What’s left of central bank independence?

The modern independent central bank was born in New Zealand in 1989. It had a short life.  The onset of the financial crisis of the north Atlantic region in August 2007 signalled the beginning of the end.  Today, only the ECB still has a significant degree of operational independence left, and it will have to give that up if it is to be effective in the current phase of the crisis. In other words, the ECB is the last central bank to understand that, if it is to play a significant financial stability role, it cannot retain the degree of operational independence it was granted in the Treaty over monetary policy in the pursuit of price stability.

Inflation targeting was invented around the same time and central bank independence, and also in New Zealand, with the Reserve Bank of New Zealand Act of March 1989 and the first Policy Targets Agreement (PTA) in March 1990.  The Reserve Bank of New Zealand Act 1989 specifies that the primary function of the Reserve Bank shall be to deliver “stability in the general level of prices.”

The Act says that the Minister of Finance and the Governor of the Reserve Bank shall together have a separate agreement setting out specific targets for achieving and maintaining price stability. This is known as the Policy Targets Agreement (PTA). A new PTA must be negotiated every time a Governor is appointed or re-appointed, but it does not have to be renegotiated when a new Minister of Finance is appointed. The Act requires that the PTA sets out specific price stability targets and that the agreement, or any changes to it, must be made public. The PTA can only be changed by agreement between the Governor and the Minister of Finance. Thus, neither side can impose unilateral changes. Note, however, that under the Reserve Bank Act the Government has the power to override the PTA. This override power, akin to the UK Treasury’s Treasury Reserve Powers, has not been invoked thus far.

A case can be made for the Deutsche Bundesbank, established in 1957 as the sole successor to the two-tier central bank system which comprised the Bank deutscher Länder and the Land Central Banks of the Federal Republic of Germany, as the first modern independent central bank, but the de-facto independence of the Bundesbank was a product of Germany’s unique historical circumstances – notably the hyperinflation of the Weimar Republic’s hyperinflation during 1923 and the limited legitimacy of the other state institutions following the Nazi era and World War II.  I therefore consider the Bundesbank to have been a pre-modern independent central bank.

From New Zealand, central bank independence spread to the UK (1997), Japan (1997), the Euro Area (1999) and many other corners of the universe.

Two kinds of central bank independence are commonly distinguished – target independence and operational independence.

Target independence

Fundamental target independence – the right to choose its own fundamental objective or objectives – is possessed by no central bank.  Even the most independent of all central banks, the ECB, has its multiple fundamental objectives laid down in an external document – the Treaty Establishing the European Community.  Article 105 states that “The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4.”

Article 2 of the Treaty states: “The Community shall have as its task, by establishing a common market and an economic and monetary union and by implementing common policies or activities referred to in Articles 3 and 4, to promote throughout the Community a harmonious, balanced and sustainable development of economic activities, a high level of employment and of social protection, equality between men and women, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance, a high level of protection and improvement of the quality of the environment, the raising of the standard of living and quality of life, and economic and social cohesion and solidarity among Member States.”

I still think it will come as a surprise to ECB Executive Board member Jürgen Stark that one of the objectives of the ECB is to promote equality between men and women – albeit without prejudice to the objective of price stability.

The Bank of England’s monetary policy objectives are laid down in the Bank of England Act 1998.  They are to deliver price stability and, subject to that, to support the Government’s economic objectives including those for growth and employment.

The Fed has a triple mandate, given in Section 2a. of the Federal Reserve Act: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.

Of all leading central banks, only the ECB sets its own quantitative operational targets.  It defines price stability is an annual rate of inflation (measured by the HICP index) below but close to two percent.   The Bank of England’s operational is set by the Chancellor of the Exchequer.  It is currently a two percent annual inflation rate for the HICP  (known in the UK as the CPI).  The Fed has no quantitative target for any of its three fundamental objectives.  Under Chairman Ben Bernanke, it has been edging slowly towards an implicit inflation target, captured by the average or median 3-years ahead inflation forecasts of the members of the FOMC.  Whether this implicit inflation target is defined in terms of the CPI or the consumer expenditure deflator, and in terms of the headline inflation rate or the core inflation rate is unclear.

Operational Independence

Operational independence is the freedom or ability of a central bank to pursue its objectives (regardless of who sets them) as it sees fit, without interference or pressure from third parties. It is not a binary variable but a matter of degree. Operational independence from an elected, sovereign government is not easily achieved.

