April 26, 2009
Central Banks Cannot Easily Maintain their Independence
Central Banks Cannot Easily Maintain their Independence- Becker
Most richer nations nowadays, and many developing nations, have "independent" central banks, such as the European Central Bank and the Federal Reserve Bank. "Independence" cannot be precisely defined, but it is supposed to indicate that the central bank of a country has the freedom to make decisions which the government, represented by the Treasury in the United States, does not like. The purpose of independence is to allow monetary policy to be decided independently of fiscal policy, although obviously even independent banks and governments may respond in consistent ways to broad economic events, such as the present recession.
The motivation for having an independent central bank is the many occasions in the past when subservient central banks accommodated the government's desire to spend more without raising additional taxes. Central banks accommodate fiscal authorities essentially by buying government securities that help finance government spending. In return for receiving government debt, a central bank would either directly print additional currency that governments can spend, or it would create reserves in commercial banks that lead to an expansion of bank deposits and monetary aggregates, such as M1. Either way, inflation would result from this monetization of the government debt, often severe inflation and even hyperinflation. Hostility to rapid inflation led to the political support behind giving central banks much greater independence from fiscal authorities.
The history of the Federal Reserve's transition in and out of independence is illuminating (see Allan Meltzer's book, A History of the Federal Reserve, 2003). The Fed fully and enthusiastically compromised its independence from the Treasury during World War II. It bought large quantities of government debt to help the government finance the large wartime deficit. Inflation from the resulting big expansion of the money supply was suppressed through wage and price controls. This inflation became open after removal of these controls at the end of the war.
For a half dozen years after that war was over, President Truman and the Treasury pressured then much more reluctant Fed officials into maintaining the Fed's subservience. Eventually, however, the Fed regained its independence in the famous Accord reached in March 1951. Nevertheless, the Vietnam War, the Great Society Program, and the reinstitution of wage and price controls by Richard Nixon in the early 1970s led to later erosions of the Fed's independence.
Even during normal times, central banks, whatever their nominal independence, are under strong pressure to accommodate expansionist fiscal policy, especially as elections approach. During extraordinary times, whether in peacetime or during wars, this pressure usually becomes too powerful to resist. So the rather complete bending of the Fed to the Treasury's wishes during the present worldwide recession is not surprising. Still, that does not make it right, and I have some doubts about the Federal Reserve's recent behavior.
One concern is the somewhat arbitrary choices the Fed made about which banks to bailout and which ones to close or merge into other banks. This added significantly to the enormous uncertainty already prevalent in financial markets. I am also worried about the Fed's support of the huge federal deficits generated by the sharp expansion in federal spending. I understand such actions are necessary to help governments fight wars, but why help finance so much spending during this recession, particularly spending that has dubious stimulating potential? One example is the almost $800 billion so-called stimulus package that will do little to stimulate the economy, but will greatly raise long term government spending in directions desired by the President and Congress (see the posts on January 11 of this year). Another example of dubious government spending that the Fed seems willing to help finance is the ill thought out Treasury plan for hedge funds and other financial institutions to buy toxic bank assets (see the criticism of this plan in my posts on March 29 and 31).
The huge increase in bank reserves is a major consequence of the Fed's monetization of the government's large spending programs. Reserves went from about $8 billion in early Fall to around $800 billion, or a hundred fold increase in only 6 months. The recession rather than the wage and price controls imposed during prior periods is keeping inflation suppressed at present. Once the economy begins to recover, the inflationary risks will be enormous. In order to soak up these reserves, the Fed would have to sell large quantities of its government securities back to the private sector. These sales would put downward pressure on security prices- that is, upward pressure on interest rates- that will slow the economy's expansion at that time. For this reason, any government in power then, whether Democratic or Republican, will vigorously resist such Fed actions.
Hence it is not obvious that the Fed will be able to conduct these sales sufficiently smoothly to prevent either a recession or a serious bout of inflation. These are not pressing concerns when a serious recession is the immediate problem, but they will become major challenges down the road.
