One of the most interesting aspects of US monetary policy since 2008 is that while Ben Bernanke certainly is not ignorant of economic history or monetary theory it seems like the Fed under his leadership has not responded nearly as aggressive to the crisis as one should have expected if one from reading Bernanke’s academic work. Furthermore, one can question why the Bank of Japan for more than a decade has failed to seriously address the deflationary pressures in the Japanese economy. Similarly why have central banks in for example the Baltic States, Bulgaria and Denmark maintained an unwavering support for keeping their currencies pegged to euro while the euro crisis has continued to escalate?

Scott Sumner has sometimes – I guess in frustration – suggested that central bankers are just stupid and this is the reason why mistaken monetary policies are continued for years. I on the other hand have suggested that one should look for a public choice based explanation for central bank behavior and that particularly William Nishanen’s Bureaucrat theory would be relevant. I have also suggested that the success of monetary policy during the Great Moderation has created a certain level of ignorance among policy makers and commentators about monetary policy.

However, there might be an additional explanation for the behavior of central bankers and that has to do with ensuring the the legitimacy of central banks (this could of course be said to be related to my Nishanenian explanation). I found a interesting discussion of this topic in a 1969 paper by Kenn Boulding – “The Legitimacy of Central Banks”.

Here is Boulding’s introduction:

The problem of legitimacy is one of the most neglected aspects of the study of social systems. There may be good reasons for this, for it is inevitably a hot subject. One can hardly discuss the legitimacy of anything without seeming to threaten it, for a great deal of legitimacy depends on things being taken for granted and not talked about at all. The more one looks at the dynamics of social systems, however, the more it becomes clear that the dynamics of legitimacy is one of the most important elements in the total long-run dynamics of society. It certainly ranks with such things as population and demographic movements, and even with technological change with which it is closely intertwined. Its importance can be seen in the remark that if a person or institution loses legitimacy it loses everything. It can no longer maintain itself in the social system. No amount of wealth, that is exchange capability, or power, that is, threat capability, can keep an institution alive if there is a widespread denial of the legitimacy of its role in society. This is because the performance of any continuous and repeated role requires an acceptance of its legitimacy on the part of those role occupants whose roles are related to it. A role in the social system is a focal point or node of inputs and outputs of many different kinds, the output of one role being the input of another. Inputs, therefore, depend on the willingness of other role occupants to give outputs, and they will not do this continuously unless there is legitimacy. Where people feel that certain outputs are illegitimate they will eventually find ways of stopping them. The corresponding inputs will likewise stop. To use a rather crude illustration, a bandit can take your money once, but anyone who wants to take it every week either has to be a landlord or a tax collector, or perhaps even a bank.

There are a considerable number of sources of legitimacy,and the functions which relate the determinants of legitimacy to its amount are extremely complex. They are certainly non-linear and they exhibit discontinuities which are to say the least disconcerting. Sometimes an institution, the legitimacy of which seems to be absolutely unques- tioned, collapses overnight. All of a sudden we reach some kind of a “cliff” in the legitimacy function and the institution suddenly becomes illegitimate. The same thing perhaps can even happen the other way, in which institutions quite suddenly become legitimate after having been illegitimate, A good example of the former is the collapse of the monarchy, beginning in the 17th century. The legitimacy of monarchy survived the Cromwellian war in England, largely because an ancient legitimacy is like a capital stock, it takes a great deal of spending before it can be exhausted. At the time of Louis XIV in the following century one might have thought that the legitimacy of monarchy was absolutely unquestioned and secure. In the following century, however, it collapsed everywhere and the only monarchs who survived were those who abandoned their power and became symbols of legitimacy, like the British, Dutch and Scandinavian monarchs. On the other side, abortion has been an institution which has been regarded as highly illegitimate and now in the face of the population problem seems to be acquiring a quite sudden legitimacy.

