Central bank independence and monetary reform

Most modern economists believe we’d be better off with an independent central bank. If the monetary authority were beholden to the fiscal authority, the latter could cover its expenditures via the inflation tax. But, in doing so, it would subject the economy to costly price hikes with no offsetting benefits in the long run. Experiences in Zimbabwe, Venezuela, Argentina, and all other episodes of hyperinflation suggest that central bank independence is crucial.

In a new Brookings paper, Sarah Binder and Mark Spindel consider whether the Fed can remain independent in a politically polarized era. They have two interesting results: (1) efforts to reform the Fed pick up when the economy (as measured by the misery index) is performing poorly and (2) these efforts find support on both the left and right. Phillip Wallach offers some interesting commentary on the latter. After reconsidering the importance of independence, I will address the former here.

What do we mean by independence? We could mean that the Fed is independent to pursue any course of action it deems appropriate. Under such a regime, it could pursue the ends that most economist suggest are appropriate. Or, it could do something else. Anything else. Potentially, something terrible. It is independent, after all.

Alternatively, we could think of a central bank as acting independently within its constitutional constraints. In creating or reforming the central bank, the polity specifies its constitution, or goal, but the central bank remains free to pursue any course of action necessary to achieve that goal. In the US, for example, the Fed has been given the goal of stabilizing prices while achieving maximum employment. We can debate the merits of that rule. But, so long as the specified rule does not require that the monetary authority accommodates the fiscal authority, it need not hamper the monetary authority’s day-to-day independence.

How, then, should we think about monetary reform with a constitutionally constrained but independent central bank? The short answer is: It depends. If you have a good rule, reform would likely make things worse. But, if you have a poor rule, reform might make things better. From this perspective, the observation that reform efforts are positively correlated with the misery index might be good news. When it becomes clear that our current rule is imperfect, legislators consider revising the rule. Of course, this presupposes the legislators understand what a good rule looks like and have an incentive to push toward such a rule.

So, what should we do? First and foremost, we should continue to promote the ideas of sound money. Good ideas not only inform legislators, but also—to the extent that these ideas are widely held—impose constraints on what reforms can be proposed and adopted.

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