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How Central-Bank Independence Dies
By Kenneth Rogoff

Since the world’s major central banks came to the global economy’s rescue in 2008, they have had more and more tasks foisted upon them, even as some politicians question their expanded role and others seek to undermine their policymaking autonomy. To escape this dilemma, monetary authorities must get back to doing what they do best.

With the global rise of populism and autocracy, central-bank independence is under threat, even in advanced economies. Since the 2008 financial crisis, the public has come to expect central banks to shoulder responsibilities far beyond their power and remit. At the same time, populist leaders have been pressing for more direct oversight and control over monetary policy. And while central banks have long been under assault from the right for expanding their balance sheets after the crisis, now they are under attack from the left for not expanding their balance sheets enough.

This is a remarkable shift. Not too long ago, central-bank independence was celebrated as one of the most effective policy innovations of the past four decades, owing to the dramatic fall in inflation worldwide. Recently, however, an increasing number of politicians believe that it is high time to subordinate central banks to the prerogatives of elected officials. On the right, US President Donald Trump and his advisers routinely bash the US Federal Reserve for keeping interest rates too high. On the left, British Labour leader Jeremy Corbyn has famously called for “people’s quantitative easing” to provide central-bank financing for government investment initiatives. “Modern Monetary Theory” is an idea in the same vein.

There are perfectly healthy and legitimate discussions to be had about circumscribing the role of central banks, particularly when it comes to the large-scale balance sheet operations (such as post-crisis quantitative easing) that arguably trespass into fiscal policy. However, if governments undercut central banks’ ability to set interest rates to stabilize inflation and growth, the results could be dangerous and far-reaching. If anti-inflation credibility is lost, governments may find it very difficult – if not impossible – to put the genie back in the bottle.

Complicating matters further, central bankers must figure out how to give normal monetary policymaking teeth at the zero lower bound, given today’s ultra-low inflation and real interest rates. The current reliance on quasi-fiscal policies is not only ineffective; it is also dangerous, because it lends weight to the argument that finance ministries should have more control over central banks.

Indeed, the primary challenge confronting central banks is not that they are too powerful, but that some see them as losing relevance. Inflation has been so low for so long that many have forgotten what it was like before independent central banks were established to rein in double-digit price growth. It has become increasingly popular to argue that low inflation is a hardwired feature of the twenty-first-century economy. And yet the complacent dismissal of future inflation risks – and thus of the need for central-bank independence – has all the hallmarks of the “this time is different” mentality that has been a recurrent feature of economic history.

One need not travel far down memory lane to remember that dozens of countries were seized by high inflation (above 40%) as recently as 1992, and that the United Kingdom, the United States, and Japan all suffered through double-digit inflation in the 1970s. The influx of inexpensive Chinese imports and the advent of the computer age certainly helped to bring that era of epic inflation to an end. But all evidence suggests that the rise of central-bank independence played an essential role.

Starting in Europe in the 1980s, one country after another granted its central bank significantly more autonomy. With the International Monetary Fund now forecasting inflation of just 1.6% across advanced economies this year, many have begun to wonder if central banks are even capable of generating inflation again. There is, in fact, a serious question as to whether central banks have gone too far – concentrating too much on inflation fighting and not enough on developing adequate tools to fight deflation. I will return to this later. The main point is that inflation has now become so low that, from a political point of view, central banks risk becoming victims of their own success.

Aside from maintaining low, steady inflation, most central banks also face the challenge of ensuring macroeconomic stability; it is widely accepted that activist monetary policy has played an important role in smoothing out business cycles throughout the post-war era. In the case of the US, the Federal Reserve has responded to recessions with sharp interest-rate cuts of five percentage points or more, on average. Yet with the Fed’s policy rate at just 2.5% today, and with the European Central Bank (ECB) and the Bank of Japan (BOJ) already at the zero bound, cuts of that magnitude will not be possible when the next recession arrives.