It requires political independence: the central bank cannot seek or take instructions from any government/state body or other institution/body. It requires technical independence: the central bank must have the tool(s) to do the job. It means that the central bank cannot be coerced or induced to extend permanent financial assistance to the government or to private agents – it cannot be raided by government or private actors. It requires financial independence, that is, a separate budget and a secure capital base. It requires security of tenure and of terms of employment; this can be achieved through a minimum term of office, removal from office only for incapacity or serious misconduct (and not for gross incompetence), and pay and other conditions of employment that cannot be manipulated by outsiders. Finally, it requires that there be some other independent body, e.g. a court, to settle disputes between the central bank and the government.

This list suggests that operational independence is not a binary variable but a matter of degree, that a high degree of operational independence is difficult to achieve and that, if it is achieved, the central bank is, almost by definition, not substantively accountable to any other agency.

As an illustration of the problems standing in the way of operational independence of the central bank, consider the issue of its financial independence. The ability of the central bank to pursue its price stability mandate or, operationally, to achieve its inflation target, is constrained by its financial resources. Unlike the Treasury, the central bank does not have the power to tax. The asymmetry is even stronger when hen one realises that among the entities the Treasury can tax is the central bank. Frequently, the Treasury is also the legal owner of the central bank.

In the UK, for instance, the Treasury owns all the common stock of the Bank of England. This raises the question: how independent can you be of the party that owns you and is able to tax you at will? The answer is that this depends on the ability of the Treasury to commit itself not to deplete the financial resources of the central bank, whether by calling for extraordinary dividends, through a forced share re-purchase, by taxing the central bank or by raiding its gold reserves. The credibility of that commitment is determined by the same political factors that prompted the delegation of monetary policy to an operationally independent central bank in the first place. It is an open issue.

The financial independence of the ECB is due in no small measure to the fact that the ECB does not face a single controlling owner, or a single fiscal actor (Treasury or Ministry of Finance) capable of taxing it. The ECB is owned by the National Central Banks of the European Union. These in turn are owned (with a number of exceptions) by their national Treasuries/Ministries of Finance. Raiding the financial resources of the ECB would effectively require the unanimous agreement of the Finance Ministers of the EU. In addition, the ECB would be able to appeal the matter to the European Court of Justice. Very few conventional central banks facing a single national Treasury are in the same comfortable position.

Table 1 shows the stylised conventional financial balance sheet of a central bank:

Table 1

Conventional central bank balance sheet

Assets Liabilities
D:
Treasury debt
M:
Base money
C: Currency
BD:

Bank reserves

L:
Private sector debt
N:
Non-monetary liabilities
TD: Treasury deposits
CBB: Central bank bills and bonds
R:
Foreign exchange reserves
W:
Financial net worth or equity

On the asset side the central bank has claims on the Treasury, D, claims on the private sector, L, and foreign exchange reserves, R. Claims on the Treasury includes Treasury securities held outright, and loans to private parties collateralised by Treasury securities. Claims on the private sector includes private securities held outright, unsecured loans to the private sector and loans to the private sector secured against private assets.

On the liability side is the monetary base, M, the sum of currency in circulation, C, and banks’ balances held with the central bank, BD, and non-monetary central bank liabilities, including Treasury deposits with the central bank, TD, and central bank bills and bonds, CBB. The excess of the assets over the liabilities in the conventional financial net worth or equity of the central bank, W. It need not be positive, even though central bankers generally would not be very happy to work with a hole in their balance sheet.

The reason central banks conventional net worth or equity can be negative without this automatically causing a default by the central bank on its obligations, is that there are a number of future cash flows (positive and negative) that are not capitalised and put on the conventional balance sheet. The most important missing asset is the present discounted value of the profits the central bank can earn thanks to its ability to issue non-interest-bearing bank notes and bank reserves that need not be remunerated at market rates. I denote the present value of this future seigniorage revenue by S. On the liability side is the present discounted value of the cost of running the central bank, E and the present value of the net payments the central bank makes to the Treasury, T.

Adding the unconventional assets and liabilities of the central bank to the conventional ones contained in Table 1 gives us Table 2, which shows the comprehensive balance sheet of the central bank or its intertemporal budget constraint.

