Central banks' independence in historical perspective

Central banks' independence in historical perspective

Journal of Monetary Economics 25 (1990) 165-176. North-Holland CENTRAL BANKS’ INDEPENDENCE IN HISTORICAL A Review Essay PERSPECTIVE Robert L. HETZE...

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Journal of Monetary Economics 25 (1990) 165-176. North-Holland



Robert L. HETZEL* Federul Reserve Bunk of Richmond,


VA _‘3?61, USA

Gianni Toniolo as editor has collected in Central Banks’ Independence in Historical Perspective (Walter de Gruyter, New York, 1988) historical overviews for five countries of the relationship between the central bank and the political system. Richard Sylla discusses the Federal Reserve System, Alec Cairncross the Bank of England, Jean Bouvier the Banque de France, Carl-Ludwig Holtfrerich the German central bank, and Giangiacomo Nardozzi the Bank of Italy. These ‘panel data’ are valuable because they provide widely differing observations over time and across countries. They can be used to formulate hypotheses to explain the relationship between the central bank and the political system. Central bank ‘independence’ implies a separation of central bank decision making from the regular decision making of the political system. This separation implies, for example, that the central bank and the Treasury are institutionally autonomous. Separation of decision making, however, occurs in two very different contexts. In one context, the separation is associated with a rule that commits the central bank to behave in a particular way. This rule could take the form of an explicit law that requires the central bank to maintain a gold standard or an implicit social consensus that the overriding objective of monetary policy is price level stability. In the other context, the separation is associated with discretionary power on the part of the central bank. When ‘independence’ is used in the first context, I will use the words ‘committed’ or ‘commitment’. In this context, the word ‘independence’, with its connotation of an absence of constraints, is misleading. When ‘independence’ is used in the second context, I will use the phrase ‘autonomy with discretion’. When used in this context, the word ‘independence’ is also misleading. Inevitably, a central bank possessing discretionary power will have to defend the exercise of that power from other participants in the political *I have benefited from comments by Michael Dotsey, Marvin Goodfriend, Tony Kuprianov, Jeffrey Lacker, Bennett McCallum, George Rich, and Alan Stockman. The views expressed in this essay are my own personal views. They should not be attributed to any of the preceding individuals or to anyone else at the Federal Reserve Bank of Richmond.



Elsevier Science Publishers B.V. (North-Holland)


R. I.. Hetzel. Central hanks’ independence

in historicalperspectwe

system desirous of usurping it. The central bank chooses its own actions, but not without regard to the response of other political actors. Like a prize fighter, it chooses its own moves, but with regard to the moves of opponents. The behavior of the central bank is conditioned by the behavior of the other actors in the political system. In the first part of this essay, I advance an hypothesis about the conditions under which commitment is observed as a means of rendering central banks independent of the regular decision making of government. In the second part, I advance some hypotheses about the way participants in the political system compete for control of a central bank that possesses discretionary power and about the way the central bank defends itself. 1. What are the observations on central bank commitment? Before World War I, the Bank of England ment and committed by the gold standard. 19th century:

was independent of the governCairncross observes that in the

. . . the government was not equipped to cross swords with the Bank of England: there were at most only two or three people in government service who were thoroughly familiar with monetary problems and it was only in a crisis or in matters of debt management that contact between the two bodies extended much beyond exchanges between the Chancellor and Governor. (p. 46) In World War I, the Bank lost its committed independence and never regained it. Cairncross notes about post-World War I relations between the Bank and the government: ‘The Prime Minister has the last word and Prime Ministers usually have strong views which they do not abandon lightly’ (p. 71). From the time of its founding in 1876 until World War I, the German Reichsbank was largely committed by the discipline of the gold standard. Holtfrerich notes: ‘In practice, the gold standard rules restricted the autonomy of the Reichsbank more than the legal subordination of the Reichsbank under the Reich’s Chancellor’ (p. 111). This committed independence ended with World War I and the hyperinflation of the Weimar Republic. Under the currency stabilization program of 1923/24, the Reichsbank regained its independence from the government, while being subject to the discipline of the gold standard. This commitment, however, was imposed externally by the Allies. With the ascendance of the Nazi government, the Reichsbank lost its independence. It retained a formal autonomy only as long as it willingly helped finance Hitler’s employment and armament programs. Hitler dismissed its head, Schact, in 1937 immediately after the first disagreement over financing. Finally, since its inception after World War II, the Bundesbank has been universally recognized for its independence and commitment to price-level stability.

