The real purpose of central banks
One of the things that has emerged from the PQE debate is a suggestion that it is time to consider ending the Bank of England's inflation-targeting mandate. Unfortunately this got mixed up with calls for ending the operational independence of the Bank of England (Richard Murphy), or abolishing central banks (Bill Mitchell, stated in response to a question at Reframing the Progressive Agenda).
What we might call the "twin peaks" approach to macroeconomic policy-setting has been adopted the world over. Separation of fiscal and monetary policy, and independence of the central bank, have become the hallmarks of good practice. Many countries have also adopted inflation targeting, though not all have: a good many developing countries still target exchange rates, and are currently learning (painfully) that exchange-rate targeting doesn't work when everyone's currencies are depreciating madly due to commodity price falls.
But the status of the central bank and the primacy of inflation control in macroeconomic policy setting are not really related to each other. To illustrate this, here's a thought experiment.
Suppose that we did what Bill wants, and abolished the central bank. Government would become its own central bank: it would spend directly into the economy by crediting private sector bank accounts, and would drain excess money through a programme of differentiated taxes. I've noted before that taxes and interest rates are essentially the same thing but with different distributional effects. Both control the amount of money in circulation. But interest rate changes indirectly influence private sector saving and borrowing, whereas tax changes directly affect private sector spending. We might expect, therefore, that tax changes would be both more powerful and more immediate in their effects than interest rate rises - though strangely, the mainstream economic community seems to think the reverse is the case.
In theory, therefore, this could work. Inflation control would be exercised by means of tax rate changes, particularly the poorly-named "indirect" taxes (VAT, sales tax, sin taxes). Indirect tax changes have direct, immediate and powerful effects on the economy: not long ago a promising recovery was derailed in Japan by an ill-considered increase in sales tax, and in the UK the VAT increase immediately after the Coalition government came to power in 2010 probably contributed to the slackening of growth later that year.*
So we do not need a separate central bank to control inflation. Government can do that itself. But why do we want to control inflation? Indeed, can we control it? We fear it, so we want it controlled, but it is by no means clear that we have effective control of it. Central banks the world over are failing to meet inflation targets. Western economies have inflation far below the standard 2% target. Why is this?
There are all manner of theories to do with commodity price falls, weak currencies and low demand. Some combination of all of these is no doubt partly to blame. But in Europe, where low inflation is firmly entrenched despite very high unemployment, the principal reason is that the inflation target has effectively been abandoned.
The ECB has price stability as its single mandate. But the primary macroeconomic targets are not set by the ECB. They are set by the member state governments and enforced by the European Commission with (increasingly reluctant) support from the ECB. The primary macroeconomic targets in the Eurozone, and to a lesser extent the EU, are the Maastricht Treaty limits on government debt and deficit. It is slavish adherence to these that makes it impossible for the ECB to meet its inflation target.
As I noted before, changes in taxation (including government spending, which can be regarded as negative taxation) are equivalent to interest rate changes. So contractionary fiscal policy across the entire Eurozone acts like very high interest rates, sucking demand out of the economy. Also, the ECB is struggling with "zero lower bound" constraints that limit the effectiveness of monetary policy in very demand-deficient economies, Consequently, the ECB simply does not have the power to offset the depressing effect of continual fiscal austerity as countries try to comply with the too-tight fiscal restraints of the Stability and Growth Pact. It cannot get anywhere near its 2% inflation target.
I would suggest that ANY country that is attempting to hit particular targets for government debt and/or deficit has de facto abandoned its inflation target. That includes the UK, whose Chancellor is targeting zero deficit by 2018 and fiscal surplus by 2020. The Bank of England still has an inflation target, but it has no more chance of hitting it than it would have if the Chancellor were "going for growth" with a highly expansionary fiscal policy. "Monetary dominance" is a myth.
Ending the Bank of England's inflation-targeting mandate would make little difference as long as the government remained firmly wedded to balancing the books. Indeed it might make matters worse: if the Bank no longer had a target to try to meet, popular pressure might make large interest rate rises hard to resist. It should be obvious by now that interest rate rises combined with fiscal austerity would be severely contractionary, possibly disastrously so. The Bank of England's inflation target is therefore serving a protective function. There are powerful voices calling for interest rates to rise back to "historic" levels. Targeting inflation silences them.
So we might need an independent central bank to provide some protection from politicians (or fiscal councils) setting insanely tight fiscal targets. However, the Eurosystem, with its one-size-fits-all monetary policy, is not able to protect individual countries from the awful consequences of severe fiscal austerity. So if it can't hit its inflation target because of over-tight fiscal policy, and it can't offset the effect on real economic activity of over-tight fiscal policy, does the Eurosystem serve any useful purpose at all?
