Central bank independence and the idiocy of Bernie Sanders

A short while ago there a considerable degree of attention was placed on Bernie Sanders’ economics policies, with one aspect of them in particular demonstrating his lack of economic understanding. In particular, Bernie Sanders supports legislation to “Audit the Fed”, which would see the Federal Reserve’s monetary policy decisions come under intense scrutiny from politicians. In other words, this legislation would remove the independence of the Fed to set its monetary instruments in a way that would allow it to achieve its monetary policy goals, and instead render monetary policy a tool to be exploited by politicians once more. In other words, Bernie Sanders supports revoking central bank independence.

The rationale for having central bank independence in the first place is to prevent political meddling in monetary policy. There is a well-established literature regarding how governments’ desires to be re-elected results in them manipulating monetary policy in the run up to an election and how such manipulations are detrimental overall.

Intuitively, in the run-up to an election, a government would want to boost the economy so it can get re-elected, and therefore would set interest rates lower than they should be otherwise, such that voters would associate them with economic growth and hence be more likely to re-elect them. After the election, the government would need to raise interest rates more than they would have done otherwise so as to prevent the economy over-heating. This gives rise to the phenomenon known as political business cycles – in essence, booms and busts are artificially created by the presence of elections.

By handing the control of monetary policy over to an independent central bank, this potential for political business cycles is reduced. The independent central bank’s motivations do not include being re-elected and therefore monetary policy under their control would not be subject to unnecessary changes before/after elections. Instead, interest rates would be set solely to benefit the economy as a whole.

(There are, of course, distinctions to be made in terms of whether a central bank is “goal” or “instrument” independence – the former is where the central bank itself decides what the aims of its monetary policy should be, whereas the latter is where the goals of monetary policy are set by the government but the central bank can choose how best to achieve those goals. Even the latter would reduce political business cycles due to the increased transparency in what monetary policy is trying to achieve preventing politicians being able to change those goals in the run-up to an election.)

In this regard, Simon Wren-Lewis put forward (as a devil’s advocate exercise) what he felt to be the strongest argument against central bank independence. Although Wren-Lewis’ point is needlessly drawn out, what it boils down to is this: that delegating monetary policy to an independent central bank meant that governments came to the view that managing demand was the responsibility of the independent central bank while fiscal policy (remaining under governmental control) should be used for political rather than economic purposes. Although this would not usually be a problem, when interest rates are close to the zero lower bound, then fiscal policy should be used to stimulate demand so as to allow an economy to recover. Wren-Lewis posits that this potential use of fiscal policy has been neglected due to politicians viewing demand stimulation as, essentially, “not their problem” and that this political attitude is due to the creation of independent central banks.

If this is indeed the strongest argument against central bank independence, then it is clear that the case against such independence is extremely weak instead. In particular, the entire argument rests on the assumption that interest rates are the only instrument available to an independent central bank. As has been shown by the use of quantitative easing and numerous discussions regarding “helicopter money”, that assumption clearly does not hold.

Furthermore, Wren-Lewis claims that a government concerned with a fiscal deficit cannot also try to stimulate demand at the same time. This ignores the re-distributive nature of fiscal policy. In particular, fiscal policy tends to take more in taxes from higher-earners (i.e. those who save more as a proportion of their disposable income) and less in taxes from low-earners (i.e. those who spend more as a proportion of their disposable income). Similarly, government benefits tend to be given to those who spend more as proportion of their income rather than those who save more as a proportion of income. Hence, it is entirely possible for fiscal policy to reduce a deficit overall, yet still stimulate demand by increasing overall taxation and/or decreasing overall spending, but increasing the redistribution from high-earners to low-earners. In other words, even if fiscal policy is concerned with reducing the deficit, it can still be used to stimulate demand when interest rates are near the zero lower bound and a government wants to reduce the fiscal deficit.

Hence, as shown, the case against central bank independence is so weak as to be non-existent. So, back to Bernie Sanders and his support for revoking the Fed’s independence – this support for an incontrovertibly nonsensical economic policy shows that he is economically illiterate. That he has come so far in the US Democratic Party’s primaries shows just how little importance voters in those primaries place on the impact that politician’s policies would actually have.

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UK price levels and inflation targeting

Over the weekend, Andrew Sentance tweeted the graph below in an attempt to show that price levels in the UK are above where they “should” be given the Bank of England’s inflation-targeting regime. In particular, he tried to use this graph as a justification for his continued demands that the Bank of England increase interest rates soon (if not immediately).Sentance inflation

If one were to take Sentance’s graph at face value, then it might seem that he has a point- price levels are above where they would be if the Bank of England had followed its 2% CPI target since 2004.

However, of course one should not take this graph at face value. For a start, it ignores the fact that the Bank of England’s inflation target is not just the central point of 2% per year, but is actually a range around that central point. In fact, the Bank of England’s official inflation target is 2% +/- 1% – in other words, inflation can be as much as 2.9% or as low as 1.1% and the Bank of England would still be within its target. Hence, the graph below also plots these upper and lower bounds of the price level over time (the top dotted line shows the upper bound, while the bottom dotted line shows the lower bound).

Clearly, the path of prices in the UK has always remained within the Bank of England’s target (assuming a start date of January 2004). Moreover, even though the price level came relatively close to breaching the upper bound in 2011/2012, more recently those prices levels are well within the upper bound (albeit above the central target).

CPI Inflation

Of course, the Bank of England did not just start targeting inflation in January 2004 – in actual fact it first started targeting inflation in 1992. However, given that it was only granted independence in May 1997, it is more appropriate to examine the path of prices from that date. This is shown in the graph below, which also takes into account the July 2003 move from targeting RPIX to targeting CPI instead.

Specifically, the red line shows the path of RPIX inflation (re-based to equal 100 in May 1997) until June 2003, from which point it shows the path of CPI. Likewise, the dashed line shows the path of prices under central target of 2.5% from May 1997 until June 2003, and then the path under the central target of 2.0% from July 2003 onwards. The dotted lines show the upper and lower bounds of +/-1% around the central target.

The picture here is even more striking than before. Due to inflation generally being below the centre of the target until about 2007, the price level was below what it would have been if the central target had been achieved (although prices did generally stay within the lower bound). Only more recently (i.e. since about 2007/2008) has inflation been above the central target for a sustained period of time, such that the price level “caught up with” where it would have been if inflation had followed the central target.

RPIX and CPI Inflation

Indeed, the end result is that the prevailing level of prices in the UK of the past 4-5 years have been close to the level that would have been achieved if inflation had stayed at the central target since 1997. In other words, the graph used by Andrew Sentance to try to claim that the level of prices in the UK is higher than it “should” be is mis-leading in the extreme – instead of prices being above the level of the central target, they are actually around the central target level and well within the upper and lower bounds of the inflation target. Hence, trying to claim that interest rates should be raised due to the price level being above “target” is not valid.