Abstract
Central banks have been involved in the financing of governments since the emergence of the Bank of England in the seventeenth century It has long been recognised that such finance of governments can lead to substantial falls in the value of money and thus in the predictability of its purchasing power and its associated usefulness. A metallic base for money served as a constraint on this until early in the twentieth century, and habit served likewise in many countries until the early 1950s. Habit then broke down. Central bank independence was introduced in part to restore monetary stability. In this article we consider how well that latest attempt has resisted the sharp rise in government spending that followed the COVID-19 pandemic.
Keywords: inflation, independence, public spending, budget deficits
1. Introduction
Many of the commercial government banks that later became central banks were initially both privately owned and given privileges in return for raising funds for the monarch. That is a legacy which has hung over central banks ever since. The fear that they will monetise government debt unless somehow constrained has always been present.
More recent is another fear: that political control of monetary policy will be used for electoral ends and will thus ultimately damage real and monetary economic stability. The second fear meant that towards the end of the twentieth century it became fashionable for countries to give their central banks ‘independence’ – in New Zealand and in the United Kingdom, to give two examples of many.
Further, it was made obligatory for countries which wished to join the euro to first make their existing central bank independent. This may in part have been motivated by a desire to avoid political manipulation but was also the result of the fear of inflation that the 1920s experience had instilled in much of Europe.
But what is this apparently all-important independence?
Numerous economists have written on the subject, but they have almost always paid attention to how to measure some undefined notion of independence rather than discussing what the term might actually mean. The context was the relationship between degree of independence, somehow measured, and inflation. This was raised in two papers by Barro and Gordon (1983a, 1983b). The pioneers in testing whether there was a relationship between low inflation and independence were Bade and Parkin (1987). Subsequent studies typical of the approach were Masciandaro and Tabellini (1988) and Alesina (1988, 1989). Capie and Wood (1991) reconsidered the issue using a wider range of measures of independence and a longer data period. Broadly speaking, the findings of this work were unanimous: independence did correlate negatively with inflation though, as Capie and Wood (1991) note, in some countries inflation was low regardless of the status of the central bank.3
None of these studies spent much time on what independence actually meant. In a much earlier paper, however, one which concluded by recommending not central bank independence but a monetary rule as the best guarantee of price stability, Milton Friedman (1962) devoted some time to considering the meaning of independence.
He wrote, ‘[t]he device of an independent central bank embodies the very appealing idea that it is essential to prevent monetary policy from being a day-to-day plaything … of the current political authorities’ (Friedman, 1962. Republished in Friedman,1968, 178 Page references are to the reprint). He went on, ‘a first step in discussing this notion critically is to examine the meaning of “independence” of a central bank. There is a trivial meaning that cannot be the source of any dispute about the desirability of independence. In any kind of bureaucracy, it is desirable to delegate particular functions to particular agencies’ (p. 179). What he called a more basic meaning of independence is that ‘a central bank should be an independent branch of government coordinate with the legislative, executive, and judicial branches, and with its actions subject to interpretation by the judiciary’ (p. 179).
That is the meaning which most writers have implicitly applied to the concept of an independent central bank. Friedman reviewed three proposed solutions for the problem of ensuring that so long as government is responsible for money, it cannot by debasement abuse that responsibility. The solutions were an automatic commodity standard, an independent central bank, and a rule binding the conduct of policy. An automatic standard, such as gold, has tended to develop towards a ‘mixed’ system with a substantial fiduciary component. Further, it is not now feasible because ‘the mythology and beliefs required to make it effective do not exist’ (p. 177).
That point is supported by the well-known quotation often attributed to Ramsay McDonald, the prime minister in the government immediately before that which took the decision on Britain’s leaving the gold standard in 1931: ‘No-one told us we could do that.’4
Many advocates of an independent bank recognise the current impossibility of a commodity standard and view an independent bank as an alternative way of attaining price stability. Hence, together with the widespread acceptance that inflation is not desirable, we have central banks given instructions to focus on maintaining some measure of price stability.
