Should central banks be independent? | CNBC Explains

Summary

The video script explores the importance of central bank independence, using historical context like Germany's hyperinflation and the Great Inflation of the 1970s to illustrate the consequences of politicized monetary policy. It discusses how central banks' focus shifted from aiding politicians' agendas to stabilizing economies post-1980s, but questions remain about their relevance and trustworthiness in the wake of the 2008 financial crisis and current low inflation rates.

Takeaways

• 🌎 Central bank independence is under scrutiny globally, with leaders in countries like Italy, India, Turkey, and Argentina challenging it.
• 💵 The historical context of central bank independence stems from Germany's hyperinflation post-WWI, leading to the creation of the Bundesbank focused on stable currency.
• 📈 The Phillips Curve, once believed to link lower unemployment with higher inflation, influenced economic policies until it failed during the 1970s' Great Inflation.
• 🇺🇸 U.S. President Richard Nixon's pressure on the Federal Reserve to lower interest rates for political gain led to economic instability.
• 📊 The Great Inflation of the 1970s saw high inflation rates across many countries, except for Germany and Switzerland, which had independent central banks.
• 🏦 The 1980s and 1990s marked a shift towards central bank independence to stabilize economies and prevent politicians' short-term interests from affecting monetary policy.
• 💼 The financial crisis of 2008 brought central banks into the spotlight, with unconventional measures raising questions about their transparency and priorities.
• 📉 Post-financial crisis, central banks face challenges with low inflation rates, questioning the relevance of their historical mandates.
• 🤔 Central banks' effectiveness relies on trust, which is contingent on their independence, yet their leaders are often politically appointed.
• 🔥 Recent political interventions, like Turkey's president firing the central bank chief, highlight the ongoing tension between political and central bank autonomy.

Q & A

Why did President Trump criticize Jerome Powell's Federal Reserve policies?

President Trump criticized Jerome Powell's policies because Powell, as the Chair of the Federal Reserve, was raising interest rates, which Trump did not agree with.

What is the concern regarding central bank independence?

The concern is that central bank independence is under threat, which could lead to political interference and potentially destabilize economies by influencing monetary policy decisions.

Why is the historical context of post-World War I Germany relevant to central bank independence?

The historical context of post-World War I Germany is relevant because it led to hyperinflation due to the central bank printing money to finance government debt, illustrating the dangers of not having an independent central bank.

What was the role of the Bundesbank in establishing central bank independence?

The Bundesbank was the first central bank to be given full independence, focusing on a stable currency and controlling inflation, which quickly gained it a reputation as the world's most independent and conservative central bank.

How did the belief in the Phillips Curve during the 1960s affect central bank policies?

The belief in the Phillips Curve led to the idea that central banks could increase the money supply to lower unemployment by accepting higher inflation, which influenced central bank policies to keep interest rates low.

What was the impact of President Richard Nixon's pressure on the Federal Reserve during his re-election campaign?

Nixon's pressure on the Federal Reserve to lower interest rates led to a temporary economic boost and his re-election, but it also contributed to the Great Inflation, a prolonged period of high inflation.

Why did stagflation occur in the 1970s, and how did it affect the perception of central bank policies?

Stagflation occurred in the 1970s due to a combination of factors including the energy crisis and loose monetary policies. It led to high inflation and high unemployment, challenging the belief in the Phillips Curve and highlighting the need for independent central banks to control inflation.

How did the 1980s and 1990s shift the approach to central bank independence?

During the 1980s and 1990s, many central banks, including the Bank of England, were granted independence to avoid the pitfalls of politically influenced monetary policy, leading to more stable economies and controlled inflation.

What was the role of the European Central Bank in terms of independence?

The European Central Bank was established in 1998 and modeled on the Bundesbank, meaning it was independent from the outset, with the goal of maintaining price stability across the Eurozone.

What challenges have central banks faced since the financial crisis of 2008?

Since the financial crisis, central banks have faced challenges such as being seen as too secretive, favoring big banks over everyday people, and being questioned about their relevance due to low inflation rates.

Why is trust considered essential for central banks, and how does independence relate to trust?

Trust is essential for central banks because it allows them to be effective in managing the economy. Independence is key to gaining trust as it ensures that monetary policy decisions are made without political influence.

How do populist leaders and low-interest rates affect central bank independence?

