Implications of the current economic crisis. for central bank independence

Transcription

1 1 Implications of the current economic crisis for central bank independence John Singleton Victoria University of Wellington Paper for Asia Pacific Economic and Business History Conference, Wellington, February There have been many dramatic changes in the world of central banking since the classic days of the Gold Standard before Some though not all of these shifts have occurred in response to financial and economic (and political) crises. New disasters, such as the one in progress, could result in the further remodelling of central banking institutions and functions. While the job of the financial historian is not to peer into the future, the example of the 1930s and 1940s suggests that the next round of central banking reforms might be uncomfortable for the current generation of central bankers. Even so, central banks have demonstrated a remarkable capacity to adapt to changes in the environment. This paper examines how crises especially the depression of the 1930s and the inflation of the 1970s and 1980s led to the remoulding of central banks. It will be argued that there are strong parallels between the 1920s, when the Gold Standard mentalité still reigned, and the 1990s and 2000s when the doctrine of central bank independence (CBI) achieved widespread acceptance. Could CBI be as vulnerable today as the ideology of the Gold Standard proved to be after the crisis of the early 1930s?

2 2 Just how secure is the current orthodoxy of central bank independence (CBI) combined with some form of inflation targeting? In the United States Congressman Ron Paul is campaigning for the Fed to be audited and ultimately abolished (Paul 2009). Although the independence of the European Central Bank (ECB) often seems impregnable, surveys by Eurobarometer show that net trust in this institution fell from around 30 per cent in Spring 2008 to below zero in early 2009 (Gros and Roth 2009). Such evidence cannot be ignored. If the economic turmoil of persists, the strength of public and political disenchantment with the status quo will grow. This paper compares the current situation with that in the 1930s when a no less dominant framework, based on CBI and the gold standard, collapsed in response to political pressure. Eichengreen and O Rourke (2009) have already given many people a fright by comparing the speed of the economic downturn of with that of 1929 onwards. Even if there is a strong recovery, there could be consequences for the institutions that failed to avert the crash. Revolutions in central banking The contingency of today s orthodoxy has been acknowledged by one of its strongest supporters, Mervyn King. In his Richard T. Ely lecture to the American Economic Association in January 2004, he pointed out that central banks and the framework in which they operate would continue to evolve: [T]he core of the monetary policy problem is uncertainty about future social decisions resulting from the impossibility and the undesirability of committing our successors to any given monetary policy strategy. The impossibility stems from the observation that collective decisions cannot be enforced, so that it is

3 3 impossible to commit to future collective decisions; the undesirability reflects the fact that we cannot articulate all possible future states of the world (King 2004: 1). The twentieth century saw two revolutionary upheavals in central banking (Singleton, forthcoming), both of which took place in reaction to the perception (and to a large degree the reality) of massive failure. The first revolution was in the 1930s and 1940s. Appalled by recent policy disasters, and influenced by corporatist, socialist, and Keynesian ideas, the central bank law was rewritten in many countries. Even where legislative change was less sweeping, governments became much more closely involved in the management of monetary and exchange rate policy. The second revolution, in the late twentieth century, addressed problems arising from high inflation, the discrediting of Keynesianism (and later of monetarism), and the perceived time inconsistent behaviour of policy makers. Many nations passed laws granting autonomy to their central banks, reversing the decisions of the mid twentieth century; others including the USA and Australia reinterpreted existing legislation in ways that strengthened de facto central bank autonomy. Goodhart, Capie, and Schnadt (1994: 48 9) compared these shifts in central bank independence to swings of the pendulum, an analogy which suggests further swings are possible. Central banking in the 1920s Central bankers set themselves ambitious objectives during the 1920s. The challenges of postwar economic and financial reconstruction were enormous, but key central bankers, including Montagu Norman of the Bank of England and Benjamin Strong of the New York Fed, were confident that they had the answers in the form of

