Sunday, February 20, 2011

Central Bank Independence

Ben Bernanke's British counterpart, Mervyn King, is taking alot of heat for supporting the government's harsh package of spending cuts and tax increases.  Paul Krugman writes:
Mervyn King, governor of the Bank of England, has stepped way over the line by turning into a cheerleader for the current government’s policies. He’s wrong on the economics — front-loaded spending cuts are the wrong policy for a still-depressed economy — but that’s not the key point; rather, the point is that if you’re going to have an independent central bank, the people running that bank have to be careful to stay above the political fray.
A Guardian story quotes Ed Balls, the Labour party shadow chancellor (i.e., the opposition's point person on economic policy):
"The last thing you ever want is for the Bank of England to be drawn into the political arena," said Balls, who was involved in Labour's move in 1997 to give the Bank independence to set interest rates. "Central bank governors have to be very careful about tying themselves too closely to fiscal strategies, especially when they are extreme and are making their job on monetary policy more complicated."
One of the things that comes with central bank independence is the expectation that central bankers should be neutral technocrats who keep a narrow focus on monetary policy.  In part, this is because central bank independence is a fragile thing, which could be undone by a change to the Federal Reserve Act in the US, or, in the UK, the Bank of England Act.  While respect for the principle of central bank independence - exemplified by the fact that Greenspan and Bernanke, both Republicans, were re-nominated by Democratic presidents - has evolved over time, it could be eroded if the central bank was seen to be a partisan actor.

However, I have a bit more sympathy for Governor King than Krugman and Balls do.  Central bankers face a dilemma because, while they are rightly expected to stay out of "politics" generally, fiscal policy and monetary policy are interdependent.  The central bank is responsible for one part of a fiscal and monetary "policy mix," and its decisions depend on (and are constrained by) the government's tax and spending decisions, and vice-versa. 

In the UK, the Bank of England is accommodating "tight" fiscal policy with "loose" monetary policy.  To a slightly less dramatic degree, this also occurred between the Clinton administration and the Greenspan Fed in the early 1990's.  The early 1980's saw the opposite mix in the US: simultaneously tight monetary policy and loose fiscal policy.  While the monetary tightening was seen as necessary to bring inflation under control, it probably wouldn't have had to have been so severe if the Reagan administration's tax cuts and spending increases weren't occuring at the same time.

Since the ultimate impact of a fiscal policy depends on how monetary policy will react, the political system, in theory, could make better-informed decisions if the central bank communicated its views and intentions.  Moreover, because monetary policy has to react to fiscal policy, it is arguably legitimate for the central bank to have preferences about it.

The argument Krugman and Balls are making implies that the benefits from a more explicit coordination of monetary and fiscal policy, which requires central banks to speak about fiscal policy, is outweighed by the damage to central bank independence that occurs when central bankers like King express themselves on "political" tax and spending matters.

2 comments:

Musgrave said...

Agreed. But I think your arguments are unnecessarily complicated. I suggest the important and central point can be put in simpler form, and as follows.

The job of central banks is to control inflation, or if you like, to help bring about the maximum level of employment that is consistent with acceptable inflation. As long as a central bank confines its remarks to matters concerning AGGREGATE govt income (from tax) and spending, then the central bank’s remarks are legitimate.

In contrast, if a central bank expresses opinions about the DETAILED MAKE UP of govt spending or income then it has entered the political arena.

Bill C said...

Thanks. That is quite reasonable, though I'd offer two quibbles: (i) the aggregate role of government is still a political question, what the monetary authority is rightly concerned with is the difference between spending and revenues and (ii) that formulation is sensible in principle, but in practice the central bank still will be faced with appearing to endorse (or not) actual proposals from the political system