Heterodoxy on central bank independence and monetary policy

In the wake of Donald Trump’s call for lower US interest rates in the midst of solid economic growth and low unemployment, The Economist magazine ran a couple of articles on the threat of populist leaders to central bank independence (CBI) and low inflation.

It is more than 40 years since the publication of the intellectual justification for CBI of Finn Kydland and Edward Prescott, propounding the idea of time inconsistency. Based on the concept of the natural rate of unemployment (NRU), political control of interest rates will give rise to the temptation for politicians to boost aggregate demand and lower unemployment in the short run, below the NRU. This will prove unsustainable over the longer run, merely producing higher inflation, with inevitable costs to economic efficiency and growth.

This was apparently what caused the stagflation of the 1970s, when unemployment and inflation rose together, undermining the putatively Keynesian Phillips curve. The upshot is that politicians and voters are better off with CBI, with the central bank given a fixed mandate of low inflation and autonomy in how it achieves this.

But what is the reality of CBI and monetary policy? Here are some quotes from heterodox economists critiquing the mainstream consensus.

Christopher Hartwell in the January issue of the Cambridge Journal of Economics, (free abstract only) contests the notion that central banks can be genuinely independent of politics and institutions:

“[T]he reality [is] that a central bank is, by definition, a monetary institution embedded within a broader system of economic and political institutions, both domestically and internationally. Moreover, the institutional nature of a central bank means that it is not insulated from political pressure or ‘power struggles’, merely that the pressure takes a different form than with a Ministry of Finance or parliament; one can make the case that political pressures and interests are constantly pulling at the institution of the central bank despite any intended insulation, with modern central banks very sensitive to one domestic interest especially, that of the financial sector. By ignoring the reality of a central bank as an institution within an institutional system, the debate on CBI has been skewed towards a myopic obsession on ‘what function [a central bank] should perform’ -or…on how to avoid actions that it would have the power to implement – instead of a focus on the normative reason for a central bank’s existence (‘why it should exist’).

…[I show] specifically that it is the overall domestic institutional framework that a central bank emerges from which makes the entire concept of central bank ‘independence’ a mirage, as political pressures are omnipresent and exert a powerful influence on the policies undertaken. This reality exists even for that rare central bank creature unmoored from (direct) democracy, the European Central Bank…My conclusion is that true central bank independence is a goal which can never be achieved within the conventional approach to centralized monetary institutions…

…Democracy has created the incentives in place for inflation, democracy (via its various constituent actors) has expressed its own preferences for inflation, but, ashamed at those preferences, democracy has disingenuously tried to tie its own hands via an ‘independent’ central bank…Simply put, if an institution’s policies are contingent on what other political institutions are doing, either domestically or internationally, it is difficult to say that this institution is truly independent.”

Next, here is Ha-Joon Chang on the emphasis of macroeconomic policy on targeting low inflation, from his popular book 23 Things They Don’t Tell You About Capitalism (Thing 6, p.51):

“Inflation may have been tamed but the world economy has become considerably shakier. The enthusiastic proclamations of our success in controlling price volatility during the last three decades have ignored the extraordinary instability shown by economies around the world during that time. There have been a huge number of financial crises, including the 2008 financial crisis, destroying the lives of many through personal indebtedness, bankruptcy and unemployment. An excessive focus on inflation has distracted our attention away from issues of full employment and economic growth. Employment has been made more unstable in the name of ‘labour market flexibility’, destabilizing many people’s lives. Despite the assertion that price stability is the precondition of growth, the policies that were intended to bring lower inflation have produced only anaemic growth since the 1990s, when inflation is supposed to have finally been tamed.”

Finally, here is Alfredo Saad Filho, a Marxist Professor at SOAS, from his recent book of essays Value and Crisis (2019, p.286):

Monetary policy is political…Inflation Targeting (IT) and CBI are primarily political rather than ‘technical’ choices. They supported the social and economic reorganisation associated with the transition to neoliberalism, including the takeover of the state’s legitimacy, resources and policy-making capacity by finance, and their deployment to strengthen minority power and promote the interests of capital-in-general dressed up as the general good. These objectives are disguised by the veil of ‘technical objectivity’, ‘rules’ and ‘policy neutrality’ provided by mainstream economics. The New Monetary Policy Consensus (NMPC) excludes troubling political dilemmas from public scrutiny, entrenches the current balance of social forces into the institutional fabric of the society, and creates rigidities preventing the consideration of alternative economic policy goals. These policy changes are normally introduced in response to domestic political imperatives, and they are validated by the financial markets, the international financial organisations and the US Treasury and State Departments. These institutions monitor the outcomes of the preferred policy framework, and they can supply expertise and resources to assist the implementation of the NMPC. Finally, mainstream economics provides academic credibility for this policy consensus, as it lends theoretical density and depth to the NMPC.

The NMPC can deliver low inflation for long periods, because demand control through the manipulation of interest rates can reduce inflation regardless of its causes. Yet, the NMPC is based on doubtful assumptions, unwarranted generalisations, overly optimistic expectations about convergence to a virtuous circle of prosperity and – importantly – the ability of neoliberal policies and institutions to extricate the economy from finance-driven crises. The NMPC also imposes low inflation targets that can lock the economy into a pattern of low growth, high unemployment and potentially intractable problems of poverty and inequality. In addition, the NMPC offers only blunt and inefficient policies against inflation, grinding it down through potentially long periods of high unemployment that reduce the economy’s growth potential while increasing its financial fragility. Finally, hyper-vigilance against inflation, which is built into IT and CBI, is incompatible with rapid or equitable growth, because it fosters the interests of a parasitical financial system at the expense of the majority of the population, and locks countries into economic development strategies that are inimical to the achievement of democratic outcomes.”

2 thoughts on “Heterodoxy on central bank independence and monetary policy

  1. I would like to add one point to your very well composed post.

    In a horizontal monetary system, money is endogenous while interest rate is exogenous.
    The Central Bank does not control the quantity of money since money supply and bank reserves are determined by the system (endogenous money).
    The Central Bank sets an interest rate target and accommodate the demand for reserves in order to meet the target (exogenous interest rate).
    A failure of the Central Bank to accommodate the money demand could generate a collapse of the payment/settlement system.

    Hence, in agreement with your post, I have hard time considering a Central Bank operating in a floating exchange regime as independent.

  2. Excellent post, excellent quotes, excellent comment by Fausto.

    Intellectually the bizarre myth of CBI derives from the no less bizarre economic theory of the automatic good (equilibrium theory).

    The successor post (another must-read) to the present one provides valuable background on the myths that organise economic theory and economic policy into a continuum of interlocking fairy tales.


    Economics may never become a science, but it can be practiced scientifically, that is, by couching it in terms that are in principle refutable and by making relentless efforts at refutation.

    Keynes’ objections are possibly the best starting point on the way to a more scientific economics.

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