The politics of central bank independence

There has been a consensus among doctrinaire economists that central bank independence is a good thing. On the surface it makes a lot of sense for price stability. Independence increases credibility and credibility reduces the cost of keeping inflation down. These assumptions are taken so much for granted that the IMF published a blog post in 2019 saying

"Independence surely remains a key principle in ensuring the sound operation of central banks—in particular, from the perspective of their price-stability objective. However, central banks will need to step up their game. Transparency about their multifaceted decisions and actions needs to be strengthened, and clear communication with the public is paramount. 

"Only by simultaneously enhancing central banks’ governance, transparency, and accountability can their long-term independence be assured. This is the surest step to help rebuild public confidence in central banks as reliable defenders of non-inflationary, job-creating economic policies."

But independence is not really needed for price stability. In The Death of the Central Bank Myth, Adam Tooze explains how

"The assumptions about politics and economics that anchored the model of the independent central bank in 1980s and 1990s were never more than a partial interpretation of the reality of late 20th-century political economy. In truth, the alarmist vision they conjured was not so much a description of reality as a means to advance the push for market discipline, away from both elected politicians and organized labor."

I was surprised to find out that even the The Economist was questioning the consensus (which it was/is a part of) on the benefits of central bank independence in 1999: Born Free. This article points to papers published in the 1998 Oxford Economic Papers that show how the intellectual consensus on central bank independence isn't really based on evidence. I skimmed through two papers in that edition -- "Central bank independence and disinflationary credibility -- a missing link" by Adam Posen, and "Central bank independence -- conceptual clarifications and interim assessment" by James Forder. A couple excerpts-

Forder:

"Support for central bank independence - usually derived from concern over problems of time inconsistent policy - became widespread in the late 1980s. This may be due to the wide publicisation by Alesina (1988, 1989) of the empirical work of Parkin and Bade (1980) combined with the theoretical analysis of Rogoff (1985). But whatever the academic influence on the process, the idea caught a highly favourable political wind. In Europe, the Delors Report and subsequently the Maastricht Treaty made the independence of the European Central Bank the centerpiece of the institutional design of monetary union ...

"Almost without exception, at least amongst professional economists, the advocacy of independence is presented as a solution to a perceived credibility problem...

"The nature of the problem that central bank independence is said to solve has caused a certain degree of confusion. There are first of all, two separate issues which are sometimes not clearly separated in the literature. One relates to the problem called 'the time inconsistency of optimal plans' by Kydland and Prescott (1977) and another to the credibility of policy announcements...

"Time consistency is a problem of policymakers acting with discretion to optimise policy on the assumption (which in a rational expectations framework is incorrect) that the future behaviour of the private sector will be affected by the policy they observe, but not by what it understands to be the implicit rule by which policy is formed.

Posen:

"This convergence upon a particular institutional fix for inflation stems from the wide acceptance of the analysis of two stylized macroeconomic facts in the papers of Kydland and Prescott (1977) and Barro and Gordon (1983): that the long-run Phillips curve is vertical - that is, inflation has no permanent effect on real outcomes; and that governments nonetheless have an incentive to spring inflationary surprises upon the public. As a result, these papers argued, a primary cause of inflation was government's inability in the eyes of the public to commit credibly to a low inflation policy. One could remove the time-inconsistency problem by making government unable to renege upon a commitment to low inflation. In Rogoff (1985), the appointment of a conservative central banker was shown to be one means to that end... 

"A direct link between central bank independence and disinflationary credibility is not supported by this paper's results. Disinflation appears to be consistently more costly and no more rapid in countries with independent central banks."