4 4 independent central banks and a modified gold standard. New central banks were established in central and eastern Europe and Latin America, whilst the German Reichsbank was remodelled in the wake of hyperinflation. The twenties were distinguished by a strong emphasis on CBI, not least in the content of the acts setting up new central banks, and in the writings of central banking experts such as Kisch and Elkin (1932: 16 41). Central bank autonomy had been squeezed during the First World War, since every government was forced to indulge in some degree of inflationary finance. After 1918 central bankers were anxious to regain their autonomy, and to a large extent they succeeded. Their greatest asset was the pervasiveness of the gold standard mentalité, a phrase coined by Eichengreen and Temin (2000) to describe the monetary orthodoxy of the early twentieth century, which attached overwhelming importance to the gold standard and, by implication, to central bankers as its guardians. Given that European governments aspired to return to the gold standard, central banks enjoyed a privileged position. Government interference in monetary policy could be portrayed as a threat to the resumption or maintenance of the gold parity. The gold standard mentalité was shared by most politicians and economists (though not by Keynes), and by all central bankers. At the end of the war a committee chaired by Lord Cunliffe had reiterated the case for the gold standard in the most uncompromising terms. Cunliffe had been in no doubt that it was imperative that after the war the conditions necessary to the maintenance of an effective gold standard should be restored without delay (quoted in Eichengreen 1985: 179). Gold had been the basis of national and international prosperity and stability before the war, or so it was assumed. There are parallels between the dominance of the gold standard mentalité in the 1920s and that of inflation targeting and CBI in the late twentieth century.

5 5 The central banking cause was boosted by the International Financial Conference at Brussels in Called by the League of Nations, this conference discussed possible solutions to current financial problems, except German reparations. All countries were urged to balance their budgets, combat inflation, and work towards restoration of the gold standard. Having ruled out the introduction of an international currency, the delegates concluded that banks of issue (central banks) should be opened in all countries, and granted protection from political controls. During the 1920s the League of Nations Financial Committee, working closely with Norman and other central bankers, devised a number of reconstruction and stabilisation schemes for the new countries of central and eastern Europe (Clavin 2003). For Norman and his peers, independent central banks and the gold exchange standard 1 would link the countries of this region more firmly into the liberal capitalist international economy, and thus insulate them from communism and militarism. Obviously these aims were political as well as economic. The first League of Nations scheme, for Austria, was subcontracted to the Bank of England. After 1918 the new Austrian republic was dogged by hyperinflation and political instability, and cut off from former imperial markets in central Europe. The Austro Hungarian central bank had been liquidated in 1919, leaving Austria and its neighbours without central banks. The reconstruction plan involved a loan guaranteed by European governments, and measures to balance the budget and achieve currency stability. A central bank was established in According to Sayers (1976: 168), in the constitution of the new National Bank the Austrians accepted the British view in its entirety: no government officials, directors elected by shareholders, no lending to governmental 1 Smaller countries might not have substantial gold reserves. They would hold reserves in key currencies such as the dollar and sterling, which were exchangeable into gold.

6 6 bodies, and a note issue with partial gold cover. A precedent was created when the League of Nations insisted that the Austrian National Bank should have foreign advisers, who kept in close touch with the League and key central banks, especially the Bank of England. This approach has modern echoes. The Central Bank of Bosnia Herzegovina (CBBH), established in 1997 under the Dayton Treaty, was designed by the IMF in conjunction with US officials. The first two Governors were appointed by the IMF, the first being French, and the second a New Zealander. For the initial six years of its life the CBBH was required to operate as a currency board without interference from the Bosnian parliament (Coats 1999). Central bankers from the New York Fed and the main European nations collaborated to reconstruct and manage the gold standard after They shuttled across the Atlantic by liner to summits on gold policy and interest rates. Their exploits are described in the recent popular history, Lords of Finance (Ahamed 2009). When Strong, Norman, Hjalmar Schacht of the Reichsbank, and Charles Rist of the Banque de France, met on Long Island in 1927, and reached tentative agreement on concerted action to relieve pressure on sterling, there were no politicians in attendance to pull their strings. International monetary policy within the G 4 was a matter for central bankers alone in the late 1920s. Believing that they had all the answers, central bankers could be rather arrogant in the 1920s. They regarded politicians as incompetent, mendacious, and opportunistic, or in modern jargon as prone to time inconsistent behaviour. In 1926 Pierre Quesnay, an adviser to Emile Moreau, the Governor of the Banque de France, described the philosophy of Montagu Norman as follows:

