Intellectual fashion is changing. Central bankers around the world no longer command the charisma of a high priesthood.
Nor should they after stoking a global bubble and then tightening just as the money supply was collapsing in mid-2008.
The onus is falling on them to justify why monetary independence is self-evidently a good thing, and why central bankers should operate beyond democratic control.
The humbling of the Bank of Japan (BoJ) this week is just the start, as Bundesbank chief Jens Weidmann warned. “It is already possible to observe alarming infringements, for example in Hungary or in Japan, where the new government is massively involving itself in the affairs of the central bank, is emphatically demanding an even more aggressive monetary policy and is threatening an end to central bank autonomy,” he said.
One could say that “alarming infringements” are in the eye of the beholder. The European Central Bank that he serves is itself a political operator of unbounded power.
Professor Richard Werner, a monetary expert at Southampton University, says the men of Maastricht misread German history very badly when they created a central bank that answers to nobody. “They thought they were modelling the ECB on the Bundesbank, but they weren’t. They have instead replicated the Reichsbank, which was not accountable to any democratic institution, and led to disaster,” he said.
No political force in Germany was able to halt Reichsbank deflation in the early 1930s until Hitler took power, tore up the rule book, and appointed Hjalmar Schacht with instructions to reflate, which he did with gusto and success.
Prof Werner said the Bundesbank was deliberately brought under the control of the German parliament when created after the Second World War to avoid repeating the mistakes of the Weimar era. “Europe has unlearned all the lessons of the Bundesbank,” he added.
The ECB’s actions have certainly been remarkable. It sent secret letters to the leaders of Italy and Spain in mid-2011 with a list of sweeping demands, covering pensions, labour reform, and sensitive political issues over which it has no constitutional authority.
When Italy failed to comply with the terms, it switched off bond purchases, let yields spiral upwards, and forced Silvio Berlusconi out of office. That may be a good or bad outcome depending on your point of view but it is not the action of a central bank. It is the action of a political authority that has entirely slipped the leash of democratic control.
The only real constraint on the ECB is the greater political power of the German Chancellory. Each stage of escalation in ECB’s emergency policies culminating in Mario Draghi’s August pledge to buy “unlimited” amounts of Italian and Spanish bonds, once the political trigger is pulled first required a green light from Angela Merkel.
Princeton professor Gauti Eggertsson has long argued that independent central banks have a “deflation bias” by their nature. This was fine during the quarter century after the Great Inflation of the 1970s, but as the inflation rate fell ever lower with each business cycle it eventually became dangerous, for there lies the dreaded “liquidity trap”.
A new paper by Paul McCulley and Zoltan Poszar argues that the taste for independent central banks goes “hand-in-hand with secular private debt cycles”. It becomes faddish during credit upswings such as the era of “monetary supremacy” from 1978 to 2008. The appeal wears off as the “deleveraging cycle” gathers force and the economy slides into slump. The US Employment Act of 1946 was the low point for the Fed. The bank was entirely harnessed to US Treasury purposes until its “emancipation” in 1951.
The implication is that politicians may have to take charge of central banks and force them to monetise debt at key moments to break the vicious circle. Indeed, the banks may have to be crushed into submission in extremis as a national priority if they drag their feet.
That is more or less what has just happened to the BoJ, the poster child of “deflationary bias”. The BoJ has agreed to raise its inflation target to 2pc , to be achieved at the “earliest possible time”, and will boost the money supply with “open-ended” bond purchases. It yielded only after premier Shinzo Abe won a landslide victory on an easy money ticket, and threatened to change the bank’s statute.
The BoJ continues to mount a fighting retreat. It will not add fresh stimulus this year beyond the $170bn (£107bn) already in the pipeline. But Mr Abe will get his way as he appoints “soulmates” to replace governor Masaaki Shirakawa and two key rate-setters over the next three months.
“Throughout the election I called for aggressive monetary easing. From now on, each party will be held responsible,” Mr Abe said yesterday. Deputy governor Toshiro Muto is already talking his language saying nothing is taboo.
The BoJ offers a cautionary tale for the West. It has been largely passive for 20 years, dabbling on the margins, buying bonds on short maturities from banks in a way that does little to revive broad money supply. “All they did was to expand reserves, but that is never going to make any difference. They created a straw man to then argue that quantitative easing does not work,” said Prof Werner, the man who coined the term QE in the early 1990s and later wrote Princes of the Yen.
The result was to let budget deficits take the strain instead. One fiscal blitz after another over the past two decades has pushed public debt to 237pc of GDP. State financing needs will be 60pc of GDP this year. This is a cul-de-sac.
The greatest indictment of modern central banks is that they chose to target the consumer price level, one variable among many, and a bad one to boot. They took their eye off credit growth and asset prices.
They might fare better to target nominal GDP growth of 4pc to 5pc and forget about the short-term ups and downs of inflation. Former rate-setter Adam Posen told Parliament on Tuesday that nominal GDP targeting would be a “serious mistake.”
That clinches the matter. Let’s do it.