R. L. Hetzel. Central banks’ independence in historical perspective


At its inception, the Federal Reserve System was committed by the gold standard. During World War I, it was under the control of the Treasury. In the 1920s the political system in the U.S. still accepted the gold standard as a norm. I assume that the Fed was essentially committed in the 1920s by a concern for price-level stability and a desire to rejoin eventually a revived international gold standard. This commitment was lost in the 1930s with the end of the international gold standard. The centralization of decision making within the Fed with the New Deal banking reform of 1935 also made it easier to bring political pressure to bear on the Fed. From the beginning of World War II until the Treasury-Fed Accord in 1951, the Fed was again subservient to the Treasury. After the Accord, under the Bretton Woods System, the Fed felt constrained by international reserve flows, so I consider it largely committed. This commitment was lost in the mid-1960s when the Fed began to ignore the discipline imposed by the Bretton Woods System. At this time, the Fed increasingly came under pressure from the political system. Sylla comments: When the Fed in December [1965] belatedly (in terms of fighting inflation) raised the discount rate from 4 to 4.5 percent, the Johnson Administration publicly and in strong terms erupted with criticism of the central bank, and Congressional hearings on the breach in economic policy followed.. . . One cannot help but wonder whether the memory of this experience made it difficult for the Fed to take a strong anti-inflation stance in the years that followed. (p. 33) The Banque de France appears never to have been committed. When it supported the international gold standard, the Banque generally set the franc price of gold higher than its equilibrium value, so it was not constrained by gold outflows. In the 19th century and for a brief period in the 1920s the Banque possessed a limited amount of autonomy with discretion. At these times, there was competition between the government and wealthy industrialists, represented by the Regents within the Banque, over whose interests the Banque would serve. The Popular Front government settled this question definitively in favor of the government in 1936. Bouvier reproduces the following quote that describes the customary position of the Banque: ‘The Banque de France, guardian of the value of the currency, must have its own goals, which, of course, must be compatible with those of the Ministry of Finance’ (p. 89). Finally, the Bank of Italy appears to have always been integrated into the regular decision making of the political system.

2. A preliminary hypothesis ahout commitment Under what conditions does central bank independence with commitment emerge? The experience of the Bank of England, which lost its independence as England moved away from free enterprise, appears typical. Caimcross notes

R. I_ Hetzel. Central hanks’ independence in historical perspectioe


of the public


in 1945 over nationalization

of the Bank:

The Labour Party’s insistence on taking over the Bank of England - the Act took legislative precedence over all other measures of nationalization - derived largely from ideological considerations.. . . [Chancellor of the Exchequer] Dalton laid stress on the need, for purposes of economic planning, to have control over the allocation of credit between different uses and groups of users. (pp. 48-49) I hypothesize that the extent of a country’s commitment to free enterprise determines the extent to which it commits central bank behavior. As Nardozzi states: ‘Public institutions and the bureaucracies of which they are composed reflect the role of the state in each country’ (p. 190). Encouragement of the individual initiative that augments the wealth of nations under free enterprise requires commitment to three economic arrangements. First, the government must allow the price system to coordinate economic activity. Second, the government must allow open competition for the right to provide goods and services. Third, the government must put in place a legal system capable of guaranteeing a stable set of property rights that allow individuals to benefit from their own efforts. Commitment to these economic arrangements requires that the political system find ways of preventing their erosion as part of the ongoing competition for political power. For example, commitment to competition in the provision of goods requires some way of limiting the incentive possessed by government to award governmentcreated monopolies to groups in return for their political support. Consider a country’s attitude toward central bank commitment in the context of each of these three economic arrangements. First, a commitment by the political system to allowing the price system to allocate capital promotes central bank independence with commitment. In pre-World War I Germany, pressure to end the committed independence of the Reichsbank derived from a desire to use it as an instrument of credit allocation. Holtfrerich says of the debates in 1889, 1899, and 1909 in the Reichstag over nationalization of the Reichsbank: Nationalization was favored by the right-wing groups and parties that stood for the interests of agriculture and handicraft.. . They expected that a nationalized Reichsbank could be made to pursue a credit policy more favorable to the wishes of agriculture and small business. (p. 112) In his essay on the Italian central bank, Nardozzi discusses the coalition between Christian Democrats (‘who.. . gave free rein to their interventionist instincts’) and the Socialists (‘who got their hands on the levers of government with the declared intention of strengthening the role of the state in the economy’). This coalition led to a central bank ‘dirigisme’ that ‘resulted in the banks delegating the major choices regarding the allocation of credit to the