What else can central bankers do? Not as much as most observers seem to think. The current monetary-policy debate suffers from a crippling confusion over the conceptual distinction between monetary and fiscal policy. At times, central banks have played a part in exacerbating this confusion, by overselling and mislabeling “alternative monetary-policy instruments.” Not only have these measures proven less effective than traditional interest-rate policies in stimulating output and inflation; they have also encroached on the fiscal-policy realm, where central banks are junior partners to treasuries and finance ministries. And they are very much at the heart of recent challenges to central banks’ independence.

Though early studies suggested that central-bank purchases of long-term government bonds – known as quantitative easing (QE) – after the 2008 crisis provided significant stimulus by pushing down long-term interest rates, it has since become clear that most of the action in long-term rates stemmed from an unrelated trend decline. Even where some effect has been found, it has arguably been due to a false belief on the part of investors that central banks were “printing money” and inflation was around the corner. This will not happen again. Today, much of the initial optimism toward QE has been sharply tempered – as it should be. When a central bank purchases long-term government debt by issuing overnight bank reserves with the same interest rates as very short-term Treasury bills, it is not “printing money,” but rather shortening the maturity structure of government debt. The problem, with respect to central-bank independence, is that treasuries and finance ministries are perfectly capable of doing this themselves; in fact, they do it all the time.

Because QE at the zero lower bound is a form of maturity transformation, it is not particularly inflationary, and the many who believed it would be were simply wrong. Of course, in cases where central banks buy up private instead of government debt, the effects are larger, because this amounts to subsidizing select private-sector entities and creating actuarial liabilities for taxpayers. This kind of “fiscal QE” undoubtedly played an important role during the response to the financial crisis. But in most advanced economies, the emergency fiscal powers delegated to central banks were not intended for routine use in picking winners and losers, which itself can lead to a political backlash.

This brings us to central banks’ third primary challenge: managing financial crises. There are plenty of good reasons why central banks should have emergency powers to buy up certain types of private debt or to guarantee financial-sector balance sheets, as the Fed did at the height of the 2008 crisis. After all, monetary policymakers have several short-term advantages over their fiscal counterparts.

For starters, in most countries, central banks can act quickly and decisively without having to pass legislation. Second, as regulators, they already have a close relationship with – and deep knowledge of – the financial sector, which makes them faster on their feet. Lastly, central banks tend to have considerable financial and technical expertise already on hand (though this is not necessarily a structural feature).

Most outside observers have praised the major central banks for their use of quasi-fiscal powers to manage the initial consequences of the 2008 crisis – and of the 2012 crisis in the case of the ECB. Yet monetary policymakers’ success in preventing a wholesale collapse of the banking sector nurtured the expectation that they would shepherd the recovery through a long period of sluggish growth that was all too typical after a deep financial crisis. Since then, the persistence of ultra-low interest rates has introduced severe constraints. Whereas normal recessions usually demand interest-rate cuts of five percentage points, most models indicate that systemic financial crises require cuts double that size.

Of course, other measures are available to support a post-crisis recovery, including fiscal stimulus and policies to promote debt write-downs, such as for subprime mortgages in the US and periphery countries’ debts in the eurozone. Fiscal stimulus can take the form of debt-financed government spending and tax cuts, but it can also take the form of redistributive policies that favor low-income individuals with a high marginal propensity to consume. Compared to normal monetary policy, however, fiscal policy is a blunt instrument that always comes with political baggage. In the US, a Democratic government would pursue stimulus through a massive increase in government spending, whereas a Republican government would do so through tax cuts.

Owing to these complications, fiscal policy is simply less wieldy than the policies that well-designed independent central banks can offer. But that makes central banks’ inability to inject stimulus at the zero lower bound an even more pressing problem. Worse, most of the ideas for restoring monetary-policy effectiveness involve transferring fiscal powers to the central bank, thus raising issues of democratic accountability.