That focus does not absolutely preclude any purchases of government debt by the central bank, but it does limit them so that the resulting money growth does not threaten monetary stability. Here we come to the importance of the COVID-19 crisis. The pandemic led, almost worldwide, to pressure on government finances and a consequent surge in government debt. Has that debt been monetised such that it will lead to damaging inflation?
2. A precedent
The Reserve Bank of New Zealand was the first modern example of an independent central bank. This was part of a complex set of responses to major problems in the New Zealand economy. By mid-1984, a crisis was believed to have arrived. (Knight, then Deputy Governor of the Reserve Bank, wrote of ‘a disastrous outcome for the New Zealand economy by the mid-1980s’ (1991).) Following a change of government there was widespread acceptance of the need to change both the nature and the direction of economic policy. A sustained programme of reform, affecting the institutions which designed and implemented policy as well as the policies themselves, was launched.
As part of these reforms of policy, the ‘mechanics’ of the public sector were reformed. Clear objectives were established for public sector organisations; accountability for the attainment of the objectives was assigned; performance-based contracts were given to the chief executives of the organisations; and they were given much increased management and financial freedom within a framework of agreed policies and total budgets.
A revision of the Reserve Bank Act was also undertaken. After some detailed study of central banks which had been more successful than average in delivering low and steady inflation, the Act was drafted, passed with bipartisan support in December 1989, and became effective on 1 February 1990.
The Reserve Bank was given a clear statutory objective. The primary function of the Bank was to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices (Reserve Bank Act 1989, s8). That was the primary, not the only, function. But it was the only macroeconomic function. (The Bank retained regulatory and supervisory responsibilities for commercial banks.)
Notably, there are no limits on the central bank’s ability to finance the government. It may seem curious that there should be no restrictions on debt monetisation, particularly as New Zealand had in the past experienced inflation because of such monetisation. Legislation against this was, however, thought to be both unnecessary and undesirable: unnecessary in view of the full-funding commitment the government had previously adopted, and undesirable because it could constrain actions undertaken for, say, liquidity management or in the course of a lender of last resort operation.
Insofar as there were lessons learned from this experience, one emerges from a comparison with the UK. Both countries have a majoritarian form of government – that is to say, a majority in parliament gives close to unchecked authority. There are few ‘veto points’ where a change can be blocked. Hence it is perhaps no surprise that a new government in the UK, which took office in 2010 after the financial crisis, made substantial changes to the structure of regulation and to the relationship of the Bank of England to that structure. But changes to the inflation mandate were not considered, and concerns about the Bank’s internal government were essentially ignored. In contrast, no changes took place in New Zealand after the crisis.5 This reflects several factors. There was of course no widespread financial crisis in New Zealand – there were substantial problems, but in one part of the financial sector only, and that a part outside the remit of the Reserve Bank (see Mayes and Wood, 2012). But it is also worth remarking that the Reserve Bank had a constitution which actually encouraged it to think about financial stability and the role of the Bank as lender of last resort.6 That was, explicitly, the reason that there were no restrictions on Reserve Bank purchases of government debt. Hence the specification of the Reserve Bank Act had been such as to make the institutions it produced more robust.
3. A general crisis
Banking crises can be of two types, although they rapidly merge into one another. The classic banking crisis is that which lender of last resort evolved to deal with: a sudden surge in the demand for liquidity by the greater part of – possibly the entire – banking sector.7 The New Zealand Act was consciously framed both to direct the attention of the Reserve Bank to the possible need for this operation and to allow it to take place.
But there is another type of banking crisis, much rarer in the whole run of recorded banking history but one that has occurred twice in comparatively recent years – one due to a shortage of capital not in one bank but across all or most of a banking system. This was the source of Japan’s banking problems and also the original difficulty in the Global Financial Crisis (see, for example, Lastra and Wood, 2010).