Populist leaders and low-interest rates can affect central bank independence by increasing political pressure to adopt policies that may not be in the long-term economic interest, thus threatening the autonomy that central banks need to maintain stability.

Outlines

00:00

🏛️ Central Bank Independence Under Threat

The script discusses the importance of central bank independence, starting with Jerome Powell's tenure as the Federal Reserve Chair and President Trump's criticism of the bank's interest rate hikes. It highlights a global trend of leaders challenging central bank autonomy, with examples from Italy, India, Turkey, and Argentina. The narrative then delves into the historical context of central bank independence, using Germany's post-WWI hyperinflation as a cautionary tale. The Bundesbank's establishment and its focus on stable currency are contrasted with the Bank of England's government control. The script also touches on the Phillips Curve theory and its eventual debunking during the Great Inflation of the 1970s, which saw high unemployment rates alongside high inflation (stagflation). The Bundesbank's and Switzerland's independent central banks are credited with better managing inflation during this period.

05:01

🌐 The Evolution and Challenges of Central Bank Independence

This paragraph examines the evolution of central bank independence, starting with the recognition of flaws in government-controlled central banks during the 1970s. It discusses how politicians' election cycles create conflicts of interest, leading to decisions that may not be economically sound in the long term. The paragraph outlines the granting of independence to many central banks in the 1980s and 1990s, including the establishment of the European Central Bank, modeled after the Bundesbank. The script then addresses the financial crisis, where central banks took on crisis response roles, leading to public scrutiny and questions about their transparency and priorities. It raises concerns about the relevance of their mandates in the context of historically low inflation rates post-crisis. The paragraph concludes with a discussion on the challenges to central bank independence, including political appointments and dismissals, and the importance of trust and autonomy for effective monetary policy.

Keywords

💡Federal Reserve

The Federal Reserve, often referred to as the Fed, is the central banking system of the United States. It plays a critical role in implementing monetary policy, controlling the money supply, and influencing interest rates. In the script, Jerome Powell, the Chair of the Federal Reserve, is highlighted as an example of a central banker whose decisions can be scrutinized by political figures like President Trump, illustrating the tension between central bank independence and political influence.

💡Central Bank Independence

Central bank independence refers to the autonomy of a country's central bank to set monetary policy without political interference. The video script emphasizes the importance of this independence by discussing historical examples where lack of it led to hyperinflation, like in Germany after World War I. It also contrasts the outcomes of the Great Inflation, where independent central banks like the Bundesbank helped control inflation better than those under political control.

💡Hyperinflation

Hyperinflation is an extremely high and typically accelerating rate of inflation. It is used in the script to describe the economic crisis in post-World War I Germany, where the central bank's actions led to a monthly inflation rate of over 30,000%. This keyword is crucial for understanding the dangers of uncontrolled money supply and the rationale behind seeking central bank independence.

💡Bundesbank

The Bundesbank is Germany's central bank, established in 1957 with a strong focus on fighting inflation and maintaining currency stability. It is highlighted in the script as the first central bank to be fully independent and is known for its conservative approach. The Bundesbank's success in controlling inflation during the Great Inflation is used as an example of the benefits of central bank independence.

💡Phillips Curve

The Phillips Curve is an economic concept suggesting an inverse relationship between unemployment and inflation—essentially, that higher inflation could lead to lower unemployment. The script mentions how this theory influenced 1960s economic policy, leading central banks to increase the money supply to reduce unemployment, which later contributed to the Great Inflation.

💡Great Inflation

The Great Inflation refers to a period of prolonged high inflation experienced by many countries during peacetime, particularly in the 1970s. The script uses this term to describe the economic challenges that arose when the conventional wisdom of the Phillips Curve failed, leading to high inflation and unemployment rates, known as stagflation.

💡Stagflation

Stagflation is a situation where the economy experiences stagnant economic growth along with high inflation and unemployment. The script mentions stagflation as a consequence of the 1970s economic policies, where traditional economic theories failed, and central banks' efforts to stimulate the economy through low interest rates led to undesirable outcomes.

💡European Central Bank (ECB)

The European Central Bank is the central bank for the euro and administers the monetary policy of the Eurozone. Established in 1998, the ECB was modeled on the Bundesbank, emphasizing independence from political influence. The script highlights the ECB's role in maintaining price stability and its independence as a key factor in economic policy in the Eurozone.

