Central bank independence

An interesting feature of democracies

Should Central bank be independent? What does ‘Independence of central bank’ mean?

Central bank has these main functions.

1. To guide interest rates in economy. Central banks sets overnight lending rates which becomes anchor for lending in commercial banks and also much wider implication in economy and financial markets. Manage liquidity in financial system in regular times and critically in times of crisis through variety of tools. Coordinate with treasury on bond market operations. Also intervene in Forex markets for managing currency fluctuations and facilitate international transactions for government and private sector on domestic and international level.

2. To be banking regulator and oversee operations of commercial banks & other financial entities (as defined in act & charter of central bank) and take necessary actions required (like putting failing bank in conservatorship).

3. To keep an eye on national and global economy, navigate economic data and apprise government of potential risks and problems in various areas. Central banks have a research division which handles this task.

This is a general outline of Central bank’s operation and responsibilities. Exact nature of Central banks’ operation is defined in act and charter of their establishment by the government. ECB (a super national entity) is different from Federal Reserve. RBI is different from BoE.

What is Independence of Central bank? It depends upon one’s thinking. There’s no such thing as unfettered Independence as government establishes the central bank, appoints its governor/chairperson and defines its functions. Independence of central banks means is that government lets central bank operate without political interference. Let the bureaucracy of central bank make monetary policy decisions based on its technocratic assessment of economy. This assessment is made by experts on economics who are immune from day-to-day national politics and electoral populism.

Fiscal policy and monetary policy are two major guiding forces in economy. There is an understanding, an arrangement, in liberal nations and especially democracies that political government will run the fiscal policy - the power of the purse and policy making. And ‘independent’ central bank will run the monetary policy and other functions as defined in its charter. Political government and Central bank - both won’t interfere in decisions of each other. Treasury/Finance ministry won’t pick up the phone and tell Central Bank governor/chairperson on what interest rates should be. The Central bank governor won’t tell finance ministry/treasury on what fiscal policy should be.

Central banks also protests direct purchase of government bonds - the overt monetary financing. The fiscal deficits shouldn’t be monetized is sacrosanct rule in economics although Central bank coordinate and indirectly support government in bond markets. Overt monetary financing is regarded as pinnacle of fiscal irresponsibility. Central banks also don’t want politicians to dictate monetary policy to benefit their political prospects. Short term economic growth can be achieved by lowering rates but it can have long term consequences. Monetary policy is thus decoupled from election cycles and populism.

The relationship between Political government and Central bank is peculiar in liberal democracies with this notion of ‘independence’ of central bank. However, despite this peculiarity of relationship, political government and central bank work in coordination and cooperation. While on odd occasions (like what’s happening in America right now), friction may emerge between political government and Central bank. Most of the time the Central bank and political government are in harmony. When economy is in crisis (Pandemic is recent example), the so called separation of fiscal and monetary policy blurs. Political government works with full backing and coordination with Central bank to tackle the crisis.

Independence is voluntarily granted to Central bank by political government. Should Central banks really be independent or allowed to be independent? To answer this question, I will first mention some relevant analysis and case studies.

European Central Bank

ECB is a weirdly structured super national central bank of Euro monetary union, the Eurozone. ECB is like a Central Bank without a State and a national treasury. There’s no central fiscal authority / treasury of Eurozone but there’s a Central bank. The design of Euro monetary union itself is flawed in certain ways but that’s another topic of discussion.

My contention with ECB emerged with Eurozone debt crisis. Recall the early 2010s period. The nations like Greece, Portugal, Italy, Spain etc faced sovereign debt crisis. This crisis was mostly a creation of flawed Euro monetary union. The common currency allowed imbalances to be created in Euro area. That’s not a big problem. The real problem was that the deficit nations were blamed for being lazy bummers living beyond their means. Euro area needs a Surplus recycling mechanism, a fiscal authority, that can invest Capital from Surplus nations (like Germany) to deficit nation (like Greece). But this doesn’t exist. To make matter worse, the deficit nations were open to attack by speculators.

The crisis was resolved after ECB’s whatever it takes pledge to preserve Euro area - an informal declaration that ECB will provide backstop to struggling member states. This approach could’ve been taken a lot sooner. It was not done sooner so as to soften up the deficit nations into accepting austerity doctrines first.

European Central bank is an example of ‘independent’ Central bank - in theory and in practice. Euro monetary union is a flawed design with its benefits and also impediments. To join the Euro means surrendering a part of national sovereignty.

India’s Central Bank

In my home country India, the Central bank - RBI - for the most part of 2000s and 2010s was governed by technocrats with strong neoclassical inclinations and rigidity. Inflation is a complex phenomenon and especially more so in a backward economy like India. In India, nearly half of the inflation index is based on food basket alone. And food prices in India are more strongly influenced by supply disruptions due to erratic monsoons, floods and droughts rather than consumer demand. India also imports nearly 80% of Oil and India is a Carbon intensive economy which makes it vulnerable to external price shocks.

Government tax policies in India are also peculiar because India relies on indirect taxation for revenues. Heavy taxes imposed on Oil & Gas also create inflationary pressure and since Oil & Gas is primary means for freight transport, this also feeds into inflation. Interestingly, Weather is critical driver of food prices in India. Erratic monsoons and flash floods frequently destroy crops which can very rapidly raise perishable crop prices in India - raising prices by as much as 5-10 times in matter of days.

Then there are more Structural problems like lack of proper roads & highways and flood control infrastructure which makes freight transport difficult especially in floods. There is also lack of Cold Storage infrastructure to preserve food and perishables. The agriculture sector itself is mostly primitive which relies on manual labor rather than modern machinery and technology. There is lack of irrigation systems and water security which makes food production heavily reliant on monsoons. All these Structural problems feed into inflation.

