Do Central Banks Serve the People?

Peter Dietsch, François Claveau, Clément Fontan

• Publisher: Polity
• Year: 2018
• Print ISBN: 9781509525775, 9781509525768
• eBook ISBN: 9781509525805
• Edition: 1
• Topic: Philosophy
• Subtopic: Philosophy History & Theory

Central banks have become the go-to institution of modern economies. In the wake of the 2007 financial crisis, they injected trillions of dollars of liquidity – through a process known as quantitative easing – first to prevent financial meltdown and later to stimulate the economy. The untold story behind these measures, and behind the changing roles of central banks generally, is that they have come at a considerable cost.

Central banks argue we had no choice. This book offers a powerfully original examination of why this claim is false. Using examples from Europe and the US, the authors present and analyse three specific concerns about the way central banks in developed economies operate today. Firstly, they show how unconventional monetary policies have created significant unintended negative consequences in terms of inequalities in income and wealth. They go on to argue that central banks may have become independent of governments, but have instead become worryingly dependent on financial markets. They then proceed to analyse how central bankers, despite being the undisputed experts on monetary policy, can still err and suffer from multiple forms of bias.

This book is a sobering and urgent wake-up call for policy-makers and anyone interested in how our monetary and financial system really works.

1
Central Banking: The Essentials

In this preliminary chapter, we aim to provide enough information about the workings of central banking for a non-specialist audience to be able to follow our subsequent discussion.

The characteristic that singles out the central bank among all of the institutions in a currency area is that it has a monopoly over the issuance of legal tender. It is not the only institution that ‘creates money’ – in fact, commercial banks are the principal creators of money today – but central bank money has a special status: it is the ultimate form of settlement between economic agents. All other monies (for instance, the sum that is credited to your bank account when you contract a loan) are promises ultimately redeemable in central bank money.

This monopoly puts the central bank in a favourable position to pursue two goals that a society is likely to have: financial stability and price stability. First, it can intervene at moments of financial turmoil to act as a lender of last resort because it can create liquidity without constraints. Second, it can contribute to a stable price level by manipulating the price of credit. Although central banks have at times had various other roles (promoting employment, managing the exchange rate and the national debt, supervising financial institutions, etc.), the goals of financial stability and price stability are constantly present. Note that, for the sake of clarity and brevity, this book focuses on three central banks, namely the European Central Bank (ECB), the Federal Reserve (Fed) and the Bank of England (BofE).

In addition to the extent of their mandates, a changing characteristic of central banks has been their degree of coordination with other state actors, especially with elected officials. Before the 1990s, governments typically had considerable direct influence on monetary policy. Things have changed with the worldwide generalisation in the 1990s of a template known as ‘Central Bank Independence’ (CBI).¹ The next section discusses what central banking was like under this template. With the 2007 financial crisis, central banking has changed yet again – these changes are introduced in the second section of the chapter. In both sections, we have to get into somewhat technical discussions about the instruments of monetary policy. We keep the technicalities to the bare minimum needed to follow the arguments of the rest of the book.

There is also a general lesson to be learned from this chapter. The breadth of the mandate of central banks and their degree of coordination with other state actors are two variables that, historically, have been positively correlated. In other words, the typical pattern is: the higher the degree of independence of central banks, the smaller their set of goals.² As we will see, the CBI template respected this pattern, but the current situation does not.

The Central Bank Independence era

The CBI template calls for various protections to ensure that central banks are not subject to ‘political’ pressures in setting their monetary policy. We will discuss the theoretical underpinnings of this prescription at length in the next chapter. For now, the following should suffice: the general worry is that, without a high degree of independence, central bankers might not be credible to market participants when stating that they are thoroughly committed to fight inflation. Markets might think that politicians will veto a hawkish monetary policy because they fear lower short-term economic growth, higher costs of servicing public debt, and the impact these might have on their chances of winning elections.

Even with laws prohibiting elected officials from directly telling central bankers what to do, one might worry that politicians could still exert strong indirect pressures by threatening them with funding cuts. But this trick cannot work with central banks because, unlike most other public agencies, they generate their own income (from the interest on liquidity lent and the returns on their financial assets). Consequently, the distance from political influence created by implementing the CBI template is real.