R. L Hetrel, Central banks’ independence in historical perspective


central bank’ (p. 177). In this political environment, there was never any possibility of a committed central bank. If the political system is committed to allowing the marketplace to allocate capital, it will find ways to commit the central bank not to allocate capital. For example, although the Bank of England engaged in private lending in the nineteenth century, as a private institution subject to bankruptcy, it had to lend on market-based criteria. Conversely, if the government uses the central bank to allocate capital, either directly by fiat or indirectly through lending at subsidized rates, it will not tolerate an independent central bank. Second, commitment by the political system to an economic system that allows competition promotes central bank independence with commitment. The obverse of free entry into an area of economic activity is free exit - a willingness by government to allow businesses to fail. Commitment to competition in the provision of goods and services requires a rule that prevents the central bank from extending credit to insolvent institutions, either financial or nonfinancial. For example, the concept of the lender of last resort function developed in the 19th century included restrictions designed to prevent the central bank from lending to insolvent institutions. Provision of credit by the central bank during a financial panic exclusively either through open market operations or to individual institutions on the security of ‘good’ paper prevents lending to insolvent institutions. An example of a rule that prevents central banks in free enterprise economies from restraining competition is a guaranteed free market in foreign exchange. Modern-day mercantilistic governments often maintain an overvalued exchange rate, which generates a shortage of foreign exchange. Foreign exchange, which must then be rationed, is distributed by the central bank to firms that are well placed politically. In interdependent modem economies, this allocation of the foreign exchange needed to pay for imports determines who can produce. It is a way of creating government-sponsored monopolies. Finally, commitment to continuity in property rights encourages committed independence of the central bank. One of the most difficult problems to solve in committing to free enterprise is how to balance the need for the government to acquire resources with the need to protect property rights. Arbitrary seizure of property by government reduces the incentive that private property provides to individuals to organize economic activity. The attitude of the political system toward the security of individual property rights influences the extent of central bank independence from demands to fund directly government deficits. The requirement that the government legislate explicitly a tax when it appropriates resources, rather than borrow from the central bank, imposes a discipline on the transfer by government of resources from the private sector. Nardozzi explains that the Italian central bank first became interested in independence in the 1970s when the procedure for central bank financing of government deficits collapsed. Because this procedure left the central bank


R. L. Hetzel, Central banks’ independence in


without direct control of the monetary base, the central bank imposed quantitative controls on credit extension by the banking system. These controls broke down when the central bank lost its ability to control the new forms of intermediation that arose in order to bypass the banking system. The attitude of the political system toward the security of individual property rights determines the degree of independence of the central bank from political pressure to produce inflation. Sylla quotes Fed Chairman William McChesney Martin as saying in 1952: An independent Federal Reserve System is the primary bulwark of the free enterprise system and when it succumbs to the pressures of political expediency or the dictates of private interest the groundwork of sound money is undermined. (p. 24) Governments find an inflation tax attractive explicitly legislated. Bouvier quotes a French

because it does not have to be director of the Treasury:

