The myth of central-bank independence

While maintaining the appearance of independence, they often do what governments want

COMMENT | ROBERT SKIDELSKY | The United Kingdom’s economic policy is adrift. That was the main conclusion from the House of Lords Economic Affairs Committee’s inquiry into the Bank of England’s failure to predict the worst inflation in 40 years. In a recent report, the Committee criticised the BOE’s internal culture and forecasting models, casting doubt on its ability to get inflation back to the 2% target by 2025.

The UK’s annual inflation rate reached a four-decade high of 11.1% in October 2022, while overall prices have increased 22% over the past three years. The House of Lords report attributed the BOE’s mistakes to “groupthink” among officials, an increasingly vague mandate (which now includes considerations like climate change), and “inadequate” forecasting tools. Former U.S. Federal Reserve Chair Ben Bernanke, commissioned by the BOE to review its performance, highlighted the Bank’s obsolete software. The Committee also raised valid concerns about central bankers’ “unelected power.”

In 1997, then-Chancellor of the Exchequer Gordon Brown set the UK’s annual inflation target at 2.5% (later reduced to 2%) and gave the BOE “operational independence” to achieve it. Since then, the Bank has taken even greater control over economic policy, pumping £875 billion ($1.1 trillion) into the British economy through its quantitative easing program in response to the 2008-09 global financial crisis. As Economic Affairs Committee Chair George Bridges observed, this outsourcing of macroeconomic policy from government to central bankers – now standard practice in developed economies – represented “an enormous transfer of power from elected representatives to unelected officials.”

Given that interest rates affect not just the value of money but also unemployment, growth, and distribution, it could be argued that monetary policy, like fiscal policy, should be managed by governments accountable to voters. Yet, despite the criticism of the BOE’s performance, the report did not question the principle of central-bank independence. Instead, they focused on ways to align the Bank’s freedom to set interest rates “independent of political pressure” with government accountability for economic policy.

The notion that central-bank independence is sacrosanct can be traced back to Milton Friedman’s monetarist counterrevolution in the 1970s, which ended the hegemony of Keynesian social democracy. Friedman argued that market economies are “countercyclically stable” at their “natural rate of unemployment,” provided that market participants are not deceived by variable inflation rates. This argument effectively narrows the scope of macroeconomic policy to maintaining price stability.

Since monetary policy, like fiscal policy, affects economic activity with “long and variable lags,” entrusting inflation control to independent central banks – insulated from political interference and operating according to mechanical rules – would prevent politicians from manipulating the money supply.

Bankers and economic-policy wonks were quick to embrace Friedman’s monetarist gospel. In a 1984 speech, then-Chancellor of the Exchequer Nigel Lawson turned the previous Keynesian orthodoxy on its head. The objective of macroeconomic policy, he asserted, should be “the conquest of inflation,” not “the pursuit of growth and employment.” Conversely, microeconomic policy should focus on “the creation of conditions conducive to growth and employment,” rather than on suppressing inflation.

Lawson’s lecture represented a return to the “classical dichotomy” of pre-Keynesian economics, which treats real variables (like employment) and nominal variables (like price levels) as separate. According to this view, supply-side reforms would increase economic efficiency, and interest-rate policies would maintain price stability.

The macroeconomic record tells a mixed story. The postwar era can be divided into two distinct periods: the Keynesian golden age (1947-1973) and monetarism’s “Great Moderation” (1997-2019). Excluding the intervening years, UK inflation averaged 4.5% during the Keynesian era, and average unemployment was 2.1%. Under central-bank management the inflation rate averaged just over 2%, while average unemployment was 5.6%. Growth rates in the two periods were 2.8% and 2%, respectively.

In other words, macroeconomic outcomes under the two regimes were starkly different. Moreover, the “misery index” (the unemployment rate plus the inflation rate) was 6.6% during the Keynesian age and 7.8% in the age of central-bank independence. Since 2020, it has risen to 9%.

To be sure, it is impossible to determine whether these developments were the result of policy or external events. As early as 1968, the economist R.C.O. Matthews questioned whether the full employment of the Keynesian golden age should be attributed to government policy or a secular postwar boom. It could also be argued that the low inflation that characterised the Great Moderation had less to do with central-bank policies than with the entry of billions of low-paid workers from Asia into the global labor market.

But given that economic policy significantly affects economic performance, it is hard to argue that fiscal and monetary policy should be kept separate. Central banks control the money supply through the rates at which they lend to commercial banks. This sets the structure of long-term interest rates, determining the rates at which borrowers can access funds, which in turn influences investment and unemployment.

Simply put, if governments are to be held responsible for investment and unemployment, they must also control monetary policy. Moreover, while central banks strive to maintain the appearance of independence, the reality is that they often do what governments want. Although it is impossible to predict what macroeconomic framework will emerge from our current age of turbulence, it will likely bear little resemblance to the Friedmanite ideal.

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Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University. He is the author of an award-winning biography of John Maynard Keynes and `The Machine Age: An Idea, a History, a Warning’ (Allen Lane, 2023).

Copyright: Project Syndicate, 2024.