Table 2

Comprehensive central central bank balance sheet (central bank intertemporal budget constraint)

Assets Liabilities
D:
Treasury debt
M:
Base money
C: Currency
BD:

Bank reserves

L:
Private sector debt
N:
Non-monetary liabilities
TD: Treasury deposits
CBB: Central bank bills and bonds
R: Foreign exchange reserves E: Present discounted value of cost of
running central bank
S: Present discounted value of
seigniorage profits (interest saved on non-interestbearing monetary
liabilities).
T: Present discounted value of net
payments to Treasury (taxes)

V :
Comprehensive net worth or equity

Comprehensive net worth or equity of the central bank, V, is the conventional net worth or equity, W, plus the unconventional asset, S, and minus the unconventional liabilities, E and T, that is:

V = W + S – E – T

Comprehensive net worth has to be non-negative, or the central bank is kaput.

What can the central bank do when it gets raided by the Treasury or if it suffers a capital loss on its assets, say as a result of its repo operations (where it makes loans against possibly dodgy private collateral), or as a result of credit easing through the outright purchases of private securities, or through unsecured loans to the private sector? After it cuts its expenses to the bone (sets E equal to zero), all it can do is to ‘print money’ to stay solvent. Increased money issuance will, sooner or later, lead to higher inflation. That means higher nominal interest rates and therefore a higher value of central bank profits on its investment account (S) in Table 2. Financial solvency will have been restored (assuming that the central bank is not operating on the slippery slope of the seigniorage Laffer curve), but it may well be the case that the lowest inflation rate necessary to restore financial solvency for the central bank is different from (and most likely higher than) the inflation target

The ECB has achieved a remarkable and unique degree of formal operational independence

There can be little doubt that the ECB is the central bank with the highest degree of formal or legal operational independence. Since it also sets its own operational objectives (medium term HICP inflation below but close to two percent per annum ), it can also be characterized as the most independent central bank, when operational independence and target/goal independence are taken together.  The ECB’s operational independence and its mandate are enshrined in the Treaty establishing the European Community and the associated Protocol. These can only be amended through a Treaty revision requiring the unanimous consent of the EU member states (currently 27 in number).

As regards formal, legal safeguards guaranteeing political independence, financial independence and security of tenure and conditions of employment, the ECB scores as high as or higher than any other central bank. Highly unusually, there is nothing in the Treaty and Protocol governing the ESCB and the ECB that permits the political authorities (in this case the Council of the European Union) to repatriate, or

take back, under extreme circumstances, the power to conduct monetary policy from the ECB. The Bank of England Act 1998 created the Treasury Reserve Powers for this purpose; the Reserve Bank of New Zealand Act 1989 contains a similar provision.

Dispute resolution through the European Court of Justice provides a further safeguard for the ECB’s  operational independence.

There is just one potential chink in the ECB’s operational independence armour. This relates to the ECB’s technical independence. There is some question as to whether the ECB has the tools to do the job of ensuring price stability.

Responsibility for exchange rate policy is divided between the ECB and the Council of Ministers. There is no substantive problem for central bank independence from the power of the Council of Ministers, acting unanimously, to enter into formal exchange rate arrangements with non-EU countries. Joining a new Bretton Woods would clearly be a political decision, to be taken by the political leadership of the EU, not by the ECB.

However, the Council can also formulate general orientations for the exchange rate. Only a qualified majority is required for this. Divided responsibility for the exchange rate could make a mockery of central bank independence. Not surprisingly, the ECB asserts that it cannot be given binding exchange rate orientations without its consent, and it has good sense on its side. Every French minister of finance since 1999 and a number of other ministers of finance have begged to disagree, however. The issue has not yet been put to the test.

Unconventional monetary policies require close central bank – Treasury cooperation

Every time a central bank makes a loan at the discount window or engages in a reverse repo secured against private collateral, it takes credit risk (default risk).  In the Euro Area, the ECB even takes credit risk when in accepts the Treasury debt of some of the Euro Area member states as collateral in its lending operations.  There is no guarantee that cross-border fiscal solidarity in the Euro Area will ensure that sovereign debt issued by fiscally incontinent member states will be made good by Germany and other member states with deep pockets.

With central banks outside the Euro Area now actively engaged in credit easing through the direct acquisition of private securities (commercial paper, corporate bonds, mortgages and ABS) and possibly in the future through unsecured lending to the private sector, the exposure of central banks to credit risk is becoming larger and could become huge in some countries before this crisis is over.  Central banks could therefore be faced, if they suffer a large capital loss, either to engage in aggressive base money creation to maintain solvency, endangering their inflation targets and price stability mandates, or to go to the nearest Treasury with a begging bowl, thus undermining the central bank’s independence.

