Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.
Previous excerpts for Chapter 8 discussed “History of Central Banks,” the “Stated Mission of Central Banks,” “Monetary Policy Tools,” and Central Bank Balance Sheets
Independence of Central Banks
As we noted in chapter 7 and elsewhere, a strong theme of monetary history is that governments choose to devalue their currencies to gain apparent short-term benefits such as increased spending ability and repayment of debt. Long-term damage to the citizens of such devaluation is the reduction of both assets and income as well as diminished confidence in both government and money. As sound money is critical to trade and commerce, uncertainty and chaos in the currency suppress and distort healthy economic activity. The result is widespread suffering.
Enabling legislation for a central bank often describes this CB institution as “independent.” In the current era, financial experts consider CB “independence” to be a key measure of prudent sovereign risk management.[1] The U.S. Fed itself notes that the Treasury-Fed Accord of 1951 “became essential to the independence of central banking and how monetary policy is pursued by the Federal Reserve today.”[2]
In explaining this Treasury-Fed Accord, the Fed historical account gives an example of the lack of central bank independence that is more nuanced than the simple printing of money to pay government expenses:[3]
“The Federal Reserve System formally committed to maintaining a low interest rate peg on government bonds in 1942 after the United States entered World War II. It did so at the request of the Treasury to allow the federal government to engage in cheaper debt financing of the war. To maintain the pegged rate, the Fed was forced to give up control of the size of its portfolio as well as the money stock. Conflict between the Treasury and the Fed came to the fore when the Treasury directed the central bank to maintain the peg after the start of the Korean War in 1950.
“President Harry Truman and Secretary of the Treasury John Snyder were both strong supporters of the low interest rate peg. The President felt that it was his duty to protect patriotic citizens by not lowering the value of the bonds that they had purchased during the war. Unlike Truman and Snyder, the Federal Reserve was focused on the need to contain inflationary pressures in the economy caused by the intensification of the Korean War. Many on the Board of Governors, including Marriner Eccles, understood that the forced obligation to maintain the low peg on interest rates produced an excessive monetary expansion that caused inflation. After a fierce debate between the Fed and the Treasury for control over interest rates and U.S. monetary policy, their dispute was settled resulting in an agreement known as the Treasury-Fed Accord. This eliminated the obligation of the Fed to monetize the debt of the Treasury at a fixed rate and became essential to the independence of central banking and how monetary policy is pursued by the Federal Reserve today.”
Summarizing this narrative somewhat bluntly, the executive branch of the U.S. government sought to enforce persistently low interest rates to help itself with low borrowing cost and to aid selected citizens. “Fierce debate” ensued with the result that the Fed emerged without a statutory obligation to the executive branch to provide targeted fixed-rate funding for the government.
As we wondered in chapter 7, is it truly possible for a central bank, a government entity, to be independent of government (or, at least, of another part of the government)? The Fed itself writes that it is more accurate to use the phrase “independent within government” rather than “independent of government.”[4] Strictly speaking, consistent with this Fed self-description, central banks cannot be independent of government.
More relevant is the ability and willingness of a central bank to pursue its publicly designated mission when it conflicts with government desires and priorities. In the modern era, the consensus among politicians and central bankers is that such “independence” does not and should not exist. In addition to the central banks’ huge expansion of bank reserves to purchase government debt in the United States, the Eurozone, Japan, and other countries, an instructive activity is “inflation targeting.”[5] Governments are debtors. The citizens, therefore, are net creditors. Deliberate devaluation of currency through inflation targeting aids governments (debtors) in both outstanding debt and future spending and harms citizens (creditors).
[1] See, for example, paragraph 113 of “Sovereign Government Rating Methodology and Assumptions,” Standard & Poor’s, June 2011.
[2] See http://www.federalreserveeducation.org/about-the-fed/history/ under the heading “1951: The Treasury Accord.”
[3] Id.
[4] See http://www.federalreserve.gov/faqs/about_14986.htm .
[5] The U.S. Fed claims to target a 2% per annum inflation rate. See http://www.federalreserve.gov/faqs/economy_14400.htm . See also, “In historic shift, Fed sets inflation target,” Reuters, January 2012; “ECB Ready to Act if Inflation Misses Target,” Wall Street Journal, April 2014; “BOJ’s Kuroda: High chance BOJ to meet its inflation target,” Reuters, March 2014.
