DATE DOWNLOADED: Wed Jun 24 10:25:57 2020 SOURCE: Content Downloaded from HeinOnline Citations: Bluebook 20th ed. Paul Wachtel Mario I. Blejer, A Fresh Look at Central Bank Independence, Cato Journal 40, no. 1 (Winter 2020): 105-132 McGill Guide 9th ed. Paul Wachtel the XXVI International Rome Conference on Money, Banking and Finance, LUMSA University, Palermo, Italy, December 14-16, 2017; and the Center for Advanced Studies on the Foundations of Law and Finance, Goethe University, May 20, 2019; and by Wachtel and Blejer at the Conference on Financial Resilience and Systemic Risk, London School of Economics, January 30-31, 2019; and the 25th Dubrovnik Economic Conference, June 15-16, 2019. This article is part of the LSE IGA Financial Resilience project supported by the Rockefeller Foundation. 105 CATO JOURNAL unaware of financial stability risks and ill prepared to respond to the financial crisis. In the less-developed, emerging market world, CBI improved policy management and governance. The arguments regarding CBI are focused on the monetary policy role of central banks that emerged in the post-World War II era as economists began to understand the importance of interest rates and credit aggregates to the macroeconomy. Historically, central banks, including some that were private-sector entities, were explicitly agents to carry out government policy (Parkin and Bade 1978). This would be true of the Bank of Japan and the Netherlands Bank among others. Other central banks, including the Swiss National Bank and the Bank of England, did not establish their statutory inde- pendence until recently. The traditional view of central bank finctions is associated with Walter Bagehot, the 19th-century British journalist who articulated the idea that a central bank should act as the lender of last resort to the financial system. By providing liquidity, the central bank can pre- vent crises and preserve stability. For example, the Fed was estab- lished as a lender, to use discounting to maintain financial stability (furnish an elastic currency in the words of the legislation). The lending functions of the Federal Reserve and other central banks diminished in importance through the latter half of the 20th century as macro monetary policy became the focus and new policy tools were developed. By the end of the 20th century, central banks were primarily associated with the macroeconomic policy role. However, the financial crisis of 2007-09 brought a renewed emphasis on the lender-of-last-resort function and the use of central bank lending to ensure financial stability. While the overwhelming majority of academic and central bank practitioners continue to support central bank independence, it is clear that, while independence continues to be protected, its golden age ended with the crisis a decade ago, and it did not end gently. The first wave of charges against central banks was straightforward: the worst financial crisis since the 1930s took place after central bankers worldwide were handed, or thought they were handed, most of the economic-management levers and were given much discretion in the design and certainly the implementation of their economic policies. Given these perceptions, there is no way they can now avoid blame, and preserve intact their prestige and standing. Indeed, the reputa- tion of independent central bankers was severely damaged by the 106 CENTRAL BANK INDEPENDENCE crisis, removing partially the implicit taboo involved in asking the unmentionable: perhaps central banks should not be, nor should aim at being, so independent after all? However, independence, at least formally, appears to be surviving. There was no lethal follow-up after the initial crisis-induced assaults. This restraint may have been the consequence of the fact that, one way or another, the crisis was controlled and central banks were instrumental in avoiding-with huge help from government and regulators-the complete collapse of the financial system. But the seeds of doubts about independence were planted and more ques- tions and criticism continue to arise. Many claim that in the 2000s, central banks unwittingly fueled the credit expansion that resulted in the crisis. This bad press may eventually translate into the political arena, as voters are chasing those that are seen as responsible for the crash and the austerity policies that ensued. Moreover, a crucial element in shielding central bankers from the popular wrath is also being questioned-namely, their success in achieving and maintaining price stability. The argument is that the central banks role in such success, although relevant, was overstated given the strong exogenous disinflationary consequences of technol- ogy and globalization. Even more serious is the near-consensus view that independent central banks spectacularly failed to achieve and preserve financial stability, just as crucial a mission as its macroeco- nomic companion. Of course, nobody claims that a country where politicians can overrule the central bank to promote excessive credit expansion or to print too much of their own currency is a good place to invest. But the tendency of independent central banks to focus on price stability and ignore the regulatory/financial stability side is also seen as a dan- gerous formula. In summary, recent crises left the impression that central banks paid no price for their collective failure and, in fact, that they emerged even more powerfil than before. Moreover, populist senti- ment has found that central banks are an attractive target to blame for any economic woes that might exist. Worse still, independence is firther endangered by the fact that the crisis pushed central banks into making choices with lasting dis- tributional consequences. By making massive purchases of govern- ment bonds, quantitative easing has held both short- and long-term interest rates low for a very long time. While this may have helped to 107 CATO JOURNAL stimulate declining economies, it has done so by making rich owners of financial assets richer still. At the same time, poorer savers relying on bank deposits have been getting next to nothing. Recent developments could be a watershed in the public approach to central banks, particularly in countries where the sensi- tivity to income distribution changes is high. The public may not tol- erate leaving decisions with important distributional and fiscal consequences (such as those related to bank resolutions) to unelected bodies. Central bankers in both developed and emerging market coun- tries are keenly aware that the circumstances that defined CBI and brought it into prominence have changed in the postcrisis world. The broadening role of central banks-to include a responsibility for financial stability-necessitates some review of central bank gover- nance and the relationship between central banks and governments. Nevertheless, many central banks continue to claim that their man- date remains relatively narrow and that independence is crucial although they are agreeable to strengthening transparency and accountability. We begin our reexamination of CBI with a discussion of its origins, starting with an important essay by Milton Friedman (1962). We then discuss why the idea caught on in the 1980s to become an uncontested element of the economics canon. We then turn to the role of CBI in the years leading up to and after the financial crisis. CBI has had some positive effects in emerging