The Greatest Myth Propagated About The Fed: Central Bank Independence
Central banks are completely contoroled by politics. That is one of the main reasons why we are doing this bad : when politicians are in charge of economy, nothing good can result
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It has been commonplace to speak of central bank independence—as if it were both a reality and a necessity. Discussions of the Fed invariably refer to legislated independence and often to the famous 1951 Accord that apparently settled the matter. [1] While everyone recognizes the Congressionally-imposed dual mandate, the Fed has substantial discretion in its interpretation of the vague call for high employment and low inflation. For a long time economists presumed those goals to be in conflict but in recent years Chairman Greenspan seemed to have successfully argued that pursuit of low inflation rather automatically supports sustainable growth with maximum feasible employment.
In any event, nothing is more sacrosanct than the supposed independence of the central bank from the treasury, with the economics profession as well as policymakers ready to defend the prohibition of central bank “financing” of budget deficits. As in many developed nations, this prohibition was written into US law from the founding of the Fed in 1913. In practice, the prohibition is easy to evade, as we found during WWII in the US when budget deficits ran up to a quarter of GDP. If a central bank stands ready to buy government bonds in the secondary market to peg an interest rate, then private banks will buy bonds in the new issue market and sell them to the central bank at a virtually guaranteed price. Since central bank purchases of bonds supply the reserves needed by banks to buy bonds, a virtuous circle is created so that the treasury faces no financing constraint. That is what the 1951 Accord was supposedly all about—ending the cheap source of US Treasury finance.
Since the Global Financial Crisis hit in 2007 these matters have come to the fore in both the US and the European Monetary Union. In the US, discussion of “printing money” to finance burgeoning deficits was somewhat muted, in part because the Fed purportedly undertook Quantitative Easing to push banks to lend—not to provide the Treasury with cheap funding. But the impact has been the same as WWII-era finances: very low interest rates on government debt even as a large portion of the debt ended up on the books of the Fed, while bank reserves have grown to historic levels (the Fed also purchased and lent against private debt, adding to excess reserves). While hyperinflationists have been pointing to the fact that the Fed is essentially “printing money” (actually reserves) to finance the budget deficits, most other observers have endorsed the Fed’s notion that QE might allow it to “push on a string” by spurring private banks to lend—which is thought to be desirable and certainly better than “financing” budget deficits to allow government spending to grow the economy. Growth through fiscal austerity is the new motto as the Fed accumulates ever more federal government debt and suspect mortgage-backed securities.
The other case is in the EMU where the European Central Bank had long been presumed to be prohibited from buying debt of the member governments. By design, these governments were supposed to be disciplined by markets, to keep their deficits and debt within Maastricht criteria. Needless to say, things have not turned out quite as planned. The ECB’s balance sheet has blown up just as the Fed’s did—and there is no end in sight in Euroland even as the Fed has begun to taper. It would not be hyperbole to predict that the ECB will end up owning (or at least standing behind) most EMU government debt as it continues to expand its backstop.
It is, then, perhaps a good time to reexamine the thinking behind central bank independence. There are several related issues.
First, can a central bank really be independent? In what sense? Political? Operational? Policy formation?
Second, should a central bank be independent? In a democracy should monetary policy—purportedly as important as or even more important than fiscal policy—be unaccountable? Why?
Finally, what are the potential problems faced if a central bank is not independent? Inflation? Insolvency?
While this two part piece will focus on the US and the Fed, the analysis is relevant to general discussions about central bank independence. We will limit our analysis to the questions surrounding what we mean by central bank independence. We leave to other analyses the questions surrounding the wisdom of granting independence to the Fed, democratic accountability, and potential problems. We will argue here that the Fed is independent only in a very narrow sense. We have argued elsewhere that the Fed’s crisis response during the global financial crisis does raise serious issues of transparency and accountability—issues that have not been resolved with the Dodd-Frank legislation.[2] Finally, it will become apparent that we do not believe that lack of central bank independence raises significant problems with inflation or insolvency of the sovereign government.
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