I'm on a panel at the "
ECB and its watchers" conference Wednesday, to discuss central bank independence. Here are my comments. Yes, there is a lot more to say, but I get exactly 15 minutes. I hope I'm not scurrying back tomorrow to retract something stupid here.
Central Bank Independence
John H. Cochrane
Hoover Institution, Stanford University
Remarks presented at the “ECB And its Watchers” conference, March 27 2019.
I believe central bank independence is a good thing, and that it is in increasing danger. I don’t think that’s a controversial view, or we would not be here.
I sense that our mission today is to decry politicians that wish to influence the central banks’ good works, especially by pressing for low interest rates.
But I’ll argue instead that much of the threat to central bank independence stems ultimately from how central banks are behaving, and has little to do with interest rates.
Principles
What is, can and should be independent? Let me suggest three principles.
1) In a democracy, independence must come with limited powers, and a limited scope of authority.
2) An independent agency must follow rules, norms, and traditions, not act arbitrarily, with lots of discretion.
3) To be independent, an agency must be, and be perceived to be, competent at its task.
What cannot be independent? A lot of government activity transfers wealth from one person to another, or fights for political power. Those activities must be politically accountable.
Limited powers: Central banks operate within legal restrictions. For example, it seems puzzling that central banks struggle to raise inflation. We all know how to stoke inflation: drop money from helicopters. To stop inflation, soak up the money supply with heavy taxes.
Yet central banks are legally prohibited from this one, most effective action for stoking or stopping inflation. Why? Well, in a democracy, writing checks to voters or confiscating their hard-earned cash must be reserved for politically accountable institutions.
Rules and norms: Most restraints on central bank actions are rules, norms, and traditions, not legal limitations. Central banking remains something of a black art, so central bankers must sometimes use judgement and discretion, especially in crises, and let the rules or norms evolve with experience. But if they are to stay independent, they must quickly return to or re-form rule, norm, or traditional limitations on their power.
From this perspective, the ECB was set up as an almost perfect central bank. It followed an inflation target. It only acted on the short-term interest rate. Its assets were uncontroversial. And it was not to finance deficits or bail out sovereigns.
The inflation target and Taylor rule are most important here for their implied list of things that the central bank should not, is not expected to, and pre-ccommits not to pay attention to or control directly: stock prices, housing prices, sectoral and industry health, regional imbalances (especially in Europe), credit for small businesses, income and wealth inequality, infrastructure investment, decarbonization, bad schools, and so on.
An independent central bank should say often, “that’s a terrible problem, but it’s not our job to fix it.” It loses power and prestige in the moment, but gains independence in the long run.
Actions:
So what are central banks doing to invite challenges to their independence?
Interest rates get a lot of attention, but they are not, I think, the core of the problem. Yes, President Trump is violating established norms by complaining publicly about interest rates. But most people in both parties understand this is a violation, and a norm worth keeping, so for the moment I think the norm against interest-rate jawboning will hold in the future.
The big threat to independence comes from the expansion of activities and responsibilities that central banks have taken on, on an apparently permanent basis, in the years since the financial crisis: Asset purchases, regulatory expansion, a much larger set of goals, and a marriage of regulatory and macroeconomic policy.
Purchasing assets in dysfunctional markets, as in 2008, is what central banks traditionally do in a crisis. (We can argue whether they should, but that’s for another day.) But once markets returned to normal, continuing to buy large portfolios of long-term bonds, mortgage backed securities, corporate bonds, imperiled European sovereign debt, and even stocks, for years on end, was a different choice.
We can argue the benefits. Maybe QE lowered some rates, a bit, for a while, and maybe that stimulated a bit.
But we have ignored the costs. Central banks took on a new, and apparently permanent power, formerly foresworn: to buy assets directly, to control asset prices, not just short term interest rates.
It is harder to say to a politician, who complains that mortgage rates are too high, that this is not our problem; we set the short term rate to stabilize inflation; we don’t pay direct attention to other assets, or to directing credit to mortgages rather than big business.
It will get worse. The US Congress has noticed the Fed’s balance sheet. Under the mantra of “modern monetary theory,” a swath of congresspeople want the Fed to print trillions of dollars to finance the Green New Deal.
The ECB and euro were set up with a clear rule that the ECB does not bail out sovereigns. In the crisis, President Draghi rather brilliantly stemmed the first debt crisis with a “do what it takes” promise, that did not have to be executed, along with a warning that this could not be permanent.
But in response, Italy took the St. Augustinian approach — Lord, give me structural reform, but not quite yet. The ECB continues to repo government debt and Italian banks are still stuffed with Italian government bonds. The doom loop looms still, and markets still expect a bailout.
The ECB has lost the long run game of chicken. It will likely have to actually do what it takes when the next crisis comes.
But there is little that is more political, little that cannot stay independent more clearly, than bailing out insolvent sovereigns, with euros that must either inflate or be backed up by taxes on the rest of Europe.
The ECB is still directly financing questionable banks and questionable corporations. These are also activities that will invite political scrutiny.
The crisis spawned a vast expansion of regulation. The US Fed is now using an immense,confusing, and constantly changing set of rules to act with great discretion on telling banks what to do.
Moreover such regulation changed from “micro,” somewhat rules-based regulation, to more nebulous and discretionary “macro prudential” regulation that directs the activities of “systemic” institutions — something nobody can define other than “we know it when we see it.” The Fed wanted to include large insurance companies, until courts struck that down, and tried for a while to systemically regulate equity asset managers, on the theory that the managers might sell in a behavioral herd and send prices down.