To prevent this, the Bank of England has agreed a full indemnity with the Treasury for any capital losses it incurred through defaults on its outright purchases of private securities (it does not, however, have any indemnity from the UK Treasury for losses it may incur on lending collateralised against private securities).  The Fed has not obtained a full fiscal indemnity even for its outright purchases of private securities.  Like the Bank of England, it also has no fiscal indemnity of any kind for losses on collateralised lending.  Under the TALF, for instance, the Fed could take on a full trillion dollars’ worth of exposure to the private sector, with the US Treasury only providing an indemnity for such losses up to a limit of $100 billion.  In the worst-case-scenario, the Fed could be $900bn in the hole through the TALF.

The total exposure of the Fed to private sector default risk is massive and growing.  It includes the three Delaware-based SPVs (Maiden Lane I, II and III) created to deal with Bear Stearns’ toxic waste and AIG’s nasty legacies in a non-transparent, off-balance sheet and tax-free manner), plus the other exposure acquired both through outright purchases or through loans secured against private assets in the dozen-plus special facilities created since the start of the crisis.  The Fed has been acting effectively like an off-budget, off-balance-sheet and off-the-Congressional-radar-screen SPV of the Treasury.  Even if one believes this was the right thing to do under the circumstances, the fact remains that it seriously compromises the future independence of the Fed.

Inevitably, when the central bank takes on significant credit risk in its monetary policy management, liquidity management and credit enhancement policies, close cooperation between the central bank and the fiscal authorities is essential.  Cooperation and coordination do not necessarily mean loss of independence. The ECB, unfortunately, often talks as if cooperation and coordination, including binding agreements, between the ECB and the fiscal authorities of the Euro Area would in and of itself constitute an infringement on its independence.  So all it is up for is regular cheap talk with the Ecofin or with the Eurogroup finance ministers.

As the crisis lengthens and deepens, the absence of close cooperation between the fiscal authorities in the Euro Area and the ECB will make both the ECB and the fiscal authorities progressively less effective.  This is in addition to the problems the ECB encounters as a result of the absence of even a minimal ‘fiscal Europe’, in the design and implementation of unconventional monetary policy involving outright purchases of private securities or unsecured lending to banks or other private counterparties.

Stick to your knitting and don’t get too close

It is a mistake for central bankers to express, in their official capacities, views on what they consider to be necessary or desirable fiscal and structural reforms. Examples are social security reform and the minimum wage, subjects on which Alan Greenspan liked to pontificate when he was Chairman of the Board of Governors of the Federal Reserve System, and Ben Bernanke’s tendency to lecture on everything, from equality and opportunity to teenage pregnancy. It is not the job of any central banker to lecture, in an official capacity, the minister of finance on fiscal sustainability and budgetary restraint, or to hector the minister of the economy on the need for structural reform of factor markets, product markets and financial markets. This is not part of the mandate of central banks and it is not part of their areas of professional competence.

The regrettable fact that the Treasury and the Ministry of the Economy tend to make the symmetric mistake of lecturing the operationally independent central bank on what they perceive to be its duties (which generally amounts to a plea for lower interest rates or other more expansionary policy measures) does not justify the central bank’s persistent transgressions.

There are but a few examples of central banks that do not engage in public advocacy on fiscal policy and structural reform matters. There used to be two I was aware of,  the Bank of England and the Reserve Bank of New Zealand. Unfortunately, Mervyn King undid 12 years of effort by his predecessor, Eddie George, and by his more enlightened earlier self, when, in front of the Treasury Committee on March 24, 2009, he said the following in response to a question from one of the Treasury Committee members, a Mr. Love:

Question: “The IMF in successive reports has forecast a larger and larger decline in world output and, therefore, one presumes in the short-term the continuing of that series. Is there an argument to be made for a second fiscal stimulus to respond to what is likely to be a further decline in the world’s economic output?”

