The Bank of Japan made a blockbuster announcement overnight, saying that after nearly two decades of economic stagnation and falling prices, it is aiming for 2 percent inflation and will print more yen on an unlimited scale—by the trillions, if necessary—to get there.
That alone is big news; the Japanese central bank has now joined the Federal Reserve and the European Central Bank in pledging bottomless resources to address their respective economic crises. The Bank of Japan, under pressure from the newly elected government of Shinzo Abe, went a step further. It released a joint statement with the government, pledging to “strengthen their policy coordination and work together” on a range of policies.
Jens Weidmann, the president of the German Bundesbank, sees in this and other developments the beginning of the end of the era of independent central banks.
“It is already possible to observe alarming infringements, for example in Hungary or in Japan, where the new government is massively involving itself in the affairs of the central bank, is emphatically demanding an even more aggressive monetary policy and is threatening an end to central bank autonomy,” Weidmann said in a speech in Frankfurt Monday. Weidmann was polite enough, on this occasion at least, not to mention the ways the ECB has risked its independence by standing ready to backstop markets for European nations’ debt (an action on which Weidmann dissented.)
So, it’s worth asking, is the era of independent central banks over? And if so, does it matter?
The answers begin with understanding why central banks are given independence from political authorities to begin with. The idea is that elected officials, with their short time spans in office and limited technical knowledge, will forever be inclined to allow higher inflation in exchange for stronger growth and lower unemployment, and that over time this will significantly worsen the economy. The lesson of the 1970s was that you want your central bankers to have the power and leeway to take actions that will be unpopular (namely, raising interest rates to fight inflation) but will make your economy better off over the long run. The lessons learned in fighting inflation back then led to the modern age of independent central banks.
In other words, independence is a more recent phenomenon than you might think: The Bank of England gained legal independence in 1997; the central banks of France, Italy and many other Western European nations that aren’t Germany weren’t truly independent as late as the 1990s, when there began a push to create the ECB. The Federal Reserve gained independence in the 1951 Treasury-Fed accord, but sure didn’t act like it in the 1970s, when the Nixon administration used all manner of tools to encourage easy money policies out of the central bank (and resulting high inflation). It was Fed chief Paul Volcker’s willful leadership, serving in the Carter and Reagan administrations, that brought independence to the Fed in practice, if not in law.
The argument against independence in the current environment boils down to this: Different times call for different measures. In the 1970s, the real problem was that central banks were tolerating too much inflation amid both analytical mistakes and pressure from short-sighted politicians.
But now, the problem is that central banks around the world are near the “zero lower bound,” with short-term interest rates sitting ultra low. Their remaining tools to pump more money into the economy to encourage recovery seem to pack less punch than their usual management of interest rates. That might change, though, if the central banks’ policy of printing money and using it to buy bonds, known as quantitative easing, was matched by coordinated spending or tax cuts by governments.
Macroeconomists have long known that in a “liquidity trap,” like that underway in the United States, Western Europe and Japan, it could theoretically be better policy to turn the normal rules of central bank independence on their head. The institutional design that made sense for one era may not be the best for another.
But the problem is that institutions can’t turn on a dime. That is true of central banks, led by small-c conservative men and women, more than most. The Bank of Japan has been dealing with a deflationary world for nearly 20 years, and only now, amid new pressure from the government, is it committing to deeper coordination. The forays by the Fed and ECB into this unconventional terrain have been filled with reluctance and hand-wringing. And, indeed, if the policies are successful, and the major economies can get out of their liquidity traps in the next few years, the central banks could be laying the groundwork for a new bout of inflation -- if they aren't able to regain greater independence from political authorities when the world changes again.
But for the moment, central bank independence isn’t what it used to be, and that’s not entirely a bad thing.