openDemocracy, April 1, 2019
On 23 October 2008, the former Federal Reserve Chairman Alan Greenspan appeared before the Congressional Committee and admitted that ‘flaws’ in his worldview had blinded him to the largest private debt bubble the world has ever seen. It was a startling admission that free market ideology, not objective ‘science’, had been guiding US monetary policy for the previous twenty years. The once incontrovertible notion of central bank independence, with its hawk-eyed prioritisation of price stability, suddenly looked vulnerable.
In the ten years since, as central banks have deployed considerable firepower to kickstart an anaemic recovery, the questions around central bank independence have only continued to mount. In the absence of excessive (or indeed any) inflation in most advanced economies, and with monetary policy requiring more and more help from the fiscal side, central bank independence seems both less necessary and less practical. Meanwhile, enhanced powers granted in the wake of the crisis raise serious democratic concerns, particularly regarding the uncertain and potentially political consequences of unconventional policies.
The time is therefore ripe to rethink the relationship between the state and the central bank. But the powers that be do not agree. “Credibility hinges on independence,” announced European Central Bank (ECB) President Mario Draghi in a recent speech, repeating familiar arguments for keeping central banks separate from the political sphere. This narrative emerged relatively recently as part of the monetarist reaction to the stagflation of the 1970s, when policymakers were perceived to have a bias towards inflationary policies due to temptations to ‘cheat the system’ for short-term political gain. To contain inflationary dangers, central bank mandates were restricted to the management of price stability, and operational independence was granted to set monetary policy free from government interference.
This reasoning was so swiftly accepted into central banking practice that it is easy to forget that it originates from a branch of neoclassical economic theory that has a very particular set of ideological beliefs. This school of thought, known as New Consensus Macroeconomics, considers active fiscal policy to be detrimental to the economy in the long run, and believes growth and employment can only be stimulated through supply-side reforms. Perhaps more revealingly, monetary policy is seen to have no long-term impacts on the economy beyond its influence on the inflation rate, hence justifying the de-politicisation of the central bank. That such conclusions are underpinned by ideology is evident, as Greenspan was forced to admit in the wake of the crisis. Yet central bankers continue to claim political neutrality. This assertion is not only inaccurate; it is preventing much needed democratic debate on the damaging consequences of many recent central bank decisions.
Quantitative easing (or 'QE'), whereby central banks purchase bonds using newly created reserves, has been widely criticised for perpetuating existing wealth inequalities by disproportionately benefiting asset-holders and homeowners. Indeed, the Bank of England’s own research found that QE had given the richest 10% of UK households a wealth boost over 116 times larger in cash terms than the poorest 10%.
But distributional concerns also afflict the traditional central bank policy instrument: interest rates. Changes to interest rates have opposing impacts upon borrowers, which are predominantly lower-income households, and asset-holders, where wealth is concentrated at the top. But thanks to the prioritisation of price stability, inflation-averse policymaking shifts the balance in favour of the latter, wealthier group.
Less widely known, but no less shocking, is the environmental impact of central bank policymaking. Analysis from researchers at LSE has shown that corporate bond purchases by the ECB and Bank of England were overwhelmingly and disproportionately skewed to carbon-intensive industries. The eligibility criteria attempted to be ‘politically neutral’, but by favouring highly-rated companies with access to capital markets they entirely excluded less-established low-carbon sectors. Instead, newly-created money helped to prop up dirty companies and shielded their outdated business models from the repricing effects of the energy transition. This neglect of environmental factors extends to macroprudential policy too, with new capital requirements continuing to penalise the patient, long-term lending urgently needed to decarbonise our economy.
But the most overtly problematic tensions between politics and central bank independence were revealed during the eurozone sovereign debt crisis. Using its status as ‘lender of last resort’ to full effect, the ECB forced a punishing austerity regime upon Greece before allowing it to access central bank liquidity. The ECB’s undeniably political involvement in the Troika has been widely condemned and has laid bare the need to rethink the status of central banks in a post-crisis world. The political neutrality of central banking is not a foregone conclusion of economic theory; it is a damaging myth. Monetary policy has real and persistent impacts on society that extend far beyond mere inflation management. Denying this reality is preventing a much-needed democratic discussion on how central bank policymaking may be undermining broader social and environmental goals.
Rather than blindly clinging to the illusion of independence, we should instead recognise central banks as the inherently political institutions they are and reform them for the better. Increasing the diversity and democratic accountability of central bankers would open up new possibilities for the role of monetary policy. For it is not the spectre of hyperinflation that haunts us today, but chronic underinvestment, ballooning private debt, rising inequality, and climate breakdown. A better approach for addressing these challenges, as many now argue, is increased strategic coordination between monetary and fiscal policy. Not only has this been used successfully in the past, but some central banks – especially in emerging nations – are already using their central banks for environmental objectives.
Broadening the reach of central bank policymaking has huge potential for improving our society and protecting the future of our planet, but it must be accompanied by democratic accountability and political oversight. Central bank independence, a tired anachronism based on dubious economics, is an obstacle to reforming these institutions for the better. It is time to abandon it, and in doing so bring central banking into the twenty-first century.