Mr King: “I am sure the Government will want to be cautious in this respect. There is no doubt that we are facing very large fiscal deficits over the next two to three years, there can be no doubt about that. I think it is right to accept that when the economy turns down and the automatic stabilisers kick in, so the increased benefit expenditures and lower tax revenues are bound to lead to higher fiscal deficits and it does not make sense to try to offset that so we are going to have to accept for the next two to three years very large fiscal deficits. Given how big those deficits are, I think it would be sensible to be cautious about going further in using discretionary measures to expand the size of those deficits. That is not to rule out targeted and selected measures that may find those areas, whether it is in the labour market, whether it is in corporate credit, that can do some good, but the fiscal position in the UK is not one that would say, “Well, why don’t we just engage in another significant round of fiscal expansion?” We can do more monetary easing if necessary. Monetary policy should bear the brunt of dealing with the ups and downs of the economy. …”

I happen to agree with Governor King on the undesirability of a further discretionary fiscal stimulus for the UK.  But why on earth did he say this in public?  This was definitely a sliding tackle, nowhere near the ball, with both feet aimed firmly at sensitive parts of the political anatomy of the Chancellor and, even more, of the Prime Minister.  It politicises the Bank of England and makes it fair game for any government minister or member of the opposition who wants to put pressure on the bank or attack it in public.  Not smart.

President Trichet of the ECB is already so far down the road of telling governments what to do and what not to do in the fiscal and structural reform domains, that one is hardly surprised by yet another lecture on budgetary policy from the Eurotower.  Traditionally, continental European central bankers speak very little about monetary policy in public, and are often unwilling to engage in public debate or answer questions about their monetary duties, but carry on endlessly about budgetary and structural reform matters.  It’s always easier to speak about things you have no responsibility for, that are not part of your mandate and about which you probably don’t know very much.

The opposite problem has been encountered in the US, when Ben Bernanke has been so often seen shoulder-to-shoulder with past and present Secretaries of the Treasury, that it is hard to tell (except for the beard) where one begins and the other ends.  A Chairman of the Fed ought not to publicly endorse or reject fiscal measures, budgets or plans.  It’s not his mandate and not his competence.  It also further politicises the Fed and undermines its future independence.

Central bankers indeed have a duty to explain how their current and future interest rate decisions are contingent on economic developments that may include or may be influenced by, the actions of the fiscal authorities and the success or failure of structural reforms. The central bank should clarify what its reaction function is, given the economic environment in which they operate, which includes the fiscal authorities and the government and ‘social partners’ engaged in structural reforms.

Independent central bankers can, and where possible should, cooperate with and coordinate their actions with those of the fiscal authorities and with those charged with structural reform. If central banks, Treasury ministers and ministers of the Economy were to act cooperatively toward each other, and with credible commitment towards the private sector, good things may well happen. The reason this does not happen in the EU, or even in the Euro Area, is not a question of principle, but of logistics. There is no coordinated fiscal policy in the EU or in the Eurozone, so the pursuit of coordination between fiscal and monetary policy in the EU or in the Eurozone is simply not possible. Mr. Jean-Claude Junker could have private breakfasts and/or public lunches with Mr Jean-Claude Trichet every day of the week, every week of the year, it would not bring monetary and fiscal policy coordination in the Eurozone an inch closer to realisation.

Central banks and banking supervision and regulation

Even a nano-second of reflection will convince you that financial stability requires the close cooperation and coordination of the source of ultimate, unquestioned liquidity (the central bank), the ultimate deep pockets (the Treasury) and the supervisor/regulator.  Recognition that such a tripartite or quadripartite arrangement is necessary for financial stability (both ex-ante, that is, the prevention of instability, and ex-post, that is, dealing with the instability that happens is spite of (or because of) the ex-ante best efforts) does not answer the question as to how many institutions should be involved, and what the lines of authority among them should be.

In the limit, a single institution, the Treasury, could be the recapitaliser of last resort, the supervisor/regulator for the financial sector and the ultimate authority over the central bank’s activities.  The US appears to be evolving in that direction.

Much of the debate concerns the merits of two (reasonably independent) institutions – the Treasury and the central bank/supervisor/regulator – as opposed to three (reasonably independent) institutions – the Treasury, the central bank and the supervisor/regulator).  I will come down, with qualms, in favour of a different triad: the Treasury, the central bank/supervisor and the regulator.

Central banks, as the ultimate source of unquestioned domestic currency liquidity play a central role in macro-prudential supervision.  I don’t think there is ever any need for the central bank to make the rules, to be the regulator.  Its view should certainly be heard by the regulator, but the manifest threat of regulatory capture means that the central bank should stay as far from making the rules as possible.  Enforcing the rules will be difficult enough, given the relentless pressure of the financial sector (including the banks) on those charged with its supervision.

