Senior mainstream economist now admits central banks are not as independent as many believe

The UK Guardian published quite an odd article the other day (May 30, 2024) by Mr GFC Spreadsheet Fudge Man Kenneth Rogoff – Why policymakers are more likely to risk high inflation during periods of economic uncertainty – which essentially claims that economic policy has been conducted for several years by institutions that do not meet the essential requirements that are specified by the mainstream New Keynesian macroeconomic approach, upon which the institutions have claimed justification. If that makes sense. He now claims that the eulogised principle of ‘central bank independence’, which is a mainstay of the New Keynesian justification that macroeconomic counter stabilisation policy should be left to monetary authorities and that fiscal policy should play a supporting but passive role, no longer exists as policy makers have had to come to terms with multiple crises. Of course from an Modern Monetary Theory (MMT) perspective such independence never existed and was just a ploy to allow the governments to depoliticise economic policy making and thus distance themselves, politically, from the fall out of unpopular policy interventions. If it wasn’t the IMF to blame, then it was the ‘independent’ central bank for austerity and interest rate hikes and all the rest of it. Now we have a senior Harvard professor admitting it was a ruse and bemoaning the fact.

Are central banks independent?

There are several strands to the mainstream neo-liberal attack on government macroeconomic policy activism.

They get recycled regularly.

One recurring theme has been that the central banks should not compromise their independence.

That is, that central banks and hence monetary policy should be independent of the political process.

The mainstream Monetarist literature, which emerged in the 1970s, promoted the idea of central bank independence because it was a way to take policy discretion from the democratically elected governments and thus reduce the scope of government economic activity.

The concept of ‘dynamic inconsistency’ entered the economics nomenclature and highlighted the virtue of so-called monetary rules – where the central bank would announce, say, an inflation target and then adjust policy (interest rates) rather mechanically to keep inflation within the announced band.

The central bank independence push was based on the Monetarist claims that it was the politicisation of the central banks that prolonged the inflation in the 1970s and into the 1980s by creating pressures on the central bank to ‘accommodate’ incompatible nominal claims on real output.

The arguments claimed that central bankers would prioritise attention on real output growth and unemployment rather than inflation and in doing so made the inflation worse or more persistent.

The Monetarists argued that central bankers should re-prioritise their policy targets towards inflation control and away from broader goals like full employment and real output growth.

This was when the ‘inflation first’ nomenclature was introduced into the public debate.

This shift in policy focus has proved very costly.

Whereas previously unemployment had been a central policy target to be minimised, under the ‘inflation first’ mantra, it became a policy tool in the fight against inflation.

It was argued that as monetary policy works with lags (delays in its impact), central bankers should take longer term perspectives and avoid the ups and downs of the economic cycle, which concentrate the minds of the politicians working in tight electoral cycles.

In the 1990s, the central bank independence notion manifest in the adoption of inflation targeting as the primary policy target.

Citizens were thus confronted with the prospect that a major arm of macroeconomic policy – interest rate adjustments – which may impact on their material well-being was being divorced from the process of political accountability.

This is what we called – ‘depoliticisation’ – in our 2017 book – Reclaiming the State: A Progressive Vision of Sovereignty for a Post-Neoliberal World (Pluto Books, September 2017) – where we argued that it has allowed elected governments to divert responsibility to ‘external’ agencies or ‘independent’ central banks for the harsh policy regimes that have undermine our material standards of living and retrenched public services.

The British Labour Party were early practitioners when Denis Healey told the British people in the mid-1970s that the British government had run out of funds and would have to borrow money from the IMF.

It was a lie, but his motive was to maintain the delicate Social Contract with the trade unions while imposing unpopular fiscal austerity.

By shifting the blame for the austerity to the IMF he was able to tell the people that the government was being forced by an external agency to inflict damage on them.

It wasn’t the government hurting you, it was them!

This is the logic that underpins the constant claim that central banks are independent.

Elected governments who want to avoid the pressures to ‘fix’ things now claim that monetary policy is the only ‘effective’ macroeconomic policy tool in normal times and that interest rate changes are the sole responsibility of the various monetary policy committees.

And if interest rate rises are unpopular, then you know who to blame.

And the citizens have no real comeback because the central bank decision makers are not accountable to the people via any normal democratic process.

And this all ties in then, to the rising democratic deficit in our nations during this period of neoliberalism.

There are several reasons – political and operational – why the notion of central bank independence is a fiction.

First, in almost every nation it is the elected politicians who appoint the management boards of central banks including the governors. That makes the flavour of the monetary policy boards reflective of the politics of the day.

