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How central bankers need to adjust

How central bankers need to adjust

Greater political influence over central banks is necessary and inevitable

by Pooma Kimis and David Marsh

Thu 3 Apr 2014

In the aftermath of the 2007-08 financial crisis, central bankers appeared to wield unbridled power. By rapidly expanding their operations and moving into many new areas of financial control and influence, they have attracted, from diverse sides, attention tinged with suspicion. The ineluctable result is that central banking independence is now being mitigated by more political control, overt and non-overt. Rather than bemoaning this state of affairs, we should welcome it as a sign of a realistic reordering of society.

Over the past 30 years, central banks in industrialised and developing countries gained significant degrees of operating freedom, above all because of the belief that decisions on controlling the volume of money are best left to operators outside the political sphere. Now that the pendulum has swung back against untrammelled independence, we need careful checks and balances to make sure that the shift does not move back too far in the direction of politicians interested in their own and not their electorates’ futures.

Central bankers were rarely more adept than anyone else in spotting the financial crisis in advance, let alone in preventing it. The financial upheavals and the ensuing economic shock were partly their responsibility. Despite this, central banks emerged with enhanced powers.

Winning and maintaining acceptance and respect – both of the market participants central banks are trying to influence and of the politicians who set the framework for their operations – depends on a complex mix of technical, psychological and communications skills. In a system of fiduciary currency, central banks’ powers are ethereal. Through the medium of electronic payments and the printing press, they are able to conjure up money out of thin air. But magic can be overstretched. If they overstep their independence, try to shift it into too many areas, or ignore its natural limitations, they will end up losing it. In many cases, that is happening.

One source of restrictiveness has stemmed from central banks’ own actions to reduce interest rates after the financial turbulence. In the UK, US and continental Europe, central bank governors have faced much greater scrutiny over what has become known as ‘forward guidance’ – an attempt to inject semi-scientific methodology into efforts to keep interest rates low for longer than normal. As has been shown in the cases of Janet Yellen, the Federal Reserve chair, and Mark Carney, the Bank of England (BoE) governor, these initiatives embody clear risks of backfiring and damaging credibility.

Nearly universally, low interest rates on central bank reserves have worked through to increasing political constraints. Low returns bring pressure on central banks’ budgets and even a need to seek government funds for recapitalisation. Furthermore, by seeking greater profitability on their reserve asset management, central banks have been forced to enter into riskier fields such as non-sovereign bonds, equities and a broader set of currencies, spreading their investment range beyond their traditional destinations of highly-liquid top-rated government securities. If such investments fail to bring anticipated rewards, or even result in losses, then central banks' efforts to increase operating freedom will result in more, not fewer, political reverberations.

A much-publicised case surrounding the Nigerian central bank represents the most open case of in-fighting. President Goodluck Jonathan has suspended Lamido Sanusi over alleged misconduct and ‘financial recklessness’ after the internationally-respected central bank governor alleged a $20bn hole in the country’s oil accounts. The Nigerian imbroglio cannot be dismissed as a purely African struggle, as it highlights issues that have come to the surface, albeit less luridly, in other countries.

In Japan, the co-opting of the central bank as a full participant – through massive purchases of government bonds – in Prime Minister Shinzo Abe’s anti-deflation policies has been viewed as an assault on central banking independence. If the policy succeeds in bringing sustained growth, Japanese political life will adjust to the new environment. If, as seems more likely, ‘Abenomics’ fails to live up to expectations, then there will be moves from within and outside the central bank to reassert its autonomy.

Intertwining of governmental and central banking policy has led to contortions in many countries. In Korea, a swing back towards greater central banking independence appears under way. Lee Ju-yeol, a Bank of Korea (BoK) veteran, has taken over the governorship after the expiry of the four-year term of Kim Choong-soo, who was criticised for being overly submissive to governmental pressures to reflate the economy after the crisis six years ago. Lee has previously complained of ‘chaos’ at the BoK, apparently in reference to Kim’s shake-up of the bank’s hierarchy – indicating, in future, a more conservative approach.

Everywhere, interplay between central banks and politicians has become more complex. This is as a result of central banking incursions on to bond markets to buy debt in addition to the central banks’ new responsibilities for financial as well as monetary stability. Yellen can cope with these pressures best, partly because she was not President Barack Obama’s first choice for the job, partly because the Fed’s de facto mandate has changed less than that of the Bank of England and the European Central Bank (ECB). All three central banks face conflicts between monetary and financial stability as the result of the need to raise interest rates in the next two years as economies pick up speed.

Both former BoE governor Mervyn King and his Canadian successor Carney have faced complaints that they have become unduly attuned to UK government policy. The make-up and actions of the ECB have become more politicised as a result of doubts about the euro’s sustainability in the past five years. The Cypriot president has forced out of office Panicos Demetriades, the country’s central bank governor, over alleged misdemeanours – the first time a member of the ECB governing council has been caught up in such cross-currents. Nominations for the ECB’s six-person Executive Board are now much more political than when the ECB started in 1998. This is a sign of how much has changed since a period that, in retrospect, will be viewed as the heyday of central banking independence.

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