence or autonomy for central banks, consistent with its role in a democratic polity and the need for an integrated and comprehensive macroeconomic perspective. 

The argument that central bank actions are purely technocratic and therefore apolitical, and therefore demanding absolute independence, is deeply flawed. This all the more surprising since we are only just emerging from the decade-long extraordinary monetary easing, whose effects are now a matter of intense debate. Central banks are not just technocratic bank regulators. Their actions have deep distributional consequences. There is a growing pile of evidence about the adverse distributional consequences of quantitative easing. This goes beyond just the issue of penalising savers and benefiting borrowers, and in contributing to important structural shifts in the nature of modern capitalism itself. 

Further, the idea central bank autonomy is not sacrosanct and is a relatively new trend, with its origins in the inflationary episodes of seventies and early eighties. In fact, there are serious question marks about the real extent of central bank independence. But things have changed dramatically over the last three decades. In fact, The Economist, no less, recently advocated revisiting the notion of central bank independence in light of the declining interest rates and persistent low inflation.   

5. About most things in life, there are no clear answers and second-best approaches may actually be the best approach. It applies as much to the mechanics of the relationship between central banks and governments. Some amount of creative tension, even played out in the public domain, may be not just unavoidable but even desirable. 

Consider the present situation in India. With banks already under ailing and the non-banking financial institutions squeezed in the aftermath of the IL&FS crisis, the credit markets have frozen up, thereby dampening economic activity. But this co-exists with signatures of rising inflationary and exchange rate pressures. The central bank justifiably feels that it is not an appropriate time to accommodate. The government equally justifiably feels that the economy could do with some monetary accommodation. 

Only the naive would argue that monetary policy is the rote application of some complicated formula. And we are not even talking about the limitations of monetary policy in demand-pull conditions, especially in supply-constrained developing countries like India. In the circumstances, how can the government be blamed for demanding lower rates, at the least politically not to be seen demanding so? In fact, such creative tensions are perhaps desirable in so far as it keeps central banks too anchored around real world considerations and not be guided solely by straitjacket mandates and disconnected expertise.  

Having said all this, I am inclined to be sympathetic to the Deputy Governor of RBI. In case of India, unlike many developed economies, the RBI would come out in much more favourable light when we examine the balance sheet of the last ten years. This coupled with the lack of maturity of institutional practices within the government is perhaps reason enough to give the benefit of doubt to the RBI over the government. But the notion of absolute independence of central banks should not be entertained.

Update 1 (06.05.2020)

This about the blurring of lines between the monetary and fiscal policy in the context of the pandemic is illuminative,

Steve Mnuchin, America’s treasury secretary, has said that on some days he has spoken to Jerome Powell, chairman of the Federal Reserve, more than 30 times. The Bank of England has co-ordinated interest-rate cuts with Britain’s treasury and recently agreed to increase the government’s overdraft. The Bank of Japan has long been an enthusiastic partner in the economic agenda of Abe Shinzo, the prime minister.

The Governor of the Bank of England, Andrew Bailey, wrote an oped in FT reassuring investors just before the Treasury announced its decision to temporarily monetise its deficit.

Imagine the reaction in India if the government and the central bank worked with such co-ordination. It would have been branded as the central bank having sold out to the government or the government having subjugated central bank independence.

Update 2 (23.05.2020)

In the backdrop of the debate around the German Constitutional Court's questions on ECB's bond buying program, Adam Tooze questions the myth of central bank independence,

In the paradigm that emerged from the crises of the 1970s, independence meant restraint and respect for the boundaries of delegated authority. In the new era, it had more to do with independence of action and initiative. More often than not, it meant the central bank single-handedly saving the day... Rather than obstreperous trade unions and feckless politicians, what central bankers have found themselves preoccupied with is financial instability. Again and again, the financial markets that were assumed to be the disciplinarians have demonstrated their irresponsibility (“irrational exuberance”), their tendency to panic, and their inclination to profound instability. They are prone to bubbles, booms, and busts. But rather than seeking to tame those gyrations, central banks, with the Fed leading the way, have taken it on themselves to act as a comprehensive backstop to the financial system—first in 1987 following the global stock market crash, then after the dot-com crash of the 1990s, even more dramatically in 2008, and now on a truly unprecedented scale in response to COVID-19. Liquidity provision is the slogan under which central banks now backstop the entire financial system on a near-permanent basis.

This about the opponents of the ECB's actions is important,

For them, the ECB serves as a lightning rod for their grievances about the changing political economy of the last decade. They blame it for victimizing savers with its low interest policy. They blame it for encouraging the debts of their Southern European neighbors. Exponents of the old religion of German free market economics regard cheap credit as subversive of market discipline. All in all, they suspect the ECB of engaging in a policy of redistributive Keynesianism in monetary disguise, everything that Germany’s national model of the social market economy was supposed to have ruled out. For these Germans, the ECB is an opaque technocratic agency arrogating to itself powers that properly belong to national parliaments, barreling down the slippery slope to a European superstate. And, for them, it is anything but accidental of course that it is all the creation of a Machiavellian Italian with trans-Atlantic business connections, Mario Draghi. For the body of opinion that had always been suspicious of the euro, Draghi’s commitment to do “whatever it takes” in 2012 was the final straw. The Alternative for Germany (AfD) emerged in 2013 not originally as an anti-immigrant party but as a right-wing economic alternative to Berlin’s connivance with the antics of the ECB. 

The Karlsruhe based German Constitutional Court plays an activist role, and has been a check on unfitted expansion of European power on the grounds of defending democratic national sovereignty. The Court's lates ruling is that the German government failed to supervise the ECB's largescale bond-buying program of 2015 to push inflation to 2%, which, it ruled, overstepped its monetary policy realm and strayed into economic policy which is that of national governments. The German government and ECB have three months to respond.

Update 3 (11.09.2021)

Fed officials market trading activities raises questions,

Federal Reserve officials traded stocks and other securities in 2020, a year in which the central bank took emergency steps to prop up financial markets and prevent their collapse — raising questions about whether the Fed’s ethics standards have become too lax as its role has vastly expanded. The trades appeared to be legal and in compliance with Fed rules. Million-dollar stock transactions from the Dallas Fed president, Robert S. Kaplan, have drawn particular attention, but none took place when the central bank was most actively backstopping financial markets in late March and April. However, the mere possibility that Fed officials might be able to financially benefit from information they learn through their positions has prompted criticism of perceived shortcomings in the institution’s ethics rules, which were forged decades ago and are now struggling to keep up with the central bank’s 21st-century function...

Mr. Kaplan was buying and selling oil company shares just as the Fed was debating what role it should play in regulating climate-related finance. And everything the Fed did in 2020 — like slashing rates to near zero and buying trillions in government-backed debt — affected the stock market, sending equity prices higher... Mr. Kaplan’s financial activity included trading in a corporate bond exchange-traded fund, which is effectively a bundle of company debt that trades like a stock. The Fed bought shares in that type of fund last year.