A prime example is “helicopter money,” whereby the central bank issues currency (or bank reserves) and transfers the revenue directly to citizens. It is remarkable how many serious commentators – even leading financial newspapers – have endorsed this idea in one form or another. Yet while one can imagine scenarios in which helicopter money would be welcome, central banks lack the authority to distribute or redistribute income directly to ordinary citizens. That right is reserved for legislatures, and if central banks were to trespass on it, they would quickly be reabsorbed into treasuries.

Besides, there is a perfectly valid and legitimate way to achieve the same effect as helicopter money: the legislature issues debt to finance income transfers, and then has the central bank buy up the debt. (In fact, insofar as this amounts to helicopter money, the BOJ has been doing it for years.) But, again, if the legislature cannot agree on the shape or size of the transfers, there is little the central bank can do about it other than complain. At any rate, the effect of helicopter money would be nil unless central banks can credibly raise their inflation targets, and it is not clear that they can.

Another dubious idea with surprisingly widespread support is to have a central bank that is stuck at the zero bound buy up and then destroy government debt. But this, too, would most likely achieve nothing. If a wife gives her husband a loan and then tears it up, there is no effect on the household’s assets. Moreover, were the central bank to destroy debt owed to it by the treasury, investor concerns about internecine government warfare could lead to higher inflation. If the central bank ended up technically “bankrupt,” the government might make recapitalization conditional on higher inflation, or it might simply reabsorb the bank into the treasury.

If these nonsensical proposals are the best options on the table, it is safe to say that central banks currently lack the instruments needed to fight deflation, let alone increase inflation, in the event of a crisis. That is a problem for many reasons. Unexpected inflation provides a simple, time-tested mechanism for reducing the real value of private debts. If the Fed had been able to raise inflation to, say, 4-5% in the years after the 2008 crisis, the lingering private-debt problems would have been much more manageable.

Perhaps the most underused instrument in the last financial crisis was debt write-downs that target the heart of the problem. Unfortunately, overblown fears of moral hazard make effectively blocked write-downs in the case of US subprime mortgages and periphery-country debt in Europe. One hopes that in the future, policymakers will be better prepared to implement creative ideas to mitigate such concerns (for example, equity sharing in the case of mortgage write-downs, and GDP-indexed debt in the case of sovereigns).

A final challenge facing central banks is that they are no longer needed as bulwarks against the temptation to inflate away excessive government debt. In a sense, this is a corollary of the first challenge: that high inflation has been gone for so long that people have come to believe it can never return. Unlike short-term stabilization policies, however, holding down inflation expectations in the face of rising debt is a long-term project. There are really two separate ideas in the mix here. The first is reasonable but debatable; the second should be discarded.

The first idea is that, owing to the steady decline in long-term real interest rates on “safe” government debt, governments can now issue much more debt than they used to. This claim makes perfect sense, provided one has also accounted for nuances such as the maturity structure of the debt. (Short-term debt is usually cheaper than long-term debt, but far more vulnerable to shocks to global real interest rates.) And in the US case, one must consider the dollar’s increasing centrality in the global financial system. Despite America’s falling share of global output, the dominance of the dollar has fueled global demand for dollar-denominated assets and reinforced its “exorbitant privilege.”

A more extreme version of the contention that debt is completely benign was endorsed recently by former IMF chief economist Olivier Blanchard. In an interesting and provocative paper, Blanchard contends that the US economy is currently in an inefficient equilibrium where, for whatever reason (excessive investment is the classic one), interest rates are below growth rates. He expects these conditions to hold “for a long time,” and concludes that any one-time increase in government debt – even a very large one – will have no effect on the long-term debt-to-income ratio, because growth will outstrip the surge.

In the scenario Blanchard describes, public debt is a free lunch, because there is too much investment in the economy anyway – so much so, in fact, that there is no need even to raise taxes to pay for it. And this is doubly true if the funds are spent on high-return investments such as education and infrastructure (never mind that less than 4% of government expenditure in advanced economies is dedicated to infrastructure investment). More to the point, if higher debt places no additional pressure on fiscal policy, there will be no need for central banks to inflate it away, and thus no need for central-bank independence.