The CBI template not only promoted a high degree of independence of central banks, it also defined their mandate narrowly by historical standards. The main task of central banks became price stability. The focus on one objective follows the historical pattern associating a high degree of independence with narrow mandates, but a further element is needed to understand why price stability became in effect the only item on the agenda. What happened to the goal of financial stability? As Chapter 3 will discuss, financial stability was put on the back burner because of the belief – widespread before the 2007 financial crisis – that modern financial technology together with price stability would be sufficient to greatly moderate credit cycles.

When observed from the perspective of how the basic institutions of society ‘hang together as one system of cooperation’,³ the CBI template stands out as implying that central banks must not consider how their policies contribute to societal objectives beyond price stability. Other institutions, including government, must take monetary policy as a given and optimise accordingly when promoting other societal goals, such as limiting economic inequalities (see Chapter 2). Under the CBI template, there is little to no coordination between monetary policy and other policy levers.

With this general picture in mind, we need to understand how monetary policy has actually worked since the 1990s. Central banks aim to nudge the general price level upward at a low and steady pace – the target of a 2 per cent rate of inflation being the norm. They do not directly control the myriad of prices in an economy – those are set by countless decisions of economic agents – but monetary policy has an indirect impact on prices through various ‘channels of transmission’.

In the media, we usually hear about central banks ‘raising’ or ‘lowering’ interest rates. How exactly does this process work? Even though the institutional details vary from central bank to central bank, every central bank identifies a ‘target rate’. In the case of the Fed, for example, the target rate is the federal funds rate, that is, the rate that banks charge each other for overnight loans on the interbank lending market. A lower target rate will incentivise commercial banks to charge lower interest rates to their customers for consumption loans or mortgages. A higher target rate does the opposite. These changing credit costs to economic agents make them modify their investment and consumption decisions, which in turn change the level of inflationary pressures on the economy.

The instruments central banks typically use to influence the target rate are called Open Market Operations (OMOs). They build on the fact that commercial banks need liquidity to settle their day-to-day transactions with each other. Commercial banks can get liquidity from the central bank, but they do not necessarily have to – they can also turn to each other. Indeed, they typically roll over their debt on the interbank lending market. To influence interest rates on this market, the central bank must change how easily commercial banks can access liquidity. This is where OMOs come in. Think of a central bank as a bankers’ bank: it provides liquidity to commercial banks against specific assets that act as collateral. Suppose the central bank intends to inject liquidity; in this case, it will acquire assets from commercial banks, using central bank reserves that are credited to commercial banks’ accounts. OMOs usually come with a repurchase agreement, that is, the central bank will sell back the assets at a later date, and the liquidity will be returned with interest. By way of illustration, OMOs function in a similar way to pawnshops: liquidity is provided against collateral when economic agents need it. In the CBI era, the duration of typical exchanges was short (usually a week).

In addition, central banks not only affect economic variables (notably the price level) through OMOs, they also have an impact by virtue of publicly announcing their plans. Speeches by central bankers are particularly effective in influencing behaviour because they shape the expectations of market participants.

In sum, in the CBI era, central banks had a direct lever on short-term credit to commercial banks (via OMOs) and indirect but reliable effects on longerterm credit to all market participants (thanks to adjustments by commercial banks and to changes in expectations). Given how monetary policy worked in this era, we can understand why it was broadly perceived as apolitical: it was easily interpreted as a purely technical matter where the goal is both narrow and consensual and the means to attain it benign.

Central banking after 2007

Since the 2007 financial crisis, the interventions of central banks in advanced economies have expanded beyond the CBI template: central banks now play a more significant role both in financial and, as we shall see in subsequent chapters, in political systems. Yet, the degree of coordination of central banks with other state actors has remained low. In a recent survey of central bank governors worldwide, only two out of fifty-four respondents asserted that ‘Central bank independence was “lost a little” or “lost a lot” during the crisis.’⁴ The current situation thus departs from the general historical pattern where a broader set of go...

Table of contents

• Cover
• Copyright
• Acknowledgement
• Introduction: Central Banks Ought to Serve the People
• 1 Central Banking: The Essentials
• 2 Central Banking and Inequalities
• 3 Central Banking and Finance
• 4 Central Banking Expertise
• 5 Whither Central Banking? Institutional Options for the Future
• End User License Agreement