The Bear’s Lair: Central bank independence is a dangerous myth

Bank of England Governor Mark Carney has announced he is staying on until June 2019, to implement the funny-money policies that British voters increasingly doubt. Republican Presidential candidate Donald Trump was criticized for “politicizing” the Fed when he called on Fed Chair Janet Yellen to raise interest rates. Similarly Bank of Japan Governor Haruhiko Kuroda and ECB President Mario Draghi are above criticism, even as their policies lead to disaster. The “independence” of central banks is a modern shibboleth, but far from being a market approach, it derives from the Keynesian Bureaucrat Fallacy, in which all-wise bureaucrats are supposed to govern us better than we can govern ourselves.

The traditional theory behind central bank independence was that politicians could not be trusted not to push for inflationary policies, especially in election years, so that a wise central bank needed to be insulated from them. Thus, the Fed was set up with a complex structure of regional banks, the heads of which would have an almost equal voice in setting interest rates with Fed Governors, who would be Presidential appointees, but with terms as long as 14 years, far longer than the political lifespan of Presidents. Similarly, the Bank of England was given formal independence by Gordon Brown, when he became Chancellor of the Exchequer in 1997. The European Central Bank, like most EU institutions, was almost entirely free from democratic control, with the independence of the Deutsche Bundesbank as its model. Finally, the Bank of Japan became independent with the 1997 revision of the Bank of Japan Act.

It should be noted that with the exception of the Fed, whose independence was established by the Fed/Treasury accord of 1951, central bank independence is a relatively new idea, dating only to the late 1990s. It was basically a reaction to the inflation of the late 1970s, which was felt to have been caused by excessively political monetary policies in the U.S. and elsewhere.

The problem with central banks’ independence is that there is no incentive structure for central bankers to make good decisions, and therefore they are subject to all the problems outlined in James M. Buchanan’s public choice theory. With nobody controlling them, and neither an electorate nor a market to which they are responsible, independent central bankers are free to make decisions based on the latest fashionable academic theories, or indeed, in a polity only slightly more degenerate than our own, based on the wishes of who bribes them most.

The British prime minister Robert, Lord Liverpool (1770-1828), who as in other cases recognized many current economic problems two centuries in advance, set out the point clearly in a House of Lords speech in July 1813, when a proto-Keynesian among his fellow-peers had suggested that Britain adopt a full fiat currency: “The noble earl has urged the extraordinary proposition, that a paper currency should be issued by government. Upon this point, all experience is against the noble earl, as in every country where that has been tried, it has uniformly produced the most ruinous effects. The great mistake continually made on the continent was, that such a paper currency having produced those ruinous consequences in every country in which it has been tried, it is therefore expected that a paper currency must produce the same consequences here. The great security of our paper currency, and that which constitutes the important difference between it and the paper currency of other countries is, that it is issued by an individual banking company, or by individuals for the sake of their own interest. The Bank of England would no doubt be willing to accommodate the public service, but they could refuse to issue their notes, and whenever they acted on any ground other than their own interest, it would be the first step to their ruin.”

Liverpool’s point was that the 1813 Bank of England was a fully private bank, and was governed in its modest paper currency issues (Britain was off the gold standard at this time, during the Napoleonic Wars) by its own economic interest, and not by the dictates of government, let alone by academic theorists.

The independence of central banks solves the problem of inflation-prone politicians, but it does not solve the problem of stimulus-prone central bankers. Believing that the problem was limited to inflation, the Reserve Bank of New Zealand Act of 1989 attempted to provide a market incentive for the Bank’s Governor by mandating that his salary would be raised each year by a factor of 2% minus the previous year’s inflation. Thus, the Governor would break-even in real terms if inflation was 1% and would get richer only if inflation averaged below that level. Regrettably, this admirable incentive structure was abandoned some years later, although it would be useful today in reminding central bankers that 2% should not be a “target” for the inflation rate, but an upper bound.

Particularly in today’s globalized world, independent central banks, who can ignore both economic realities and politicians, are prone to groupthink – a case of “Extraordinary central banker delusions and the madness of crowds.” Once Ben Bernanke had come to power, convinced that a prolonged period of zero interest rates and “helicopter money” was what the U.S. economy needed, and that “quantitative easing” would supply the missing “stimulus” the malaise spread to Britain (via Mark Carney, who in Canada had appeared resistant to it) and to the ECB.

Above all, it reinforced the errors of the Bank of Japan, where two decades’ unsuccessful pursuit of the same policies (encouraged by Bernanke himself in the late 1990s) still failed to convince the Bank that another avenue must be tried, but instead led it to redouble its efforts in delusionary finance. Now all four of the rich world’s major central banks are locked into this erroneous trajectory, despite the damage it is doing to the real global economy in terms of productivity shrinkage and its manifest unfairness to the world’s savers, the bedrock of any sound economic system.

In the United States, the central bank incentive structure could be improved by abolishing the Fed governors (or eliminating their role in monetary policy.) Have a Fed chairman appointed by the President and confirmed by Congress if you must, but then give him only one vote in a Federal Open Market Committee consisting of all twelve of the regional Fed Presidents plus himself. The regional Fed Presidents in turn are elected by their boards of directors of nine members, six of which are currently nominated by local banks (three by the banks themselves, divided into “large” “medium” and “small” classes and three by the banks as a whole “to represent the public”) while the final three members are nominated by the Fed Governors.

Take away the Fed Governors’ role in nominating regional Fed board members, which gives Washington altogether too much power, and divide the regional Fed boards equally between members nominated by local banks and members elected directly by the public in the region, and you will get a system that should work. Direct election of half the boards would ensure that the needs of middle class savers were represented and that well-founded common-sense notions, such as that the target for inflation should be zero, were given proper weight.

Each regional Fed bank would then have a direct responsibility to assist the economy of its region, with directors chosen equally by local banks and by the public, and Washington would have only a minimal say in monetary policy. Since the regional Fed Presidents would be incentivized to keep their local Boards of Directors happy, all elements in the interest rate setting process would have proper incentives to do the best job they could, from the market via local banks and from local electorates via the elected members.

This structure resembles that of the 1958-1999 Deutsche Bundesbank, in providing bottom-up incentives from the regions for the central bank to do its job properly. That structure was devised by the great Konrad Adenauer and Ludwig Erhard to eliminate the misguided behaviour of the Weimar Republic’s Reichsbank. It worked very well for over 40 years, and the great majority of Germans would much prefer to return to its rule. As at least a first step in eliminating the irresponsible groupthink of today’s central bankers, a Trump administration, should we get one, should restructure the Federal Reserve System accordingly.

As Liverpool knew very well, the ideal monetary system on which to base a soundly growing economy involved a Gold Standard. However, in 1813 Liverpool recognized that an immediate return to the Gold Standard was impracticable while the war continued. Instead, he favoured a market-driven system whereby modest issues of paper money, made by banks in response to their needs and with due regard to their balance sheets, would preserve the domestic circulation while preventing a collapse into hyperinflation, allowing a return to gold within a few years of the war’s end. It was a pragmatic solution, but one driven by sound monetary principles, avoiding the faddists who demanded a government-issued paper currency.

Those monetary principles remain sound today, and are compromised by the faddism of “independent” central banks, who have no incentive, political or economic, to pursue sound policies. Accordingly, we must restructure central banks themselves so that while remaining independent of national political forces, they are properly incentivized by the needs of the financial markets and of the economy as a whole.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)