Every major economic crisis has its victims. Some bounceback, while others experience long-lasting, even permanent, damage. When itcomes to the global crisis that erupted in 2008, output growth has been aresilient victim. Central bank independence, by contrast, has been underminedseverely – and possibly forever.
In the 1970’s, the Western world was confronted with aunique phenomenon: simultaneous recession and rising inflation. Germany’ssuccess in maintaining low inflation in this environment was explained by thefact that the Bundesbank was de facto independent from the German government. This triggereda global movement, in which country after country adopted legislation toincrease the independence of its monetary authority. Soon, inflation began tofall.
With rapid economic growth leading to lower-than-expected outlays andhigher-than-expected income for Western governments, maintaining central banks’independence from political pressure was easy. Governments did not need theircentral banks to print money.
But, in a less favorable economic climate, printing moneybecomes a handy alternative to difficult decisions and painful adjustments,such as tax hikes and deep cuts in government spending. Indeed, since the onset of the ongoingfinancial and sovereign-debt crisis, advanced-country governments and centralbanks have allowed fiscal policy to prevail over monetary policy.
The Bank of Japan is the most recent example of a majorcentral bank bowing to its government’s wishes, which Prime Minister Shinzo Abebluntly declared should be accommodated. The BOJ’s recent decision to buy anunlimited number of government bonds to meet its new inflation target of 2% haseffectively ended the guiseof autonomy.
Likewise, the Bank of England is effectively buying almostevery new British government bond that is issued, even with annual inflationabove the legally established ceiling of 3%.  Although British inflationhas been higher than 4% in recent years, even rising above 5%, the Bank ofEngland has continued to loosen monetary policy. Meanwhile, the US FederalReserve is now buying more than 90% of newly issued US Treasury securities.
All three countries are violating the most importantcentral-banking commandment: Thou shalt not engage in monetary financing ofgovernment spending. But this is not surprising, given that these countries’central banks have never actually been independent.
For example, Article 4 of the Law on the Bank of Japan states that the bank “shall…alwaysmaintain close contact with the government and exchange views sufficiently, sothat its currency and monetary control and the basic stance of the government’seconomic policy shall be mutually compatible.” This means that the BOJ canpretend to be independent, but only for as long as the government permits.
Similarly, Article 19 of the Law on the Bank of England permits the Treasury to directthe Bank’s monetary policy, if it is “satisfied that the directions arerequired in the public interest and by extreme economic circumstances.” Afavorite phrase among politicians, “public interest” is sufficiently vague toallow substantial room for maneuver, as is “extreme economic circumstances.”Indeed, these criteria have resulted in the Bank of England accommodating theUK Treasury’s wishes fully.
In the US, the FederalReserve Act can be amended by a simple majority in Congress, a fact ofwhich the Fed is acutelyaware. Moreover, in the last few years, the system of checks and balances inplace within the Fed’s Board of Governors has been severely hampered by the factthat, in his first term, President Barack Obama had the rare opportunity toappoint or re-appoint almost all of its members, enabling him to replace hawkish governors with doves.
By law, the European Central Bank is among the world’s mostindependent. And the cumbersomeand difficult process of amending the ECB’s statutes – which, as part of the Treaty on the European Union, cannot be changed withoutagreement of all European Union member states – protects it from politicalpressure. But, rather than taking advantage of this, the ECB has accommodatedEuropean politicians, behaving less and less independently since the beginningof the crisis.
In southern Europe, central banks have traditionally beenpart of the government, which means that representatives from most EU memberstates consider central-bank subjugationnatural. Given that they all have an equal say in ECB decisions – and that,since 2008, majority voting has replaced unanimity in ECB decision-making – the ECB hasbegun to resemble the Banca d’Italia far more than the fiercely independentBundesbank. The ECB’s policy of purchasing large quantities of government bondsfrom ailing eurozone countries reflects this change, prompting two experiencedGerman bankers, Axel Weber and Jürgen Stark, to resign from their respective posts as BundesbankPresident and the ECB’s chief economist.
Independent central banks are becoming a relic of the past.The fact that inflation has increased in many Western countries, despite thesevere recessions of recent years, could mean that financial markets have begunto account for this fundamental shift. If central bank independence is the keyto maintaining long-term price stability, the era of low inflation may well beover.