7 7 The economic and financial organization of the world appears to the Governor of the Bank of England to be the major task of the twentieth century. In his view politicians and political institutions are in no fit state to direct with the necessary competence and continuity this task of organization which he would like to see undertaken by central banks, independent at once of government and of private finance. [Central banks] would succeed in taking out of the political realm those problems which are essential for the development and prosperity of the nations: financial security, distribution of credit, movement of prices (quoted in Boyle 1967: 205). This was heady stuff, and it could not survive the depression, when public and political opinion turned against central banks, and the gold standard mentalité and CBI were consigned to oblivion. Reaction to the depression The mystique of central banking was tarnished by the depression. Central bankers plainly do not deserve all the blame for the depression, though the classic accounts of Friedman and Schwartz (1963) and Meltzer (2003) do highlight their theoretical confusion, indecision, and policy errors. Crucially, the gold standard and CBI became associated with mass unemployment and deflation. Politicians who rejected the gold standard mentalité and showed little interest in CBI came to power in several core countries, including the US (Franklin Roosevelt), Germany (Adolf Hitler), and France (Leon Blum) in the 1930s. Roosevelt was particularly dismissive of central bankers. In a contemptuous message to the World Economic Conference in 1933, he denounced the old fetishes of so called

8 8 international bankers (quoted in Kindleberger 1987: 216), which may be translated as the gold standard mentalité of Montagu Norman and his cronies. Even more brutally, Roosevelt remarked in 1940 that the Federal Reserve system is so unimportant, [and] nobody believes anything that Marriner Eccles [its chairman] says or pays any attention to him (quoted in Meltzer 2003: 556). This was an exaggeration, but it illustrates how far central bankers had sunk in status within a few years. Even in Britain, where there was political continuity, the central bank was demoted. According to Montagu Norman: When the Gold Standard was abandoned, there took place an immediate redistribution of authority and responsibility between the Bank of England and the Treasury (quoted in Kynaston 1995: 28 9). In 1932, the government, acting on Treasury advice, introduced a cheap money policy, insisting that Bank Rate be capped at 2 per cent. With the formation of the Exchange Equalization Account, also in 1932, the government assumed control over exchange rate policy. The Bank of England now acted as the government s agent in the management of sterling and not as a principal. Similar arrangements for exchange rate management were enacted in the US. Few central banks were state owned before Between 1936 and 1945, however, the central banks of Denmark, Canada, New Zealand, Bolivia and Guatemala were nationalised, and new state owned central banks were set up in Ireland, Poland, Thailand, Ethiopia, Costa Rica, Paraguay, Nicaragua, and Afghanistan. After the Second World War, further nationalisations extinguished the private shareholdings in the central banks of the UK, France, Germany, the Netherlands, Norway, Czechoslovakia, Yugoslavia, Hungary, Rumania, Argentina, India, Indonesia, Egypt, Spain, El Salvador, and Peru (De Kock 1974: 304 5). In most

9 9 cases, including the UK and France, nationalisation merely confirmed the previous extension of greater state control. How did central banks survive these upheavals? In essence, they learned to roll with the punches because they were not in a position to engage in party politics. Adaptation took three forms. First, central banks assimilated new ideas and doctrines, including the belief that governments could and should manage macroeconomic activity. Secondly, they came under the control of a new wave of governors and senior managers who were sympathetic to reform. Thirdly, they worked with governments to implement new legislation, or reinterpret old legislation in ways that allowed at least some room for manoeuvre. Governments imposed some changes, for example by passing legislation, and by appointing new central bank governors and chairmen, but it would be simplistic to attribute everything to external manipulation. The internal thinking of central banks was bound to be influenced by developments in the intellectual climate, not least because staff professing old ideas retired and were succeeded by staff professing new ideas. The changing of the guard was particularly dramatic at the Fed. Marriner Eccles, an outsider with unorthodox views, became chairman of the Board of Governors in December An obscure Utah banker, Eccles was talent spotted by the Roosevelt administration, which was eager to appoint people with new ideas to important positions after the policy mishaps of the previous few years. According to Meltzer (2003: 466): Eccles held a Keynesian view long before that view became dominant among academics and central bankers. Mixed with that view were vestiges of older ideas about underconsumption, overinvestment, borrowing, speculation, and

