Independent Central Banks? R.I.P.

On the day that ECB President Draghi provided more details over his plan to support the euro and monetary union over the objections of the Bundesbank President Weidmann, it may seem counter-intuitive to say, but ultimately, Weidmann is right. 

The ECB's bond buying plan is in fact "tantamount to financing governments" even if the monetary impact is sterilized. Spain and Italy have increasingly relied on financing deficits and debt with shorter-term instruments. Weidmann intimates that this subjugates monetary policy to fiscal policy and puts at risk the independence of the central bank.

Exactly what should a central bank be independent from? In whose name does it make its decisions? 

Lord Acton famously said that power corrupts and absolute power corrupts absolutely. That is a pre-modern understanding of power. One of America's contributions to political theory is not to eschew power per se, but to hold it accountable with checks and balances (see Federalist 10, for example).

Of course, the conventional wisdom is that monetary policy is so important we want to it be conducted independent of politicians, who could manipulate it for short-term crass political objectives. Yet, few, if any, would make the same argument about national security, that it is too vital to leave to politicians. Civilian authority over the national security apparatus is a hallmark of parliamentary democracies. And while, there are "wag the dog" tales, there is little evidence that short-run political gain was the major consideration in the examples often cited.

The kind of issues that central banks face that conventional thinking wants to insulate from politics are not really technical issues, such as the precise collateral rules, but vitally important issues and trade-offs, like the Phillips curve, that posits an inverse relationship between the rate of inflation and the rate of unemployment. Assuming the Phillips curve is valid for the sake of this exercise, that trade off is fundamentally political in nature.

From a somewhat larger perspective, what is at stake is the distribution of scarce resources between creditors and debtors and that is ultimately not a technical issue but a question of values. The mantra of an independent central bank is really protect the interests of the creditors over the debtors. In order to deal effectively with the crisis, we need both the politicians in the treasury and finance departments to be working with central banks; not at cross purposes.

The ECB's decision today to buy what it says will be unlimited (and we think that simply means unspecified amounts) amount of short-term sovereign debt obligations and on pari passu basis (no senior creditor status) are not technical issues in the least. The bond buying forces other countries, not just Germany, to share in the new risks to the ECB's balance sheet. It also forces tax payers (through the central bank) to take the same haircut as an investor who chose to buy a peripheral debt instrument.

Weidmann is right. These issues are not technical but political in nature and should be authorized by democratic institutions. Those democratic institutions, namely elected governments, agreed to certain modes of behavior and rights and obligations. The ECB has abridged those agreements. To whom is the ECB accountable to then ?

Just like after the Great Depression, the national government's balance sheet and deficit spending became a conventional tool to underwrite aggregate demand, so too out of this crisis, it appears central bank balance sheets will be a permanent or quasi-permanent feature for years to come.

The concept of independent central banks became fashionable after the inflation of the 1970s. It reached its pinnacle under the Reagan-Thatcher era. It has been greatly diminished. And inflation has not run rampant. The interests of the creditors has not been run roughshod over.

The notion of independent central banks itself is more myth than reality. The independence may have been from immediate political control and accountability, but they were not independent. They were the institutionalized arm of creditors. They either acquiesced or actively advocated the interests of the creditors and of course, in the wake, created larger, if not more, debtors.

There will be some who mourn the independent central bank. We say the central banks were never really independent and given the political nature of their decisions, need to be held accountable to what Weidmann called "democratic authorisation". 

The Federal Reserve is a compromise formation as its three mandates (price stability, full employment, and long-term interest rate stability) is a way to institutionalize the interest of both creditors and debtors. Yet as market participants know well, it is rarely about either/or and more often about trade offs. There is a fine line between what has come to be known as independent central banks and plutocracy.