The economy of a country is significantly influenced by central banks. They regulate key factors including inflation, interest rates, and the money supply. These decisions determine the financial ranking of the economy and the income tax of individuals. But central banks are often insulated from political control, and that continues to be a matter of debate. Central bank independence is essential to keeping a monetary policy path stable and credible. Central banks operate best when they’re free of political pressures. But in a democracy, in which elected leaders are responsible to the people, some say, central banks should be accountable to the government.
What is Central bank independence?
The independence of a central bank refers to its ability to make policy without influence from the political or governmental systems. This independence is key to keeping monetary policy steady and predictable. Most central banks, including the Federal Reserve in the United States and the European Central Bank, are set up to run independently of the government.
The Role of Central Banks
To appreciate why independent central banks matter, it helps to understand what they do. Central banks are responsible for setting monetary policy, which regulates inflation, interest rates, and the money supply. They also affect how much it costs to borrow, consumer spending, and investment.
Central banks’ main task is to maintain low and stable inflation. Too much inflation can be bad for the economy. If it is too high, then the economy could endure stagnation. Central banks also serve as a “lender of last resort,” assisting commercial banks during a crisis.
Political Pressure on Central Banks
One major challenge is political pressure. In democracies, elected officials embody the will of the people. It is not uncommon for politicians to attempt to influence central banks to generate short-term benefits largely before elections. This can lower interest rates to stimulate economic growth and decrease elevated unemployment. While this can be helpful in the short term, in the long run this can cause higher inflation and instability.
The other problem is when governments want to print more money so they can finance their spending. If the central bank gets politically captured, this might exert great pressure on it to print money so that it can start funding the purposes of the government. This means that hyperinflation can occur, which has already happened in countries such as Zimbabwe and Venezuela.
Benefits of Central Bank Independence
Central bank independence is important for a number of reasons.
- Credibility: An independent central bank can pursue long-term targets. This instills confidence in its decisions. It’s going to be strong on inflation and not make decisions based on political reasons in the short term.
- Inflation Under Control: Independence allows a central bank to focus on maintaining low inflation. Politicians may want to reduce interest rates to secure votes, but this can produce higher inflation. An independent central bank can steer clear of such perils.
- Avoiding Populism: Politicians might seek to intervene with monetary policy for temporary gain. Others might advocate for low interest rates shortly before an election. This means inflation is likely to be higher down the line. An independent central bank can withstand such political pressures more easily.
- Stability: A central bank targeting its mandates with independence from politics enables economic stability. It can forge ahead based on economic data and expert analysis instead of making dangerous bets based on political dogma.
Global Trends in Central Bank Independence
The independence of central banks has increasingly become a worldwide trend. It has become a marked period due to soaring inflation and economic turmoil in many countries. In its wake, countries such as Germany and the United States set up institutional measures that granted independence to central banks.
Most developing countries appreciate the value of working towards central bank independence as an inflation hedge. But in developed economies, even the fight for independence remains as political pressure rises. Economic crises challenge the resolve of central bank independence and tend to spark animated discussions about its merits.
The Case for Political Oversight
And while the independence of central banks has many positive aspects, it also warrants political oversight.
- Democratic Accountability: Elected representatives answer to the citizenry. Some say that an unelected body should not control so much of the economy. They argue that central banks should report to popularly elected leaders who represent the views of the people.
- Coordinated Policies: Others are calling for central banks and governments to coordinate overall. In a crisis, fiscal policy (government spending) and monetary policy (central bank) might call for some action. Coordination between them may provide a boost to economic recovery.
- Responding to Social Needs: Politicians often focus on social goals like reducing unemployment or poverty. Goals may not be in lockstep with a central bank whose main interest is inflation and interest rates. Some claim that central banks should be more attuned to these larger social concerns.
Challenges in Maintaining Independence
Even with the advantages of independence, it is not always easy to keep central banks free from political influence. One issue is that central bank leaders are often appointed by the government. This raises concerns about whether they will prioritise political goals over economic stability.
Another challenge comes during times of financial crisis. In such times, central banks may face pressure to prioritise economic recovery. Balancing short-term needs with long-term stability can be difficult.
The Impact of Political Interference on Monetary Policy
The consequences can be brutal when political interference starts to invade central bank decisions. And in some countries, governments have pushed central banks to cut interest rates or expand the money supply to help finance national debt or stimulate growth. Such measures can deliver temporary economic spurts, but often at the price of longer-term problems, like runaway inflation or debt crises.
In countries where central banks are not independent, politicians can stoke monetary policy to finance government spending, creating inflationary spirals that damage the economy. For example, countries such as Argentina and Zimbabwe provide historical illustrations of how central banks forced to operate under government control often print way too much money, leading to a devaluation of their purchasing power and economic collapse.
Conclusion
The project of central bank independence is a complex one. Independence of the central banks ensures the stability of the economy and the control of inflation. But there are arguments for some political engagement. The trick is to find balance between the two. Central banks must retain independence to make sound economic decisions, but they also need to be accountable to the public.
The trick is to keep that balance there. Central banks can also be too independent. It can lead them to drift too far from what is needed in society. The right solution will depend on the specific needs and challenges of each country. And so being independent, but with a nod to political oversight, would be the best path forward.