There is no provision in the Reserve Bank Act to deal with a ‘capital’ crisis. There could have been. For while there could be no instruction for the Reserve Bank to provide capital when needed – as with all central banks, its balance sheet is too small to allow that – there could have been formal procedures under which it could approach government to request capital support under certain circumstances. This provision was not there. It was not there because it was thought that such a crisis could never happen, nor was its absence due to a desire to allow banking system failure under such circumstances. Rather it was due to no more than lack of complete foresight, and thus the inability to write a complete contingent contract dealing with all possible states of the world.
And that is the fundamental problem, if it is in fact a problem. It is impossible to design a contract so complete that nothing ever happens to require its being rewritten, thereby letting the government of the day tame or at the least reshape the central bank. That is the basic reason for almost every financial crisis leading central banks into the arms of government for assistance, relaxation of law, or some other form of support or guidance.
This is exactly how the COVID-19 crisis can lead central banks into the arms of government – or, perhaps better put, can lead governments to seize central banks in their arms. A sudden increase in the demand for finance, regardless of the cause, can do it.
4. Some English historical experience
We next review some historical experience in one of the world’s major central banks, the Bank of England. We concentrate on this because it was the model for many other central banks, and because it illustrates many aspects of the problems we discuss.
The Bank of England was founded in 1694 out of the needs of the state to finance war. In return, the Bank was given a charter from the state that gave it a privileged position in banking in the country. The renewal of the charter clearly rested on the Bank’s satisfying the state’s requirements. And so began a relationship of dependency. The state needed the Bank and the Bank relied on the state for its privileges. When the Bank’s charter was renegotiated in 1697, for ten years, it was given protection from competition from rivals; its position was strengthened further in the renewal of 1708 when a fresh loan was required from the Bank. At the renewal of 1715 its privileged position was further enhanced when it was given the job of managing the government’s debt. The Bank’s position depended on its fiscal usefulness to the state.
In the nineteenth-century age of laissez faire, the Bank’s independence was still limited. The Bank’s essential function was management of the gold standard and it was constrained by the rules of the standard, particularly after these were redefined in the 1844 Act. The main objective was to maintain convertibility of the currency into gold and the main control instrument was the short-term interest rate. The interest rate was made effective by discounting bills and, increasingly as time passed, by open market operations. These were all things the Bank became expert in and it was left to get on with the job without political interference.
However, a financial crisis that involved a scramble for cash presented a serious problem. In the crisis of 1825 the government instructed the Bank to pay out to the last penny (Feaveryear, p 237.). Instruction was thought to be needed as it was feared the still privately owned bank might otherwise have looked after its immediate profits due to either insufficient attention to the long term or caution over its own survival. The 1844 legislation made it difficult for the Bank to perform its key role in a crisis, that of lender of last resort. The Act needed to be suspended and that required a letter from the Governor to the Chancellor seeking the necessary exemption. That happened in the crisis of 1847 and again in 1857. Then, at the height of the Victorian boom in 1866, crisis struck again in the famous case of Overend Gurney. The Chancellor agreed that it was ‘requisite to extend their discounts and advances upon approved securities, so as to require issues of notes beyond the limit allowed by law’. But he continued: ‘No such discounts or advance, however, should be granted at a rate of interest less than 10 per cent, and Her Majesty’s Government reserve it to themselves to recommend if they should see fit, the imposition of a higher rate’ (quoted in Fetter, 1978 [1965]; see also Gregory, 1964 [1929]).
When crisis struck, government dictated how the Bank should behave. Fetter concluded of the nineteenth century, ‘the Bank and the Government … continued the fiction of official independence’ (Fetter, 1978 [1965: 280).
