Do central banks need to be "independent"?

Simon Wren-Lewis has a wonkish post, The strong case against independent central banks Mainly Macro 03/05/2016 raising points I'm glad to see being discussed. He gives some background on the development of thinking about central banks and economic management. Here he describes the post-Bretton Woods state of affairs, which Yanis Varoufakis would call the birth of the Global Minotaur. But "delegation" here, he means "giving central banks the power to decide when to change interest rates (independent central banks, or ICBs)":

A story some people tell is that this all fell apart in the 1970s with stagflation. In the sense I have defined it, that is wrong. The Keynesian framework had to be modified to deal with those events for sure, but it was modified successfully. Attempts by New Classical economists to supplant Keynesian thinking in policy circles failed, as I note here.

The more important change was the end of Bretton Woods and the move to floating exchange rates. That was critical in allowing the focus of demand management to shift away from fiscal policy to monetary policy. The moment that happened, it allowed the case for delegation to be made. Academics talked about time inconsistency and inflation bias, but the more persuasive arguments were also simpler. Anyone who had worked in finance ministries knew that politicians were often tempted and sometime succumbed to using monetary policy for political rather than economic ends, and the crude evidence that delegation reduced inflation seemed strong.

And he notes that the conservative-leaning consensus before the 2008 crisis revealed its huge problems to a wider public:

However the consensus assignment had an Achilles Heel. It was not the global financial crisis (which was a failure of financial regulation) but the Zero Lower Bound (ZLB) for nominal interest rates. Although many macroeconomists were concerned about this, their concern was muted because fiscal action always remained as a backup. To most of them, the idea that governments would not use that backup was inconceivable: after all, Keynesian economics was familiar to anyone who had done Econ 101.

That turned out to be naive. What governments and the media remembered was that they had delegated the job of looking after the economy to the central bank, and that instead the focus of governments should be on the deficit. Macroeconomists should have seen the warning signs in 2000 with the creation of the Euro. There monetary policy was taken away from individual union governments, but still the Stability and Growth Pact was all about reducing deficits with no hint at any countercyclical role. When economists told politicians in 2009 that they needed to undertake fiscal stimulus to counteract the recession, to many it just felt wrong. To others growing deficits presented an opportunity to win elections and cut public spending.

Macroeconomists were also naive about central banks. They might have assumed that once interest rates hit the ZLB, these institutions would immediately and very publicly turn to governments and say we have done all we can and now it is your turn. But for various reasons they did not. Central banks had helped create the consensus assignment, and had become too attached to it to admit it had an Achilles Heel. In addition some economists had become so entranced by the power of Achilles that they tried to deny his vulnerability.

And that vulnerability is essentially the conservative obsessions that are part of Hoover Hoover/Heinrich Brüning economics that wound up having a pro-cyclical bias in a depression economy.

Yanis Varoufakis, James Galbraith and the "twin deficits," aka, the Global Minotaur

Yanis Varoufakis is the innovative Professor of Economic Theory at the University of Athens in Greece. His book The Global Minotaur: America, the True Origins of the Financial Crisis and the Future of the World Economy (2011) describes the post-Second World War development of the international financial system, which he sees a s falling into three broad periods: the Bretton Woods regime, the post-1971 years based on the United States' "twin deficits," and the post-2008 world which is still taking shape.

A second English edition is due in February 2013. The Spanish cover for the second edition is pretty awesome:

Varoufakis has a blog which you should probably be reading.

What does he mean by the "Minotaur"? In the Greek myth, the Minotaur was a half-man, half-bull creature that lived in the famous Labyrinth on the island of Crete and had to live on human flesh. Each year, King Aegeus of Athens had to send to King Minos of Crete six young males and six female virgins as a tribute to feed the Minotaur because of some war that Athens lost.

Varoufakis uses it as a metaphor for the "twin deficits" of the United States in the post Bretton Woods period, the twin deficits being the chronic US trade deficit and the corresponding chronic public budget deficits.

Varoufakis doesn't use the image as exclusively or even mainly pejorative:

The Minotaur is a tragic mythological figure. Its story is packed with geed, divine retribution, revenge and much suffering. It is also a symbol of a particular form of political and economic equilibrium straddling vastly different, faraway lands; a precarious geopolitical balance that collapsed with the beast's slaughter, thus giving rise to a new era. (p. 24)

After the foreign exchange system of Bretton Woods ended with a 1971 decision by the Nixon Administration, the dollar remained as the world's reserve currency. This meant that other countries would hold dollars in sufficient quantities that the US would wind up running trade deficits on an ongoing basis. Other major factors like the increase in oil prices and the export prowess of Europe, Japan and China would of course contribute mightily to this same trend.

Jamie Galbraith in The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too (2008) relates that, although Paul Volcker himself in the 1980s talked about the "twin deficits," they weren't generally understood. Economic theory assumed that large, chronic foreign trade deficits (and the related balance of payments issues) move into equilibrium over time, i.e., that a large chronic trade deficit is impossible to sustain over decades and will eventually collapse, either in a controlled way or a catastrophic one. As Galbraith notes, Volcker assumed in the 80s that the chronic trade deficits were a function of the budget deficits that were a trademark of the Reagan Administration.

Why might Volcker have thought that? Because of accounting. Galbraith:

There is a basic relationship in macroeconomics, as fundamental as it is poorly understood, that links the internal and the international financial position of any country. A country's internal deficit, that is, its "public" deficit and its "private" deficit - the annual borrowing by companies and households - will together equal its international deficit. [my emphasis] (p. 55)

The international deficit is usually taken to be the sum of the "current account" and "capital account" balances.

