Independent central banks

“The Economic Consequences of Banking Crises: The Role of Central Banks and Optimal Independence,” Daniel Hansen, May 2022, American Political Science Review, Volume 116, Issue 2, pp. 453 – 469

The independence of central banks from the control of governments has been seen as extremely crucial to achieve economic growth and stability. Economists strongly believe that people in government usually try to influence officials in the central bank to adopt easy monetary policy that is inimical to economic growth in the long-run. After all, easy monetary policy help governments to borrow money at low interest rates to fund populist spending and also helps in the easier availability of credit which many believe to be important for economic growth. Both these together can lead to a rapid rise in prices that can in turn lead to a loss of confidence and severely undermine economic growth.

Predefined inflation mandate

Moreover, an independent central bank that focuses primarily on keeping inflation within a predefined range will automatically keep other crises in check, it is believed. In short, the predominant view among economists today is that an independent central bank with an inflation mandate can promote economic growth by keeping inflation and banking crises in check at the same time.

“The Economic Consequences of Banking Crises: The Role of Central Banks and Optimal Independence” by economist Daniel Hansen of Carnegie Mellon University disagrees with the current mainstream view on the advantages of independent central banks. Hansen argues that the benefits that independent central banks claim to offer in terms of controlling inflation can actually come at the cost of underwhelming response to major crises. This, in turn, can lead to prolonged unemployment and other economic costs that can be avoided if central banks did not focus so much on controlling price inflation. In particular, Hansen notes that during times of crisis such as the 2008 financial crisis, the response of central banks such as the Federal Reserve was focused on keeping price inflation in check rather than on resolving the crisis.

Such myopic focus on price inflation, he argues, turned focus away from the urgent need to bail out the financial system by easing liquidity and led to unemployment, economic contraction and other negative effects. This, according to Hansen, resulted in economic costs that far outweighed the benefits of keeping price rise in check. Apparently, there can also be severe political consequences to central bank independence as tough economic conditions could lead to political turmoil. Economic contraction and high unemployment caused by central bank independence can also lead to populist backlash that further undermines economic growth, he argues. Many have argued that the rising populism in America led to the trade war between the U.S. and China.

More importantly, Hansen believes that an actual inflation mandate is not necessarily required to achieve the goal of central bank independence. He argues that central bank independence can be achieved simply through laws that prohibit the politically-motivated appointment/dismissal of central bank officials. If so, there is no need to create rules that tie the hands of central bank officials to maintain price inflation within a predefined range.

Critics of Hansen are likely to argue that in the absence of an explicit inflation mandate central banks may be prone to expanding money supply at a far more aggressive pace. This, in turn, could lead to business cycles marked by more severe economic contractions. Some may even argue that the idea of central bank independence itself is largely a myth as in many cases central bank officials are appointed by political authorities. Even in cases where central bank officials enjoy total independence from the executive wing of government, there is no reasonable guarantee that they will act with the best interests of the larger economy in mind. Central bank officials may well collude with politicians in return for various kinds of benefits. If it be the case, a predefined inflation mandate may offer at least some kind of protection from discretionary monetary policy actions.