Blanchard may be right, but several of his points are debatable. Is the economy really in an inefficient equilibrium, with interest rates set to remain below the growth rate indefinitely, or is this just a temporary situation that might eventually be reversed? The suggestion that the risk of a debt run does not begin to rise as debt becomes very high is even more debatable. Standard models suggest otherwise, and it is certainly no accident that investors in times of crisis are more concerned about high-debt than low-debt countries. As Harvard University’s Emmanuel Farhi and Matteo Maggiori have shown both empirically and theoretically, one also should not underestimate the frequency with which historically “safe” assets have turned out not to be so safe after all.

Yet another iteration of the benign-debt argument is Modern Monetary Theory (MMT), which, as I understand it, would allow the government to pile up debt longer and at lower cost by instructing the central bank to pursue continuous QE, issuing bank reserves to buy up long-term government debt. The effects of such a mandate would depend on whether bank reserves bear market interest rates, as is now the case, or whether they are non-interest-bearing. As we have seen, there is no meaningful difference between the central bank expanding reserves to buy back newly minted long-term government debt and simply issuing very short-term debt in the first place. If bank reserves pay interest, the first-order effect of the MMT prescription is to shorten the maturity structure of government debt without providing any extra tools for the government to run higher deficits. But if the reserves do not pay interest, any increase in interest rates would prompt a rush by banks to withdraw them, and inflation would soar.

As already noted, short-term debt is typically the cheapest way to finance government borrowing, and there is a case to be made that the cost savings from issuing short-term debt have been even greater than usual after the financial crisis. But there is a reason why governments don’t bet the farm on global real interest rates never rising again: historically, interest rates have an inconvenient habit of doing precisely that. MMT’s overreliance on short-term debt is thus highly risky. If global real interest rates were to rise, the government would immediately feel pressure to raise taxes and cut spending. Should it fail to respond quickly, suddenly rising risk premia would exacerbate the problem.

It is tempting to assume that global interest rates for safe assets could not spike, and that any conceivable shock would, if anything, drive them down. Yet if we have learned anything from the past, it is that tomorrow’s shock may not look anything like yesterday’s shock. It is one thing for a hedge fund manager to bet big on what interest rates will do in the next few years, and then retire. It is quite another thing for a government to play that game.

Is monetary policy destined for irrelevance in an age of low interest rates? Not necessarily. As I have argued elsewhere, with certain institutional changes, central banks could pursue an effective negative-interest-rate policy. I emphasize “effective” because, while some central banks have engaged in very mild forms of this already, none has tackled the most important issue: the risk of wholesale cash hoarding when rates turn too far negative.

The cleanest solution to this problem is to move entirely to digital currency. But, for many reasons, including privacy concerns, that will not really be an option for the foreseeable future. Alternatively, phasing out large-denomination banknotes has much to recommend it – including clear benefits in terms of tax evasion and crime prevention. During an emergency period of negative interest rates, getting rid of large notes would significantly raise the costs of wholesale cash hoarding by financial firms, pension funds, and insurance companies. If on top that, one imposes administrative charges on large-scale redeposits of cash at the central bank, it should be possible to have a far more effective negative-interest-rate policy than is possible under current institutional arrangements.

Another alternative is to create a crawling-peg exchange rate between electronic money (bank reserves at the central bank) and paper notes. The idea would be to move toward an equilibrium in which all contracts and taxes are denominated in electronic currency, but transactions could still be executed with paper money. When the central bank’s policy rate is negative, it would no longer exchange electronic currency for paper notes at a one-to-one rate. Instead, if the interest rate on electronic currency was -5%, the value of paper cash tendered at the central bank would depreciate at a rate of -5%.

