By Nad Moledina, Head of Research, King’s Private Equity Club
This article argues that the prior grounds on which the central bank predicates its legitimacy are no longer valid. As a result of the dramatic distributive consequences of the unconventional monetary policy employed, it should be subject to greater democratic accountability. It details the theoretical justifications for Central Bank Independence (CBI), before going on to examine how the role played by the central bank changed post-crisis due to the unconventional policy instruments employed. Finally, it demonstrates how the systematic and direct consequences of such policies challenge their legitimacy as a technocratic body and consider potential reformations.
The Justification for Central Bank Independence
Central banks possess a unique and unchallenged position as the authority on all matters of monetary policy. They are afforded independence within a mandate given to them by the elected government, on the basis that their independence renders them effective in ensuring the long-term price stability necessitated for the effective functioning of markets. In contrast, it is argued that monetary policy under the purveyance of elected government would be subject to the fluctuations of the political cycle. The entrance of political actors into the realm of monetary policy produces perverse incentives to create short-term gains to boost their chances of electoral victory (Dietsch et al. 2018:31). An overt example of this can be found in President Trump’s criticism of Jerome Powell, his nominee as Chairman of the Federal Reserve, for refusing to lower interest rates, going so far as to brand him “an enemy of the state” (Gogoi 2020). Unnecessarily lowering interest rates would increase short term economic growth, which may be helpful for an election boost, but in the long run, would cause unnecessary inflation and price instability. Hence there is both a distinct tension and misaligned incentives between the cyclical nature of democracy and the long-term price stability necessitated for the effective functioning of markets and contracts.
This tension is reconciled through the provision of a mandate by the democratic government, placed in the hands of an independent and technocratic body, insulating it from short-term political fluctuations. In this case, the ‘ends’ are set by the elected government, and the ‘means’ decided upon by the central bank – this is their technical role as ‘experts’. The degree of their mandate varies between different central banks, but the primary and common objective has been price stability, in line with the CBI template (Dietsch 2017:4), which is what I focus on. However, van’t Klooster (2018:589) notes that the mandates provided by the central bank are often subject to wide-ranging interpretation, which affords the central bank significant autonomy despite what may be the imposition of defined goals. Furthermore, the means to which these ends are achieved is at the discretion of the central bank, and the ability for the government to act as a ‘check’ is minimal, with “limited or no opportunity for elected officials to object” to the actions taken (van’t Klooster 2018:589). This limited power of elected officials to object is demonstrated clearly through Trump’s vitriolic rhetoric – despite his profound disagreement with the actions taken, once Powell has been appointed, there is little he is able to do. However, it is this very absence of vulnerability to political motives that affords the central bank the credibility necessitated for market participants to trust their decisions – that they will not invoke “inflation surprise”, which facilitates long-term economic planning (Fontan et al. 2016:322). Thus the lack of accountability of the central bank results from the fact that democratic interference is viewed as a hindrance to achieving monetary policy aims.
The Changing Role of the Central Bank
The role of the central bank changed dramatically following the 2008 crisis, when unconventional monetary policy was introduced. Prior to this, the primary two tools utilised by the central bank were Open Market Operations (OMOs) and the discount rate, which altered the short and long term interest rates respectively (Dietsch et. al 2018:16). OMOs allow the central bank to set the short-term interest rate on the overnight money markets, influencing the rate at which banks lend to each other, and hence the short-term cost of credit within the economy. Money is lent to financial actors in exchange for assets, to be consequently repurchased with interest after a short period. The second tool is the manipulation of discount rates – changing the interest charged on direct lending from the central bank as the ‘lender of last resort’. Importantly, these traditional instruments utilised by the central bank do not have distinct distributive implications via a “transmission mechanism” (van’t Klooster 2020:589). That is, in the long-term, there is not a clear causal link between the usage of these instruments and distributive outcomes (Fontan et al. 2016:335). In setting the interest rate through these channels, the central bank engineers what are largely technical trade-offs between inflation and economic output to ensure price stability (van’t Klooster 2020:587). The lack of democratic oversight experienced by central banks was justified under the usage of these prior instruments – it was a largely technical role with little room for normative judgements (Dietsch 2017:7, 2018:16). Hence, the potential consequences of central bank independence were outweighed by the benefits. This all changed with the employment of unconventional monetary policy in the wake of the 2008 crisis, dramatically altering the role of the central bank and subsequently the consequences of affording it such independence.
With interest rates already at the zero lower bound, central banks were limited in the effectiveness of their existing tools, turning to unconventional monetary policy. I focus on the effects of Quantitative Easing (QE), employed to further reduce the cost of borrowing and ensure the flow of liquidity throughout the economy. QE consists of essentially permanent OMOs, purchasing assets from financial institutions without the imposition of repurchase – primarily government bonds from third parties (Dietsch 2017:5). It drives bond yields down, making it cheaper to borrow while raising the price of government bonds, incentivising investors to place their liquidity elsewhere and to spur “productive lending” (Dietsch et al. 2018:26). Through the purchase of their assets, institutions now have excess liquidity, which they then reinvest in other, primarily higher yield corporate assets, driving asset prices up (McLeay et al. 2014:24). This is the portfolio balance effect (Dietsch et al. 2018:25). The resultant boosting of asset prices is entirely intentional – it is hoped that an increase in the net worth of assets will drive the holders of these assets to spend more through making them “wealthier” (Bank of England 2020). However, it is also noted by the Bank of England (in a paper 8 years prior) that such policies tend to disproportionately benefit the top 5% of households who hold 40% of these assets (Bank of England 2012). Thus in employing such policy instruments, the actions of the central bank now have direct and dramatic distributive consequences, largely to the benefit of the wealthy.
