Jerome Powell was a few months into his job
as the Chair of the Federal Reserve when
U.S. President Donald Trump complained
about the central bank’s policies.
“I put a very good man in the Fed.
I don't necessarily agree with it, because
he is raising interest rates.”
He’s not the only one complaining.
Italy, India, Turkey and Argentina are just
a few of the countries seeing leaders push
back against central bank independence - and
some are succeeding.
In the last few years, we’ve seen
central bankers get fired,
resign and have their decisions
and motivations questioned.
That's led to a number of voices declaring
that the independence of these public
institutions is under threat.
But why do we even care whether central
banks are independent or not?
It’s kind of a long story.
Let’s go back almost a hundred years
for some context.
After the First World War, Germany was in
a lot of debt and its costs were racking up.
Soldiers needed pensions.
War widows needed compensation.
France and Great Britain were
demanding massive reparations.
And other countries did not want to lend
Germany any money.
So Germany’s central bank printed more and
more money and loaned it to the government,
hoping to make up the difference.
What they ended up with instead was hyperinflation.
All that cash caused prices to skyrocket.
At the height of the crisis, hyperinflation
reached rates of more than 30,000% per month,
meaning prices were doubling every few days.
That’s why in some historical photos, you’ll
see Germans burning cash to keep warm
because it was cheaper than buying wood.
This – and more recent examples like the
hyperinflations in Zimbabwe and Venezuela – has
shown us the damage out of control inflation
can to do an economy and its people.
So when the Bundesbank became Germany’s
central bank in 1957, its laser focus on a
stable currency and keeping out of control
inflation at bay were no surprise.
It was the first central bank to be given
full independence, and it quickly gained
the reputation of being the world’s most independent
and conservative central bank.
At the same time, the Bank of England and
most of its European counterparts were still
controlled by their governments.
Let’s get into why that matters.
Throughout the 1960s, most policymakers believed
you could permanently lower unemployment by
accepting higher inflation. This economic
concept is known as the Phillips Curve.
So conventional wisdom was that the central
banks could increase the money supply, inflation
would go up a bit, and more
people would have jobs.
It sounds great, right?
Politicians loved this idea too.
After all, a low unemployment rate is helpful
when you’re trying to get reelected.
Take former U.S. President Richard Nixon.
He inherited a recession when he was
inaugurated in 1969.
"Our destiny offers not the cup of despair,
but the chalice of opportunity."
And when it came time to getting reelected he was
focused on keeping the economy moving.
The best way to do that, he thought, was to
lower interest rates.
"A lot of the people are going to say, well here we
go back into high interest rates again..."
...I don't think that's a justified assumption."
Behind closed doors, he pressured the Federal
Reserve Chairman to do just that,
and even though the Fed is supposed to
be independent from the government,
the central banker appeared to comply.
The economy got its boost, and Nixon was reelected.
But he got a rude awakening not too long after that. Enter the Great Inflation, the first prolonged,
major period of inflation the world
had seen during peacetime.
Annual inflation rates reached levels of over
10 percent across OECD countries, and some
people began to panic. What’s worse?
The Phillips curve didn’t hold true
over the long term.
Inflation was high and so was unemployment.
It was lose-lose, a phenomenon known as stagflation.
Many people pointed to the 1970s energy crisis as the
culprit, which caused the price of petrol to skyrocket.
"Gasoline stations ran dry. Airlines cut back flight
schedules. Factories were forced to close."
But the general consensus today is that the
monetary policy of the time played a significant
role as well. Just take a look at this chart.
You can see the inflation rates in the U.S., U.K.,
Italy and Japan spiking during the Great Inflation.
But Germany, home to the Bundesbank, kept
inflation at a much more modest level.
So did Switzerland, which also had a very
independent central bank.
The 1970s exposed flaws in having governments
controlling central banks.
The nature of election cycles means politicians
have an inherent conflict of interest when
making decisions that impact the economy.
"As the recovery gathers pace, so our political
fortunes will continue to improve."
It’s tempting for them to skip unpopular
choices like raising interest rates
or cutting the budget deficit
in an election year.
So during the 1980s and 1990s,
many central banks,
including the Bank of England,
were granted independence.
The European Central Bank was established
in 1998, and was modeled on the Bundesbank,
meaning it was independent from the outset.
The system had changed.
Politicians still set the broad goal –
keep prices stable.
But it was up to the central bankers
to make it happen.
"I want an end to the stop-go,
the boom-bust economics of the past."
Billions of people around the world got used
to low and stable inflation and the security
of knowing the interest rates on their bank
deposits and mortgages were under control.
"Interest rates have come down.
Inflation is down."
But then the financial crisis happened...
"But will these moves by central banks
solve the problem?"
...pushing central banks into the spotlight.
They announced emergency measures and
unconventional steps to prop up the economy.
Essentially central banks became 'crisis response
units' trying to stop the next Great Depression.
"The ECB is ready to do whatever it takes
to preserve the euro."
Some people began to question whether the
institutions really had their best interests at heart.
Protesters complained central banks were too
secretive and that they cared more about bailing
out big banks than helping everyday people.
And of course, there was failing to spot
the financial crisis in the first place.
Even though central bank independence was
put in place to stop inflation from going
too high, some point out that a decade after
the crisis, the actual challenge is inflation
rates being too low. So is their
mandate still relevant?
It’s a question many are trying to answer,
including some central banks themselves.
But however they evolve, central bank bosses
argue trust is key for them to be effective.
And to be trusted, they have to be independent.
"Without independence, policy
is bound to go astray."
Yet it’s not that easy.
Despite their supposed independence, most central
bank heads are appointed by a political process.
For example, the European Council
picks the ECB head
and the U.S. President selects the Fed boss.
"There are few more important positions than this."
In extreme situations, governments
fire central bankers too.
Take Turkey.
Its president Recep Tayyip Erdogan fired his
central bank chief in July 2019.
Many speculate this was due to his unwillingness
to lower interest rates at Erdogan’s request.
Research has consistently shown that economies
perform better and prices are more stable
when central banks are independent. But
with populist leaders in power and interest
rates at historic lows, whether central bankers will
be able to hold on to the autonomy they‘ve
enjoyed for the last generation remains to
be seen.
