The Bear’s Lair: There are no independent central banks

It has long been a nostrum among economists that central banks should be independent of their countries’ governments. The 1998 decision granting “independence” to the Bank of England was specifically motivated by that thesis. Yet in practice, central banks have not stood staunchly against the free-spending proclivities of their governments; instead, they have indulged them, forcing down interest rates to unprecedented levels in a way that enhanced government profligacy. If indeed central banks are not independent of their governments, what use are they?

This line of thought was prompted by a paper co-authored by former Treasury Secretary Larry Summers, which examined recent inflation statistics according to the formula used before 1983 and discovered that on that formula, inflation peaked at an annual rate of 18% in the year to November 2022. Clearly, had the Fed been working with those inflation statistics, it should have pushed interest rates up very much faster and especially further than it did; whenever the interest rate peak occurred, it could scarcely have involved a Federal Funds rate of less than 10% — a peak of a mere 5.5% is completely non-credible when faced with an inflation rate well into double digits.

The difference between the two statistics is down to two factors. First, and more subtly (I’m not sure whether the Summers paper took account of it) is the disgraceful fudge introduced in 1996 of “hedonic pricing” whereby every pointless doubling of computer processor speed was allowed to drive down prices as though the functionality of those processors had actually doubled – obviously not the case, as the software became relentlessly more complex to achieve the same modest results. Hedonic pricing has suppressed reported inflation since 1996 by about 1% per annum – compare your grocery bills from a decade or two ago with the price change reported officially since then and you will see this effect in action.

The second effect, on which the Summers paper focused, is the effect of interest rates on prices. Higher interest rates raise the price of mortgages, which in turn raise rents, because landlords have to eat, too. Before 1983, the Consumer Price Index took account of the cost of housing in general, both actual rents and mortgages; consequently when interest rates rose, so did the price index. (Today the CPI includes something called “owner equivalent rent” which is heavily fudged.) The decade of foolish zero-interest-rate policies from 2010-21 suppressed this factor, making everybody feel artificially rich (except those poor slobs who had not yet made it onto the housing “ladder”). The rise in interest rates from early 2022 thus came as a dreadful shock to the system. With rates stable since last fall, the pre-1983 rate of inflation has declined below the double-digit level, but it is still considerably higher than the reported 3% or so. Meanwhile, everybody except a few tech-stock billionaires rightly, given the true rise in prices, feels much poorer than they were in 2019.

Conversely, if we had used today’s measure of inflation in the 1970s, reported inflation would have been both lower and slower to respond to rises in interest rates. The effect of this would very likely have been to delay and weaken further the Fed’s response to inflation, thereby keeping interest rates lower and making the true rate of inflation even worse than it was. Britain recorded an inflation rate of 25% in 1975; the United States might also have done so, with all the collateral damage to American wealth and well-being that would have caused. Conversely, the fudging of government statistics today certainly made the Fed too slow to respond to inflation in 2021-22; it may well be causing it to underreact now, failing to raise Federal Funds rates to the 7% or so that I believe necessary to quell the remaining current inflation (whose rate appears to be rebounding).

The theory that central banks could be independent is alas outdated. A central bank that operated as did the Bank of England in the glory days of Montagu Norman (1920-44) and Lord Cromer (1961-66) would be wonderful but is not going to happen. Yes, it was delicious to have Norman omit to tell the leftist Labour government of 1931 about the possibility of Britain going off gold, so that we got a National Government with the wholly admirable Neville Chamberlain at the Exchequer. It was also truly gratifying to hear Cromer’s weekly lectures about the feckless overspending of Harold Wilson’s Labour government. However, such glories are impossible in today’s bureaucratic state. For one thing, Norman and Cromer were committed to small government, balanced budgets and ideally a currency linked firmly to gold, but you will not find a central banker in today’s world with their healthy approach to monetary policy.

Even Paul Volcker, who brought under control the last U.S. episode of monetary madness, was only able to do so because his preferred President, Jimmy Carter, was voted out by the electorate and replaced by a President Ronald Reagan to whom he owed no loyalty. He could thus pursue monetary stringency long beyond the point where it seemed likely to endanger Reagan’s 1984 re-election. Fortunately, Reagan’s other policies were so good and so popular that they overcame the lingering effects of tight money – and the declining rate of inflation, at least, pleased an electorate that had never expected to see such a development.

Since central bank chiefs are appointed by governments, they will always be inflationist, because that makes government’s life easier (and ordinary people’s lives worse, but governments don’t care much about that)! Hence you will today get the same inflationist response to economic developments in every country – the days when the Deutsche Bundesbank would hold out against inflationism are long gone. The central banks and the overspending politicians are joined at the hip because the central bankers know that, if they follow an effective anti-inflationary policy, they will be replaced. In that sense, the vaunted “independence” of central banks is a chimaera – they are in a symbiotic conspiracy with overspending politicians against the interests of the people.

There are two possible solutions to this problem. One, the more drastic, is to return to a commodity-based standard of money and eliminate central banks altogether. Even in the 19th century, the Bank of England could not properly be trusted with maintenance of the Gold Standard; it caused more crises than it averted (though Peel’s 1844 Bank Charter Act was responsible for a couple of those crises). In the 1920s, the loose money policies of the Fed, pursuing “price stabilization” in a system where the Gold Standard did that job, single-handedly over-inflated the 1925-29 U.S. bubble. Then, the Fed’s over-restrictive policies of 1931-32, not compensating for the disappearance of so many banks, made the subsequent downturn worse than it need have been. The Reichsbank’s record under Rudolf von Havenstein in 1919-23 was also less than stellar. The only function of a central bank in a Gold Standard system is to give governments somebody to blame when unexpected recessions occur; that is not a sufficient justification for their existence.

I used to believe that, if its governing statute was drafted correctly, a central bank could be “Volckerized” even in a fiat money system – forced to act with the anti-inflationary diligence (if not necessarily the capability) of the great Paul Volcker. Recent U.S. developments have made me doubt that. By statute, the U.S. border is protected against illegal entry, yet an administration that for whatever reason wishes unlimited illegal immigration can, it has been proved, ignore the statutes prohibiting it. Similarly, whatever were the statutory limitations on a central bank, the short-term political benefits of running a “sloppy money” policy as in 2010-21 are so great that no administration and its appointees to the central bank could be trusted to obey the statute. We have already seen the defects of a politicized central bank, in the Bank of England’s money market coup against the brief administration of Liz Truss. There is no reason to trust that such shenanigans can be averted from a sufficiently dishonest left-wing administration and its tame central bank, whatever the statutory requirements to do so.

Of all the excellent arguments for a Gold Standard, the built-in ineptitude of central bankers is perhaps the strongest.


(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.)