Central bankers have had a hard time of it over the past few years. After many were a bit slow off the mark back in 2007 and 2008, when the crisis first broke, we have since seen some imaginative policy responses. These include offering banks secure long-term funding, buying up private sector mortgages, and even acting as the implicit backstop for governments. And yet, despite it all, central banks still get criticised from all sides. At my end of the spectrum, I rail against the new orthodoxy that has already taken hold in some institutions, preventing them from adopting more genuinely unconventional policies that could have more impact in restoring growth and jobs. At the other end, Austrians and not-really-monetarists fret that excessive money creation will fuel inflation or asset bubbles. And now, central banks are getting accused of being too political.
Sometimes this is not without cause. BoE Governor Mervyn King was certainly too political back in 2010 when he lavished extensive (and ultimately unwarranted) praise on the coalition government, as Adam Posen has pointed out. Some Germans might also have a case that, by promising a monetary backstop for the euro, ECB President Draghi has stepped into fiscal and thereby political territory. (For what it is worth, I still think he deserves the ‘Man of the Year’ award from the FT.)
Central banks are also used to politicians sticking their noses in where they shouldn’t. Despite being one of the architects of the independence of the Bank of England, Ed Balls found it difficult to butt out when that independence had been granted. Prime Minister Abe in Japan has already promised to increase the Bank of Japan’s inflation target, and is putting lots of pressure on his central bank; whoever the new Governor is, they could struggle to assert their authority. But these instances are really just politicians doing what they always do – pronouncing on things that they probably shouldn't, and that they actually know very little about.
More worrying are some of the attacks from within the profession itself. Stephen King, HSBC’s Chief Economist, is one prominent City scribbler to have taken up this call. At the moment, the argument goes; monetary policy is working by unconventional channels. These channels can work very differently from normal cuts or increases in interest rates. And, as some central banks’ own research has shown, the unconventional policies are acting to shift income and wealth from one part of society to another. Coupled with the relative lack of growth, this means that central bankers are redistributing income more than they are spurring aggregate demand. HSBC’s King, for one, thinks this is therefore political, not economic.
Stephen King is not a bad economist, and his argument holds together logically. But the biggest hole in it is that he hasn’t stopped to think about how monetary policy normally works.
The old lesson six-formers are taught is that, by increasing interest rates, the central bank can make it more desirable to save, and so people as a whole spend less, taking demand out of the economy. Interest rate cuts work in reverse. This appears to be King’s view of the world.
The reality, however, is somewhat different. Various studies have shown that the impact of interest rate changes on individuals’ spending patterns is actually quite small, if it exists at all. In the jargon, the marginal propensity to consume – whether people spend or save an extra Â£1 of income – doesn’t move (much) when interest rates change. Instead, research suggests that the biggest impact of interest rates on aggregate spending is via redistribution. Even in normal times, monetary policy is redistributive. It ‘works’, or influences spending, precisely because different groups in society spend or save to different degrees. An interest rate cut shifts income from creditors (normally richer people) to debtors (normally poorer people). And because debtors have a higher marginal propensity to consume than creditor, total spending rises – they spend more of the Â£10 (say) they implicitly get from creditors than the creditors did themselves. When rates rise, rich people save more of the money that they implicitly get from the poor, sucking demand out of the economy.
This means that, while there are still big questions about central banks that need to be answered, politicisation is not really one of them. The normal functioning of monetary policy acts by affecting savers and borrowers differently – indeed; policy needs that difference to have an impact. The real question is still about how central banks could do more to generate growth. And there, just perhaps, maybe some central banks are not political enough.