But telling banks and other institutions what to do, who to lend to, when to buy and sell assets, with billions on the line, using a high degree of judgment and discretion, is a political act that invites loss of independence. Your “bubble” is my “boom,” your “fire sale” my “buying opportunity.”
More than current actions, the ideas swirling around central banks seem to me even more dangerous for their future independence.
It is taken for granted that central banks should embrace the task of managing and directing the entire financial system. This only starts with managing bank assets to try to manage “systemic” risks. It goes on to managing asset prices and housing prices, I guess so that nobody ever loses money again, and directing the “credit cycle.” And central banks should go beyond short rates and asset purchases, and use regulatory tools to direct the macroeconomy and asset markets.
Nobody even seems to stop and think that such actions are intensely political, and will invite strong attacks on central bank independence.
Moreover, faith that we economists and the central banks we populate have any actual technical competence to implement such grandiose schemes is evaporating, and rightly so. That the already vast regulatory system failed to stop the last crisis eroded a lot of trust. In many ways the revelation that elites didn’t know what they were doing led to today’s populism. That once this horse was out of the barn, Europe’s regulators nonetheless kept sovereign debt risk free, inviting a second sovereign debt crisis, eroded more trust. If the next crisis blindsides larger, and much more pretentious grand plans, that trust and the independence it grants will vanish.
Even monetary policy is becoming more dangerous to independence. Much of the post-crisis analysis hinges on how monetary policy effects income transfers, for example from investors to mortgage borrowers or from all of us to bank balance sheets. Well, if the point of monetary policy is to take money from Peter, and give it to Paul, on the grounds that Paul has a higher marginal propensity to consume, Peter is going to call his congressman.
I sense that a lot of this expansion of tools, scope, and discretion comes from a natural human and institutional tendency towards aggrandizement. It’s fun to become the grand macro-financial planner, always in the news. It’s boring to be a limited, technical institution that says “not my job.”
For example, I think a lot of QE was simply done to be seen to be “doing something” in the face of slow supply-side growth. Remember, monetary problems, especially any ill effects of 1% rather than 2% inflation, do not last 10 years. Long run growth comes from productivity, and structural reform, not stimulus, and not money.
But in the language of central bankers, “growth” and “demand” seem to be synonyms. This morning, describing a decline in growth with no decline in consumption, President Draghi used the word “demand” many times, and “supply” never. Like helicopter parents, central banks want always to be in charge.
Maybe you disagree, but think of the costs. For sure, the promise of endless QE, and reiterating the promise that central-bank provided demand stimulus is the vital answer, lessened the pressure for structural reform.
More generally, imagine that about 5 years ago, central banks had said, “We’ve done our job. The crisis is over. ‘Demand’ is no longer the problem. If you think growth is too low, get on with structural reform. Low inflation and interest rates are fine. Welcome to the Friedman rule. QE is over, and we are no longer intervening in asset markets. In place of intrusive bank regulation, countercyclical buffers, stress tests, and asset price management, we are going to insist on lots and lots of capital so there can’t be crises in the first place. We’ll be taking a long vacation.”
Just how much worse would the overall economy be? We can argue. How much better would the threats to central bank independence be? A lot.
Well, it’s not too late.
Suggestions
Let me offer some practical suggestions:
1) Separate monetary policy and regulation. Regulation is much more intrusive, and much harder to resist political pressure. Using regulatory tools for macroeconomic direction is inherently going to threaten independence. The ECB’s Chinese wall between regulation and monetary policy is a good start.
2) Transfer, or swap, all balance sheet assets other than short term treasuries to a “bad bank,” controlled by fiscal authorities.
3) Solve the sovereign debt problem. Stop the doom loop: get own country sovereign debt out of banks, or backed by capital. Create a mutual fund with a diversified portfolio of government debts, and force banks to hold that if they don't want big risk weights. Allow pan-europeans banks that hold diversified portfolios. Then insolvent sovereigns can default without shooting their hostage.
4) Abandon the pretense that risk regulation, asset price management, and credit allocation policy will stop another crisis. Move to narrow deposit taking and equity financed banking, or at least allow these to emerge rather than fighting them tooth and nail.
The US Fed is clearly perceived to be defending monopoly profits of large banks, a big threat to its independence. If you don’t like President Trump’s tweets, wait for President Elizabeth Warren’s. And she knows where the regulatory bodies are buried.
5) Europe needs structural financial reform more than continued bank support from the ECB. For example, corporate bonds should be held in mutual funds marketed directly to investors.
6) Be quiet. Federal Reserve officials should not give speeches about inequality or other hot-button partisan political issues, no matter how passionately they feel about them.
7) But don’t throw away the bad with the good. In the face of political criticism, I sense central banks, rushing to apply the label “normalization.” The Fed is rushing to reduce the quantity of reserves and go back to older reserve management schemes, losing the lessons of how well an abundant reserves system can work.
Independence is not ours to claim. Central banks are government agencies, not private institutions with rights. Governments grant them independence when it is useful for government to pre-commit not to use some of its vast powers for political ends. Independence must be earned by, well, not using power in ways that must be politically accountable.
Central banks need to answer, What economic problems, are not your job to worry about? What tools will you not use? Central banks need to choose the power and allure of trying to fix everything, and thus acting politically, vs. the limitations that allow independence. They can’t have both. And we voters need to tell our politicians which kind of central bank we want. We can’t have both either.
Having laid out the options, it seems clear to me that nobody wants a limited, and hence independent central bank. The trend to central banks as the large, integrated, monetary-financial-and macroeconomic planners, integrating broad control of financial markets and their participants, is desired by central banks, politicians, and not contested by voters. So they shall be, but not independent.