In opposition, it could be argued that QE also benefits the not-so wealthy, as the provision of liquidity into the economy reduces the ‘cost of money’, making it cheaper for ordinary people to borrow and gain access to credit. This is a valid sentiment, but in the case of QE, the cheaper provision of credit comes about only by virtue of funnelling money to the wealthy and increasing their net worth. This effect could be also achieved through instruments that have more egalitarian outcomes, such as helicopter money (Fontan et al. 2016:334) and if QE purchases are irreversible, arguably more effectively. The availability of alternatives with more egalitarian consequences demolishes the argument that the inequality perpetrated by QE was necessary and there was no alternative – this is a false dilemma.
The Implications of QE on Central Bank Independence
As a result of the new mechanisms utilised, there has been an intrusion of normative judgements into the realm of the central bank – namely, they have become the arbiter and authority in enacting wide-scale and systematic distributive consequences. This was not the case with the prior instruments of OMOs and discount rate manipulation. While the ‘end’ of price stability remains, the means have now changed with the introduction of QE. Through QE, the central bank has intentionally enacted and perpetuated a significant degree of wealth inequality, becoming the discretionary party in deciding on permissible levels of inequality. This newfound discretionary power of is difficult to reconcile with the banks’ technocratic nature and lack of democratic accountability. Such delegation of duty was justified on the basis of the central bank playing a largely technical role of ensuring price-stability, under tools that at the time, did not have direct or significant distributive implications. As a result of the drastic distributive consequences of the new policy instruments employed, the prior grounds on which the central bank predicates its legitimacy as a technocratic body are no longer valid.
In response to criticism, it is argued by central banks they are merely acting to achieve the ends given to them (Fontan et al. 2016:337), namely that of price stability. From a fundamentalist and literal perspective, should they integrate trade-offs between concerns that do not feature on their assigned mandate, the central bank would be overextending beyond their democratic legitimacy, and even more so if they prioritised other ends over their directed objective. In this respect, it is clear that the narrow mandate provided to central banks does not account for complexity of the changing means employed. But is a revision of their mandate sufficient to account for the consequences of these changing means, or is greater democratic control necessitated?
Fontan et al. (2016:328) argue that as a result of their narrow mandate, central banks only take distributive concerns into account when it is instrumental to their directed objectives- they do not observe inequality as consequential or relevant in itself. If we were to integrate distributive concerns into the mandate of the central bank, they would be forced to take this into account, rather than pursuing price-stability in isolation. However, this integrated approach would then result in the central bank making trade-offs between price-stability and inequality, which may facilitate more equitable outcomes, but would still render it a significant amount of discretionary power in arbitrating these outcomes.
But it is precisely this significant and unchecked discretionary power on normative judgements that is problematic from a standpoint of democratic accountability. A solution to the challenge of discretion would be for the legislature to decide upon a distributive standard and ensure adherence of the central bank through oversight – legislative committees. This would allow the central bank to retain a degree of independence with its resultant benefits in monetary policy, but would reduce their discretionary power on distributive outcomes. Fontan et al. (2016:342) propose a “moderate approach”, where distributional standards are only integrated in “extraordinary policy instruments”, as opposed to universally, thereby reducing unnecessary hindrance to monetary policy efficacy.
Conversely, many central bankers have argued not only that observing distributional concerns is not within their mandate, but nor should it be – that such duties are best left to the government – the fiscal authorities (Fontan et al. 2016:341). While the mere act of suggestion may seem overtly political, a priori from a standpoint of democracy, it is a salient point: it seems inherently undemocratic to allow an unelected and essentially unaccountable technocratic body to arbitrate distributional outcomes. Such decisions should be left to the elected government, not the central bank.
Through their suggestion that distributive concerns fall within the realm of elected government, central bankers advocate for an approach where the fiscal authorities act in a corrective capacity to align distributive outcomes in line with the democratic consensus. This argument is explored extensively by Fontan et al. (2016:345), who observe a critical flaw among others – namely that these very distributive outcomes that require addressal are generated via the actions of the central bank. The fiscal authorities would be essentially cleaning up the ‘mess’ made by the monetary authorities. It does not require an analysis of optima to observe the nonsensical inefficiency that would occur. But within the denial of responsibility lies an argument for an extended separation of powers.
This could consist of an elimination in their discretionary capacity on distributive matters through the prohibition of tools that invoke it, such as QE – a reversal back to the grounds of the original CBI template. The challenge would be the reduced efficacy of monetary policy beyond the zero lower bound, but in such cases, the central bank could liaise with fiscal authorities through policies like the Economic Impact Payments or ‘stimulus checks’, as they came to be known. (Treasury 2021). This was the direct deposit of payments to citizens’ bank accounts – strongly reminiscent of the “helicopter money” proposal of Milton Friedman (Diestch et al. 2018:89), except the source were the fiscal, not monetary authorities.
Conclusory Remarks
The technocratic and unaccountable role of central banks was predicated on prior instruments which had indiscernible long-term distributive implications. As a result of the new tools utilised, central banks now exhibit significant discretionary power in enacting increasingly unequal distributive outcomes. Consequently, the present lack of accountability held by central banks is untenable. I have presented two proposals for reform; both are preferable to the current situation of the central bank as an omnipotent and unaccountable authority on distributive outcomes.
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