Question

How independent is the central bank? What factors contribute to and what factors work against independence? Discuss arguments for and against the independence of the central bank.

Answer 1

For several decades now, these decisions have been taken in most advanced economies by independent central bankers, free of political interference. However, US President Donald Trump’s criticism of the Federal Reserve has cast a spotlight on that independence. Political influence on central banks like the Fed is seen widely as an unwelcome retrograde step, yet there are strong arguments in favor of it and any moves in that direction would mean that traders would have to switch their focus to government policy.

Keeping an economy growing at a rate compatible with the full utilization of resources over the long run in an environment in which price inflation is stable has been an age-old goal for macroeconomic policy. Monetary policy and the institutional arrangements for carrying it out have long been regarded as important to achieving this goal. Such has been the importance accorded money in this respect, that numerous monetary arrangements and policies have been proposed which, if adopted, their proponents argue, would make such a goal attainable. These arrangements include the gold standard, the real bills doctrine, a compensated dollar, 100% reserve requirement banking, a fixed growth rate rule for the money supply, a bimetallic standard, a currency board, free floating exchange rates and inflation targeting. Keeping an economy growing over the long run at rates sufficient to provide full employment for labor and capital with low inflation or a stable price level has been an important goal for economic policy. Money and monetary policy have figured importantly in achieving this goal. Currently, it is argued, central bank independence is important to achieving this end. Many small factors contribute to central bank independence, and so the literature does not yield a consistent definition of it. Rather, the emphasis is on three aspects of independence, the degree to which, * the governing board of the central bank is isolated from the political process, *central banks can refuse to finance government budget deficits; and price stability has primacy as the ultimate goal of central bank activity.

Various indices of central bank independence have been compiled and used in empirical work to see how closely independence is related to such important performance characteristics of an economy as the rate of inflation, the growth of output, investment, and real interest rates.

Politics in business of state. Politicians all over the world are only concerned with staying in power. They will do whatever it takes as long as they can stay in control. Hence, it can be said that the actions of the politicians are controlled by political cycles. They become extremely generous and accommodating during the pre-election years. The business, on the other hand, operates based on business cycles. It is not necessary that periods of boom and bust will coincide with the political cycles. Also, if they do, politicians may have a conflict of interest. For instance, if there is too much inflation during an election year, politicians might simply skip the necessary but unpopular decision of implementing rate hikes. Hence, it is likely that the politicians will end up jeopardizing the entire economy for selfish gains. This is the reason why central banks need to be independent. They can take tough decisions regardless of the election cycle. The economy and elections are not naturally correlated. Hence, it is imperative that the decisions regarding the economy be taken independently.

Inflation: Controlling inflation is the primary objective of any central bank. In order to do so, they need to control the money spent by the government. If decisions regarding the economy can be taken by the government, they will take only populist decisions. For instance, governments may decide to provide free health care and retirement benefits even though they don’t have the financial wherewithal to implement such decisions. The bottom line is that if the government is given control of the economy, they might resort to indiscriminate money printing which will ultimately lead to economic collapse. This is what has happened in many ancient civilizations including Rome. Hence, to prevent this, central banks have been made independent of government authority.

Deficit Spending: Governments all over the world are fond of undertaking populist projects even though such projects are not supported by economic fundamentals. Consider the case of sports stadiums built for the Olympics in Greece and for FIFA World Cup in Brazil. In both cases, the government should not have indulged in deficit spending, but it did. These instances would become more common if the government had full control of the monetary policy. Hence, it is important to keep the monetary policy separate from the government in order to maintain the financial health of the state.

Separating the central bank from the state to be an independent body has many advantages that have been noted above. However, there are some disadvantages as well.

Secretive: The biggest criticism against the central bank is that their operations are very secretive. Many times their actions are completely unexpected. Many financial crises in the past have only taken place because the central bank took unexpected action. To prevent this from happening again, central banks need to ensure smooth transitions. Their policies should not be secretive and should not shock the economy.

In Favor of Big Banks: Many analysts are of the opinion that all the policies created by central banks are in favor of big banks and not in favor of the common people. For instance, their biggest goal is to reduce inflation. However, after the 2008 crash, they followed a policy of quantitative easing to save the big banks. This has ended up creating more inflation than any government policy ever has.

In summary, one can say that there are pros as well as cons to having independent central banks. However, the pros seem to be outnumbering the cons as of now. This is the reason why central banks across the world have witnessed increased autonomy.