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.

Comments

[Kevin]

"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."

I think Friedman would agree, but argue there wouldn't be as many problematic shocks if the money supply grew at a constant rate. Even you agree that the Fed's decision to use expansionary monetary policy too aggressively in the 2000's contributed to the collapse.

[Gordon Longhouse]

These days central bank independence of a greater or lesser degree is almost taken for granted.

More controversial is the issue of whether the central bank should only seek to manage consumer price inflation, asset price inflation or both.

Also should it wait for inflation to take hold or should it act when it anticipates that inflation will happen if it fails to act?

Alan Greenspan continues to maintain that a central banker can only act against rises in the CPI after they take place.

The Reserve Bank of Australia has raised interest rates to counter what it thought were asset price bubbles even when inflation was within its 3% per annum target. (This target is set by agreement between the Treasurer, a cabinet appointment, and the RBA head). I wold suggest that the RBA practice is the better.

When it does this it cops considerable criticism from politicians trying to distance themselves from the consequences for their constituents.

Ideally the rise and fall of interest rates would be looked upon in political terms as a natural phenomenon like the rise and fall of temperatures and therefore mostly out of the control of the political process. I do not see this happening anytime soon so central bankers will continue to have to account for themselves to politicians as the quid pro quo for their de facto independence.

[Michael F. Martin]

"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."

I worry less that Bernanke will not have the nerve than I do that he will not be able to act as quickly. Will the Fed have actionable data that inflation has set in before it is too late? Six months ago, there was a trillion in the reserve system. Now that trillion is mostly in corporate cash accounts. There appears to be nothing stopping the financial services industry from rapidly, and simultanesouly, raising lending rates to pull the cash back into the banking system.

[Don the libertarian Democrat]

"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."

That's fine, but I still think his view here, if used in conjunction with his other suggestions for Economic and Monetary Stability, would work well, and not need as much fine tuning as thought.

[Jack]

The Carter/Volcker/early Reagan era was a confusing time. I'm not at all sure Volcker (who I generally like) did the right thing.

The true "inflation" must have been earlier and among the reasons we were forced off the gold standard. Nixon tried wage/price controls to restrain the predictable adjustments but they just as predictably failed. OPEC then wanted oil repriced in some relationship to gold or their own currency. R/E and other hard assets were similarly repriced, with boomer demand adding fuel to housing prices.

At the time I thought it was silly to raise interest rates in response to an outside price increase in oil that we could not or were unwilling to change. In many instances the high interest just added more costs to doing business on top of the cost push of oil prices resulting in yet higher prices.

While the Carter admin responded with demand lowering policies including CAFE standards, lowering the speed limits etc. those may not have been enough to have broken OPEC's pricing, but oil prices did tank and stay down for quite a long time. Did we create a steep recession to crack OPEC?

Today there is all this fear of lighting off an inflationary trend. But, after tallying up Fed injections and the deficits we should consider the other side of the equation such as the amount of money supply that is no longer in housing equity, stock market losses, and loss of entire incomes for many. Also we'd want to reflect on the combo of very low inflation during the high employment era of the 90's.

With 10% or more of our people on the sidelines, seeking, and needing jobs, along with the near infinite supply of offshore labor that was surely a factor in being able to run the nation at 5% unemployment without triggering inflation, I doubt inflation is our main problem.

Having the Fed try to respond to asset pricing seems a nightmare. Consider, (when the system isn't broken!) higher prices for commercial, rental or residential homes are the trigger to build more of them; classical economics at work. Tightening lending would simply slow the response. As for tightening on prospective oversupply that's exactly the job of local lenders and builders. The wisdom of a capitalist market has got to be left to investors and lenders taking their best shot. (Just don't let 'em get too big!)

[Russell]

It is plain as the nose on your face that the Fed has done a poor job of managing the money supply this decade. In fact, it has yet to be explained in a cogent way how the Fed can know what the appropriate interest rate is.

The mere fact that prices are flat does not mean there is no inflation. To the exent that prices should be falling because of more efficient manufacturing or production (say, like with computers or LCD TVs) or because of excess production like in residential or commercial real estate and are not falling is a reflection of inflation, inflation by the Fed pumping money into the economy. Inflation robs value from savers and creditors. Why is that honest or good. Why do we need inflation other than to feed a debt addicted economy?

If we don't need inflation, then we don't need a Federal reserve. Just maintain a static money supply and let supply and demand adjust prices. Then we don't have to worry about an independent or politicized Fed doing the wrong thing. Short of that, there should be complete transparency as Gary Becker suggested.

[Jack]

Russ, some good points: "The mere fact that prices are flat does not mean there is no inflation. To the exent that prices should be falling because of more efficient manufacturing or production (say, like with computers or LCD TVs)"

........... and they have done so! And perhaps? with all the increased productivity wages for working folks SHOULD have risen substantially, but! all the gains have accrued to the top 10% giving most the fairly accurate feeling they are treading water.