My (initial) understanding of the papers that are the intellectual framework is

• Kydland and Prescott (1977) said "even with well-intentioned policymakers sometimes there are inflation surprises, and when the private sector incorporates them in an average inflation estimate when setting wages it leads to an inflation spiral"
•  Barro and Gordon (1983) introduced the credibility problem by saying "why would a monetary rule be followed after it's been announced, instead you could just announce the rule to reduce inflation expectations and then break your promise if that helps you optimize."
• Rogoff (1985) ran with the assumption of the credibility problem and said "if we take the credibility problem as fact, the solution is a conservative, independent central banker."

Also- Alan Blinder wrote about What Central Bankers Could Learn from Academics--and Vice Versa in 1997. He argued that academic economists were barking up the wrong tree and proposed other directions for research. These directions did not include a review of central bank independence.

"theorists have lavished vastly too much attention on a nonexistent time-inconsistency problem while ignoring a much more real problem that arises when central bankers "follow the markets" too closely. Academic economists could also be more helpful to practical policymakers if they would develop an empirically coherent analysis of the term structure of interest rates, model the central bank as a committee, investigate the robustness of Brainard's conservatism principle, and study the conditions that make either "opportunistic" or "deliberate" disinflation the preferred strategy."

Debt and Deficit and Other Illusions

Occasionally people say that government debt represents borrowing from our collective economic futures. This is usually wrong. Michael Pettis has a nice thread explaining why.

In the following excerpt from The Economics of Imperfect Competition and Employment, Robert Eisner uses a neoclassical framework to explain why an extra dollar of government debt today is not a dollar taken from the pockets of our grandchildren. If we're at full employment, prices will rise proportionally with new debt, so the actual burden of the debt is not greater. If we're not at full employment, output will rise with new debt, as tax cuts or increased government spending put more money in the hands of workers and entrepreneurs, so the nominally larger debt actually shrinks as a proportion of the economy. Good for us, good for the grandkids.

"But once we get entangled in a world of government debt and changing price levels, the going gets treacherous. A number of widely held positions prove untenable. And many of the usual assertions about the effect of public debt and deficits become misleading at best and, at worst, particularly in presumed policy applications, egregiously wrong. Take the notion, for prime example, that an increase in the public debt will involve a transfer of wealth from the current to a future 'generation'. But surely, this proposition, if true, must relate to an increase in the real value of the public debt. Under what circumstances will government budget deficits lead to increases in the real value of the debt?

"Assume again a market-clearing, full-employment equilibrium. Then have the government cut taxes, thus producing a budget deficit which is financed by a mixture of interest-bearing debt and fiat money in the same proportions as the already existing value of government interest-bearing debt and money. In this situation, we should expect a new equilibrium -- with rational expectations, an immediate new equilibrium -- in which the general level of prices had increased in the same proportion as interest-bearing debt and money. There would hence be no increase in the real public debt or the real quantity of money and no change in any real magnitudes. And, of course, with no change in the real value of public debt, there is no transfer from one generation to another.

"Now assume, in good Keynesian fashion that, for whatever reason, markets are not clearing and that there is an excess supply of labor so that output is below its 'natural' rate. The cut in taxes and resultant budget deficit, again financed by a mixture of interest-bearing debt and money in the same proportions as the existing debt and money, will increase effective demand. Output will rise so that prices will rise less than in proportion to the increase in interest-bearing debt and money. Indeed, the increase in wealth that agents in the private sector perceive in the form of their government bonds and money may be viewed, in good neoclassical fashion (cf. Haberler, 1941; Pigou, 1943, 1947) as the forces increasing demand and output.

"But with increased output, we can expect more current consumption as a consequence of the increased wealth of households and also plans for more future consumption in accordance with the life-cycle hypothesis (Modigliani and Brumberg, 1954). Then in accordance with a conventional, neoclassical production function and rational expectations, there should be more current investment as well, as agents undertake to acquire the capital to be used in producing the goods and services to meet the expanded future consumption demand.

"We find therefore that the deficit and increase in the public debt result in an increase in capital and the provision of more output both currently and in the future. We are not increasing current consumption at the expense of the future generation. We are rather increasing consumption for both generations."