markets. However, in developed economies with an increased emphasis on financial stabil- ity, thinking about CBI needs to be modified. Finally, we examine a case study, the independence of the U.S. Federal Reserve in the postwar period. We find that CBI is often more an aspiration than reality. Despite its legislated independence, the Fed has been repeat- edly subject to political criticism from both the president and Congress, both of whom have attempted to influence policymaking. Central Bank Independence: History of an Idea The earliest mention of CBI that we have been able to identify is Milton Friedmans 1962 essay titled Should There Be an Independent Monetary Authority? Friedman states that the central bank should be organized with the objective of a monetary structure that is both stable and free from irresponsible government tinkering 108 CENTRAL BANK INDEPENDENCE (p. 224). He considered three organizing structures beginning with a commodity standard, which he dismissed because a filly automatic standard is not feasible in a complex banking system. Recall that Friedman was writing at a time when the Bretton Woods system tied currency values to the dollar and the dollar to gold. Friedman (1962: 224) then turns to the idea of an independent central bank and notes that so far as I know, these views have never been fully spelled out, which leads us to suspect that the term CBI originates with Friedman. A central bank exists with a kind of mon- etary constitution that specifies its objectives and tools and estab- lishes a bureaucracy to carry out the mandate. An independent central bank is one whose mandate-to achieve responsible control of monetary policy-is unaffected by anything the government might do. An independent central bank would not be subject to direct con- trol by the legislature and presumably the executive as well. In Friedmans argument, a completely private-sector central bank, like the prewar Bank of England, might have such characteristics, although Parliament could always revoke its charter, just as govern- ment could change the underlying monetary constitution of an independent central bank. Regarding independent central banks, Friedman (1962: 226-27) avers: It seems to me highly dubious that the United States, or for that matter any other country, has in practice ever had an independent central bank in this fullest sense of the term. Even when central banks have supposedly been fully inde- pendent, they have exercised their independence only so long as there has been no real conflict between them and the rest of the government. Whenever there has been a serious con- flict, as in time of war, between the interests of the fiscal authorities in raising funds and of the monetary authorities in maintaining convertibility into specie, the bank has almost invariably given way, rather than the fiscal authority. Thus, the irony of Friedmans ground-breaking effort to define CBI is that he rejects it. He finds it intolerable in a democracy to have so much power concentrated in a body free from any kind of direct, effective political control (p. 227). Friedman concludes that an independent central bank with wide discretion to independent experts (p. 239) is not the answer. Instead he prefers his third organ- izing structure-namely, legislation that specifies the rules for the 109 CATO JOURNAL conduct of monetary policy and restricts the central banks discre- tion. Rules maintain public control through the legislative process and insulate policy from the whims of politicians. All in all, Friedman (1962) provided us with a durable definition of CBI-a monetary constitution that defines the objectives of the central bank and establishes an organizational structure that can use policy instruments to pursue those objectives independent of political interference. However, his definition includes a prescient warning that independence exists only so long as there is no real conflict between the central bank and the government. Nevertheless, the idea that a central bank should be able to exer- cise its policy discretion in pursuit of the goals stipulated by polit- ical authorities became a virtually uncontested tenet of modern policymaking. The arguments in favor of an independent central bank began to crystallize in the 1980s after a decade or more of traumatic inflation- ary experience that put a spotlight on central bank policymaking and its failures. 2 CBI came into prominence as a result of four disparate and largely simultaneous influences. First, the inflationary episodes of the 1970s led to a great deal of dissatisfaction with central banks, which were blamed for allowing it to happen. Central bank organ- ization, governance, and policymaking needed to be rethought. Second, central banks were being established or reconstituted in many countries-in developed countries, newly independent countries, and later, in the transition countries. In every instance, the role and position of the central bank in government structures (Friedmans monetary constitution) needed to be defined. Third, the rational expectations revolution in macroeconomics led to major changes in thinking about the role of monetary policy. Last, initial empirical investigations suggested that countries with more independent central banks seemed to experience less inflation. By 1990 or so, these four influences came together resulting in the universally held conclusion that central banks should be independ- ent of political influence. On the history of rules versus discretion, see Buol and Vaughan (2003). 2Friedman did not change his view that independence does not provide an ade- quate incentive to pursue monetary stability (see Friedman 1982). 110 CENTRAL BANK INDEPENDENCE Inflationary Episodes of the 1970s The inflationary experiences of the 1970s were economically dis- ruptive, politically unappealing, and hard to eradicate. It was appeal-ing to blame central banks and to suggest changes in their governance as a solution. For example, the Federal Reserve under Paul Volcker changed its policy procedures in 1979 in order to address the persistent high inflation. The difficulty in bringing infla- tion under control made central bank operations more than a matter of technical interest for the first time. Policy Role of Central Banks The policy role of central banks only came into focus in the 20th century. Although some central banks have been around for a long time (notably the Rijksbank was founded in 1668 and the Bank of England in 1694), many central banks are of more recent vintage and many started as private institutions. The Federal Reserve opened in 1914 and the Bank of Canada in 1934; the Reserve Bank of India and the Central Bank of Argentina started in 1935 as private institutions. The formal role of central banks and their relationship to the govern- ment evolved slowly. Further, in the postwar period, many newly independent countries established central banks and had to define their relationship to the government and planning mechanisms. Finally, many more central banks were formed or reconstituted when transition began around 1989. Thus, there was considerable interest around the world regarding the monetary constitution. Macroeconomic Modeling Developments in macroeconomic modeling in the 1970s- including the natural rate of unemployment, the expectations- augmented Phillips curve, and rational expectations-had implications for understanding what a central bank can accomplish. Th