Central Bank Independence As A Secret Ingredient?

Following up on my comments on the paper: “Deficits Do Matter: A Review of Modern Monetary Theory” by Farah Omran and Mark Zelmer, I am going to do a high level discussion about their claims about the value of an independent central bank. (For new readers, I am discussing this paper as I will be on a panel about Modern Monetary Theory (MMT), and Mark Zelmer is one of the participants. I am using my articles here as a way of thinking about my prepared remarks.)

The headline of this article is somewhat dramatic, but that is the only snappy way I can think of summarising my interpretation of the article. If one believes those authors, creating an independent central bank is a major innovation in economic policy that generates positive outcomes by itself. The MMT prescription of downgrading monetary policy (and a general hostility towards the concept of central bank independence) would in this case be a damaging policy shift.

The usual response I would give is to look at what they wrote, and respond to substantive points. In this case, I am skipping that, and instead offering a summary of why this is a thorny topic of debate. The bulk of the argument of those authors was to positively cite the mainstream literature on the topic, and then enumerate the advantages of central bank independence. The catch is that if I wanted to spend a lot of time on this, I would end up citing MMT proponents’ critiques of the mainstream literature, and end up writing a 20,000 word literature review. (Central bank independence was The Big Idea of neoclassical macro in the 1980s and 1990s, and there was a correspondingly large heterodox response.) Since writing such a literature review is not advancing my objective of finishing my inflation book, I am not going to do that.

If we step back to the view from 30,000 feet, the Omran & Zelmer text is pretty much what you would expect them to write if their target audience are believers in neoclassical economics. They share the theoretical assumptions of the authors of the papers they cite, and they assume that their readers also agree with their assumptions. Unfortunately, that is a horrifically bad assumption to make if the readers are MMT-aligned.

Such a writing style is defensible: a literature cannot get very far if 90% of every text includes repetitive discussion of underlying theoretical assumptions. However, you cannot do that if you are in a debate with someone who has different assumptions. In that case, you need to step back and spend a lot of time discussing the nuances the literature — and you cannot hope to “review MMT” in 18 pages if you are doing that.

I am now going to give a fairly minimal list of points where I see disagreement — without attempting to justify the disagreement.

1. What does “central bank independence” even mean? Reading between the lines of some neoclassicals, they mean that the central bank can do literally whatever it wants — including railroading the central government into bankruptcy. The minimal interpretation is that it means that the central bank sets a policy rate, and not the finance minister. If we use the minimal interpretation, nothing would stop the the finance minister from demanding an unlimited unconditional overdraft at the central bank — which I imagine would cause quite a few people to say is inconsistent with “independence.”

2. MMT proponents all agree that neoclassicals are wrong in how interest rate policy effects the economy. Unfortunately, not all MMT proponents agree exactly on what the effects of interest rate policy are. Warren Mosler notably has the most unorthodox position — it works exactly backwards from the way neoclassicals suggest; but some other MMT proponents have a more nuanced position that interest rate policy has mixed and uncertain effects. If a central bank does not know what its interest policy will accomplish, why does its independence matter?

3. With regards to the previous point, the most important specific theoretical point is that neoclassicals put a great weight on the value of “credibility” and the ability to manage expectations with an inflation target. This can be seen as the “secret sauce” of an independent central bank.

4. Neoclassicals in 2023 might have more mixed views, but the “1990s consensus” was that inflation was damaging to an economy, and inflation control is the main objective of macroeconomic policy. The ECB mandate reflects this attitude. Although this was historically a major area of dispute, at least parts of the mainstream would now accept that growth/employment should also be considered as part of their mandate.

5. The neoclassical view on the inflationary effects of fiscal policy are all over the map. To the extent that they believe the rather silly theory of Ricardian Equivalence, fiscal policy has no effect on growth/inflation. (Although those authors cite Ricardian Equivalence, this seems to be a minority view in 2023.)

6. Neoclassicals believe that monetary policy is the most “efficient” way to fine tune economic growth and inflation. MMT proponents argue that to the extent interest rate policy works, and is blunt — it cannot target sectors nor regions.

7. (Related to previous.) Neoclassical theory tends to suggest that inflation will adjust smoothly to policy rate shifts (as well as more nebulous “expectations management”). My argument is that to the extent monetary policy “works” in lowering inflation, it does by rapid rate hikes crashing the economy via a financial crisis — which is not a smooth process. (Post-Keynesian/MMTers say similar things, but the language I see tends to be more arcane, so I am unsure how well my version captures others’ views.)

8. Neoclassicals and MMT proponents disagree over what caused the inflation stability of 1990-2020. Neoclassicals talk up central bank independence, MMT proponents point tight fiscal policy and labour market changes.

Even if we put aside all of the theoretical argle-bargle, the final point is not trivial. It is very hard to believe that an independent central bank can achieve inflation stability if fiscal policy makers decide to run the economy red hot. For an economy that is not borrowing in a foreign currency, all the central bank can do to stop runaway fiscal spending is to force a default (or else manage to panic the government over interest rate hikes — but why should high interest rates bother an entity that cannot default?).

The ECB managed to carve out an extra-constitutional role for itself, but every other central bank ultimately answers to the government. If the government wants higher inflation, they will always be in a position to get it. However, in the real world, inflation is politically toxic. In the 2010s, it was elected politicians who were running austerity policies, and central bankers (that were not at the ECB) were desperately trying to get inflation back up to 2% targets.

Concluding Remarks

I have zero expectations that I will convince anyone watching my panel to re-examine their views on how interest rate policy works. Instead, I want to focus on two points. The first is that you cannot “debate MMT” and assume that the neoclassicals are correct about how monetary policy works — if we assume one side is right, there is no debate! The second is that if fiscal policy needs to be subordinated to the inflation objective anyway, the independence of the central bank is largely a red herring. If the government wants high inflation, the central bank is not going to stop it.