4.1 First World War years
That was true again on the outbreak of war in August 1914, when there was a major crisis. The Governor was invited to Downing Street and told to sign a statement and to promise that during the war ‘the Bank must in all things act on the direction of the Chancellor of the Exchequer whenever in the opinion of the Chancellor the national interests are concerned and must not take any action likely to affect credit without previous consultation with the Chancellor’ (Sayers, 1976: 99–107). Cunliffe, the Governor, initially refused to sign and had the support of the Bank, where, they believed, ‘it was impossible for the Bank thus to renounce its functions’. But some face saving was allowed and Cunliffe agreed to comply.
The Governor throughout the interwar years, Montagu Norman, made it clear that ultimate authority rested with the Treasury. ‘I assure Ministers that if they will make known through the appropriate channels what they wish to do in furtherance of their policies they will at all times find us willing with good will and loyalty to do what they direct, as though we were under legal compulsion.’8 Norman went further than that when he told a meeting of Commonwealth bankers, ‘I am an instrument of the Treasury’.
4.2 Post-Second World War
It is often assumed (or asserted) that after the Bank was nationalised by the Labour government in 1946 everything changed and the Bank thenceforth became a subsidiary of the Treasury. But in fact very little changed. While there were complex drafting requirements to specify the functions, powers, and purposes of the new public corporations being formed after the war, in the case of the Bank this was unnecessary because there was ‘never any question that it should not continue doing what it had been doing for a very long time’ (Chester, 1975: 196).
Throughout the period from the 1950s to 1980 the Bank operated with considerable freedom, with what it liked to think of as independence (see Capie, 2010: 773–780). Its principal function of defending the exchange rate was restored. Things were as they had been in the golden age before the First World War. Many actions were taken but most important was the use of its oldest instrument – Bank Rate. Bank Rate was regarded as primarily of use for external purposes. And movements in Bank Rate were not merely executed but were determined by the Bank. The Bank argued that knowledge of interest rates was a key part of their expertise and they knew better than any other part of government where interest rates should be and when they should be changed. Whenever there was a developing threat to sterling, the Governor would tell the Chancellor that a rate change was proposed on a particular date. The Chancellor’s reply was simply a one-line memo of approval. There were only a few isolated cases of resistance or postponement (see Capie, 2010: chapters 4, 5, and 6). The relative freedom began to come under serious pressure in the 1970s following the loss of the explicit exchange-rate target. When monetary targets were in place, monetary policy was increasingly politicised and politicians and civil servants had a simple number which they wanted to see met or to be told why it was not. Further, as these monetary targets were chosen domestically, they could if desired be changed, even to facilitate lending to government.
Thus it can be seen that from the Bank of England’s founding a dependent relationship with government was accepted. Since the country was at war more often than it was not between 1688 and 1815 and the state needed funds, it needed the Bank, and the Bank depended on the state for preservation of its privileges. What can be called the ‘fiscal threat’ was almost always present.
4.3 Post-Global Financial Crisis years
The financial crisis of 2007/2008 exposed weaknesses in the mandate given to the Bank of England, as well as defects in how the Bank (and the Financial Services Authority) responded to the crisis. This inevitably required not only action from the government to deal with the crisis, but also changes in the mandate. The former plainly compromises central bank independence. Does the latter? The changes have concentrated authority in the Bank, but of course a consequence of this is that there is more that can go wrong and affect the Bank’s reputation and thus its authority.
There are some similarities with the US Federal Reserve (the ‘Fed’). Much of Allan Meltzer’s history of the Fed is concerned with its independence. ‘The purpose of independence is to prevent government from using the central bank to finance its spending and budget deficit’ (2009: 1256). But Meltzer argues, following Friedman, that independence needed to be defined in law. If it were not, its interpretation was left to its Chairmen and Board of Governors. A fundamental problem, according to Meltzer, was the failure of the Fed ever in its history to set out its lender of last resort policy. On some occasions it would respond in one way, and on other occasions in another way, depending on the views being taken at the time by either the Chairman or the Board, thus generating uncertainty. Nowhere was this more evident than in the 2007/2008 financial crisis.
