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Willem Buiter had some very interesting things to say about central bank independence before he went to work for Citi as chief economist...

What's left of central bank independence? (May 5, 2009)

The modern independent central bank was born in New Zealand in 1989. It had a short life.  The onset of the financial crisis of the north Atlantic region in August 2007 signalled the beginning of the end.  Today, only the ECB still has a significant degree of operational independence left, and it will have to give that up if it is to be effective in the current phase of the crisis. In other words, the ECB is the last central bank to understand that, if it is to play a significant financial stability role, it cannot retain the degree of operational independence it was granted in the Treaty over monetary policy in the pursuit of price stability.

Inflation targeting was invented around the same time and central bank independence, and also in New Zealand, with the Reserve Bank of New Zealand Act of March 1989 and the first Policy Targets Agreement (PTA) in March 1990.  The Reserve Bank of New Zealand Act 1989 specifies that the primary function of the Reserve Bank shall be to deliver "stability in the general level of prices."


A case can be made for the Deutsche Bundesbank, established in 1957 as the sole successor to the two-tier central bank system which comprised the Bank deutscher Länder and the Land Central Banks of the Federal Republic of Germany, as the first modern independent central bank, but the de-facto independence of the Bundesbank was a product of Germany's unique historical circumstances - notably the hyperinflation of the Weimar Republic's hyperinflation during 1923 and the limited legitimacy of the other state institutions following the Nazi era and World War II.  I therefore consider the Bundesbank to have been a pre-modern independent central bank.


Unconventional monetary policies require close central bank - Treasury cooperation

Every time a central bank makes a loan at the discount window or engages in a reverse repo secured against private collateral, it takes credit risk (default risk).  In the Euro Area, the ECB even takes credit risk when in accepts the Treasury debt of some of the Euro Area member states as collateral in its lending operations.  There is no guarantee that cross-border fiscal solidarity in the Euro Area will ensure that sovereign debt issued by fiscally incontinent member states will be made good by Germany and other member states with deep pockets.


Inevitably, when the central bank takes on significant credit risk in its monetary policy management, liquidity management and credit enhancement policies, close cooperation between the central bank and the fiscal authorities is essential.  Cooperation and coordination do not necessarily mean loss of independence. The ECB, unfortunately, often talks as if cooperation and coordination, including binding agreements, between the ECB and the fiscal authorities of the Euro Area would in and of itself constitute an infringement on its independence.  So all it is up for is regular cheap talk with the Ecofin or with the Eurogroup finance ministers.

As the crisis lengthens and deepens, the absence of close cooperation between the fiscal authorities in the Euro Area and the ECB will make both the ECB and the fiscal authorities progressively less effective.  This is in addition to the problems the ECB encounters as a result of the absence of even a minimal `fiscal Europe', in the design and implementation of unconventional monetary policy involving outright purchases of private securities or unsecured lending to banks or other private counterparties.


This threatening irrelevance of the ECB is caused by two factors, largely beyond its control.  The first is the absence of a `fiscal Europe'.  This means that the ECB is more restricted in the amount of private credit risk it can take onto its balance sheet than central banks that are clearly backed by a fiscal authority (national central banks outside the Euro Area, backed by their national treasuries).  Credit easing policies therefore pose greater risks to the ECB price stability mandate than similar policies do in the UK and the US.

The second cause of the increasing irrelevance and ineffectiveness of the ECB in these later stages of the financial crisis is the excessive independence granted the ECB in the Treaty.  Governments will be extremely reluctant to transfer supervisory or regulatory powers to a central bank that is under no constraint to pay any attention whatsoever to the elected and accountable politicians, both in the executive and legislative branches of government.

So I conjecture that central banks are facing a choice: remain relevant to crisis prevention and resolution, but lose much of your independence, or remain independent and become irrelevant.

Also Central banking as partisan politics (June 27, 2009)
As long as the financial stability role of central banks remained in the background, the notion of central bank independence appeared to have something to recommend it.

Setting the official policy rate is, by the standards of other political interventions in the economy, a relatively `technocratic', non-political or at any rate non-partisan and non-party political act.  Like any interest rate change, it hurts those who are long the official policy rate (or other rates linked tightly to it) and it helps those short the official policy rate.  But as the official policy rate is an overnight rate in most countries, the distributional effect of this change in the inter-temporal relative price of money is likely to be minor.


Once central banks get involved in lender-of-last resort operations, recapitalisor-of-last-resort operations and other rescue operations of banks and other financial institutions deemed to big, too complex, to international, too interconnected or too politically well-connected to fail, centrals banks and central bankers become normal political actors, indeed partisan political actors.  They should not be surprised to be treated as such.

By laying out pros and cons we risk inducing people to join the debate, and losing control of a process that only we fully understand. - Alan Greenspan
by Carrie (migeru at eurotrib dot com) on Sun Jun 6th, 2010 at 02:57:32 PM EST
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