Second, in many jurisdictions, the Finance or Treasury ministers can overturn a monetary policy decision should they wish.

There are various means through which this power can work.

Third, and most importantly, on a practical or operational level, the central bank and the treasury functions must be closely coordinated daily to ensure that the policy targets of each are capable of being met.

Fiscal policy interventions impact on the reserve balances in the cash system.

Central banks manage the corridor or spread within which the short-term interest rates can fluctuate with liquidity variability.

Liquidity management must therefore be performed in close liaison with the treasury department, so that the central bank can understand what fiscal injections/withdrawals are coming up on any given day and the implications for the banking reserve system.

Fourth, we have countless historical examples where central bank officials have imposed their views and influence on the fiscal process.

For example, the ECB is clearly not legally constructed to enforce European Commission dictates with respect to the Member States about fiscal policy, labour market policy, product market policy or anything else like that. It would be strictly illegal under the treaties (legal system) for it to become involved in those things.

Yet there are many examples over the last 24 years where Presidents of the ECB and/or senior ECB officials have demanded more fiscal austerity and further labour market deregulation.

The ECB’s role as part of the so-called Troika in June 2015, at the height of the Greek stand-off with the European Commission, highlights the point.

The ECB breached its legal obligation to maintain financial stability by threatening the Greek government with damage to the Greek banking system if the government failed to deepen the austerity. It was clearly acting as a political agent.

Central bankers around the world regularly make ‘fiscal’ statements despite claiming their institutions are ‘free’ from the political cycle.

And Rogoff?

Rogoff, one of the senior gatekeepers of the New Keynesian fictions over many years, now claims:

Listening to central bankers, one would think that the recent bout of high inflation was merely an excusable post-pandemic forecasting error made under extreme uncertainty. But while this narrative now prevails in markets and the financial press, it presumes a level of central-bank independence that is simply unrealistic in today’s volatile economic and political environment.

Well, as I explained above, it was always ‘unrealistic’ to presume the fiction being promoted about central bank independence had any basis in reality.

He went on:

The problem is that most central banks are not as independent as many believe. In a global environment marked by political polarisation, onerous government debt burdens, geopolitical tensions, and deglobalisation, central-bank autonomy cannot be absolute. As unelected technocrats, central bankers may have short-term operational independence but governments ultimately control appointments and oversee budgets. In many countries, the government also has the power to reset monetary mandates.

As above.

The question then is what does that admission do for the mainstream claims that fiscal policy should be passive and central banks should run the macro policy show to achieve optimal outcomes.

The answer is that it blows the whole mainstream story out of the water.

We now no longer have any basis for claiming that central banks should hike rates to target some inflation rate or that fiscal policy should target surpluses.

Rogoff also pays his own colleagues out:

Economists who drink central banks’ inflation-targeting Kool-Aid and view existing arrangements as sacrosanct fail to recognise that the belief that central-bank independence can help control inflation is barely four decades old. While Finn Kydland and Edward Prescott rightly received the Nobel prize in Economics in 2004 for developing a theory of inflationary bias in monetary policy, their proposed solution – simply instructing central banks to follow specific guidelines – was rather naive.

Not naive – blatantly ideological and political.

Kydland and Prescott knew exactly what they were saying and the implications of their intervention when they wrote their famous article in 1977 – ‘Rules Rather than Discretion: The Inconsistency of Optimal Plans’.

They were part of the early Monetarist onslaught aiming to kill off the notion that governments through their discretionary fiscal interventions could maintain full employment.

This was a time when economists were abandoning the previously dominant Keynesian views that governments should aim to minimise unemployment at all times.

The Monetarists convinced the academy that it was better to take economic policy making out of the hands of politicians and instead impose a rules-based order which was independent of the political process.

That is what Kydland and Prescott aimed to achieve.

And everybody knew it was impossible for reasons noted above but they considered if the economists said it enough times then the rest of us wouldn’t have a clue anyway and it would become the new policy praxis, which it did.

It was one of those situations where the population has no way of contesting the shift in policy practice and arrogant economists would hide behind their sophistry, masquerading as rigourous technical science, just in case anyone dared to question their authority.

It was a plan not an expression of naivety.

I also thought it was telling that he used the association with drinking kool aid – as in cult-type practices.

Rogoff also makes a further admission:

The problem is that simple rules inevitably run into periods where they work very badly and must be thoroughly revised. This occurred, for example, after the global financial crisis when central bankers’ perception of what constituted a restrictive policy rate changed dramatically; it appears to be happening again now. In these key periods, central banks are extremely vulnerable to political pressure.