Sorry for the long quote, but Boulding’s discussion seem highly relevant for central banks and their behavior during the present crisis. Today (nearly) nobody dare suggesting that we could do without central banks. Take Denmark. In Denmark there is massive public support for the rather irrational institution of monarchy and only few Danes would seriously question the legitimacy of the monarchy. However, even fewer Danes would question the legitimacy of the Danish central bank. However, as history has shown support for institutions can disappear overnight. It is therefore, in the institutional interests of Kings (in the case of Denmark the Queen) and central bankers to insure that their legitimacy is maintained. Obviously we don’t have only to talk about the legitimacy of the central bank but also for example the legitimacy of certain policy rules for example inflation targeting or a fixed exchange rate regime.

Boulding discusses a number of sources of legitimacy:

The first consists of the payoffs of the institution in question:

If an institution provides good terms of trade with those who are related to it, up to a point this contributes to its legitimacy, especially in the long run. The case is clearer on the negative side. An institution which has very poor payoffs, demands a great deal of input from other people and gives very little output to them, is likely to have its legitimacy eventually eroded on this account. 

Therefore, a central bank which fails to “deliver” will eventually become illegitimate. The same can be said for a policy rule like inflation targeting. If inflation targeting stops working (as certainly is the case for example in the euro zone) then public support for it will  be eroded and sooner or later the central bank will have to give it up. However, the central bank is crucially dependent on the legitimacy and it therefore also be in the central bank’s bureaucratic interest to continue to claim that “everything is fine” despite this is in clearly conflict with reality. As Boulding explain: “therefore, a strong tendency to “throw good money after bad” and to continue making sacrifices for some institution, even after some possibly expected long-run payoffs have failed to materialize.”

The second source of legitimacy is age. The Danish monarchy’s legitimacy certainly has a lot to do with the fact that it has been around forever and the same goes for the legitimacy of many central banks. The Federal Reserve will have been around for a 100 years next year. In Denmark the present exchange rate regime has more or less been in place since 1982. Similarly, New Zealand was the first country introduce inflation targeting in 1988. There is no doubt that age provide significant legitimacy to different monetary regimes around the world and the despite of the seriousness of the crisis few well-established monetary regimes have really got under pressure.

The third source of legitimacy is mystery. In the words of Boulding: “Something which is not understood but which is dimly perceived as obscurely grand and magnificent, acquires an aura of legitimacy in the minds of those who do not understand it. The temples and impressive ceremonies of religion, the “state” of kings, the mystique of the brass hat and the military leader, the sanctity of priesthoods of all kinds and even the mystery of science and the laboratory are all related to this aspect of legitimacy”

This I think makes a lot of sense in the case of monetary institutions. Few people understand monetary theory and central banks are generally perceived as very complicated and even mysteries by most ordinary people. The mystery can only be maintained through the “temples”, “ceremonies” and the “brass hat”. Just think of a rate announcement from the ECB. There is a lot of ceremony to that. The same phrases are repeated again an again – and the central bankers all look the same in their dark suits and white shirts and ties (I look like that everyday as well – even though I occasionally would wear a bow-tie and probably are more comfortable with colours than most central bankers are…) As part of maintaining the mystery central bankers of course will also be careful in not questioning these rituals.

A forth source of legitimacy consists of the alliance of an institution with other legitimacies. Boulding terms this the “the legitimacy syndrome”. Just think of the relationship between the ECB and the European Commission. The languages and thinking of the two institutions are very similar. Think of now Prime Minister Mario Monti in Italy – he might as well have been ECB chief instead of the other Mario (Draghi). The thinking, the appearance and the norms very much seem to be the same. There are also strong alliances between central banks in different countries – one central bank would very rarely criticize another central bank. The Swedish Riksbank with its flexible inflation targeting and floating exchange rate regime would be very careful in for example avoiding saying anything bad about the Danish fixed exchange regime.

Concluding, the survival of monetary regimes crucially dependents on the legitimacy of these regimes. This legitimacy can be maintained in many ways by central banks. Among these are the need for mystery and alliances with other legitimate institutions. I think that this should be kept in mind when we are discussing why central banks fail to do the “right thing”.

Kenneth Boulding end his paper with a warning to central banks and it rings as true today as it did in 1969:

“I am pretty certain, however, that whatever mutation may supplant the existing system has not yet been made, but if the legitimacy of the system rests firmly on its payoffs then the social invention which will supplant it, if it ever comes, should be welcomed with joy rather than fear. It is only what I do not now mind calling the fraudulent legitimacies which fear competition.”