The challenge is to try to keep short term political quick-fixes from doing predictable long term damage, and ensure that monetary and fiscal policies work together effectively

The challenge is to try to keep short term political quick-fixes from doing predictable long term damage, and ensure that monetary and fiscal policies work together effectively

By Lucrezia Reichlin*

Throughout 2016, populist movements in developed countries have set their sights on central-bank independence.

To the populist bull, unelected technocrats wielding policies that have political and distributional consequences may as well be waving a red cape.

In the United States, a bill seeking to audit the Federal Reserve – and thus to subject quotidian monetary-policy decisions to congressional review – was narrowly defeated in early 2016. And, during his campaign, President-elect Donald Trump accused Fed Chair Janet Yellen of politicising Fed decision-making.

In Europe, the populist clamor against unelected European Union bureaucrats and the independent European Central Bank has grown louder; and in the United Kingdom, Labour Shadow Chancellor of the Exchequer John McDonnell has called for “democratic control” over interest rates, implying that the Bank of England’s monetary policy has been geared toward helping financial institutions.

With populist movements gaining ground, and even joining some governments, their complaints will, sooner or later, translate into policy proposals that could change the relationship between central banks, treasuries, and legislatures. A large question for 2017 is whether that would be a good thing, or whether central-bank independence should be defended against the coming populist attack.

The diverse range of critiques against central banks have included claims that quantitative easing (QE) and low interest rates favor the rich; special credit policies favor the banks, without really helping the economy; and the keen focus on inflation comes at the expense of other objectives, such as maintaining full employment and combating inequality.

These arguments come from both the left and the right, and some overlap with concerns voiced by conservative economists – such as John B. Taylor in the US and Otmar Issing in the eurozone – that central banks have assumed an excessive role in managing the economy since the 2008 financial crisis. Extraordinary policies such as QE and long-term lending facilities, and some central banks’ increased involvement in the financial sector, have pushed the boundaries of monetary policymakers’ legitimate remit.

But, whereas populists tend to favor limiting central banks’ political and operational independence, and broadening their mandate, conservative economists want the opposite: to maintain central banks’ independence while limiting their mandate and policymaking scope.

The concept of central-bank independence originated in the nineteenth century, and has evolved differently in various currency areas. But it was only more recently, in the 1990s, that central-bank independence became linked to inflation targets. While some central banks have more flexibility than others in managing price stability, they have all publicly committed to numerical targets. Without such accountability (and transparent communication), their independence would be hard to justify.

Numerical targeting of price stability was born of the inflationary 1970s; but central banks have struggled with the opposite problem since 2008: low inflation, or even deflation, when short-term interest rates have reached the zero lower bound. More broadly, the financial meltdown has challenged the intellectual framework and some of the key principles that previously guided virtuous central banking.

For example, we can no longer treat capital-market friction as merely a second-order indicator; nor can we assume that the efficient market hypothesis will always provide a workable approximation of market activities, or that financial quantities – particularly the size and structure of central-bank balance sheets – are irrelevant. Owing to pervasive market failures, central banks have been able to step in as market makers and influence risk premia through active balance-sheet policies.

As a consequence, central banks’ operational framework has changed. With more instruments such as QE at their disposal, central banks have moved from a one-instrument, one-target model, to one with multiple instruments and multiple targets. This change was precipitated by the financial crisis, but we can expect that central banks will continue to use their balance sheets proactively even in “normal times,” to counter financial friction or address liquidity squeezes.

This new operational model could be justified as a means to ensure price stability, but when central banks are mandated to maintain financial stability as well, central-bank accountability, and thus central-bank independence, is threatened. Moreover, in a debt-ridden, low-inflation environment, central banks may not even be able to achieve price stability unless they coordinate with fiscal authorities.

As we have learned in recent years, maintaining a “Chinese wall” between fiscal and monetary policymakers can result in excessive delegation of responsibilities to central bankers. As we head into 2017, these are the two problems that stand out: the weakening of accountability when central banks are given multiple objectives, and the incentive – particularly visible in the eurozone – for fiscal authorities, which must answer to voters, to push all responsibility onto independent central banks.

If we believe that central banks should be protected from short-term political interference as they pursue monetary-policy objectives, it behooves us to implement reforms that will allow for democratically accountable coordination among monetary, fiscal, and financial authorities. This will probably require that other parts of the government be granted a degree of independence to pursue clear, quantifiable objectives under public scrutiny.

Central banks have come to play a major role in economic policymaking, but fiscal policy is now back, partly owing to populist pressure. The challenge ahead – which will be particularly difficult to meet in the eurozone – is to ensure that monetary and fiscal policies alike are effective and legitimate. Populist solutions may be ill-advised, but the problems populists have identified with respect to central banks are real.


Lucrezia Reichlin, a former director of research at the ECB, is Professor of Economics at the London Business School. Copyright: Project Syndicate, 2016, published here with permission.

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13 Comments

The concept of CB independence is great.
Unfortunately, the CBs seem to take the view that because they have no mandate in regard to social issues they can ignore the effects of rampant credit growth and asset inflation on the integrity of society.

To quote Hazlitt: "Inflation discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse.”

This destructive phenomenon is as true for credit growth and asset price inflation as it is for consumer prices.

Populist solutions may be ill-advised, but the problems populists have identified with respect to central banks are real.

Indeed.

Inflation in China slowed somewhat in December, as the Consumer Price Index decelerated to 2.1% from 2.3% in November. Very much like in the US, Europe, and Japan, the CPI level in China continues a lengthy stretch significantly below the official monetary target. For China, the PBOC has set 3% as its definition of “price stability.” The last time inflation was at that level was for November 2013, meaning that for the next thirty-seven months the central bank has been unable to achieve its basic mandate. Read more

Central banks underwriting transfers of wealth from one citizen cohort to another, based upon an evidenceless premise is beyond unacceptable. Democratic principles demand such action undertaken by unelected officials must be halted immediately and subject to rigorous public review.

clamour: a loud uproar.and why not?no matter what they come up with the results seem to be the same boom and bust cycle,more poverty and bigger wealth gaps.

