Central Bank Independence. The Reason It Should Stay

Once upon a time there was the independence of the central bank. Will there still be in the future? The macroeconomic predicament is intertwining with a change in the physiognomy of political parties, and this is already causing quakes affecting what has hitherto been seen as a cornerstone of economic policy: monetary policy must be managed by independent central banks. In reality, while political tremors trying to dislodge the pillar of independence are not novel in history, the real unknown is how strong they will be this time.

The reason is the so-called political cycle of central bank independence. The starting point is that it falls to incumbent governments to write the rules that make central banks independent. When and why do they do it? In general, politicians controlling government would like to be directly in charge of all economic policymaking, including monetary policy. In fact, monetary policy can be a very powerful policy lever: by printing money governments can immediately see off a whole series of macroeconomic imbalances: recessions and stagnations, budgetary imbalances, and bank bailouts.

But there is a problem: precisely because monetary intervention is quick and effective, politicians tend to abuse it. Any abuse in monetary policy, especially when it is read by markets and economic agents, tends to create price bubbles. The relevant prices can be consumer prices, so that monetary abuse only generates price inflation. It is this kind of abuse that contributed to create that toxic mix of inflation and recession in the 1970s which convinced politicians – at different times and in ways varying from country to country – to entrust monetary policy to a central bank enjoying independence from governments in office. The independence of central bankers thus became the necessary – albeit not sufficient – condition for monetary policy to be credible and effective again. The independence of the central banks – so say the data – made a decisive contribution not only to monetary stability, but also to financial stability, without prejudice to economic growth.

Then came the 2008 crisis, which opened a period marked by multiple and related imbalances: drop in growth and employment, widening income inequalities, adverse dynamics in public spending, and instability of banks and finance. The fight against inflation – which had once forced politicians to give central banks their independence – has now ceased to be seen as a priority. In parallel, the demand for state intervention in markets has grown among citizens. Sovereign and populist movements are usually the ones clamoring for interventionism, for its short-term effects at the expense of its economic sustainability. When citizens forget the damages caused by monetary policy abuses, and politicians want to recover full control over monetary policy, there you have a new turn in the historical cycle of central bank independence, this time to the detriment of the autonomy of monetary policymakers.

In the 2015-2018 period, the independence of central banks has already come under question in a number of countries: Greece, Venezuela, Turkey, United States, India. It is too early to say whether the clock of independence will be turned back, but there are at least two certainties: while it is true that there is no economic reason to return to the past, it is equally beyond doubt that what makes the clock of policymaking tick is the analysis of political costs and benefits, certainly not the maximization of an unspecified social welfare function, as traditional macroeconomic theory wants us to believe - if indeed it still wants that.