"because of excess production like in residential or commercial real estate and are not falling is a reflection of inflation,"

........... as home building is a risky and typically thin margin operation prices of NEW homes can not drop much; if they do the reaction of (rational) home builders and (rational) bankers is that of not building. Used homes are likely to bear most of the brunt of a falling market as the individual seller may have A. an urgent reason to sell -- job change, loss of one or more incomes, divorce, and B. have equity or be forced to take a short sale.

Not sure why you conclude the Fed's is typically in the biz of "creating INflation" as most often they're in the news for rightfully or wrongfully standing on the brakes.

And Ha! if you don't like the Fed trying to prop up what's left of our economy, I suggest reading or considering what it's like to live in the downward spiral of a deflationary era. Our system isn't set up to deal with deflation very well.

[Chris Graves]

I have to disagree with Judge Posner on his skepticism toward instituting a monetary rule. I also disagree with his depiction of the role that President Reagan played in Paul Volcker's efforts to bring the money supply under control, and inflation with it. First, Reagan did offer public support for Fed Chairman Volcker's inflation-fighting monetary policy. Here is a link to an article by Robert Samuelson recounting Reagan's role in offering support for Volcker's tight monetary policy even though he certainly was wary of the short-term political consequences of Volcker's policy.

http://www.slate.com/discuss/forums/thread/2232562.aspx

Later, Reagan appointees to the Fed led by Wayne Angell did vote to challenge Volcker. The thinking by the mid-1980's in the Reagan Administration might have been that inflation was then under control and the Fed needed to engage in a more expansionary monetary policy for the sake of the 1986 election. Of course, that was a mistake by the critics of Volcker in the Reagan Administration.

This series of events set in motion the appointment of Alan Greenspan who tried to iron out the business cycle by following short-term inflationary policies to counter economic downturns and then raise interest rates to head off inflation if and only if there was significant upward movement in the general price level. Greenspan's policy set the stage for the 2008 financial meltdown as he built up a series of bubbles during his tenure leading the Fed. Inflationary policies simply do not work even when a very insightful and experienced Fed Chairman follows what he believes to be carefully balanced counter-cyclical discretionary monetary policy. There is no way to accurately detect and measure inflation as it is occurring until it is too late.

So, discretionary policies simply do not work in the long-run. Rather, they head off the day of reckoning as Fed Chairmen decide that re-inflating the economy is more responsible and less harmful than taking a massive recession to purge inflation as Volcker did in the 1980's. Even conservatives such as Judge Posner and Professor Becker have argued against the horrors of recession and depression during the recent financial crisis rather than following a Volckeresque policy to restore financial stability through regularizing the growth in the money supply.

Of course, what we are doing now is re-inflating as we sow the seeds of an even more dramatic financial failure later. A steady monetary rule would head off these problems in the first place as Kevin and other commentators have pointed out above. But, let us be aware that it is likely that a monetary rule would lead to slower growth than what we have grown accustomed to in this age of Keynesian discretionary policies that are based on inflation. The big payoff of a slower and more predictable rate of monetary growth is sustainability.

[Darko Oracic]

The 2008 crisis was caused by Fed's contractionary policy. In 2006 and 2007 money supply (M1) growth became negative and short-term interest rates became higher than long-term interest rates. That created a credit crunch and a recession. A monetary rule that would not allow the Fed to reduce money supply growth below a limit or to raise short-term interest rates above a limit, would prevent such a crisis.

[Trent Rock]

" ....and very few people have even the slightest understanding of the Fed’s role and responsibilities"
Hahahahah..when I was in college. I asked my fellow econ students if they knew who Alan Greenspan was. Most did not :(

I'm with Posner on this issue. Especially the electoral cycle part.

[Robert]

The first issue to be considered here is whether there is even a need for a central bank. For nearly the first 125 years of its life the Nation did not have such an institution. Instead, in times of financial crisis smaller banks were supported by bigger ones. Contrarily, within 20 years of the Federal Reserve coming into existence the Great Depression rocked the economies of America and the West; real recovery did not begin until World War II. Nowadays, the Fed decides to "warm" or "cool" the economy by tinkering with the money supply. But it certainly got that wrong in the early 2000's with low interest rates leading to a housing bubble and the calamitous events of September, 2008. Why do we allow a bunch of elites to have this much power over the economy with limited accountability for their mismanagement? Doing away with the Fed might solve the problem.

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Now that trillion is mostly in corporate cash accounts. There appears to be nothing stopping the financial services industry from rapidly, and simultanesouly, raising lending rates to pull the cash back into the banking system.

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[Shelia]

I worry less that Bernanke will not have the nerve than I do that he will not be able to act as quickly. Will the Fed have actionable data that inflation has set in before it is too late? Six months ago, there was a trillion in the reserve system. Now that trillion is mostly in corporate cash accounts. There appears to be nothing stopping the financial services industry from rapidly, and simultanesouly, raising lending rates to pull the cash back into the banking system.

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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.

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