While I am not necessarily disagreeing with the conclusion (because I actually don't know either way), where is the evidence in NZ of "more poverty" ? Do you have better data than this ? (which doesn't actually show an increase).

Or evidence of wider wealth gaps in NZ ? Do you have better data than this ? (which also doesn't actually show a widening).

There are plenty of voices out there pitching the idea that because such things are growing worse elsewhere, they must be in New Zealand as well. The problem is that is not what the local data shows.

However, if you have later data than 2014 (and I mean credible data, not stuff from some organisation who has a 'conclusion' and tries to fit bit-and-pieces to bolster their position), I would be genuinely interested. However, I am sceptical of cheap, throwaway slogans. Endlessly repeating them doesn't make them true.

And yet:

Patience, like money, is not infinite. The Japanese being the exception, four QE’s are, in fact, a stark admission of failure for at least the first three (leaving the fourth to be at least similarly suspect). Populist revolt is not something that sprang up overnight, a sudden rush to torches and pitchforks, in the ballot box sense, born of irrational emotion. Yet, that is exactly how it is being portrayed by those who have been given chance after chance after chance to succeed.

Klaus Schwab, the man behind the World Economic Forum, the organization behind the annual Davos retreat, warned recently that globalization is “a very easy scapegoat.” He suggested instead that “emotional turmoil” has gripped so much of the world because, among other things, things are changing and new technology is threatening jobs.

Bank of England Governor Mark Carney recently made a similar assessment. Somehow maintaining a straight face, he said that “monetary policy has been highly effective” before going on to recognize, as the Financial Times quotes, “anxiety about the future has increased, because productivity hasn’t recovered and, as a consequence of the latter, because real wages are below where they were a decade ago — something that no one alive has experienced before.” Forgive us, then, if we don’t arrive at the same conclusion about monetary or any other policy. A major negative result “that no one alive has experienced before” is legitimate cause for some kind of legitimate uprising, no? Read more

Moreover, those in receipt of unearned capital gains gleaned from rising bond prices, discounting citizen funded future, but static above market yield coupon payments, spawned a new class of wealthy investors/traders. Seepage to other asset classes for those eligible to be in receipt of excessive debt funding also benefited more than most.

David, I have a problem with the data; the use of 60% of median income is deceptive. Median individual income (about $33k) or household median at double that is well below the widely regarded individual living wage of about $40,000, both figures before tax but after government transfers. Sixty percent of the median wage is less than half the living wage! The median wage is poverty, never mind 60% of it.
http://www.stats.govt.nz/browse_for_stats/income-and-work/Income/NZIncom...
The second issue is with inequality; our income statistics are seriously out of kilter with most of the rest of the world since we don't consider capital gains as income. Try adding a hundred or two thousand to your top quartiles average annual income and tell me we don't have a very unequal society.

Isn't it 60% after housing costs ? That it a lot different to just 60%.

It certainly is a lot different David, but not in a good way since housing takes such a large share of the median income. In some areas the median renter is almost equal to the median income; 60% of what's left and you would be very deep in poverty.
There is something seriously wrong when the median income is insufficient to put a roof over your head and raise a family without government handouts. How did that happen?

that could be a statistic worth knowing,what percentage of data is credible and have a margin of error or accuracy rating system using pinocchio points.manipping the data isnt restricted to youi call centres.

Policies are based on data but in NZ result /motive is decided first and than the data is manipulated - One good example is Non resident buyer data.

Each and every Kiwi knows what is happening in housing market - Supply is important but is that the only reason of speculation or is the policies of current national government supporting elite few kiwi and their overseas friends.

One thing is very clear that people or leaders deny, lie and manipulate only when are at wrong.

Is she even thinking about the right things? Is she trapped in the intellectual framework of the currently fashionable ideas?

The problem we have is enabled by the current thought paradigm. Boom and bust based on housing debt and immigration flows in and out. It seems to work in a rough and ready way, but surely we can do better.

The reason I go on about the current account deficit is it is a nice simple measure, how much more we spend than we earn as a country.

Currently, the inflation targeting policy is a bit of double-speak. Basically it is a sort of non confrontational exchange rate targeting regime whereby in general we agree to devalue our currency at roughly the same rate as everyone else. If we have free capital movement then this forces us to accept the same general monetary policy settings as everyone else. So, if we mimic the US inflation rate we end up mimicing their interest rates.

The answer may be to adopt a reasonably free capital flow policy, which is what the RBNZ is fumbling towards under the double-speak of "prudential measures". Not allowing foreign income for mortgage purposes, the debt to value limits, and debt to income limits are all effectively ways of restricting capital inflows into the banking system. If the banks can't lend as much, they will not need to borrow so much from overseas.

Confusion about what the objective is - is the problem. Them inside the beltway including central banks want to increase - decrease - stimulate - cool "the economy" or "GDP" . Them inconvenient folk outside the beltway really want economic personal security, opportunity, and hopefully a bit more cash in pocket. No wonder the two don't understand each other.
But what could be wrong with what the people want. And why does the professor use that slightly stinky term 'Populist' about what tbey want.

I want to see an independent central bank that has direct control over the quantity of money, where its only task is to strictly maintain the value of that money. Using the intermediary of interest rates to influence the quantity of money has been repeatedly shown to be insufficient. That central banks now take on more and more functions to protect the stability of the system show that it is the wrong approach.