Central Bank Independence and the Future of the Euro

Panicos Demetriades

• Publisher: Agenda Publishing
• Year: 2019
• ISBN:
  9781788212861
• Topic: Economia
• Subtopic: Settore bancario

Over the past decade central banks have taken on new and expanded roles in an attempt to manage the global financial crisis. The European Central Bank (ECB) has been no exception. If anything, because of the incomplete architecture of the euro, the ECB has faced more serious challenges than either the Bank of England or the Federal Reserve. With the onset of the euro crisis, the ECB was forced to take on powers that went well beyond the conventions of standard monetary policy to prevent European Monetary Union from unravelling.

Panicos Demetriades, former Governor of the Central Bank of Cyprus during the country's bailout in 2013, examines the role of the ECB and its adoption of these new powers, which have led to legal and political challenges, high level resignations and the controversial removal of central bankers from their posts without due process. Demetriades argues that at a time when stability and action are needed to secure the future of the euro, the very foundations of the Euro-system are being eroded, namely its ability to act independently. The book provides a lively and insightful account of the processes that can make or break the euro.

1

Central bank roles: historical context

From financing wars to inflation targeting: a brief history of central banks

Central banks are institutions that issue currency, provide banking services to governments and commercial banks and have responsibility over monetary policy, including setting short-term policy rates (at which they provide short-term liquidity to commercial banks through monetary operations). Often central banks have responsibilities relating to financial stability, which sometimes include regulating and supervising commercial banks and, more recently, resolving banks that are failing.

Central bank legal frameworks vary considerably from country to country, largely reflecting differences in attitudes shaped by diverse historical experiences. A key feature of the European Central Bank (ECB), unlike the United Kingdom’s Bank of England (BoE) and the United States’ Federal Reserve (the Fed), is that it is explicitly prohibited by the Treaty on the Functioning of the European Union (article 123 – known as the monetary financing prohibition) from financing government deficits. Moreover, although all three central banks have mandates in which price stability is central, price stability is the ECB’s overarching objective: it can support other goals, including financial stability, growth and employment, only to the extent that they do not interfere with price stability. By contrast, the Fed has a dual mandate set in law: it aims to maximize employment and stabilize prices (as well as moderate long-term interest rates). The Bank of England’s objectives are set annually by the government, however. Ever since the bank was granted operational independence, in 1997, the main aim of monetary policy has been the achievement of low and stable inflation; other government objectives, including employment and growth, have been subordinated to price stability – very much like the ECB. Nevertheless, although, in the BoE case, the mandate can be changed by the government in any given year, the ECB’s mandate cannot change without a revision in the TFEU; such a change requires unanimous agreement by all EU member states.

The Swedish Riksbank was the first institution recognized as a central bank. It was established in 1668 as a joint-stock bank, and chartered to lend funds to the government and to act as a clearing house for commerce. It was followed by the Bank of England, which was established by royal charter in 1694 to raise money to fund a war with France. The Bank of England was also a joint-stock company. Over 1,200 people purchased the stock of the bank, totalling £1.2 million, which was the value of the loan made to the government by the bank. The first shareholders of the BoE came from a wide variety of backgrounds; they included carpenters, grocers, merchants, knights and royalty. The Banque de France was established in 1800 by Napoleon I, with a specific remit to stabilize the currency after the hyperinflation of paper money during the French Revolution. Over time, early central banks came to serve as banks for commercial banks, holding their deposits and providing emergency loans during times of financial distress, which explains their emergence as lenders of last resort.

During the gold standard period, which prevailed until 1914, central banks held gold reserves to ensure that their notes could be converted into gold. Maintaining gold convertibility served as the economy’s nominal anchor. As the price of gold was determined by market forces, early central banks were, in effect, strongly committed to price stability. During the same period, however, the first tensions between maintaining price stability and financial stability emerged. At times of financial distress central banks often refused to provide liquidity to commercial banks, opting instead to protect their gold reserves. The Bank of England, for example, was severely criticized for precipitating the panics of 1825, 1837, 1847 and 1857. Stability returned when the BoE adopted Walter Bagehot’s “responsibility doctrine”, whereby it would place the public interest above its private interest by lending freely against any sound collateral.

