Military dictators are independent as well…

Over the last couple of decades independent central banks have become the norm and it is seen as dangerous if politicians threaten the independence of the central banks. Judging from the short-termism of politicians this in many ways makes perfectly good sense and any modern economist would acknowledge that central bank independence is a good way to ensure a rules based monetary policy – contrary to they discretionary monetary policies normally dominating politicized central banks.

I have long been a strong proponent of this mainstream view among economist and if you are going to have central banks then it is better that they are independent rather than an extended arm of the Finance Ministry. I normally I like to mention the Turkish central bank as an example of how the de-politicization of the central bank led to a marked drop in inflation and general significantly better performance for the Turkish economy over the past decade. However, I have increasingly come to question this view as I have come to think that independence often has to mean unaccountable.

We want independent central banks because we want to protect them from political interference when they are doing a task that they have been asked to do. We do not want central banks to be independent to do whatever the management of the central bank find in their own personal interest.

Imagine that the independent central bank of Phantasia (CBP) desired that the democratically elected government if Phantasia had moronic economic policies and as a consequence should be punished and that the best way to do this would be to cut the money base in half and throw the Phantasian economy in to deflationary depression. Would that be ok? Obviously not. 99% of all people would say that that is completely unacceptable haviour and that the CBP had misused its monetary monopoly.

So central bank independence should obviously not be interpreted as meaning that central banks can do whatever think is in their own subjective interest.

So obviously we only want central banks to be independent if they implement monetary policies that are in the interest of those who have given them this monopoly on monetary power. Therefore, central banks should be given a task to fulfill. Furthermore, you want the task given to the central bank to be easily controllable. Luckily it is easy to measure how far the central bank is from hitting nominal targets – for example an inflation target or a NGDP target or a exchange rate target for that matter.

What you don’t want is fuzzy and unclear targets because then you are clearly reducing the accountably and increasing the room for Phantasian style monetary policy. Even though most central banks in the Western world today have some kind of nominal targets they are rarely defined very clearly. Furthermore, performance pay is not widespread among central bankers – the New Zealand Reserve Bank is the only exception as far as I know. And when was the last time you heard of a central bank governor that was kicked out because he failed to hit the nominal target he promised to hit?

Therefore, if you want independence for central banks – which I continue to believe it the best solution if you are going to have a monetary monopoly – then you also want to make sure that you have the highest degree of accountability. Therefore, any central bank law should clearly stipulate what nominal target the central bank should aim at and what consequences it will have for the central bank management if these targets are no hit. Central banks can hit whatever nominal target they are ask to hit so the least you can ask them to do is to hit those targets and if they don’t hit the target it should have consequences.

George Selgin would of course tell us that the real problem is that central banks are given a monopoly in the first place – I find it hard to disagree, but I will leave that debate for another day…

UPDATE: Scott Sumner also has a comment on central bank accountability.

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