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“Saying no” is the key to central bank independence

EU Quantitative Easing |“Saying no” is the key to central bank independence Anthony Harrington

When supposedly independent central banks start buying large chunks of their own sovereign debt, usually, the presumption goes, at the behest of their own Chancellors, does that expose the fact their “independence” is a political fiction?

In setting out to address this question in a recent speech, Adam Posen, an external member of the UK Bank of England Monetary Policy Committee (MPC), and Senior Fellow at the Peterson Institute for International Economics, takes the European Central Bank’s recent burst of government bond buying as a case in point [PDF, 199 KB].

He is quite adamant that people who think that a Central Bank’s independence depends, ultimately, on whether or not its reputation for independence is “believable”, have drifted into some kind of idealist fantasy where only ideas have reality. As he puts it:

“An unfortunately sizable number of people seem to believe that central bank independence is largely a matter of reputation, and that any apparent fraternization with or accommodation of debt issuers imperils that reputation. That supposed reputational damage is then presumed to have significant costs for central banks’ counter-inflationary credibility.”

Instead, he suggests, Central Bank independence is a matter not of reputation but of reality. By this he means that what the bank actually does is far more important than what the public perception of the bank might be from moment to moment (though of course it would do no “independent” central bank any good to be thought of as being in thrall to the politicians).

“The substance of central bank independence is giving monetary policy setting committees the legal autonomy to refuse demands to purchase debt instruments - even when demands come at moments when politicians are very anxious that those bonds be bought.”

The ECB President, Jean Claude Trichet has pointed out on several occasions that the ECB is well used to going head to head with various national governments, including the French and the German governments from time to time. It took issue with both governments, for example, some years ago when it suited France and Germany to pretend that the constraints of the Financial Stability Pact (FSP) did not really apply to them. And it is constantly calling on eurozone members to take a “collegiate responsibility” towards ensuring that the FSP is honoured both in their own individual instances and collectively.

If central European banks were to always refuse to intervene in debt markets, out of fear that intervening would compromise their independence, that would be a sign of their immaturity or insecurity, much like an uncertain adolescent, rather than a sign of their independence, Posen argues. Instead, central banks need to respond to the global financial crisis by using all the tools available to them, including large-scale bond purchases if that seems appropriate. This is the way to enhance their credibility and independence for the future, he counsels.

It is an interesting argument. However, off to one side of this debate is another, having to do with the monetisation of government debt, or “quantitative easing” to give it its modern name. This is where a government rolls the printing presses till the plates burn out, and as Dylan Grice, an analyst/blogger for Societe Generale observes, even independent central banks can get sucked in to this process. What happens, he says, is that a central bank, independent or not, “decides” (on its own or with a shove from the politicians) to engage in a spot of quantitative easing to help to stimulate the economy. This is almost always accompanied by a statement to the effect that the bank will “sterilise” all this additional liquidity it is putting into the system once the desired economic effect has been achieved. This, Grice points out, is exactly what Rudolf von Havenstein, President of the Reichsbank during the Weimar Republic’s spell of hyperinflation, thought he would be able to do, too.

What banks discover in the midst of a Government debt crisis is that they need to keep printing money because the alternative, namely, imposing much tighter liquidity constraints, is way too scary to contemplate. Theoretically, at any point the banks can stop printing money, but they are trapped by their own mindset and their own fear. The question is not whether they are independent, but rather, whether they, or whoever’s pulling the strings, can still think straight…

Further reading on quantitative easing and central banks

Tags: banking , EU , European Central Bank , European Monetary Union , financial crisis , fiscal stimulus , inflation , regulation , sovereign debt
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