The early history of central banking in the United States was even more turbulent than in Europe, not least because of Americans’ deep-seated distrust of concentrated financial power and government intervention.¹ The first two central banks, both of which were modelled on the BoE, were relatively short-lived, as they failed to have their charters renewed when they expired. The first Bank of the United States was established in 1791 and operated until 1811. The second Bank of the United States was established in 1816 and lasted until 1836.

The period that followed is known as the free banking era. It lasted until the onset of the US Civil War, in 1861 and was characterized by virtually free entry into banking, minimal regulation, several banking panics and numerous bank failures. In addition, the payments system was notoriously inefficient, because of the extremely large number of dissimilar-looking state bank notes circulating, alongside numerous counterfeits; counterfeiting became a profitable business precisely because of the lack of a uniform currency.

In 1913 the Federal Reserve was created and given a mandate of providing a uniform and elastic currency and to serve as lender of last resort. The Fed’s monetary policy in the 1920s and 1930s, however, which followed the real bills doctrine, prevented it from being effective as a lender of last resort, as reserve banks would lend only against eligible self-liquidating collateral. As a result, the Fed failed to prevent banking panics, many banks failed, the money supply collapsed and massive deflation and depression followed.

The early history of central banking in Europe and the United States reveals that central banks were created in order to supply banking services to governments and to issue and manage a country’s currency. Fairly early on in their history central banks started acting, reluctantly at first, as lenders of last resort for commercial banks facing financial distress (Goodhart 1988). It was only after the First World War that central banks began to be concerned with macroeconomic stabilization and, more specifically, employment fluctuations. This development was very much in response to the changing political economy conditions emanating from the Great Depression and the rise of labour movements worldwide. In the three decades that followed the Second World War central banks became much more activist in terms of stabilization policies, reflecting the widespread adoption of Keynesian ideas, shaped by the failures that had led to the Great Depression. A related idea that became influential among policy-makers during this period was the Phillips curve, which pointed to the existence of a trade-off between inflation and unemployment. If policy-makers wanted to reduce unemployment, they had to accept a permanently higher rate of inflation.

The oil shock of the early 1970s led to the build-up of considerable inflationary pressures, however, and “stagflation” – namely high unemployment and inflation – as policy-makers erroneously responded to a supply-side shock by stimulating aggregate demand. These developments initially led to the adoption of monetarist ideas in the conduct of monetary policy in the 1970s and early 1980s, which involved trying to reduce the growth rate of the money supply in order to bring inflation down. In its purest form, the quantity theory of money envisages a dichotomy between real and monetary variables – the “classical dichotomy” – in which employment and GDP are determined by real factors while inflation is, as Milton Friedman proclaims, “always and everywhere a monetary phenomenon” (Friedman 1970). Monetarists challenged the idea that the trade-off between inflation and unemployment is a permanent one by introducing inflation expectations into the Phillips curve and by arguing that, in the long run, unemployment will return to its “natural” rate, which is determined by the structural features of the labour market. Unemployment, they argued, could be kept below its “natural rate” only if inflation was not anticipated. If inflation expectations were adaptive, the attempt to keep unemployment below the natural rate required ever-accelerating inflation. Further refinements of these ideas were associated with the emergence of the new classical school of thought, which put forward the notion of “rational expectations” and the Lucas critique. These developments highlighted the dangers of forecasting using models that rely on empirical relationships such as the Phillips curve (Lucas 1976). If policy-makers use – or even abuse – such relationships, Robert Lucas argues, they will sooner or later break down, as they are not structural relationships.