Because the rest of the world was not willing to continue to finance the trade surpluses the US had run under the Bretton Woods system, "The old wisdom, which held that budgets should be balanced or perhaps balanced over the business cycle, continued to be spoken, but it was obsolete." The post-Bretton Woods system, the "Global Minotaur," stabilized during the Reagan Administration. As Galbraith relates:

... the Federal Reserve's policy of a super-high interest rates and a super-strong dollar helped Reagan out. By attracting a flood of investment capital back into the United states the strong dollar policy reconciled fiscal stimulus, recovering employment, and a rapid end to inflation. The dollar now became the unchallenged world reserve currency, which meant the United States not only could, but had to, run trade deficits to the extent of the demand for reserves. So long as the domestic private sector remained of a mind to accumulate financial assets, which it did through the Reagan term, the trade deficits had to be translated, as a matter of accounting, into federal budget deficits of a similar size. [my emphasis] (P. 58)

Galbraith discusses this in the context of how the unhealthy fixation by the Democrats in the United States on balancing budgets came to be, unrealistic though it is, a story particularly relevant to the current situation where President Obama and the Republicans are eager to cut benefits on Social Security, Medicare and Medicaid in the name of the budget-balancing dogma, even in the middle of a depression.

Varoufakis focuses on the international function of the twin deficits, especially its role as a global surplus recycling mechanism (GSRM). The purpose of a a GSRM, in Varoufakis' words, is, "To prevent the build-up of systematic surpluses in some countries and of persistent deficits in others."

In general, any economic system contains units that are prone to showing surpluses and others that are more likely to report deficits. To maintain balance, the system must feature surplus recycling mechanisms that maintain the flow of surpluses from the future to the present, from the urban centres to the rural areas, from the developed regions to the less developed ones, etc. ...

The two surplus [internal] recycling mechanisms characteristic of the United States since the Second World War have been the simple transfer union instituted by the New Deal in the late 1930s and the complicated military-industrial complex, which developed in the 1940s. The former works straightforwardly, by ensuring that the unemployment and health benefits of deficit states are paid for by Washington, dipping into taxes raised in surplus states, e.g., California and New York. The second mechanism, too, turns on a political arrangement: whenever a conglomerate like Boeing receives a large Pentagon contract to build a new fighter jet or missile system, it is stipulated that some of the production facilities must be located in depressed, deficit states. This recycling takes the form not of loans and transfers but of productive investments in deficit regions that utilize surpluses produced in the surplus regions. [my emphasis] (pp. 64-65)

The GSRM function of the US twin deficits, which Varoufakis calls the Global Minotaur, reversed the GSRM function of the Bretton Woods arrangements, which he also refers to as the Global Plan. The long-term tendency of the twin deficits was a destabilizing one, because "they had to keep deepening, accelerating, growing."

These destabilizing moves, which threatened to undermine the international order, were counterbalanced by the Minotaur's most intriguing aspect: the fact that it worked just like a GSRM - a weird, most peculiar, terribly unruly GSRM; but a GSRM nonetheless. In fact, it worked in precisely the opposite way to how the original GSRM had worked under the Global Plan.

Under the Global Plan's GSRM, the United States was the surplus-amassing country with the good sense to recycle part of its surpluses to Western Europe and Japan, thus creating demand for its own exports, but also for the exports of its protégés (Germany and Japan primarily). In sharp contrast, the Global Minotaur worked in reverse: America absorbed other people's surplus capital, which it then recycled by buying in their exports. (p. 110)

Varoufakis sees the twin deficits/Global Minotaur system as having permanently broken down with the financial crisis of 2008. He describes several features of the twin-deficits systems, which he calls "handmaidens," such as the creation of the shadow banking system, the Walmart phenomenon of an drastic shift to a low-wage service economy, and various more-or-less crackpot economic theories that were believed by those who Paul Krugman derisively calls the Very Serious People. Varoufakis then gives his own account of how those factors functioned in causing the crash and influencing policy in the aftermath.

The path of destruction left by decades of neoliberal policies of deregulation and piratical financial practices have been sobering for those like Varoufakis trying to point the way to a more hopeful future. The two most hopeful signs for a new GSRM to take over the function of the Global Minotaur are "a grand coalition of emerging countries, which would forge a de facto GSRM on the basis of planned investment and trade transfers between them," and a global International Currency Union based on the policy defended unsuccessfully by John Maynard Keynes and the Bretton Woods conference in 1944.

One thing Varoufakis is sure about is his answer to the question, "Can the Minotaur survive?" (He means the GSRM system, not the US as such.)

No, I do not believe it can. The Crash of 2008 knocked so much of the financial stuffing out of the American economy, and depleted New York-based financialization of so much of its over energy, that its magnetic power over foreign capital will not recover. Wall Street may have been fully resurrected, and those banks that were too big to fail may have grown even bigger (at least in relative terms), but the capitalization of Wall Street is now too thin to attracted the tsunami of foreign capital that kept the Minotaur alive and kicking. What is more, the new regime that has been established since 2008-09 in the United States and Europe - the 'system' I have labelled bankruptocracy - is too introverted and insufficiently attractive to act as a 'drawing card' for the necessary capital inflows. No, the Global Minotaur today is at the stage the Global Plan [the Bretton Woods regime] was at after 1971: a state of gradual, but irreversible, disintegration. (p. 224)

Tags: global minotaur, james galbraith, predator state, yanis varoufakis