The track record of central banks in forecasting has been appalling.

When they first adopted Milton Friedman’s monetary targeting approach – the Bank of England was the first in the early 1970s and soon abandoned the practice.

Friedman had told everyone that the 1970s inflation was because the money supply was increasing to quickly, and, as the central bank controlled the supply, they should set strict growth rules which would control the inflation rate.

First, central banks cannot control the money supply growth, which is the result of a multitude of decisions by businesses and household seeking credit from the banking sector.

The mainstream textbooks still teach that fiction and students in banking courses leave totally ignorant of the real world.

Second, the underlying theory – Quantity Theory of Money – that justified the monetary rule was inapplicable to the real world and Keynes had destroyed it in the 1930s.

But, in total denial of the evidence, the central banking community became rabid Monetarists and other central banks tried to impose monetary targetting in the late 1970s and into the 1980s and all failed badly.

It became obvious that the central bank cannot control the growth in the broad monetary aggregates (the money supply).

At that point, they shifted strategy to inflation targeting through the adjustment in interest rates.

But then found that such a policy was largely ineffective given the ambiguity of distributional impacts of interest rate changes (debtors lose, creditors win – but what is the net outcome?).

Also, as we have seen very clearly demonstrated in the current period, it is highly likely that interest rate hikes are actually inflationary – through income boosts to those with financial assets, the impact on business costs, and the impact on landlords who pass the higher costs on via higher rents, which feed into the CPI.

So Rogoff is only admitting that the tools that the mainstream have claimed for decades would lead to optimal outcomes are so deeply flawed that they are incapable of providing an accurate assessment of the situation.

He wasn’t content to end there though and his next step was to dismiss the basic economic forecasting machinery that central banks use to determine their assessments of the state of the economy and the impacts of their interest rate changes:

This is partly because, despite their bells and whistles, central banks’ “new Keynesian” forecasting models are fundamentally based on extrapolation.

The “bells and whistles” are all the ridiculous assumptions and equations that are used in these ‘models’ to give them an air of technical authority.

They are essentially fictions – relationships that are made up to support the theoretical propositions.

I wrote about these issues in this blog post among others – Mainstream macroeconomic fads – just a waste of time (September 18, 2009).

Rogoff then bemoans that fact that the central banks are being compromised and:

… increasingly pressed to focus on issues they lack the necessary tools, expertise, or political legitimacy to address, such as inequality, climate change, and social justice.

The ‘expertise’ they have is that they can create the funds necessary to achieve these positive outcomes and government should always use that capacity if there are the requisite resources available rather than lie about not having the financial capacity.

The odd part of this Op Ed is that it is actually hard to work out what he is on about.

Towards the ending he hints that the loss of central bank independence has increased the possibility of a new outbreak of inflation because there is now an inflation bias in the system, as a result of the central banks being compromised by government.

You might ask yourself – during the GFC, what would have happened if the central banks didn’t support the fiscal expansion?

Substitute pandemic for GFC and ask the same question.

What these crises have taught us is that the constraints imposed by the mainstream prior to the GFC on government policy created entrenched and high underutilisation of labour, increased inequality, declining infrastructure quality and more.

The experience of the Eurozone, where at the height of the GFC, policy makers were forced by the fiscal rules and central bank conditionality to impose harsh austerity, is a testament of what happens when the mainstream are dominant.

The pragmatic responses of the policy makers during those crises demonstrated that the mainstream theories are not capable of producing accurate predictions or explanations of what will happen when policy settings are pushed to extremes.

But then Japan has been teaching us that for 3 or more decades.

The other point to finish on is this.

The claims about the virtues of ‘central bank independence’ were, in part, pitched in terms of the so-called need to ‘anchor expectations’.

The story line went that if the ‘markets’ believed that the central bank was sincere in its diligence to expunge inflation from the system, then inflationary expectations would be stable – ‘anchored’.

So when we look at the data over the last few decades, most nearly all time series produced by various bodies across the world, show that there has been no substantial rise in medium- and long-term inflationary expectations.

The question then is this: Rogoff claims that central banks have lost their independence and are now being bullied by politicians to do things they should not be doing, and that has created an inflationary bias, so why haven’t the price expectations series started to head to the sky?

Answer: it was bunk all along.

Conclusion

Very odd contribution but telling even if that wasn’t his intention.

That is enough for today!

(c) Copyright 2024 William Mitchell. All Rights Reserved.