India has a very large shadow economy and informal sectors which are not connected to formal banking and credit system. This informal sector economy which is prominent in rural India runs of hard currency transactions and around 70% of India is rural. More than half of India’s labor force is employed in Agriculture sector and other informal areas of self employment. Interest rates is not the best instrument to regulate demand even in modern economies and in backward economy which is peculiar combination of organized and unorganized economic sectors, it makes even lesser sense to manage consumer demand with interest rates when a very large part of economy is outside formal banking system.

The Neoclassical managers of India’s RBI did not heeded to these ground realities. Rather they applied usual doctrine of curbing demand with rate hikes to solve inflation. This caused significant damage to India’s growth in early 2010s when central bank tried to curb inflation with aggressive rate hikes. Recall that commodity inflation at that time was a global problem which also impacted India. As a result of high interest rates along with other factors, India’s growth stumbled. Investment fell, NPAs (non performing loans) especially on infrastructure projects increased rapidly in sectors which are connected to formal banking system. From growing at nearly 10% in late 2000s, India’s growth stumbled to less than 5% by end of 2013.

In 2014, the right wing Modi regime came to power in India. The ideologues in Modi regime which dictated economic policy (some of them were not professional economists) had serious problems in their economic thinking (as is always the case with right wingers). But they, somewhat correctly, believed that interest rates are not best tool for inflation management in India’s situation. These ideologues believed that investment climate needs more certainty in India and thus interest rates should be fixed at moderate level and not tinkered too much unless very necessary.

The ideologues were not professional economists. The Modi regime removed liberal economist Raghuram Rajan from India’s Central bank and installed a bureaucrat named Shaktikanta Das as RBI governor, a man who didn’t have a degree in economics. I was critical of these changes at India’s Central Bank as I believed that while Neoliberal economists have flawed thinking and are disconnected from ground realities of Indian economy, they were still more technically qualified to run Central Bank.

After government installed their puppet bureaucrats in Central bank, experts feared that India will become like Argentina and Venezuela - failed economies - where Capital will flee the country and there will be run on the Rupee. That never happened and Indian economy remained the same as before. India’s Central bank adopted a policy of moderate and stable interest rates and stopped making wild fluctuation of rates based on erratic inflation data. It also acknowledged that Climate change is a significant factor in inflationary pressures in Indian economy. Even the liberal critics who opposed changes in management of India’s Central bank later started to accept them positively.

Case of India shows that monetary policy cannot be left to the helms of Neoclassical economic doctrine as understanding of ground reality of national economy is critical to guide Central bank’s policy.

The Volcker Shock in America

The political leaders are believed to be cretins who’re busy with populism, demagogy and short term narrow minded thinking purely in interest of their political career. The Central bank economists and professionals are believed to be technocrats with sound knowledge and qualification to best comprehend the economy.

But straitjacket of economics professionalism can also be destructive. The doctrine of monetarism and its implementation by Volcker at Fed in 1980s is prime example of that. Monetarism - doctrine of quantity theory of money, preached that inflation should be managed by controlling money supply. Central banks should focus on controlling money supply and rest of variables will automatically adjust to that.

Money supply is endogenous and Central bank can’t control quantity of money. Volcker’s policy of high interest rates triggered economic downturn in US economy - which was precisely its real purpose - to create a recession. Inflation is a complex phenomenon but with high enough interest rates, Central bank can constrain demand in economy. The problem is that at such high rates for constraining demand also has other negative effects. The investment collapses, businesses face major loses and many go bankrupt. This translates into labor market downturn creating unemployment and downward pressure on wages. All this happened in 1980s. Volcker shock was also partly responsible for shuttering of US manufacturing industry.

The neoclassical narrative of keeping a ‘reserve army of unemployed’ for controlling inflation by suppressing wages is also flawed. But there’s a bigger question here. Should Central Banks have such unbridled authority over monetary policy to the extent that they can create recession in economy - supposedly to cure inflation? And importantly, are Central bank’s economic doctrines sound and rational?

Jerome Powell and Trump regime

Now we talk about present situation in America. Independence of Central bank is an arbitrary arrangement in Democratic systems. What really matters is that the monetary policy should be under ambit of sensible and competent leadership. There’s no doubt that current leadership in Federal Reserve is sensible and competent in contrast to wild, erratic and ignorant Political cretins of Trump regime.

The senseless policies of tariffs and trade war, the mass deportations, mindless austerity legislation, dismantling of government, mass firing of government workers & shutting down critical agencies etc - these policies of Trump regime demonstrates that they cannot be entrusted with guiding monetary policy. Trump regime will make a mess of monetary policy.

Jerome Powell is a competent man who resists political pressure for cutting interest rates. There are considerable upside risks to inflation and Fed’s assessment is correct. I do not think Powell will voluntary step down but problems will arise next year when his chair tenure expires. Trump regime will very likely appoint a minion as Fed chairperson who will follow diktats from White House. This will create major problems at Federal Reserve and harm America’s standing in global community.

The flawed Neoclassical thinking and doctrines like monetarism showed that economic professionalism can be destructive in Central bank’s policy making. On the flip side, the highly incompetent and stupid political government like Trump regime shows that monetary policy may be best suited in hands of independent Central bankers.

The concept of ‘Independence’ of Central Bank is voluntary and arbitrary arrangement made by political government. It can be viewed from different perspectives - positively and negatively. At the end of the day, it’s all a matter of one’s judgement on which party is best suited for handling policy. Are the people running monetary policy competent? I can confidently say that Trump regime has no competence in guiding monetary policy. Let Fed work independently.