As for banking profits, if small retail depositors are excluded and wholesale clients have no way to hoard cash without incurring high storage and tax costs, banks should be able to pass the negative rates on to depositors. Yes, there are a number of second-order issues associated with this approach, which I address in detail in my 2016 book The Curse of Cash. But the real-world experience with negative rates so far suggests that these issues would not be a problem.

Aside from a negative-rate policy, another idea is to give monetary authorities more scope to cut interest rates – namely, by raising inflation targets. But this approach is less elegant and probably far less effective. For starters, raising the inflation target from 2% to 4% probably buys a lot less space than one might think. Contracts would almost surely adjust more frequently, in which case interest-rate cuts would need to be even larger to achieve the same effect as before; even during normal times, there would be costs of higher inflation, owing to the greater dispersion of relative prices.

Another problem is that changing long-established targets could undermine central-bank credibility. After all, the ECB and the BOJ have not even been able to reach 2% inflation, let alone 4%. And even if inflation were to reach 4%, that still wouldn’t necessarily provide enough room for maneuver in the event of a deep recession or financial crisis.

One naive objection to negative interest rates is that they are unfair to savers. But modern technologies make it easy to exempt small depositors so that only a very small percentage would be affected. Moreover, an effective negative-rate policy would benefit savers with more diversified portfolios, because it would push up equity, housing, and long-lived-asset prices, thereby countering the sharp drop that usually occurs in a deep recession or financial crisis. It would also increase long-term interest rates by driving inflation and growth. And, most important for most workers and families, a negative-rate policy could help restore employment and income growth after a deep recession or crisis.

This is not to suggest that a negative-rate policy obviates the need for other forms of stimulus – higher government spending, tax cuts, or both – during recessions. But it would restore some of the balance between monetary and fiscal policymaking, the former being generally much faster and more reliable. Finally, if a negative-rate policy sounds radical, you don’t even want to know about all the radical ideas that fill the pages of the major economics journals. Like deep recessions and financial crises, all would entail severe risks. At least with a negative-rate policy, we will have solved the problem of central-bank impotence at the zero bound, which would be of immediate use for Europe and Japan – and could help the US in the future.

The challenges facing central banks stem both from their effectiveness in reducing inflation and from their ineffectiveness in dealing with the zero lower bound. They are now vulnerable to populist attacks that threaten to undermine their independence. Some would have central banks finance massive increases in government debt indefinitely, while others, in the case of the US, want to slash interest rates when the economy already seems to be running hot. The idea that high inflation in advanced economies is strictly a twentieth-century problem is extremely dubious. “This time is different,” until it’s not.

In fact, the case for having an independent central bank that is hardwired to control inflation remains strong, buttressed by the experience of countries where central-bank independence has been compromised. If central-bank independence is rescinded and monetary policy politicized, it will be only a matter of time before high inflation returns. And if that happens, it may be even harder to put the inflation genie back in the bottle.

In the 1920s and 1930s, governments tried to reestablish the gold standard, which had been abandoned during World War I. They soon learned that once investors witness a bond being broken, it is exceedingly difficult to regain their confidence. The same problem would face countries that tear down central-bank independence and then try to resurrect it. At a minimum, they would face years of sky-high interest rates before public trust is restored.

As anyone who has worked at a central bank understands, operational independence is rarely granted by constitutional decree; and even where it is, the letter of the law has little meaning if political support is lacking. In reality, central-bank independence is fragile, and must be defended every day. In these difficult times, central bankers need to find new instruments to restore the effectiveness of normal interest-rate policies.

To that end, they should seriously consider laying the groundwork for an unconstrained negative-rate policy, which would be far preferable to serving as junior partners in debt-maturity management and quasi-fiscal policymaking. To maintain their relevance, and to shield monetary policy from populists of the left and the right, central bankers cannot afford to rest on their laurels. If they do not rise to the occasion, one of the most important macroeconomic developments of the modern era may not survive.

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. The co-author of This Time is Different: Eight Centuries of Financial Folly, his new book, The Curse of Cash, was released in August 2016.
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