Meltzer argues that in the years 2007–2009 the Fed lost much of the independence it had regained in the 1980s: ‘[Bernanke] worked closely with the Treasury and yielded to the pressures from the chairs of the House and Senate Banking Committees and others in Congress’ (2009: 1243). Further, he states that he ‘has acted frequently as a financing arm of the Treasury’ (2009: 1256).
In 2008 the Fed almost trebled its balance sheet, much of it in illiquid assets. The policy of ignoring inflation and claiming to be concerned solely with unemployment, the other goal of the Fed, continued into 2012. The dual mandate allowed something that was politically convenient but, as Taylor (eg 2011.) argues, far from obviously either effective or even worth trying.
5. The European Central Bank
If ever a central bank were designed to be independent in the sense of entirely free of political influence, it was the European Central Bank (ECB), with the Bundesbank as its template. It was made quite explicit that political interference would not be tolerated. However, in the context of the banking crisis and subsequently of the COVID-19 crisis, the behaviour of the ECB can surely only be described as political. It has bought government debt not in the conduct of monetary policy but to finance governments. The ECB has denied this but its willingness to buy the debt of governments seen as bad risks must raise doubts. There is a justification given for these purchases – they are intended to make the monetary transmission mechanism work across the whole area, a phrase interpreted by the ECB as keeping rates on the debt of all Eurozone governments within a narrow corridor. But that justification is not robust. And that is for the major reason that debt markets and banks in certain countries are shunned over doubts about solvency. Again, independence has not withstood a crisis. Rather, the central bank adopted a politically chosen goal other than the one it was given, under extensive and well-reported pressure.
It has behaved as if all Eurozone government debt is of equal standing. It may seem bizarre to be concerned about debt issued by a sovereign; such governments do not default. That is a lesson often drawn from contrasting the experience of countries which have got into grave financial difficulties after borrowing in another country’s currency, with the experience of countries which borrow solely in their own. But to apply that to the Eurozone is to conflate two meanings of ‘sovereign’. Eurozone countries have shared and not given up their sovereignty in the European Union – except when joining the Eurozone, when they give up monetary sovereignty, the control over their national monetary policy. They no longer have a national monetary policy. They do retain some influence over the monetary policy of the ECB, but it is dilute influence over a monetary policy not exclusively their own.
Hence there can be legitimate concerns about the ability of the ECB to resist fiscal pressures. Some members may wish to resist them, but others do not. Despite its constitution, the ECB has manifestly had its independence compromised by the COVID-19 crisis. But, as has been argued above, central banks have always been potentially if not always actually subject to the fiscal demands of government.
6. Conclusion
It may seem tempting to conclude by constructing a counterfactual, so as to consider what a ‘truly independent’ central bank might have done in the two most recent crises, the banking one and the COVID-19 one. But we resist that temptation, as the whole argument of our article is that such a truly independent central bank cannot exist. There is, however, another and more fruitful way of getting close to the question. What might a central bank guided by and adhering to the principles set out by Thornton, Bagehot, and Hawtrey have done in these circumstances? The answer is clear. They would have provided liquidity until the liquidity aspect of the crisis was over. They would have had nothing to do with the provision of capital to support individual banks – that is not their responsibility, beyond their balance sheet capacity, and it is a contradiction of the principles guiding lender of last resort action. As for buying almost all the debt the government cared to issue, that would certainly not have been done – the harm to price stability that would follow had been abundantly illustrated during the Napoleonic Wars.
An altogether different approach was chosen in most major countries. James Bullard, President of the Federal Reserve Bank of St. Louis, said, ‘I am a little – maybe more than a little bit – worried about the future of central banking. We’ve constantly felt that there would be light at the end of the tunnel and there’d be an opportunity to normalise but it’s not really happening so far.’ (Bullard, 2012)
That describes very well what has happened to the ‘independent’ central bank of every major Western economy, not just in the financial crisis James Bullard was discussing, but also in the more recent COVID-19 crisis. The history of central bank dependence on government does not need to be revised.
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