Unlike budgetary policy, monetary policy allows us not to have to confront Parliament, not to have to confront touchy trade unions or socio-professional categories. Monetary policy therefore goes with a fairly strong degree of political and social anesthesia. (p. 91) In modern economies, only a small fraction of the revenue raised by inflation derives from seigniorage. Most of the revenue derives from the interaction between inflation and a tax code not indexed for inflation. In the U.S., the central bank abandoned the discipline of the Bretton Woods System and initiated a long period of inflationary money creation in the mid-1960s. At this time, the government needed to finance a politically controversial War. It also had to finance an enormous expansion in social and income transfer programs. The interaction between a progressive income tax specified in nominal terms and inflation generated significant amounts of revenue needed to finance the increase in government expenditure. Inflation is also attractive to the political system because it facilitates the imposition of implicit, unlegislated taxes that transfer income to politically potent constituencies. Inflation is generally associated with government price controls that transfer income to these constituencies. After the mid-1960s the U.S. government became heavily involved in allocating credit to housing. When Reg Q was extended to S&L deposits in 1966, the ceiling on these deposits was set higher than the ceiling on bank deposits in order to allocate credit to housing. High inflation then combined with low Reg Q ceilings on savings accounts to tax small savers. The revenue from this implicit tax accrued to holders of fixed-rate mortgages and to others with a financial interest in the housing industry. Although the Fed maintained the same degree of formal autonomy, it lost its committed independence after the mid-1960s.

R. L Hetrel, Central banks’ independence in

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3. Ongoing competition for control of the central bank The essays in the Toniolo volume make clear that central bank autonomy with discretion produces a continual competition in the political system for control of the central bank. This competition is usually hidden. Bouvier, for example, complains that the archives of the Banque de France are closed so that the student of central banking must rely on the accounts of politicians. These accounts are inevitably self-serving and conflicting. For this reason, the tentative hypotheses advanced below about the nature of competition for control of the central bank derive exclusively from the U.S. experience. Because of the institutional autonomy of the Fed, competition for control of monetary policy in the U.S. is often conducted in public arenas and is, therefore, observable. Power is widely diffused within the U.S. government and different parts of government constantly compete for the ability to exercise power. There is no provision in the Constitution that the Federal Reserve System formulate monetary policy. Although Congress has delegated that authority to the Fed, it has done so without explicit, substantive rules to guide monetary policy. The result is that the Fed must engage in an ongoing competition for effective control over monetary policy with other parts of government. Attempts by politicians to influence monetary policy could derive from a desire to lower ‘high’ interest rates, from a desire for a strong economy to mask a budget deficit, or from a desire to raise revenue from an inflation tax. Apart from wartime, these attempts do not take the form of a direct takeover of the Fed. Instead, they assume the form of pressure on the Fed to take particular policy actions, leaving the Fed to take the heat for bad aftereffects like inflation.

3.1. Competition in the political arena Economists have studied the economics of takeovers and corporate control. In contrast, they have hardly considered how political groups compete for control. Competition for control in the political marketplace is subject to different constraints than competition in the economic marketplace. It is a trite observation that the U.S. is a republic, not a democracy. Political decisions are not made by majority vote of the entire electorate, but by a small body of men. A politician wins elections by selecting a mix of issues. This mix includes a few major issues on which the politician espouses the majority view of the electorate. The mix of issues also includes many issues of primary concern to a single well-defined group whose members vote primarily according to the politician’s position on the particular issue. Although the majority of the electorate might oppose this position in a general referendum, this majority does not weight the particular issue significantly in deciding how to vote.


R. L. Hetrel. Central hanks independence in


The classic example is a tariff that benefits a small group of workers and businessmen, but imposes only a small, hidden cost on a large number of consumers. In selecting these special-interest issues, politicians must protect themselves from accusations that they are pandering to special-interest groups at the expense of the average voter. The art of politics consists of identifying special-interest issues that can be defended by reference to the common good. Tariffs are defended as preventing unemployment, minimum-wage laws as raising the incomes of poor families, etc. Refutation of such assertions involves arguments that appear complex to the voter of average literacy in economics. Much of the debate in the political arena does not involve a substantive examination of implications of particular legislative proposals. Instead, it involves posturing by politicians so that the public perceives them as supporting whatever public good is identified with particular legislation. A second characteristic of the political arena is that voters are asked in an election to consider many complex issues, for example, arms control, nuclear waste disposal, etc. The average voter, whose economic welfare is not disproportionately affected by any one issue, will rationally inform himself only minimally on each issue. For this reason, voters assess a politician’s position on complex issues not just on the merits of his argument. but also on the basis of what they perceive to be his motives. [See Poole (1986).] Voters are influenced by their perception of whether a politician supports a particular position out of cynical self-interest or out of a desire to advance a sociallydesirable goal. Note, for example, presidential debates. Candidates do not attempt to educate or to explain an issue. Instead, they try to align themselves with the public perception of what constitutes an outcome generally recognized as desirable. The Fed chooses procedures for formulating policy that reflect the characteristics of the political arena in which it competes to retain control of monetary policy. Its implicit strategy for monetary policy is chosen in order to be defensible in a political arena where points are scored by the tone of media coverage. Points are scored if a participant successfully aligns himself with a goal perceived by the public as a good, for example, low unemployment. Points are also scored if a participant conveys the impression that his motivation is disinterested public service. The next two sections elaborate the way these characteristics of the political marketplace shape the way the Fed defends its autonomy. 3.2. A caring Fed Newspaper coverage of the economy concentrates on major current economic problems, for example, unemployment near the trough of recessions and inflation near the peak of booms. A standard tactic of politicians desirous