Is the Federal Reserve Losing Its Independence? Posner
Even in a democracy, it is believed that certain government functions should be placed beyond the control of democratic politics. The usual example is the judiciary (though most state judges in the United States are elected, this is a considerable anomaly). But another example is the central bank, which in the case of the United States is the Federal Reserve. A central bank has considerable, often decisive, influence over short-term interest rates, and, through them, over long-run interest rates as well. Typically (and to oversimplify), a central bank reduces short-term interest rates by buying short-term government securities, which pumps cash into the economy when the cash is deposited in bank accounts and then withdrawn and spent. Interest is the price that people or firms demand to part with cash--the more cash there is in the economy, the lower that price will be. In addition, by increasing the demand for these securities, the purchase increases their price, which in turn reduces their yield--the interest that they command. The central bank increases short-term interest rates by the reverse operation--selling short-term government securities, which sucks cash out of the economy, since the central bank can retire the cash rather than having to spend it.
Long-term rates tend to follow the path of short, both because of substitutability and because the more cash the banks have to lend, and so the less they have to pay for the capital that they lend, the lower the interest rates at which they will lend, including lending long term, because competition will tend to keep the spread between the banks' borrowing and lending costs from increasing just because their borrowing costs are falling.
The reason for making the central bank politically independent is that the bank's power over interest rates could be abused for political ends. Suppose the economy, though not in recession, is somewhat sluggish, and the government, perhaps because an election is looming, wants to juice it up. So it orders the central bank to reduce interest rates by buying government securities, thus pumping money into the economy. Reduced interest rates will stimulate lending, borrowing, and therefore economic activity, but the increase in the money supply can (since the economy is merely sluggish, and not in recession) create inflation. Very low interest rates in the early 2000s in the United States caused asset-price inflation, with destructive consequences, as we know.
Inflation can have other political objectives besides stimulating the economy in order to improve a government's popularity. It is a method of taxation. Suppliers are required by law to accept the official currency in payment of debts, so government can buy goods and services just by issuing money to its employees and other suppliers without having to raise the money by borrowing or by (explicit) taxation. The suppliers will respond by raising prices, but if the government refuses to pay (for example, refuses to raise wages), then the suppliers, to the extent dependent on the government for business (or employment), will have to accept the cheapened money.
In addition, inflation can be used to benefit some groups in society at the expense of others. Inflation benefits debtors, when debt is not indexed for inflation, and hurts creditors. A strongly pro-creditor central bank might even engender deflation, which would mean that debtors would be repaying their debts in dollars worth more in purchasing power than when they took out their loans. A central bank might do that (reduce the money supply, so that the purchasing power of a given quantity of money increases) in order to strengthen its currency, which would enable the country to buy imports more cheaply and increase the return on its foreign investments. (That was the ground on which Britain deflated by returning to the gold standard after having gone off it in World War I. That was a government decision; there was no independent central bank.)
Since the harms of inflation are now widely recognized, a central bank that focuses on limiting inflation will be reasonably popular; and since the value of its being independent of political influences so that it will limit inflation (and deflation) will be recognized, its independence will not be challenged. But the independence of the central bank in the United States, as in other countries, is not guaranteed by the Constitution, as the independence of the federal judiciary is. It is a matter of statute, and Congress could eliminate or reduce the Federal Reserve's independence from the normal political process at any time. Its independence is therefore legally precarious.
That is part of the reason why the modern Federal Reserve has focused on controlling inflation, and, specifically, why it did not prick the housing bubble of the early 2000s, as it could have done at any time by pushing up interest rates, until the bubble got completely out of hand in 2006 and 2007. Had it pricked the bubble earlier, precipitating a fall in housing prices with consequent defaults and foreclosures, at a time when it was unclear that the run up in housing prices was a bubble, it would have been blamed for causing a recession, because proof of a bubble is difficult.
