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Trust, not rules, foundation of central banking

Trust, not rules, foundation of central banking

Review of Paul Tucker's 'Unelected Power'

by Meghnad Desai in London

Wed 13 Jun 2018

The aftermath of the 2008 financial crisis led to a boom in one sector in particular – books by central bankers and finance ministers. Former Bank of England Governor Mervyn King, Federal Reserve governors Ben Bernanke and Alan Greenspan, and Hank Paulson, US Treasury secretary between 2006-09, have all written memoirs with explanations for the crisis and prescriptions for the future. Now Paul Tucker, the BoE deputy turned academic, has made his contribution.

Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State is a massive tome. Unlike his peers, Tucker takes an academic multidisciplinary approach to examining the case for central bank independence. This specific discussion occupies the final 180 pages of Unelected Power. Before we get there Tucker takes us through 'the economics of credibility, political science of sectional interests, political theory of legitimacy and the sociology of trust'. My advice is to stick to the last 180 pages and turn to earlier chapters as and when Tucker refers to them. The salient points of the opening sections are, in any case, reproduced in the book's conclusion.

Tucker offers a systematic review of the arguments for central bank independence, as well as a closing segment expressing doubt about its continued relevance in the current low inflationary environment. He refers mostly to the Fed, the BoE and European Central Bank. Other monetary authorities, including the Bank of Japan, are rarely touched on.

It was only after the abandonment of the gold standard by the US in 1971 that the power of issuing money and the creation of credit became a subject of public debate. Inflation was ascribed to the presence of too much money and its causes were traced to wage bargaining. While the possibility of any long-run trade-off between inflation and employment was denied, there was scope for monetary policy to have an impact in the medium term. Central banks could use interest rates to anchor inflationary expectations. After much debate, economists (at least in the US) arrived at a consensus and the 'great moderation' prevailed from the mid-1980s onwards. Central bank independence was a pillar of this consensus.

But independent of what? Tucker sets up a comparison between the military and the judiciary, which are free from daily interference by the state and central bank. What limits can be imposed on an ostensibly autonomous institution? Obviously there must be clarity about the objectives to be pursued and boundaries must be set as to what an agency cannot do. Tucker treats this point at length.

The 2008 crisis was a turning point. Experts on the great moderation failed to anticipate the fallout and US economist Robert Lucas even argued that such crises could not, in theory, be predicted. Serious questions were raised. If central bank independence was granted on the basis of the trade-off of inflation and unemployment, yet the crisis showed that price stability was not sufficient for financial stability, what was the point of central bank independence?

As it happens, it was this independence that gave central bankers and their friends in the finance ministries the clout to act swiftly and flood markets with liquidity. This stopped the crisis from turning into a great depression, though countries were not spared the great recession.

Thus, although central bank independence was underpinned by an inadequate (if not false) theory, it proved useful in tackling the crisis when it happened by unorthodox means. It was not rules – discussed so thoroughly by Tucker – but personalities, especially Bernanke, that did the trick.

This is not to fault Tucker. It is in the nature of an economic problem. For predictable outcomes, rules can be made and boundaries drawn. But uncertainty, as Keynes said long ago, cannot be dealt with in any systematic way. It is only in extreme events, infrequent though they may be, that policy-makers need to improvise. At that stage, what matters is not rules but trust, which markets must have in the probity and capacity of the individuals in charge – the central bank governors.

Lord (Meghnad) Desai is Emeritus Professor of Economics at the London School of Economics and Political Science, and Chair of the OMFIF Advisers Council. Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State is published by Princeton University Press.

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