💡Interest Rates

Interest rates, as discussed in the script, are a tool used by central banks to control inflation and manage the economy. By raising or lowering interest rates, central banks can influence borrowing costs, savings, and investment. The script illustrates the political pressures on central banks, like the Federal Reserve, to keep interest rates low to stimulate the economy, which can conflict with their mandate to control inflation.

💡Financial Crisis

The financial crisis mentioned in the script refers to the global economic downturn that began in 2007-2008. Central banks were pushed into the spotlight during this period, implementing emergency measures to stabilize financial markets and prevent a deeper recession. This keyword is important for understanding the role of central banks as 'crisis response units' and how their actions can be scrutinized during times of economic stress.

💡Monetary Policy

Monetary policy is the policy adopted by a central bank to influence economic activity through, among other things, setting interest rates and controlling the supply of money. The script discusses how central banks use monetary policy to manage inflation and stabilize economies, with the independence of these banks being crucial for their effectiveness in achieving these goals.

Highlights

Jerome Powell faced criticism from President Trump for raising interest rates.

Leaders in Italy, India, Turkey, and Argentina have challenged central bank independence.

Central bankers have been fired or resigned amid questions about their decisions.

The importance of central bank independence is underscored by historical context.

Post-WWI Germany's central bank's actions led to hyperinflation.

Bundesbank's establishment in 1957 focused on stable currency and controlling inflation.

Central banks like the Bank of England were previously controlled by governments.

The Phillips Curve theory suggested a trade-off between inflation and unemployment.

President Nixon pressured the Federal Reserve to lower interest rates for re-election.

The Great Inflation of the 1970s challenged the Phillips Curve theory.

The 1970s energy crisis contributed to high inflation and unemployment.

Germany and Switzerland's independent central banks kept inflation under control.

Election cycles create conflicts of interest for politicians managing the economy.

Many central banks gained independence in the 1980s and 1990s.

The European Central Bank was established with independence as a core principle.

Central banks became 'crisis response units' during the financial crisis.

Critics argue central banks are secretive and prioritize big banks over the public.

The challenge post-financial crisis is low inflation rates, not high.

Central banks are questioning the relevance of their mandate in the current economic climate.

Trust in central banks is key to their effectiveness, which requires independence.

Central bank heads are often appointed through political processes.

Governments have fired central bankers, as seen in Turkey in 2019.

Research shows economies perform better with independent central banks.

The future of central bank independence is uncertain amid populist leaders and low interest rates.

Transcripts

Jerome Powell was a few months into his job as the Chair of the Federal Reserve when

U.S. President Donald Trump complained about the central bank’s policies.

“I put a very good man in the Fed.

I don't necessarily agree with it, because he is raising interest rates.”

He’s not the only one complaining.

Italy, India, Turkey and Argentina are just a few of the countries seeing leaders push

back against central bank independence - and some are succeeding.

In the last few years, we’ve seen central bankers get fired,

resign and have their decisions and motivations questioned.

That's led to a number of voices declaring

that the independence of these public institutions is under threat.

But why do we even care whether central banks are independent or not?

It’s kind of a long story.

Let’s go back almost a hundred years for some context.

After the First World War, Germany was in a lot of debt and its costs were racking up.

Soldiers needed pensions.

War widows needed compensation.

France and Great Britain were demanding massive reparations.

And other countries did not want to lend Germany any money.

So Germany’s central bank printed more and more money and loaned it to the government,

hoping to make up the difference.

What they ended up with instead was hyperinflation.

All that cash caused prices to skyrocket.

At the height of the crisis, hyperinflation reached rates of more than 30,000% per month,

meaning prices were doubling every few days.

That’s why in some historical photos, you’ll see Germans burning cash to keep warm

because it was cheaper than buying wood.

This – and more recent examples like the hyperinflations in Zimbabwe and Venezuela – has

shown us the damage out of control inflation can to do an economy and its people.

So when the Bundesbank became Germany’s central bank in 1957, its laser focus on a

stable currency and keeping out of control inflation at bay were no surprise.

It was the first central bank to be given full independence, and it quickly gained

the reputation of being the world’s most independent and conservative central bank.

At the same time, the Bank of England and most of its European counterparts were still

controlled by their governments. Let’s get into why that matters.