10 10 income distribution. Eccles repeated many times that the depression was due in part to inequality in income distribution. Eccles agreed with Congressman Goldsborough that in a depression monetary policy was as ineffective as pushing on a string (Wood 2005: 231). The Fed under Eccles was more radical in its thinking than the US Treasury was in the mid to late 1930s. Even Norman and his colleagues at the Bank of England were forced to sing a new tune after When Leslie Lefeaux, the Governor of the Reserve Bank of New Zealand, contacted the Bank of England in early 1936 to express outrage at the new socialist government s plans to take his institution into full state ownership, he was told to calm down. Deputy Governor Sir Ernest Harvey replied: I need not remind you that ultimate authority regarding credit and currency must rest with Governments and that a Central Bank in any country is obliged to frame its own policies within limits set by Government decisions. 2 Norman added: I share your view that anything that tends to reduce the true independence of a Central Bank is unwelcome. But let me repeat my conviction, which I am sure is yours also, that fears aroused by apparently sweeping legislative changes 2 Bank of England Archives [Henceforth BoE], G1/339, Cable: Sir E. Harvey to L. Lefeaux, 10 Jan

11 11 may be proved groundless by the willing collaboration and prudent administration of the people concerned with putting them into effect. 3 Central banks could not defy the will of elected governments. They had to work with them, even when their policies were unpalatable, and exert whatever influence they could behind the scenes. This is how most central banks behaved from the mid 1930s until the resurgence of CBI in the late twentieth century. Any central banker with the temerity to rebel against these constraints James Coyne of the Bank of Canada in 1961 being the most prominent example after Schacht was put down firmly (Macfarlane 2008). Conclusion The latter stages of the Greenspan era were tinged with triumphalism (Kahn 2005). Even Milton Friedman, no friend of the Fed or of central bank discretion, thought that Greenspan had performed exceptionally well (Nelson 2007). Otmar Issing assured an audience at Cambridge in 2000 that they could have faith in central banks in the new millennium (Issing 2000). But could they, and what might they think or do if cracks were to appear in the three pillars of central bank independence, inflation targeting, and Greenspannery? One lesson of the 1930s is that central banks risk being punished after a crisis, especially if they have given the world the impression that they are in control of events. By the early 2000s the regime of CBI and inflation targeting was as deeply ingrained as the earlier regime of CBI and the gold standard had been in the 1920s. 3 BoE, OV59/10, Letter: M. Norman to L. Lefeaux, 30 April 1936.

12 12 Yet governments rapidly lost confidence in the skill of central bankers in 1930s, and the results were sweeping reform and loss of autonomy. Central banks cannot assume that there will always be a political consensus in favour of the principles of the 1990s. In his blog on 5 May 2009 Willem Buiter speculated that the current financial crisis signalled the beginning of the end for central bank independence, not least because the prudential and lender of last resort function are very hard to depoliticise. Guido Tabellini (2009) points out that even if governments are willing to delegate monetary policy to central banks when the objectives are clear and success is readily measured, when larger and more uncertain questions open up, politicians will be tempted to break central bank independence and take back decision making. As Sir Ernest Harvey and Montagu Norman understood in the 1930s, governments will always have the final say if they want it. Central banks must adapt to changes in the political environment because they cannot prevent them. The potential for the current orthodoxy in central banking to come under sustained attack over the next ten years cannot be discounted. Acknowledgements: An earlier version of this paper was presented at the workshop on The Global Financial Crisis: Historical Perspectives and Implications of New Zealand, Reserve Bank of New Zealand, June Bibliography Ahamed, L Lords of finance: the bankers who broke the world. New York: Penguin Boyle, A Montagu Norman. London: Cassell

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