– Discussions over changes to the powers of the Bank of England have reignited a debate over whether and how central banks are independent from governments.
Central bankers are responsible for preserving the value of a currency by controlling inflation. To this end, many of them are immune to political pressure from governments.
Once a sacred cow in the Western world, this independence has been questioned more often in recent years as central banks have stepped in to support governments when they have been hit by the global financial crisis and then by the coronavirus pandemic.
Here are some questions and answers on a topic that is rapidly spilling over from academia into politics and could have a profound impact on inflation over the coming decades.
The favorite to become Britain’s next prime minister, Liz Truss, has promised to review the remit of the Bank of England, potentially including its ability to set interest rates without government interference.
It came after the UK’s central bank raised rates to the highest since 1995 on Thursday, while also forecasting a long recession and double-digit inflation – a double whammy for household finances.
BoE Governor Andrew Bailey is not alone. Central bankers around the world are under fire from politicians for failing to predict and prevent the current episode of high inflation.
WHAT IS CENTRALBANKINDEPENDENCEANDWHYIS IT THAT THIS QUESTION?
A central bank is independent if it can make policies, such as setting interest rates or printing money, without interference from elected officials or the private sector.
The idea is that governments would rely on the central bank to stage a boom when they need re-election and stop rate hikes that would be too painful for their constituents.
This would cause the economy to overheat and inflation to get too high until an inevitable collapse.
Instead, central bankers should focus squarely on inflation, sometimes married to another goal such as full employment, and let politicians deal with issues of redistribution and equity.
IS IT THAT THIS WORK?
Data shows that central banks that were more independent, such as those in Germany, Austria and Switzerland, had lower inflation between 1970 and 1999 than those that were closer to their governments, for example in Norway, in New Zealand and Spain.
But this relationship weakened in the new millennium when new forces came into play, such as greater globalization and the introduction of the euro.
The alternative, however, is hard to digest.
In Argentina, where the central bank is firmly under the control of the president, inflation is approaching triple digits, the peso has lost half its value in less than a year and a half and citizens are facing restrictions on they want to buy foreign currencies or sell goods abroad.
Most central banks in the developed world and many emerging banks are formally independent, although to varying degrees.
In practice, the line between central banks and governments can become blurred and in some cases just a polite fiction.
Turkey’s central bank is formally independent, but that hasn’t stopped the country’s president, Tayyip Erdogan, from firing governor after governor if they don’t grant his wishes.
Even in the United States and Europe, central bankers are regularly accused of financing states through massive purchases of public debt, which have become commonplace since the global financial crisis.
Although these “quantitative easing” programs are always justified by the need to stimulate inflation when it is too low, they place central bankers neck and neck, rather than at a distance, with their governments.
Nowhere has this been more visible than in Japan, where the central bank owns half of the public debt.
No, central banks were until recently an arm of government.
The idea of having a fully independent central bank was discussed by economist Milton Friedman in 1962, who rejected it on the grounds that it would not survive the first “real conflict” with the government.
The Federal Reserve has enjoyed operational independence since 1951, but presidential interference lasted until at least the 1970s.
Then-Fed Chairman Arthur Burns came under pressure to keep policy loose to help US President Richard Nixon win re-election.
The ensuing decade-long episode of high inflation, triggered by an oil shock that Burns’ Fed sought to accommodate, reinforced the idea of central bank independence.
This gained momentum in the 1980s and took off in the 1990s when many central banks, including the Bank of England, were reformed and others were created in what was once the bloc of ballast.