Tuesday, 12 March 2013

(Central Bank) Independence Day

Stagnant growth, painfully high unemployment levels, depleted consumer confidence, substantial deleveraging and reduced investment by businesses are all documented effects that have lingered from The Great Recession and have been witnessed to varied degrees throughout the global economy. However there is one consequence of the financial crisis that is now only becoming apparent, this being the undermining of central bank independence. With fiscal consolidation being the dominant (albeit tremendously wrong) policy prescription of the day, greater onus has been put on central banks by their respective governments to revive growth and return to the path of prosperity. This has forced central bankers to become more innovative with regards to monetary policy creation and challenged the long established view of the importance of an independent central bank.

But let’s first look at how this independence came about and why it is was widely employed. Economies in the 1970s were characterised by a unique problem: contractions in growth coupled with increasing inflation. A problem, that according to Walter Phillips’ famous original analysis in a 1958 The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957’ , could not exist. The one country who managed to achieve relatively low inflation levels in this harsh economic environment was West Germany, where inflation averaged around 5% during the decade while comparably US inflation rate reached highs of 13% and averaged at around 7%.

Policy makers put the country’s success down to the fact that the Bundesbank was independent from the German government. This, coupled with the rise of Monetarism led by Milton Friedman, triggered a global movement in which countries increasingly adopted legislation to increase the independence of their monetary authority. The main argument put forward for independence is that a central bank would be free from political pressure and the numerous difficulties arising from the dual-mandate that a government had of sustaining high output (resulting in low unemployment levels) while also keep the price level relatively low and stable. It was shown by the use of game theory that with both policy goals, the government would have the incentive to ‘cheat’ the public into believing that the inflation would be a certain level and change it to increase their own pay-off . Thus by giving central bank independence and assigning them to oversee one of the policy goals, sustained output or low inflation, then their actions would be deemed credible by the public thus allowing policy to work effectively.

So what policy goal to give an independent central bank? Inflation or employment targeting? Well Friedman in his famous 1968 paper ‘The Role of Monetary Policy’ claimed that monetary policy could not successfully target employment as a criterion of policy , it could not peg real quantities but only nominal ones and that by following a steady course of action, a monetary authority could promote economic stability. Thus the prospect of unemployment levels being the mandate of monetary policy was ended and instead the rules-based inflation targeting became the economic norm. First initiated by the Reserve Bank of New Zealand in 1988 and now currently used by a number of central banks including those in  Australia, Brazil, Canada, India, South Africa and the United Kingdom.

However due mainly to The Great Recession, this established view is being fiercely challenged across the developed world. With interest rates at the zero-lower bound and no help (with regards to expenditure) from the state forthcoming, monetary policy is being pushed to its limits when trying to accommodate other goals than just price stability. For example in the US, the Federal Reserve is buying $85bn of bonds a month until the US jobs market sees a substantial improvement and plans to keep interest rates at close to zero at least until the US unemployment rate falls below 6.5%. While in the UK, incoming governor of the Bank of England, Mark Carney, has already sparked debate by suggesting that economic output could be targeted instead of inflation and it appears that Chancellor or the Exchequer, George Osborne, plans to grant Carney greater powers to revive growth in the Budget later this month.

The most vigorous attack on Central bank independence however is occurring in in the Land of the Rising Sun, Japan. Newly elected Prime Minster, Shinzo Abe, has pledged to use both fiscal and monetary expansion to stimulate growth and defeat the persistent deflationary problem the country has faced for years. When running for office, Abe said he would set a ‘policy accord’ with the Bank of Japan for a mandatory inflation target of 2%, backed by unlimited monetary stimulus. So far he has got he wish, under increasing political pressure the Bank of Japan changed its inflation target from 1 to 2% and nominated Haruhiko Kuroda, a fierce advocate of past BoJ policy, to be the next head of Japan's central bank. Kuroda has since promised aggressive steps to raise inflation to 2%, which has only reinforced the Yen’s continued rapid decline. Focus on this radical shift in policy has only increased with the Yen’s decline in value and the riskiness of this policy shift has already been discussed at great length. The Bundesbank President Jens Weidmann has claimed that the BoJ's independence is under threat and warned against government interference in monetary policy.

Some may ask so what? So what if the central bank is being forced under political pressure to focus on output and inflation too, surely that is a good thing? In some sense yes. There is a case that monetary policy should focus more on output, as unemployment is not just a problem that has economic consequences but also massive social implications as well (as is being seen in Spain and Greece). Furthermore there is the argument that greater flexibility and openness in monetary policy circles, along with greater debate into monetary tools and their effects can only be beneficial for the improvement of our knowledge on both central banking and monetary policy.

In other ways however caution must duly be applied. Greater burden on Central Banks for creating growth reduces the responsibility on governments. Especially on those already pursuing destructive austerity measures which have increasingly being proven to be doing much more economic and social harm than good. With most noticeably an article, written by IMF chief economist Olivier Blanchard and Daniel Leigh, stating that fiscal multipliers in the advanced economies are considerably larger than had been previously assumed and thus austerity is much more damaging to output in the near term than was anticipated. Furthermore the lack of effectiveness of monetary policy in certain economic times, such as the liquidity trap situation that most developed countries are currently in, means that greater responsibility on central banks will not necessarily lead to the desired outcome to revive growth. As John Maynard Keynes proclaimed to President Roosevelt, using monetary expansion to create growth is “like trying to get fat by buying a larger belt”.

One thing seems certain for the independence of central banks, it is being severely challenged. It remains to be seen whether the long-established central bankers will coordinate a counterattack to save central bank independence and policy as we know it.