Thursday, November 1, 2012

The vanishing independence of central banks

As I have claimed recently, central banks have lost considerable independence in the current crisis. Indeed, both the US Federal Reserve and the European Central Bank engage in quasi-fiscal policy because the corresponding governments do not or cannot apply proper fiscal policy. This means that what the politicians do not do, the central bank has to. This is almost as if the politicians would tell the central bank what to do.

But is central bank independence really what we need? As Marvin Goodfriend highlights, a central bank that is completely independent can leads to stop-and-go monetary policy and inflation bursts, as past history has shown. This has been fixed by imposing on central banks a price stability mandate. But central banks have no bounds on their credit policy. Look at the Fed now: it increased its balance sheet to proportions never seen before. That may be OK under some very special circumstances, but the current ones violate the principles that Walter Bagehot set for the Bank of England: the central bank should stand ready to stabilize the financial markets by lending any required amount at an interest rate above market rates. And now they are certainly below market, and for a long time. The solution is to get back to Bagehot's principle and imposing that the central bank cannot lend below market. And this will force the politicians to conduct proper fiscal policy, because the central bank will not.

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