R. L. Hetzel, Central banks’ independence in historical perspective


of influencing monetary policy is to portray the Fed as ‘uncaring’ about the economy’s major problems. Congressmen detail the suffering caused by problem number one and then demand of the Fed chairman what the Fed is doing to deal with it. The chairman had better have a simple, direct answer if he does not want to be portrayed in the media as uncaring. Congressman:

Mr. Chairman, the unemployment rate is in double digits. Children in my district go to bed hungry and families are breaking up because wage earners cannot find work. What are you doing about unemployment?

And two or three years later: Congressman:

Mr. Chairman, the inflation rate is in double digits. Children in my district go to bed hungry and families are breaking up because wages cannot keep up with inflation. What are you doing about inflation?

The Fed’s policy procedures reflect the need to defend itself within this format for debate. These procedures, labeled ‘lean against the wind’ by Chairman Martin, entail setting a short-term interest rate on the basis of the contemporaneous behavior of the economy. The Fed retains discretion to alter the rate it sets on the basis of an ongoing subjective assessment of the priority to assign to either reducing inflation or stimulating real growth. These procedures mean that the Fed is constantly adjusting the funds rate in response to changes in economic activity and inflationary expectations. As a natural by-product, it raises the funds rate when economic activity is strong and lowers it when economic activity weakens. Monetary policy actions are always defensible in a debate where the Fed must regularly produce evidence that it ‘cares’ about the economy’s number one problem. The Fed can always be seen to be doing ‘something’ about that problem. Furthermore, that ‘something’ will ‘look right’, without the need for a defense requiring an explanation of a model of the economy. Although the Fed has at times debated the use of money as an intermediate target, it has never accepted it in this role for any significant period of time. Over short periods of time, there is very little positive correlation between movements in GNP and money. Too often, changes in money do not ‘look right’ in the context of the concerns of the political system. More fundamentally, the Fed is unwilling to specify an explicit strategy for monetary policy that will constrain the setting of its policy variable each period in a way that will ensure the achievement of explicitly formulated ultimate objectives. An explicitly formulated strategy, as opposed to its implicit strategy conducted with discretion, is unacceptable because it would inevitably produce policy actions that common sense suggests are inconsistent with dealing with the public’s contemporaneous concerns about the economy. These actions would


