Illusions of Central Bank Independence

Beginning in the 1970s, much was made of the importance of central banks operating as independent entities.

The point was that they must be immune from political partisanship, the exigencies of contemporary conditions, or ideologies that might undermine macroeconomic stability, or those that served the narrow interests of financial sector actors.

Central bank independence was deemed to be necessary to halt what was then a trend towards accelerating price inflation, leading to the phenomenon known as “stagflation.” An independent pursuit of price stability would help curb borrowing-and-spending urges of politicians by allowing market-driven interest rates to rise in response to increased deficits.

For the most part, there has been general acceptance that central banks largely achieved their independence to choose monetary instruments or goals without being guided by or serving in support of national Treasuries. While the success of choking off stagflation in the 1970s was a high water mark for central bank independence, they have since lost domestic independence by giving in to external pressures (see, “taper tantrum”). They are now locked in a codependency relationship with the goals of domestic political and financial forces as well as the models of their global counterparts.

It turns out that their loss of independence might not be the fault of central bankers, as such. As in all aspects of life, “incentives matter” and those are determined by the institutional framework within which choices are made.

There are reasons to believe that much of the analysis of central bank behavior, including the theory that guides their “monetary” policies is within a theoretical framework that may no longer be applicable. For their part, central bankers rely on monetary theory to provide an explanation and anticipation about how changes in the circulating medium impact on the behavior of economic agents.

However, none of the circulating media issued by any government have some other important attributes of “money.” For example, commodity-backed money could be converted into an asset (e.g., gold), and because paper certificates issued as debts (e.g., private bank notes or government-issued notes) are convertible, those debts can be extinguished.

The convertibility available in a true (commodity-based) monetary system limited the supply, and it also put the “demand for money” at the heart of monetary theories. Conversion of paper bills into specie (or “hoarding” commodity-based coins) imposed supply-side limits on issuers of the circulating medium (e.g., private note-issuing banks or governments) that reduced their capacity to inflate the monetary system.

The concern for the demand side involved understanding the economic and financial effects arising from changes in decisions to hold more or less of one’s income or portfolio in liquid form. For example, if more money was withheld from circulation, there would be discernible effects on the real economy and financial sector (e.g., higher interest rates, decreased output and employment, lower price levels). In other words, an increase in the “demand for money” matters.

By contrast, the circulating media of the current global regime of fiat currencies constitute debts of the issuers (i.e., governments or central banks) that are neither convertible nor redeemable. Without constraints on how many pieces of paper or digital entries can be issued, fiat currencies originate as a form of debt supported by other debts (e.g., Treasuries). While fiat currencies can be considered an asset by those who choose to or are forced to accept them as legal tender, they constitute debts of the issuer (e.g., central banks) that can accumulate without limit. (Indeed, this is a “germ” of truth in the otherwise dubious claims of supporters of Modern Monetary Theory.)

When it comes to demand for fiat currencies, there are different incentives and outcomes of increased idle cash balances (i.e., “hoarding”) that would be observed under a system of true (commodity-based) money. Since fiat currencies tend to depreciate over time, individuals or firms mostly hold their cash balances on deposit within the banking system so that they are potentially available for others to use if they wish to borrow them.

As such, it is inappropriate to speak of “hoarding” within a fiat currency system. But it is also misleading to speak about “demand for money” since the properties and attributes of this circulating medium are different from “money.” This puts monetary economists in a bind, since the system they are studying is a chimera that does not comport with the realities of the current global system of circulating meda.

If central bankers follow models provided by monetary economists, they are in pursuit of the same chimera, one that has led them down an unlikely path of embracing “unconventional policies” (e.g., ZIRP and NIRP, QE, LSAPs, etc.). In sum, the disappearance of a system of true (commodity-based) money since 1971 left central bank policy unmoored from a relevant theory and so from reality.

With ample indicators that central banks have largely succumbed to external pressures, their claims of behaving independently ring hollow. Facing irresistible pressures to aid and abet spending requirements of politicians, central banks have lost much of their political and operational independence. They have also been pressured to follow the policies of their global counterparts rather than acting according to their own domestic needs.                                    

On the one hand, the Federal Reserve has never been a truly independent central bank, if it were taken to mean that their policies are conducted independently of fiscal policy. From its beginnings in 1914, the Fed provided funding for the Federal government, especially during the two World Wars. (And the US Treasury receives about 95% of the Fed’s net earnings.)

Consider that zero-interest rate policy (ZIRP) benefited the Federal government and those financial institutions that the Fed supposedly oversees. The introduction and perpetuation of ZIRP lowered borrowing costs for fiscal deficits, while ZIRP itself depended on extensive purchases of Treasury debt under quantitative easing (QE).

By following unconventional policies, the Fed created conditions for endless and increasingly large fiscal deficits by monetizing freshly-created debt instruments issued by the Treasury, and by relying on open market operations. An unhealthy cycle emerged from historically-low interest rates. As politicians seized the opportunity to borrow more due to low debt servicing costs or using a “crisis” to justify spending hikes, the Fed became a handmaiden to profligate fiscal policy.

