Opinion
A Primer on Central Bank Independence
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...the designers of an independent central bank must focus on how to make it politically legitimate without undermining its ability to make credible policy commitments.
By Kim Schoenholtz and Stephen Cecchetti
"These are my principles. If you don't like them... well, I have others." -- Groucho Marx
Central bank independence is controversial. It requires the delegation of powerful authority to a group of unelected officials. In a democracy, this anomaly naturally raises questions of legitimacy. It also raises fears of the concentration of power in the hands of a select few.
An independent central bank is a device to overcome the problem of time consistency: the concern that policymakers will renege in the future on a policy promise made today. Keeping inflation low and stable requires a credible policy commitment to price stability that will, from time to time, be highly unpopular. When inflation rises, the central bank must promptly raise interest rates. And, should deflation threaten and the policy rate hit the zero bound, the central bank must respond by using its balance sheet flexibility. In this way, an independent central bank improves economic performance: it can achieve lower and more stable inflation rate without sacrificing long-run economic growth. (For a summary, see Fed Vice Chairman Fischer's recent speech.)
With the financial crisis, an earlier rationale for central bank independence re-emerged: the need to prevent or limit panics. This was in fact the original reason for creating the Federal Reserve System in 1913 (see, for example, America's Bank). For a central bank to serve as the lender of last resort, as leading central banks did in the recent crisis, it must have some degree of independence. In particular, it must delay disclosure about the recipients of its funds: otherwise, banks worried about being seen as fragile will not borrow, perpetuating the financial system's liquidity shortfall and the panic. At the same time, the central bank must not lend to insolvent banks; otherwise, the stigma associated with borrowing will discourage solvent, but illiquid banks, from seeking funds.
Read full article as published by The Huffington Post.
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Kim Schoenholtz is Professor of Management Practice in the Department of Economics and Director of the Center for Global Economy and Business.
Central bank independence is controversial. It requires the delegation of powerful authority to a group of unelected officials. In a democracy, this anomaly naturally raises questions of legitimacy. It also raises fears of the concentration of power in the hands of a select few.
An independent central bank is a device to overcome the problem of time consistency: the concern that policymakers will renege in the future on a policy promise made today. Keeping inflation low and stable requires a credible policy commitment to price stability that will, from time to time, be highly unpopular. When inflation rises, the central bank must promptly raise interest rates. And, should deflation threaten and the policy rate hit the zero bound, the central bank must respond by using its balance sheet flexibility. In this way, an independent central bank improves economic performance: it can achieve lower and more stable inflation rate without sacrificing long-run economic growth. (For a summary, see Fed Vice Chairman Fischer's recent speech.)
With the financial crisis, an earlier rationale for central bank independence re-emerged: the need to prevent or limit panics. This was in fact the original reason for creating the Federal Reserve System in 1913 (see, for example, America's Bank). For a central bank to serve as the lender of last resort, as leading central banks did in the recent crisis, it must have some degree of independence. In particular, it must delay disclosure about the recipients of its funds: otherwise, banks worried about being seen as fragile will not borrow, perpetuating the financial system's liquidity shortfall and the panic. At the same time, the central bank must not lend to insolvent banks; otherwise, the stigma associated with borrowing will discourage solvent, but illiquid banks, from seeking funds.
Read full article as published by The Huffington Post.
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Kim Schoenholtz is Professor of Management Practice in the Department of Economics and Director of the Center for Global Economy and Business.