Although monetarist ideas influenced monetary policy in the 1970s and 1980s, it became quickly apparent that control of the money supply was fraught with many difficulties and that, in any case, the relationship between inflation and money growth was not stable enough to conduct monetary policy on that basis. Thus, monetary targeting began to be abandoned from the early 1980s onwards. At more or less the same time it was also recognized that the credibility of monetary policy suffered if it was seen to be in the hands of elected politicians. As a result, monetary policy came to be increasingly delegated to independent central banks mandated with stabilizing the macroeconomy around a low target rate of inflation. This monetary policy framework – known as inflation targeting – was first introduced formally in April 1988 in New Zealand, where it succeeded in bringing inflation down from around 16 per cent per annum in 1987 to around 2 per cent per annum in 1992. New Zealand’s example was followed by Australia and Sweden in January 1993 and March 1993, respectively. The Bank of England adopted an inflation target in 1992 but did not become operationally independent until 1997. The European Central Bank has been independent since its inception and has been targeting inflation since the creation of the euro on 1 January 1999. The US Federal Reserve, which has been operationally independent in the conduct of monetary policy, formally adopted an inflation target of 2 per cent in January 2012, although evidence suggests it had been informally targeting inflation at the same rate since the mid-1980s.²

More often than not, inflation targeting emerged as a political response to the inability of elected politicians to achieve macroeconomic stability. In the United Kingdom, the BoE was made operationally independent by the newly elected Labour government of Tony Blair soon after it took office in 1997. The bank, at the same time, became accountable to meet the target; failure to meet the target came with the obligation to explain why it failed to do so in an open letter to the Chancellor of the Exchequer. Before 1997 interest rates were set by the UK government, with an eye on elections and politics (see Box 1.1).

In Europe, the ECB was created from the blueprint of the German Bundesbank – a fiercely independent central bank with an outstanding record in controlling inflation. The idea was to emulate the Bundesbank’s success throughout the monetary union. For countries with a poor record in controlling inflation, such as Italy and Greece, this was a very attractive proposition, as they stood to benefit from the credibility of the ECB.

Monetary policy under inflation targeting can be described in terms of two policy variables: a medium-term inflation target, which serves as an inflation anchor; and a response of interest rates to macroeconomic shocks that create fluctuations in inflation and output. Although the overriding objective of monetary policy is to ensure that, on average, inflation is equal to the target, there is also a subordinate decision of how to respond to shocks as they occur (King 1997). The success of inflation targeting rests on the central bank’s credibility, which is critical for anchoring inflation expectations. Central bank independence (CBI) is, in fact, a sine qua non for central bank credibility. After all, the whole point of delegating monetary policy to unelected bureaucrats is to convince economic agents that politicians, who are subject to electoral pressures, are not involved in the setting of interest rates. Credibility additionally requires the central bank to communicate its actions in a clear and transparent manner and to be accountable for its actions to parliament and the general public. To this end, monetary policy decisions in an inflation-targeting framework are always followed by press conferences in which the decisions are communicated and explained.

Box 1.1 How the Bank of England was set free

In an article in the Financial Times on 5 May 2017, former Bank of England Governor Mervyn King provides some fascinating insights into the politics behind monetary policy decisions prior to 1997.

Governments would often “reward themselves” with a rate cut after a satisfactory reception of a budget. Elections influenced both the nature and timing of decisions on interest rates. Moreover, decisions would be made without systematic analysis or process.

Although a more systematic approach was introduced after 1992, when an inflation target was adopted, politics was never far away. King refers to one occasion when a Chancellor of the Exchequer said at the beginning of a meeting to discuss interest rates: “I want to make it clear that interest rates are not going to change but now I have made that clear I would like to hear the arguments.” By contrast, today interest rate decisions are determined by majority vote of the nine-person Monetary Policy Committee, following several days of deliberations and analysis.

The Bank of England’s independence certainly helped remove inflation from a major source of concern among businesses and households. By contrast, inflation seemed like an intractable problem in the 1970s, when it reached 27 per cent. Even in the 1980s, when Margaret Thatcher was prime minister, it averaged 8 per cent. Since the Bank of England became independent in 1997 it has remained low and stable.

Ironically, as King explains, the Bank of England was made independent 200 years to the month after a raid on the Bank of England’s gold reserves by the then prime minister, William Pitt, and the suspension of convertibility that led James Gillray to draw the cartoon that inspired the “Old Lady of Thr...