It certainly isn't needed to create money. The right to create money is conferred on central banks (base money) and private banks (broad money) by government, and the value of money thus created arises entirely from the trust that people have in government. In the hydra-like Eurosystem, the authority of the ECB and national central banks to create money comes from the governments of its 19 member states.
Even in the Eurozone, it would in theory be possible for private banks to be provided with reserves directly by Treasury departments: conversely it would in theory be possible for member state governments to be the only banks. These are extreme positions and I am not suggesting either. I merely point out that both are logically coherent. Central banks and private banks are not essential for fiat money creation.
Occasionally we find cases where the central bank is more trusted than the government, but these are unlikely to be associated with genuine fiat currency systems. For example, Bulgaria has a Euro currency board, which means that its monetary policy and to a large extent its fiscal policy too are in practice dictated by the ECB. And the people like it that way. They haven't forgotten 1996, when Bulgaria experienced hyperinflation. They don't trust their government, and they only trust their central bank because it doesn't really have control of the currency.
So we do not need a central bank to control inflation. Even more importantly, we do not need a central bank to create money. All we need is a trusted government. This is the reason for Bill's call for central banks to be abolished. He thinks they serve no useful purpose.
Of course we might want to have a central bank for other purposes, like acting as lender of last resort for the banking system (though as we saw in 2008, the burden of rescuing a collapsing banking system eventually falls on government). It can be convenient to separate the support of the banking system from the support of the real economy. But in the Eurozone, it is hard to see what other useful purpose the central banks serve.
However, there is another reason for having an operationally independent central bank in a democracy. In democracies - even those that have a "fiscal council" or balanced-budget laws - fiscal policy is set by politicians. Politicians disagree on fiscal policy: indeed political parties' pitch to voters is mostly about how bad the fiscal policy of the other side is. For the party in office, the temptation to set fiscal policy to their own electoral advantage is very great: while for parties aiming to dislodge the party in office, the temptation to make headline promises to reverse existing fiscal policies is equally great. So we should expect fiscal policy settings to be significantly determined by the electoral cycle.
An independent central bank can dampen the swings in fiscal policy caused by changes in government. It can't offset them fully, especially when interest rates are close to the zero lower bound, but it can mitigate their effect. It acts, in effect, as an automatic stabiliser, anchored by its mandate: it doesn't much matter what the mandate is as long as there is one. The high inflation of the 1970s was in my view at least partly due to the loss of the Bretton Woods anchor, which resulted in ten years of confusion before a new anchor (inflation targeting) was adopted.
So it is public choice theory, not inflation control, that makes an independent central bank necessary. This, I'm afraid, fatally undermines Richard Murphy's call for the ending of the operational independence of the central bank. The last thing we need is a central bank that is ALSO driven by the electoral cycle. No central bank at all is probably better than this.
And this raises another issue. Those who think central bank governors should be directly elected should perhaps consider whether elected governors might themselves be driven by a desire to remain in office. The prospect of fiscal and monetary policy being driven by two different electoral cycles that are out of phase with each other is too awful to contemplate.
But if the real purpose of central banks is to protect economies from the whims of politicians (including those in other countries - fiscal policy effects spill over to other economies) - and thereby help to maintain trust in government even when it doesn't deserve it - there must be serious questions about the purpose of the Eurosystem, since it is manifestly unable to dampen fiscal policy swings. There could definitely be a case for abolishing the ECB and returning responsibility for monetary policy to national central banks.
Of course, an independent central bank dampening swings in fiscal policy is smoke and mirrors. The central bank is a political institution. Its mandate is set by politicians and it is only as independent as politicians allow it to be.
There is a widespread view that inflation targeting by independent central bank prevents irresponsible management of the economy by politicians. But I would argue that the reverse is the case. The "twin peaks" model, in supposedly protecting the economy from the whims of politicians, enables politicians to be irresponsible while blaming the central bank for the consequences of their irresponsibility. This is what is happening all over Europe. Politicians are irresponsibly driving economies into stagnation or depression through a misguided belief that debt is bad and government must "live within its means". And central banks are being held responsible for the resulting lowflation, lack of growth and high unemployment.
It is a dysfunctional model. But until there is greater understanding of macroeconomics among politicians and voters, I can't think of a better one.
PQE, inflation and the problem of voter power
Krugman, Bowman and the monetary financing of government
Inflation is always and everywhere a political phenomenon - Pieria
*If this is correct, then we should expect that the enormous VAT increase in Greece imposed with immediate effect under the terms of the recent bailout should have a serious negative impact on growth, since it is equivalent to a whopping interest rate hike. It's worth remembering that the Russian central bank's political decision to raise interest rates to 17.50% in November last year knocked the stuffing out of an already recessionary economy. Greece's general VAT rate has been raised to 23%, which for most industries is a rise of at least 10%. I await the Q3 and Q4 GDP figures for Greece with academic interest and personal foreboding.