The limits of independence

Dr Eric Crampton
9 November, 2021

We are going to miss central bank independence when it is gone.

It was hard-fought.

It mattered.

It held for thirty years.

But it has just about been blown because central banks, including the Reserve Bank of New Zealand, are breaking the deal.

Central bank independence from political interference requires that those banks stick to their narrow remits. Expanding into policy areas rightly belonging to legislatures will invite legislatures to end that independence. If an incoming government views the central bank as fundamentally politicised, central bank independence cannot last long.

A brief refresher on central bank independence may be in order.

Monetary policy, before central bank independence, was at least partially a political game. Politicians seeking re-election favoured looser monetary policy in the leadup to elections, with any corrections held until after the election was over.

Economists recognised that, over the longer term, there is no trade-off between inflation and unemployment. A hit of inflation can only temporarily reduce unemployment rates. When higher inflation expectations work their way into wages and prices, unemployment reverts to its longer-term trend. The higher inflation rate remains.

Getting inflation back down again can be painful. So not starting the cycle in the first place makes the most sense. Well, unless you’re a President or Prime Minister seeking re-election and can encourage your appointee to make sure that the timing of booms and recessions suits your election needs.

Empirical economists struggled to pin down these ‘political business cycles’. While finding the signal in noisy real-world data can be difficult, other evidence is a bit more straightforward. American President Nixon recorded conversations held in the Oval Office, including conversations with Federal Reserve Chairman Arthur Burns. Economist Burton Abrams found that President Nixon pressured Burns to pursue expansionary monetary policy in February 1972, early enough to affect the November election.

Recognising that the power to interfere in monetary policy was simply too perilous, politicians found a way of binding themselves against the temptation. Their solution harkens back to Odysseus’s journey home from Troy in Homer’s Odyssey.

Odysseus knew that anyone hearing the sirens’ call would be driven to dash their ship against the rocks, and that all would then be eaten. But he wished to hear the call nonetheless.

So Odysseus stopped his sailors ears with wax and had them bind him to the mast so he could not be tempted by the sirens’ calls. They safely sailed past the temptation, while Odysseus heard the sirens’ song.

The sailors had one goal: to sail a straight course past the sirens’ isle. And they succeeded.

The solution for monetary policy was not that different. Politicians bound themselves against interfering in monetary policy by setting central banks with an inflation target and the independence to pursue it. Rather than stopping central bankers’ ears with wax, they appointed central bankers of hawkish disposition.

But Odysseus’s solution depended on his crew serving faithfully. After all, the crew might instead have delivered the bound Odysseus into the hands of his enemies. Had Odysseus expected an unfaithful crew, he would not have agreed to have been bound in the first place. And a bound captain would have sought every opportunity to unbind himself if the crew strayed.

So too for legislatures and central banks.

Central bank independence requires that central banks act within their strict bounds and not set out on other adventures. Indeed, the purpose statement of the Reserve Bank Act recognises “the Crown’s right to determine economic policy”.

Central banks have one big job that is not done by anyone else in government:  monetary policy. Prudential supervision of the financial system is often also a core responsibility of central banks, including the Reserve Bank of New Zealand and the European Central Bank.

A mandate over financial stability requires monitoring and regulating against events that bring systematic risk. Definitions of systematic risk are always a bit fuzzy. But when central banks seek to impose higher bank capital requirements to prevent bank collapses that can trigger cascading failures, they will run stress tests showing the regulations to be warranted. The results can be debatable, but at least there is a framework for testing requirements.

That kind of framework matters. Because everything in the global economy connects to everything else, a remit for ensuring financial stability could too easily be considered a remit over everything.

New technologies spark investment booms that are sometimes followed by crashes, but central banks are hardly expected to have broad oversight of the tech sector. Wars can cause financial calamity, but central banks are not given responsibility for either foreign policy or defence spending. And, in either case, a central bank asserting a mandate for regulating financial flows into tech companies or into defence contractors would be drawing a bow too long to be tenable. Defence policy is clearly Parliament’s prerogative. 

And so we come to where central banks have been breaking the deal that gave them independence in the first place.

On Monday, Jenny Ruth at BusinessDesk reported that the Reserve Bank of New Zealand “tried to bury its own research that found climate change is not a threat to financial stability.”

Climate change is real, and it is important. But while it will result in a lot of financial disruption as everyone adapts to rising carbon prices and rising sea levels, it will not cause the kinds of issues that threaten the soundness and efficacy of the financial system.

A 2018 Reserve Bank report, which the Bank sought to prevent ever seeing the light of day, concluded as much.

In late October, the Bank published results of stress tests checking the resilience of the insurance sector against the increase in severe weather events that may come with climate change. While more frequent severe weather events would reduce insurance profitability, insurers remained profitable and solvent. There is no systematic risk to be mitigated.

Nevertheless, the 2021 annual report of the Reserve Bank of New Zealand refers to climate change more often than it mentions inflation. The term “climate change” appears 22 times, and carbon appears 23 times. The word inflation, all on its own, is mentioned less frequently than either climate change or carbon. And the Bank’s discussion of climate policy ignores the Emissions Trading Scheme.

The problem is not that climate change policy is unimportant. Getting it right is desperately important. The problem is rather that, like defence policy, climate change simply is not the job of a central bank.

The Reserve Bank of New Zealand is hardly alone in straying away from the core mandate that justifies its independence.

Last November, economist John Cochrane addressed the European Central Bank’s Conference on Monetary Policy.

He highlighted the many risks facing the global economy from sources outside of central bank control but for which central banks might wish to prepare. Worse pandemics. War between China and Taiwan. Cyber attacks against the financial system.

But the European Central Bank only seemed interested in one risk: climate change. And it seemed interested in this risk because of the potential for expanding the Bank’s remit and mandate. Cochrane warned that policies that can be worthwhile on their own grounds, if authorised by a legislature, can nevertheless be very bad ideas for central banks to pursue because they make mockery of a Bank’s limited remit.

Cochrane’s warnings for the European Central Bank apply even more strongly to the Reserve Bank of New Zealand.

If the German government were to tire of the central bank ignoring inflation to pursue other goals, its view is only one of many. In New Zealand, a change in government could have more dramatic effects. If an incoming future National government decided that the Reserve Bank had become a fundamentally politicised institution that had forgotten its core mandate in favour of every fashionable trend, what might it do?

The Minister of Finance can remove the Governor of the Reserve Bank from office. Such a move might normally be at the expense of Bank independence; in other cases, it could instead restore independence.

It may be desirable to avoid situations where we need to figure out whether an incoming Minister has removed the Governor to end or to restore Bank independence. 

Central banks have a very big and important job. Straying from that core task is dangerous – as my colleague Matt Burgess points out in a report to be released later today.


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