But in retrospect the hit that the Federal Reserve would have taken by pricking the bubble would have done less damage to its prospects for continued independence than the current depression, and the Fed's response, may be doing. Had the Fed merely pushed down interest rates when it became apparent last summer that the economy was sliding into a recession or worse, it would have been doing something that it was expected to do: the converse of raising interest rates to prevent inflation is lowering interest rates to prevent recession, and this is consistent with stabilization, which is part of the Fed's explicit statutory mandate. The Fed did lower the federal funds (overnight bank lending) interest rate, which has become the conventional way in which it influences interest rates. That rate is now virtually zero, yet the reduction has not done the trick. The reason is that the impairment of the banks' capital (because of their heavy involvement in home mortgage lending) has discouraged the banks from lending, since lending is risky. And so the fact that they can borrow from one another at essentially a zero rate of interest to meet loan demands has not incited them to lend in amounts necessary to maintain economic activity at a normal level.
The Fed in some desperation therefore began last fall lending substantial sums to banks in an effort to increase their safe capital to a point at which they would increase their lending by relaxing their credit standards and reducing interest rates on their loans. The Fed also began buying up private debt (as distinct from government securities), for example credit card debt, in the hope that the sellers of the debt would use the cash they received for their debt from the Fed to issue more debt, that is, to lend more. It even has begun buying long-term private and public (Treasury) debt.
The dangers to the Federal Reserve's independence that are created by such activities are twofold. First, the scale of the Fed's intervention is so great as to create a serious risk of a future inflation, albeit a risk that, at present, the bond markets (judging from long-term interest rates) do not consider large. The Fed in the last year has expanded the supply of money by about a trillion dollars, and is intending to expand it further. In principle, it can reverse the expansion process by selling Treasury securities (and the other debt that it has bought) and retiring the cash it receives from the sale. The problem is that a sudden large withdrawal of cash from the economy could cause interest rates to spike, bringing on a recession, as when the Fed reduced the money supply in 1979-1982 to break the 1970s inflation, which was getting out of hand (it reached 15 percent in 1979). A gradual withdrawal might be too slow to prevent inflation.
It is true that when the Fed buys short-term debt, such as credit-card debt, the transaction unwinds naturally in a short time: the debt is paid by the debtors, and the cash received from them can be retired. But this assumes that the debt is paid in full, which it may not be, and that the Fed does not immediately buy more short-term debt, and perhaps feel obliged to continue doing so, because the market has become dependent on its participation. And the Fed as I said is buying long-term as well as short-term debt, and that does not unwind automatically in the short term; it can be sold but it might be sold at a loss, depleting the Fed's balance sheet and leaving excess cash in the economy to create inflation.
If the Fed's actions precipitate inflation or have other untoward consequences, there is likely to be a political backlash against the Fed. We live at present in a blame culture, and really the Fed is lucky that so far most of the public's and the Congress's and the media's ire has been directed at the bankers rather than at Greenspan or Bernanke.
Second, and perhaps more ominous, the types of intervention that the Fed is now engaged in can create an impression of politicization of financial policy or even of impropriety. If the Fed merely issues an offer to buy some specified quantity of Treasury bills, or an offer to sell some specified quantity of those bills, it is not picking and choosing among companies or industries. But if it decides, or participates in deciding, whether Bank X should be allowed to fail while Bank Y receives a huge bailout, or when it uses its position as a bank's creditor to alter its management or influence its business decisions, it invites accusations of favoritism or worse. (Or when it decides to buy one type of private debt rather than another.) The latest portent is the allegation that Bernanke, the Fed's chairman, participated with Henry Paulson, the then Secretary of the Treasury, in pressuring Bank of America last December not only to go through with its planned purchase of Merrill Lynch but also to conceal Merrill Lynch's immense losses from Bank of America's shareholders. I have no idea whether the allegation is true; but that it should be made at all is an example of the political danger to the Federal Reserve if it becomes involved in the operation of individual banks.
I am not suggesting that the Federal Reserve is wrong to take radical measures to combat a depression. The Fed's "easy money" monetary policy may have warded off a deflationary spiral, which would have been disastrous (there is still a mild deflation--the Consumer Price Index for example is below what it was a year ago--and it could still get worse). And the Fed's bank bailouts may well have limited the decline in lending touched off by the near collapse of the banking industry last September. I merely contend that such measures pose greater threats to the Fed's political independence than would early intervention to prick the housing bubble and by doing so perhaps have prevented the grave economic situation in which the nation finds itself.