May 23, 2010
Central Bank Independence
Should Central Banks Be Politically Independent? Posner
The case for central bank independence from the political branches of the government is simple. Central banks control the amount of money in the economy. For example, by selling short-term government securities for cash, they reduce the amount of money in the economy and this drives up short-term interest rates, while by buying such securities for cash they increase the amount of money in the economy and that drives down short-term interest rates. (Long-term interest rates are also affected, and in the same direction.) Politicians like the money supply to increase before elections, because a reduction in interest rates stimulates economic activity; consumers borrow more to consume, and businesses borrow more to invest in production. In principle, consumers and businesses should anticipate inflation (if the money supply is increasing faster than the output of goods and services), resulting in higher long-term interest rates and various distortions in economic activity, and take preventive measures that will reduce the stimulative effect of the central's bank low-interest-rate policy. But we know from the reaction of consumers and producers to the very low interest rates of the early 2000s that the effect of very low rates on consumption and production are not fully and immediately offset by anticipation of future consequences.
Thus if a nation's central bank is controlled by politicians, it can be expected to reduce short-term interest rates at particular phases in the electoral cycle, and this tendency, because unrelated to any economic reasons for low interest rates, can be expected to have an inflationary effect. Moreover, inflation can easily get out of hand. When inflation is anticipated, the amount of money in circulation increases; people hold smaller cash balances because inflation erodes the value of cash. The more rapidly money circulates, the higher the ratio of money to output and therefore the higher the rate of inflation. (Money that does not circulate—money that people keep under their mattresses, for example—are not really part of the money supply because they are not exchanged for goods or services.)
As inflation mounts, the cure—a sharp reduction in the money supply and concomitant increase in interest rates—becomes more painful. When Paul Volcker, the chairman of the Federal Reserve, pushed short-term interest rates to 20 percent in August 1981 to break an inflation rate that had reached 15 percent, he precipitated a very sharp recession. President Reagan was furious but Volcker stuck to his guns. A politically dependent Federal Reserve probably would not have done so.
In fact the Federal Reserve is not completely independent from politics. Unlike the Supreme Court, its independence is not dictated by the Constitution. The United States did not have a central bank when the Constitution was promulgated, and the Constitution didn't require the creation of one. The Federal Reserve dates only from 1911, and before then experiments with central banking in the United States had been sporadic. The Federal Reserve's independence—which is a function of the long terms of the members of the Federal Reserve Board (14 years, though the chairman's term is only four years, albeit renewable), the fact that they cannot be removed before the expiration of their terms, the fact that the Federal Reserve is self-financed rather than financed by annual congressional appropriations, and the fact that the members of the Open Market Committee (the organ of the Federal Reserve that controls the money supply) include presidents of the local federal reserve banks, who are chosen by private banks rather than by the President—is a gift of Congress; and what Congress has given, Congress can take back. Hence Federal Reserve chairmen and members can't just thumb their nose at Congress.
Particularly not in an economic crisis, such as hit the country and the world in September 2008. Essentially the Federal Reserve recapitalized the banking industry by buying its mortgage-backed securities (and other bank debt as well), thus pouring cash into the banking system. (As did the Treasury Department.) By greatly expanding the money supply, the Fed sowed the seeds of a future inflation—but in times of economic desperation the attitude is: let the future take care of itself.
The Supreme Court is the best example of a government institution that is outside political control. The Justices can as a practical matter be removed from office only if they commit crimes, and their decisions on matters of constitutional law can be nullified only by the very cumbersome process of amending the Constitution. Also, there is widespread public respect for the Supreme Court, and for courts and judges in general. The Federal Reserve has neither constitutional standing nor the enthusiastic support of the people. Its close links to the banking industry are noted and very few people have even the slightest understanding of the Fed's role and responsibilities. It performed ineptly in the run up to the financial crisis and in refusing to bail out Lehman Brothers. Bernanke's reappointment drew sharp opposition in the Senate, and there is some indication that Senate Majority Leader Reid extracted from Bernanke during the confirmation process a quasi-promise not to raise short-term interest rates too soon, lest by doing so the Fed choke of an economic recovery.
So the Fed is best described as quasi-independent rather than independent. A constitutionally independent Fed—an institution parallel to the Supreme Court—would create something close to a dictatorship over the business cycle, and this is too much power for a democratic society (perhaps any society) to cede to a bevy of economists and financiers. But the quasi-independence of the Fed, by giving it a great deal of discretion over monetary policy (even if the discretion is not complete), worries some economists, who think the Fed apt to misuse it, whether because of unsound economic theories or in an effort to mollify the political branches. But occasional proposals, as by Milton Friedman, to tie the Fed to a precise formula for increasing or decreasing short-term interest rates seem too rigid, because a formula cannot prescribe the correct response to unpredictable shocks to the economy, as we experienced in the financial collapse of 2008.
