In the United States, President Trump has struggled to decide whether Jay Powell or China’s Chairman Xi is the greater enemy to the U.S. In Turkey, President Erdogan concluded that “interest rates are the mother of all evil,” switched out his central bank governor for refusing to lower interest rates, and reined in the independence of the central bank with the stroke of a pen. In India, Indonesia, Ukraine, and elsewhere, lawmakers are tightening the political grip on monetary authorities. These examples reflect a new reality in monetary policy circles: the political retreat from central bank independence, or CBI.
We lack a convincing account of CBI reversals, however, because the very possibility of backsliding has seemed remote. The conventional wisdom is that politicians will be tempted to abuse the printing presses for political ends, undermining economic stability. One view is that CBI derives from the desire of politicians to tie their own hands so they cannot hear the siren call of monetary expansion. This view holds that CBI should only increase because it enhances economic stability and welfare. The strong correlation between strengthening CBI and low inflation over the past 30 years makes this view seem like simple common sense.
But, in reality, history is replete with episodes of CBI backsliding. As often as central banks have attained greater political independence, they have been subject to political attacks, members of their governing boards been replaced with political proxies, their mandates re-engineered to meet political targets, and laws enacted to dissolve their political independence. Given the benefits of putting monetary policy in the hands of financial experts, why would governments choose to undo CBI?
In a recent working paper, we develop a new account of CBI backsliding. The main innovation of our argument is the claim that CBI emerges foremost not from politicians’ desire to tie their own hands, but rather from the need for sovereign lenders — such as states, international organizations, domestic and international private banks, and sovereign wealth funds — to mitigate the risks associated with sovereign states. Specifically, we argue that the political separation of governments and monetary authorities creates incentives for each such entity to monitor and discipline the other, thereby curtailing the political hazard of sovereign lending. This creditor pressure for CBI is met with a government’s demand for monetary policy control. We argue that the origins of CBI and reversals are rooted in the push and pull of forces inherent to this conflict between governments and sovereign lenders. Reductions in the power of sovereign lenders, especially in the context of increased government demand for monetary policy control, drives CBI retrenchment.
With this framework in hand, it is possible track the rise and fall of the Reichsbank’s independence in the interwar period. CBI was instituted by creditors in the early 1920s under an elaborate system of international controls to help protect reparations and debt-servicing schedules. However, the weakening of international creditors and the diminishing political potency of multilateral organizations during the Great Depression substantially reduced the opportunity costs of reining in CBI. In the absence of creditor-imposed constraints, the Nazi regime was able to subordinate its monetary authority in the service of its ideological agenda.
Turning to the present, the monetary responses to the current pandemic, which have kick-started the monetary financing of sovereigns, brings central banks to the outer limits of their mandates and will only increase the political pressure on monetary authorities to deliver on wider public goals. This increased demand for monetary control is met with a decline in multilateralism and a turn to protectionism by governments, threatening the international policy anchor for monetary authorities. Furthermore, the emergence of China and Russia as alternative sources of sovereign lending similarly weakens creditor-imposed constraints that root CBI. Taken together, we predict that the next chapter in the history of central banks will bring CBI retrenchment.
This post comes to us from professors Andreas Kern at Georgetown University and Jack Seddon at Waseda University School of Political Science and Economics. It is based on their recent article, “The Political Economy of Independent Central Banks,” available here.