How not to weaken central banks’ independence

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THERE ARE more than a few echoes of the Nixon era in the presidency of Donald Trump. Monetary reverberations are among them. Facing re-election in 1972, Richard Nixon felt he needed a strong economy at his back, and made a habit of haranguing Arthur Burns, the chairman of the Federal Reserve at the time. Burns recounted the meetings in his diaries: “The president looked wild; talked like a desperate man; fulminated with hatred against the press; took some of us to task…” Historians reckon Burns was too accommodating of Nixon’s demands, and so helped launch the inflation of the 1970s. Mr Trump is now waging his own assault on the Fed’s independence. He has repeatedly complained about the central bank’s decisions and urged it to take a more doveish stance.

More strikingly Mr Trump, who has already chosen three of the five sitting members of the Fed’s board of governors, has named Stephen Moore and Herman Cain to fill the remaining two vacancies. In contrast to candidates who have come before, both are political activists. But the parallel with the 1970s is less apt than it seems. There are different ways to politicise monetary policy, and Mr Trump’s is particularly poisonous.

Nixon’s inflation helped inform modern ideas of central-bank independence. In 1977 Finn Kydland and Edward Prescott, who won the Nobel prize together in 2004, published a seminal paper on the problem of “time inconsistency”. Governments can promise to keep inflation low, they argued, but that promise becomes harder to keep as time goes on. Once the public expects low inflation, there are political advantages to generating a burst of higher-than-anticipated price growth, which reduces the real (inflation-adjusted) value of debt and generates a short-run increase in real incomes and output. As governments succumb to the temptation to inflate, expectations adjust and the inflation rate needed to surprise the public rises ever higher. In the absence of a mechanism to keep inflation low, prices accelerate. Along with policy rules and inflation targets, central-bank independence became one of the ways governments’ promise not to inflate were made credible.

Yet even as independence became more common, it remained incomplete. Governments are often responsible for setting central banks’ mandates, appointing their heads and determining what tools they can use to do their jobs. Many elected leaders have succumbed to the temptation to jawbone monetary policymakers. In the months before the election of 1992, George H.W. Bush urged Alan Greenspan to cut interest rates; he later blamed the Fed for his loss at the polls. In his memoirs Paul Volcker recalls an awkward meeting with Ronald Reagan and his chief of staff, James Baker, in which he was ordered not to raise rates in the run-up to the election of 1984. During the financial crisis, central banks around the world came under fire from politicians for having allowed financial excess to build up, bailing out banks during the crisis and using unconventional measures to support damaged economies.

These political intrusions did not prevent central banks from keeping inflation low. On the contrary, economists are increasingly asking whether stubbornly low rates of inflation, interest and growth show that the need for independence was overstated. Inflation was high around the world in the 1970s. Perhaps rather than a weak-willed Fed chairman being to blame, the problem lay in factors specific to that period, or a flawed understanding of the relationship between monetary policy and inflation.

Faced with today’s chronically low interest rates, central banks may need to revise their policy frameworks to stop economies falling into slumps. But without a shove from politicians, they may be too institutionally conservative to do so. Shinzo Abe, Japan’s prime minister, won election in 2012 on a promise to rejuvenate the economy, and immediately pressed the Bank of Japan to be more zealous. The result has been an impressive run of growth rather than a macroeconomic disaster. Structurally low interest rates also mean that central banks need more help from fiscal policymakers when demand slackens. That co-operation will inevitably weaken central banks’ institutional independence.

The fool’s mandate

Might one argue, then, that by pressing the Fed to aid his re-election campaign Mr Trump is undercutting a norm that has outlived its usefulness—even, that he could be helping America claw its way out of the low-rate trap that has ensnared most of the rich world? In fact, the selection of Mr Moore and Mr Cain suggests a very different sort of politicisation is at work. Neither is a professional economist; both have worked extensively in Republican politics. Mr Moore advised Mr Cain during his campaign for the Republican presidential nomination in the election of 2012, which was derailed after a promising start by allegations of sexual harassment. Both have expressed monetary-policy positions that might mark them out as hawks. In 2008, when the American economy was on the brink of a deep recession, Mr Moore said that the Fed should be raising rates rather than cutting them, and predicted high inflation to come. Mr Cain has said he favours a return to the gold standard. But politics, rather than data or principles, appears to guide their views. Mr Moore now joins the president in complaining that the Fed is holding back growth unnecessarily. Mr Cain has repeatedly claimed, falsely, that statistical agencies faked economic data in an effort to boost the fortunes of Barack Obama.

Perhaps, if appointed, the pair would surprise Mr Trump and vote as his prior picks have, in an orthodox fashion. If they behave instead as party loyalists, the greatest risk is not that an ineffectual Fed will allow inflation like that of the 1970s to take hold. The opposite might well result if the pair revert to hawkishness when power changes hands. The danger is rather that the Fed will become a political weapon, and that America will move closer to becoming a nation where the welfare of the ruling party trumps that of the country as a whole.

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