The regulation and supervision of financial institutions and markets is a deeply political activity. Property rights are being assigned, restricted, qualified or taken away.  Banks are stopped from doing things they want to do and forced to do things they do not want to do.  Barriers to entry and exit are created, lowered or removed.  Such activities don’t fit the image of an independent, a-political central bank very well.

I consider it to be inevitable that when a central bank becomes deeply involved in the supervision of systemically important financial institutions and markets (let alone in their regulation), it will become politicised and lose its independence, even in the domain of conventional monetary policy (setting the official policy rate).  This view is strongly supported by the increasing politicisation of the Fed – by far the least operationally independent of the leading central banks in the advanced industrial countries.

The same fate may await the Bank of England as it gets to play a larger role in macro-prudential supervision.  When a central bank as macro-prudential oversight of, and responsibility for, the banking system, there is always a risk that monetary policy will be perverted to keep the supervisory state clean (no major bank insolvencies on my watch; better not raise the OPR right now;, never mind the inflation target).  It is an unfortunate fact of life that the deep knowledge of the relevant individual financial institutions can only be acquire through close and frequent interaction with and exposure to those in charge of these institutions. Cognitive regulatory capture, and cognitive supervisor capture are therefore always a threat.

There are many reasons why the ECB is the most independent central bank in the world.  I have discussed many of them earlier in this post.  But a reason not yet mentioned but, in my view, very important, is the fact that the ECB plays no meaningful supervisory and regulatory role.

Some members of the ECB’s Executive Board and Governing Council are pushing to change this.  And there is a powerful argument that the source of ultimate euro liquidity has to play a central role in Euro Area financial stability and that this requires both the power to collect relevant information from individual systemically important financial institutions and the power to prescribe and proscribe certain kinds of behaviour by financial institutions and other market participants.

There are two problems with this extension of the role of the ECB into the supervisory domain.  There are no Treaty-based obstacles to any kind of financial supervisory role by the ECB, as long as it does not involve insurance (whatever that means).  But even some ECB Executive Board members are concerned that a significant supervisory role for the ECB would politicise the institutions and provide the Great Unwashed heads of state and of government (especially those from Paris) with a means of breaching the ‘noli me tangere’ cordon sanitaire that the ECB has constructed to preserve its sole control over monetary and (de facto) exchange rate policy.

I have the opposite concern.  The ECB is so ludicrously over-independent, even for the performance of the traditional monetary policy tasks, that there is a real risk that, should it be granted a role in banking and financial supervision, it would be able to hide the (unavoidably political) supervisory decisions and actions behind the Treaty shield of monetary policy independence.  It is one thing to have monetary policy makers that are utterly unaccountable in any substantive sense (in the eyes of the ECB, accountability means ‘reporting obligations’!).  So have financial supervisors that cannot be held to account substantively – that cannot be fired for incompetence, for instance – would be intolerable.

I would favour granting the ECB greater financial supervisory powers, provided is independence were reduced and its substantive accountability enhanced.  I believe many policy makers will take the same view.  This means that it is unlikely to happen.  We are therefore likely to see an evolution where leading central banks other than the ECB become progressively less independent but more relevant for crisis resolution and financial stability, while at the same time the ECB remains independent but becomes increasingly less relevant as its capacity to prevent financial instability and to respond to it, should it nevertheless happen remains minimal.

This threatening irrelevance of the ECB is caused by two factors, largely beyond its control.  The first is the absence of a ‘fiscal Europe’.  This means that the ECB is more restricted in the amount of private credit risk it can take onto its balance sheet than central banks that are clearly backed by a fiscal authority (national central banks outside the Euro Area, backed by their national treasuries).  Credit easing policies therefore pose greater risks to the ECB price stability mandate than similar policies do in the UK and the US.

The second cause of the increasing irrelevance and ineffectiveness of the ECB in these later stages of the financial crisis is the excessive independence granted the ECB in the Treaty.  Governments will be extremely reluctant to transfer supervisory or regulatory powers to a central bank that is under no constraint to pay any attention whatsoever to the elected and accountable politicians, both in the executive and legislative branches of government.

So I conjecture that central banks are facing a choice: remain relevant to crisis prevention and resolution, but lose much of your independence, or remain independent and become irrelevant.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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