The Fed will face an impossible choice of reducing monetary growth rates to offset price inflation, but will be reluctant to do so since that would push up interest rates. The persistent adherence to unconventional monetary policy has central banks stuck between “the devil” of sustained and rising price inflation or “the deep blue sea” of sovereign insolvencies. With the annual interest expense on US Federal debt already exceeding half a trillion dollars, if interest rates returned to their historical average, the annual interest on that debt would exceed $1.3 trillion.

Of course, the Fed is not alone. Consider the statement on the European Central Bank (ECB) website: “The political independence of the ECB is instrumental to its primary objective of maintaining price stability.” But when Mario Draghi was ECB President, his comment to do “whatever it takes” to save the euro erased any pretense of independence. His statement gave a general perception that euro-member governments could expect the ECB to rescue their economies, no matter what they did on the fiscal side.

If central bank independence required that policies not serve the interests of financial sector actors they are meant to regulate, the advent of unconventional policies put that possibility to rest. By manipulating the spread between interbank borrowing costs and deposit rates, ZIRP boosted profits for private banks.

Meanwhile, most purchases during the first round of quantitative easing were private-sector assets, including distressed mortgage-backed securities as well as corporate debt and junk bonds. Whatever the intention, the results show clearly that central bank policy provided clear advantages to commercial and investment banks.

On the other hand, besides losing independence from a domestic perspective, few central banks act independently of their international counterparts. As it is, almost all follow the same (flawed) monetary model, with few rejecting or even questioning the negative consequences of unconventional monetary policy. In particular, the Modern Quantity Theory of Money encourages a myopia concerning the efficacy of monetary policies, with the response of aggregate price levels being the single most important metric.

And so it is that since 2007-08, central bank policy decisions across the globe tend to mirror the moves taken by the Fed, itself having taken a cue from the Bank of Japan’s response to the bursting of asset bubbles in the 1990s. An ongoing synchronization of policies contributes to an uninterrupted global buildup of fiscal imbalances and microeconomic distortions.

In the distant past, central banks faced disciplining effects of a commodity standard that operated whereby changes in specie and capital flows or changes in interest and exchange rates would inhibit or punish “bad” behavior. Even after the gold-exchange standard ended in August 1971, similar punishments would be meted out to countries if their central bankers operated outside of the global norm. The collapse of Japan’s “bubble economy” at the end of the 1980s and the 1997 economic crisis of East Asia were corrections for the imbalances and distortions from an export-led growth model and monetary policies that supported it.

With most central bankers embracing similar unconventional policies, they are less fearful of the punitive effects of international flows. Unfortunately, when one or more central banks move away from the current consensus policy stance, the wheels may come off the global economy. (More on that in a moment.)

Ironically, central bankers have seen their capacities and influence increase in the wake of crises while also losing much of their independence from a domestic and an international perspective. For example, recent legislation in the US expanded the Fed’s oversight of commercial banks, including expanded supervisory powers and a larger role in bank resolution. As such, the Fed is obliged to exceed its essential duty to maintain macroeconomic stability, involving monitoring and curbing price inflation while also taking steps to keep unemployment rates low.

For example, the moratorium on the eviction of renters issued by the CDC increases the difficulty faced by the Fed to fulfill its statutory obligations. Unable to proactively oppose actions of an executive branch cabinet official that clearly threaten the integrity and solvency of the banking sector provides more evidence that claims of independence are hollow.

As commercial banks see their balance sheets erode as landlords holding mortgages lose rental income and the ability to service their debts, foreclosures and bankruptcies will have macroeconomic knock-on effects. It is also likely to have significant microeconomic effects, in that there will be a decrease in affordable housing as fewer units will be in play, an outcome that will disproportionately harm low-income tenants.

And so unconventional monetary policy combined with erosion of central bank independence has allowed the formation of multiple asset price bubbles, with the largest and most troubling being the global debt bubble. Sooner or later, there must be an “exit strategy” away from unconventional policies. Perhaps it will begin by raising policy rates to curb rising expectations of price inflation.

But when they do, there will be an increased risk of a debt crisis that could trigger a severe recession. Yet if they continue their policy stance, they might encounter excessive price inflation that could be a prelude to stagflation, as widespread negative supply shocks occur from rising bank insolvencies and company bankruptcies.

The upward movement in interest rates is likely to cause a widening of interest rate spreads paid by governments and private sector actors. If there is a combination of rising inflation and greater economic uncertainty, the premium paid by private borrowers will rise further to cover increased inflationary and recessionary risks.

As private debts in advanced economies become unsustainable as interest spreads relative to safer government bonds become ever wider, defaults will occur among highly leveraged firms and their shadow-bank creditors. Next will come insolvencies of highly-indebted households that will have knock-on effects for the banks that provided them with financing.

It could play out as in the 1970s with nominal government fixed-rate debt in advanced economies being reduced or eliminated by unexpected price inflation. Meanwhile, emerging-market governments that have debts denominated in foreign currency would almost certainly be forced to default or unilaterally restructure their debts. As financial markets react by dumping assets to avoid further capital losses, the foreign exchange value of the currency would plunge, contributing to a spiral of crisis.

It turns out that unconventional monetary policies have been almost certainly baked into a debt crisis that cannot be avoided, making it a matter of when, not if. Alas, blame for this grim outcome will likely fall at the feet of the usual suspects, “neo-liberal” policies and unfettered markets. Meanwhile the true culprits, the global fiat currency regime and unrepentant central bankers, will be absolved of their sins.

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