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.