Why is central bank independence important?

Central banks are today some of the most important institutions in the economy, charged with regulating interest rates and the overall flow of money supply. This makes them responsible for a nation, or group of nations, monetary policy. Normally, since they have this responsibility central banks are charged with keeping inflation and prices stable, but some reserve banks have added duties, such as the FED which also has to keep unemployment low.

In order for central banks to pursue these objectives it’s generally assumed that they should be independent from political power and decision making. Nonetheless, lately central banks have seen their autonomy being challenged, such in: the US, where Donald Trump has repeatedly criticized the FED’s actions, Modi’s India where the governor resigned in December over clashes with the PJP’s leader, Turkey in which Erdogan fired the governor for allegedly refusing to lower interest rates or Argentina where Mauricio Macri’s government is hoping that the central bank will issue more pesos.

But why were central banks given more autonomy in the first place?

To answer this, we first have to go back to the 1960s and 70s when reserve banks where far more influenced or out-right controlled by government policy. Around this time, economists and specially politicians believed that you could lower unemployment by increasing inflation, a theory backed by the Philips Curve, so general wisdom demanded central banks to increase money supply to curb unemployment. This theory made it irresistible for politicians to pressure central banks to stimulate the economy ahead of an election, so as to boost their chances of winning. Everyone knows that an incumbent leader is more popular with a low unemployment rate and a bustling economy. This was what exactly happened with Richard Nixon ahead of the 1972 election in which he pressured the FED’s chairman, at the time, to increase the money supply. However, this decision is largely seen as having left the US economy vulnerable to the great increase in inflation the world saw throughout the 70s that was largely caused by the oil embargo. Nonetheless, the monetary paradigm of the time is widely seen as a reason for the prolonged inflation bubble.

It was from this point on, that the world started coming to the conclusion that giving independence to central banks could largely be a positive outcome. From the graph below, we can see that countries such as Germany and Switzerland, home to very independent central banks had lower inflation rates than countries such as the US or UK where the reserve banks were not as independent.

After all it makes sense that central banks should be independent, since chairman’s have a long-run view of the economy instead of just the next election year cycle. It’s much harder for politicians to pursue unpopular measures that might bring short term difficulties, but they are necessary to assure the overall health of the economy in the long run. To raise interest rates or cut budget deficits in an election year, are examples of those unpopular measures. Given this, the world gradually moved in the direction of giving more autonomy to central banks in the 1980s and 90s, and the results have been clear. Inflation has been far more stable as well as interest rates. This in turn has helped consumers and businesses by not having to adapt to new prices and interest rates in very short spans of time.

Times of change

Nevertheless, the 2008 global recession has changed the view of many with regards to central bank independence. Many believe that central bankers don’t have necessarily the public interest on their minds and that their actions are too secretive, pointing to the fact that they are not elected and are autonomous from public branches, and thus some believe they should have more oversight. Others point out that too much reserve bank’s independence may cause a contradiction between monetary policy and fiscal policy, which is a government responsibility. Which in turn could destabilize the economy and make it more difficult to wither recessions. Moreover, the general rise in populism has also put these institutions under threat of attacks both by the right in the case of Donald Trump and by the left, in the case of Jeremy Corbyn which criticizes the Bank of England’s actions and wants to use it as a tool to finance bigger public investment.

With this, central banks dependence or attempts to curb their autonomy, have become a good indicator of authoritarian like regimes. One such example is Venezuela, where inflation has reached 10 000 000%. Another one is Zimbabwe where inflation reached 89.7 sextillion percent year-on-year in mid-November of 2008. So, there is a tendency for authoritarian regimes to attack central bank autonomy and make reckless decisions with regards to monetary policy.

All in all, one thing is clear, central banks are going to have to change the way they operate and adapt it to the new reality. Even top figures, such as Mario Draghi, recognize that monetary policy and, therefore, central banks have to act in a more coordinated manner with fiscal policy (government) in order to allow for a more cohesive strategy when dealing with the economy and achieving more stability. The world is changing and the central banks’ operation process is too.