Central Bank Independence-Becker
Governments that control central banks have often used their power to increase the money supply and create inflation. A growth of the money supply increases the revenue collected by the government through an inflation imposed tax on the holders of money.
These and other abuses of governmental power over central banks helped create the intellectual support for independent central banks. During the past several decades several central banks, such as the Mexico central bank, have become more independent of their government.
I have little doubt that central banks should have considerable independence Yet complete central bank independence from politicians does not seem desirable since banks also can abuse their powers. At times they can be tone deaf to what is happening in the economy, and at other times they are too much under control of the private banks that they regulate.
An analogy is often drawn between an independent judiciary and an independent central bank. Just as an independent judiciary often prevents legislatures and heads of governments from abusing their power to formulate and interpret laws, so an independent central bank is supposed to prevent governments from inflating the money supply, and in other ways creating monetary mischief. Yet the analogy between central banks and the judiciary is incomplete and not perfect. If the Supreme Court gives an unpopular opinion, such as its recent decision on the unconstitutionality of bans on spending by corporations during elections, that does not directly reflect on the governing policies of the President or Congress. Indeed, President Obama has openly criticized the opinion and clearly expressed his opposition. On the other hand, when central bank policies help create inflation or unemployment, the governing party will be blamed because the electorate cannot distinguish the effects of central bank behavior from the effects of presidential and legislative decisions.
Milton Friedman in "Should there be an Independent Monetary Authority" (1962) and elsewhere argued against complete independence of the Fed and other central banks because that would give too much power to the top bank officials. He also opposed making a central bank subservient to political leaders because that could lead these leaders to misuse the bank's powers in order to promote their short –term political gain. His solution was a monetary rule, such as a fixed growth rate in the money supply. Such a rule would make many important central bank decisions completely automatic, and independent of the desires of both central bank heads and government officials. Taylor-type interest rate rules that have greatly influenced some central banks are generalizations of Friedman's rule on money supply growth that are linked to inflation and the growth of GDP. Taylor-type rules also can operate automatically, and could be largely independent of both central bankers and politicians.
Yet even if a central bank followed a rigid rule to determine its interest rate and money supply policies, it would be necessary to periodically evaluate how well the rule was working. And since central banks are unlikely to continue to follow a fixed rule in the face of a financial crisis, evaluations of its discretionary decisions are also necessary. While the bank should provide its own evaluations, these would tend to be biased toward justification of what it had done.
This is why I support substantial but not complete independence of central banks from legislative and executive oversight. Such oversight can force central banks heads to justify what they did in a public and open arena. The need to provide regular reports on its behavior to legislative committees would bring out mistakes made by the central bank. It would also induce central bankers to take more careful decisions since they would anticipate having to justify what they did in a public forum.
The US approach to the Fed makes a reasonable compromise between independence and oversight. The President appoints, subject to Senate approval, all seven members of the Board of Governors of the Federal Reserve for 14-year terms. Neither the President nor the Senate can remove any member prior to the expiration of their terms because of disagreements with bank policies. The President chooses, subject also to Senate approval, the Chairman of the Board, the most powerful position on the Board, from among the sitting Governors. The chairman serves for four years and can be reappointed. The chairman must report twice a year to Congress on the Fed's policies, and he is asked to testify on other occasions before Congressional committees. He also collaborates with the Treasury on various occasions, as during the 2008-09 financial crisis.
Some critics believe the Fed has too much independence from Congress and the President. Following this line of criticism, Representative Ron Paul of Texas in 2009 introduced a bill that would provide for greater Congressional oversight of the Fed. Others believe that the Fed and other central banks have too cozy a relation with governments, and that political pressures excessively influence central bankers to conform to short-term political wishes.
The best way to help meet both objections is to make public all the Fed's decisions (and that of other central banks), with no more than a short lag. Rather than being an asset, central bank secrecy is a handicap to businessmen and consumers who make investment and other decisions that are affected greatly by what the bank does. To maximize public information, the central bank, whenever feasible, should follow known interest rate and money supply rules that are clearly related to the rate of inflation and the degree of slack in the economy.
Under these conditions, present laws on the length of the chairman's term and that of the other members of the Fed's Governing Board, and the laws requiring periodic reports of the chairman before Congress, would be effective. A system that has the Fed following rules that govern its policy decisions, combined with some discretionary authority in crises, and also with some congressional oversight would provide a reasonable mixture of central bank independence and control by Congress.