Throughout the 1960s, most policymakers believed you could permanently lower unemployment by

accepting higher inflation. This economic concept is known as the Phillips Curve.

So conventional wisdom was that the central banks could increase the money supply, inflation

would go up a bit, and more people would have jobs.

It sounds great, right?

Politicians loved this idea too.

After all, a low unemployment rate is helpful when you’re trying to get reelected.

Take former U.S. President Richard Nixon.

He inherited a recession when he was inaugurated in 1969.

"Our destiny offers not the cup of despair, but the chalice of opportunity."

And when it came time to getting reelected he was focused on keeping the economy moving.

The best way to do that, he thought, was to lower interest rates.

"A lot of the people are going to say, well here we go back into high interest rates again..."

...I don't think that's a justified assumption."

Behind closed doors, he pressured the Federal Reserve Chairman to do just that,

and even though the Fed is supposed to be independent from the government,

the central banker appeared to comply.

The economy got its boost, and Nixon was reelected.

But he got a rude awakening not too long after that. Enter the Great Inflation, the first prolonged,

major period of inflation the world had seen during peacetime.

Annual inflation rates reached levels of over 10 percent across OECD countries, and some

people began to panic. What’s worse?

The Phillips curve didn’t hold true over the long term.

Inflation was high and so was unemployment.

It was lose-lose, a phenomenon known as stagflation.

Many people pointed to the 1970s energy crisis as the culprit, which caused the price of petrol to skyrocket.

"Gasoline stations ran dry. Airlines cut back flight schedules. Factories were forced to close."

But the general consensus today is that the monetary policy of the time played a significant

role as well. Just take a look at this chart.

You can see the inflation rates in the U.S., U.K., Italy and Japan spiking during the Great Inflation.

But Germany, home to the Bundesbank, kept inflation at a much more modest level.

So did Switzerland, which also had a very independent central bank.

The 1970s exposed flaws in having governments controlling central banks.

The nature of election cycles means politicians have an inherent conflict of interest when

making decisions that impact the economy.

"As the recovery gathers pace, so our political fortunes will continue to improve."

It’s tempting for them to skip unpopular choices like raising interest rates

or cutting the budget deficit in an election year.

So during the 1980s and 1990s, many central banks,

including the Bank of England, were granted independence.

The European Central Bank was established in 1998, and was modeled on the Bundesbank,

meaning it was independent from the outset.

The system had changed.

Politicians still set the broad goal – keep prices stable.

But it was up to the central bankers to make it happen.

"I want an end to the stop-go, the boom-bust economics of the past."

Billions of people around the world got used to low and stable inflation and the security

of knowing the interest rates on their bank deposits and mortgages were under control.

"Interest rates have come down. Inflation is down."

But then the financial crisis happened...

"But will these moves by central banks solve the problem?"

...pushing central banks into the spotlight.

They announced emergency measures and unconventional steps to prop up the economy.

Essentially central banks became 'crisis response units' trying to stop the next Great Depression.

"The ECB is ready to do whatever it takes to preserve the euro."

Some people began to question whether the institutions really had their best interests at heart.

Protesters complained central banks were too secretive and that they cared more about bailing

out big banks than helping everyday people.

And of course, there was failing to spot the financial crisis in the first place.

Even though central bank independence was put in place to stop inflation from going

too high, some point out that a decade after the crisis, the actual challenge is inflation

rates being too low. So is their mandate still relevant?

It’s a question many are trying to answer, including some central banks themselves.

But however they evolve, central bank bosses argue trust is key for them to be effective.

And to be trusted, they have to be independent.

"Without independence, policy is bound to go astray."

Yet it’s not that easy.

Despite their supposed independence, most central bank heads are appointed by a political process.

For example, the European Council picks the ECB head

and the U.S. President selects the Fed boss.

"There are few more important positions than this."

In extreme situations, governments fire central bankers too.

Take Turkey.

Its president Recep Tayyip Erdogan fired his central bank chief in July 2019.

Many speculate this was due to his unwillingness to lower interest rates at Erdogan’s request.

Research has consistently shown that economies perform better and prices are more stable

when central banks are independent. But with populist leaders in power and interest

rates at historic lows, whether central bankers will be able to hold on to the autonomy they‘ve

enjoyed for the last generation remains to be seen.