R. L. Hetzel, Centrul hanks’ independence in historical perspective

be indefensible in the political arena where the Fed must defend itself from attack as uncaring. 3.3. A pure Fed In deciding whether to support the position of a politician on a complex issue, voters assess his motivation. If they believe he is disinterested and motivated by a desire to achieve a recognized public good, they are more likely to support his position. If they believe that the politician’s motivation is hypocritical and derives from a self-serving attempt to buy support from a special-interest group, they are less likely to support his position. This assessment of motivations exercises an influence apart from the intrinsic merit of the politician’s position. Fed chairmen have been skillful in this kind of debate. Frequently, politicians’ attacks on the Fed are transparently self-serving, for example, when they attack the Fed for creating ‘high’ interest rates. In response to such attacks, the Fed can criticize the budget deficit of the federal government. Congressmen make it easy for the Fed to suggest that they are making the Fed a scapegoat for their own irresponsible behavior. An instance where the Fed fared poorly in the competition for control over monetary policy occurred in 1972. Through its own actions, the Fed lost its ability to make political pressure for ‘low’ interest rates look hypocritical. Fed Chairman Burns had publicly campaigned for wage and price controls long before they were seized on by the Nixon administration in August 1971. As a consequence, after these controls were imposed, the Fed was unable to argue persuasively against their extension to the interest rates charged on bank lending. Politically, it was impossible to argue that wage earners, but not banks, should bear the cost of price controls. Sylla reiterates the thesis originally developed by Poole (1979) and elaborated by Woolley (1984) that ‘the Fed created all the money it did in 1972 to prevent interest rates from rising to the point that controls on rates would have been legislated’ (p. 34). Extending price controls to interest rates would have ended Fed control over monetary policy. In a forum where debate has little to do with analysis of issues, scapegoating is a significant tactic. The converse of identification of one’s own position with promotion of a recognized public good is identification of an opponent’s position with a recognized public bad. If one’s own motives are disinterested, by implication, the motives of one’s opponents are self-interested. In this game of scapegoating, the Fed must avoid the populist image of a hard-hearted central banker who operates behind closed doors in order to promote the interest of large banks at the expense of the small user of credit. The Fed avoids the image of an agency engaged in the secret exercise of power by cultivating an image of a technically competent agency handling complex problems. Above all, it must cultivate the image of the disinterested public

R. L Hetzel, Central banks’ independence in

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servant in a capital dominated by politically opportunistic politicians. The Fed has been very successful in projecting this image, probably because it possesses significant plausibility in the politically opportunistic world of Washington. These considerations shape the way the Fed implements monetary policy. Fed procedures for implementing policy are designed to allow it to use the interest rate as its instrument without conveying the message ‘the Fed sets interest rates’. Such a message sets the Fed up as a scapegoat for unpopular ‘high’ interest rates. In the 197Os, when the Fed controlled the funds rate directly, it devised procedures that associated funds rate changes with variability in money growth. The tolerance ranges for money growth that triggered funds rate changes were not derived from the four-quarter targets for money, so these procedures had nothing to do with monetary control. They provided an appearance of monetary control, rather than funds rate control, however. The four-quarter targets also provided the appearance of monetary control. Because of base drift in these ‘targets’, however, they imposed no monetary discipline. Apart from the 1970s the Fed has set the money-market rate of interest indirectly with a borrowed reserves target. The Fed then is able to talk about ‘increasing the degree of pressure on bank reserve positions’, rather than about ‘raising interest rates’. This additional layer of complexity in its procedures facilitates the Fed’s explanation of rate rises as due to market forces. The Fed retains use of discount rate changes for occasions when it needs to project the image of a central bank responding vigorously to a recognized problem. The Fed’s public statements emphasize nonmonetary determinants of interest rates, especially fiscal policy. Fed discussions of monetary policy are in practice often discussions of fiscal policy. References to monetary policy are frequently confined to assertions that money demand is unstable. The implicit inference is that monetary policy is complex and should be left to the technically competent Fed. Emphasis on fiscal policy as the primary determinant of interest rates makes attempts by Congress and the Executive Branch to scapegoat the Fed for ‘high’ interest rates appear hypocritical. 4. Summary I have argued that the degree of central bank commitment depends upon the degree of a country’s commitment to the economic arrangements that underlie free enterprise. These arrangements involve voluntary exchange coordinated by the price system, open competition for control over resources, and a stable set of property rights. Because ongoing political pressures act to remove the distribution of resources from the marketplace, they tend to erode a free enterprise system. These pressures provide an impetus to integration of the central bank into the regular political process. Central bank commitment is one aspect of an attempt to commit to the economic arrangements that


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support free enterprise. A country develops ways of committing its central bank to a degree that depends upon its commitment to free enterprise. I also offer some tentative hypotheses about the ongoing competition for control over autonomous central banks that possess discretion. This competition shapes the character of monetary policy and the procedures for implementing it. Central banks design monetary policy in a way that makes it defensible in the political arena where battles for control are fought. References Poole, William, 1979, Bumsian monetary policy: Eight years of progress?, Journal of Finance 34, 473-484. Poole, William, 1986, Monetary control and the political business cycle, The Cato Journal 3. 685-699. Woolley, John T., 1984. Monetary politics: The Federal Reserve and the politics of monetary policy (Cambridge University Press, Cambridge).’