The ascendancy of Jeremy Corbyn in the Labour leadership race and discussions with Richard Murphy in the media have brought to public attention a debate about the purpose of central bank independence. This is something I have written about extensively, so this is a good opportunity to offer some context for the readers of this blog. Corbyn is right to raise this, as an integral part of the way the market-state relationship is balanced today is the idea of institutional independence from political control. How did however institutional independence come to be accepted as best practice in the design of regulatory frameworks?
Historically, attempts to depoliticise banking rested on distrust of the capacity both of politicians and of the public to behave in a way conducive to a nation’s best interests.
Thomas Hutchinson, an 18th century governor of Massachusetts, for instance, declared that ‘the great cause of paper money evil was democratic government. The ignorant majority, when unrestrained by a superior class, always sought to temper with sound money’. The very concept of central banking is, perhaps as a result of beliefs such as Hutchinson’s, associated with secrecy and intrigue. The idea of an American central bank was formulated in a secret meeting in 1910 on Jekyll island, where participants travelled pretending to be taking part in a duck hunt. As a result of processes starting at that meeting, the Federal Reserve was created in 1913 to implement banking and currency reforms with the aim to prevent periodic banking crises, such as the panic of 1907. Central bank authority focused on ensuring that the value of money was not undermined by inflation, an idea consistent with Hayek’s argument that mechanistic rules ought to limit the central bank’s discretion (and as a consequence the influence of political processes over central bank policies).
Focusing on the purported depoliticising effects of independence, we could see New Labour’s decision to give the Bank of England operational independence as a decision responding to a change of belief-system, not an economic one. It established New Labour’s anti-inflationary credentials and delivered on the party’s campaign promise to de-politicise the setting of interest rates. In fact, Bank of England independence forms part of a global trend during the 1990s, when more than 30 countries passed legislation increasing the legal independence of their central banks and represents one of the most dramatic changes in monetary frameworks since the collapse of the Bretton Woods regime. Bank of England reform came a decade after the start of the trend in central bank independence, which began with the 1989 reform of the Reserve Bank of New Zealand. The British decision, however, was not linked to changes in Britain’s exchange rate regime, the collapse of the former Soviet Union, the adoption of an IMF programme, the decision to join the Euro area – explanations that cover most cases of central bank reform in the 1990s, but it was motivated by the internalisation of the idea of independence by the labour leadership. A similar ideas-based explanation can be found for the German Bundesbank’s independent structure. The Bundesbank’s independence resulted from the balance of power politics in Western Germany that could only be maintained by detaching government from the setting of monetary policy.
The core of the intellectual case for central bank independence revolves around the assumption of a persistent inflationary bias built into politicians’ monetary policy preferences.
It is argued that this bias can only be negated by vesting authority in policy makers who can be trusted to choose a policy rule that is non-accommodating of inflationary tendencies; namely central bankers. Central bankers are assumed to be better placed than politicians to enforce such a rule, since there is no clear symmetry of interest between the central bank and the labour market in the way that there is between the government and the labour market. Put in a simpler way, there is an assumption that political control over monetary policy makes the business cycle dependant on the political-election timetable, with politicians trying to manipulate economic performance to gain short term political gain.
Research certainly finds that the conservative governments that preceded Labour prior to 1997 engaged actively in trying to manipulate economic indicators for political purposes. Accepting this argument as to the perverse incentives of politicians and their effects on distorting the economic cycle is a key precondition to allowing the idea of independence as a beneficial change to take root. The de-politicisation of central banking and the transfer of control over interest rates to independent central banks was also a key consequence of the success of the argument that Keynesian demand management was illegitimate. This was largely achieved by Friedman when he sought to demonstrate that a market economy would tend to gravitate towards a natural state of unemployment determined crucially by the cost of productivity and the distribution of labour. For this reason, governments, Friedman argued, could not affect the rate of unemployment in the long term, unless they increased spending and cut taxes, which would result in an expansion of the money supply, and thus inflation. Friedman’s imperative to maintain monetary and fiscal stability could only be sustained therefore if the economy was run on an ‘autopilot’ for regulating the quantity of money. This autopilot was achieved via the ploy of institutionally independent central banks and inadvertently led to a re-naturalisation of economic relations. Such re-naturalisation of economic relations suggests a return to the view that market processes need no state direction that last held sway prior to the Great Depression.
The orthodox account of economic justifications for central bank independence miss-specifies the whole nature of monetary relations within contemporary capitalism.
In examining justifications for central bank independence I remain unconvinced with the three foundations of this idea. The three foundations are the success of the Bundesbank and the German economy, the academic literature on the assumed inflationary bias of politicians, and the literature on the effects of central bank independence. Bundesbank’s unwavering inflation targeting has been very costly on German growth and sparked a number of serious recessions. Also inflation targeting, as a goal of monetary policy does not automatically require the independence for the central bank, and further that the causal relationship between strict monetary policies and independence is not one-directional. It could be for instance, that countries have independent banks because they have chosen monetarist policies and not the other way around as commonly assumed.
This presentation of the reasons for the proliferation of the idea that institutional independence (in general and central bank independence in particular) is beneficial, allows us to return to a consideration of the place of technocracy in modern economic governance.
The politics of macroeconomics is not so much the struggle for the authority to impose efficient institutions, as it is the struggle to legitimize self-appointed authority on the basis of technical expertise.
The most important question to ask about the process of central banking therefore is who defines the social welfare function that acts as the guide for central bank interventions in the economy? Yet, this question cannot be asked within an orthodox intellectual framework that essentially denies the constitutive role of politics in the economy. Within orthodox macroeconomic analyses, the social welfare function is said to approximate the policy preferences of the ‘representative’ individual within society. However, those models conceptualize the representative individual as one who adopts the same cognitive approach to the question of monetary policy-making as that of orthodox macro-economists.
By little more than a definitional trick, it seems, orthodox macro-economists are thus able to elevate themselves to the position of legitimate intellectual guardians of society’s concerns for the key settings of economic management.
Stiglitz offers a summary of his critique of the idea of the ‘rational’ individual in Freefall (2010) and concludes that homo-economicus is just a useful fiction that has been mistaken by economists as a description of reality. This fiction is then used to assess policy and to predict behaviour leading to patently unrealistic results. Such a result is similar to the one discussed above, of mistaking consumer choices with citizen choices, of a democracy of means with a democracy of votes.
The intellectual case for central bank independence is therefore less clear than its current political appeal would seem to suggest.
It is undeniable however that financial markets have a significant impact on the way in which society is organized, since the allocation of credit is the sine qua non of distributional politics. Consequently, when the decision to cede operational autonomy to central bankers is justified in terms of the need for market sensitive policies, it is equally clear that a particular way of organizing society is being simultaneously constructed and defended against possible redefinition. As a result, the social basis of financial trading has changed markedly in recent years in a way which is selective of a social structure of accumulation grounded in the monetary orthodoxy that central bank independence was designed to deliver.
Corbyn could therefore be right in seeking to expose the politics that lie beneath the Bank’s façade of independence.