The Convenient Myth of Independence

Trump’s attempt to fire Cook has thrown into sharp relief the question of “central bank independence” and the evolving relationship between the Fed and the executive. The origin of central bank independence is relatively straightforward. The story goes something like this: during the Keynesian postwar period, central banks were largely subordinated to the demands of their national treasuries: they supported government debt sales, coordinated with governments on setting interest rates, and would generally acquiesce when pressured to change relative exchange rates. Even the Federal Reserve, which had regained statutory independence in 1951, supported the government under its so-called “even keel” practice.

This system, however, came apart in the 1970s due to rising inflation and currency instabilities. Soon after, organized labor was crushed and finance unshackled. The mobility of global capital had another consequence. After the world’s major currencies were no longer “pegged” to the dollar, their relative values could change erratically: when investors feared that a government was overspending and risking inflation (thus eroding the real value of the currency), they would sell cash or assets denominated in that country’s currency. The result could be a dangerous slide in the currency and an attendant balance-of-payments and debt crisis.

To prevent such crises, central banks gradually became more conservative and monetary policy became less accommodating of government priorities. This reflected the broader ideological shift to neoliberalism that was taking place across the advanced capitalist world and foresaw a very different role for central banks.

The theoretical framework for central bank independence emerged around this time. The conservative economist Milton Friedman’s early critique of the Keynesian era of discretionary economic policy planted the seeds for others to develop more formal models of independence.

William Nordhaus described how governments manipulated monetary policy specifically for electoral gains, and Finn Kydland and Edward Prescott formalized these concerns into the so-called time inconsistency problem: governments have incentives to promise low inflation but renege on these promises for short-term employment gains.

The result is that firms and consumers expect high inflation and adjust their behavior accordingly, resulting in poor economic outcomes. Thus, discretionary economic policy making contains an “inflationary bias.” This is bad for beneficiaries of asset price growth and for consumers. According to the new orthodoxy, the only discretionary macro policy should be to maintain price stability (to keep headline inflation low) and that duty should be assigned to an independent, conservative central bank. That is, someone that has a greater aversion to inflation than the average politician.

More recently, the theory of central bank independence was further developed through the fields of principal-agent theory and institutional design: here, the time inconsistency problem is solved by delegating the duty of price stability to an independent agent whose mandate is clear and whose interests align with the long-term interests of society, rather than the short-term interests of politicians.

The Europeans went one step further and created a new kind of “external constraint,” by irrevocably fixing their exchange rates (formerly used as an adjustment mechanism) within a monetary union whose currency is issued by a central bank entirely outside of their national purview and without a corresponding European finance ministry to substitute.

King’s NICE world capsized in 2008 — and with it the myth of the independent central bank. The financial crisis demanded active management by central banks because states were either unwilling or incapable of doing what was needed. But since the Great Recession, central banks have been under siege from some variant of populism while propping up the financial system practically alone because governments have been dogmatically committed to a policy of austerity. Now that the imperatives of safeguarding this system by maintaining low inflation and protecting the interests of holders of government debt are clashing with the whims of the Trump administration, this system is at risk of disintegrating.

It is true that central banks enjoyed notional, statutory independence after 2008, but in reality, their hands were always forced by urgent fiscal and financial market realities. This put central banks in a difficult position. With governments unable to spend to get out of the crisis, central banks became what some have called “lonely stewards” of the global economy. Governments, having tied their own hands, turned central banks into fiscal actors under duress, forcing them to overstep their mandates politically while still having to respond to the occasional spasms of the financial market. These circumstances invited the political backlash that is now seemingly accelerating.

From Cooperation to Lonely Stewardship

To understand this sequence of events, one has to first understand both the period of notional independence and the post-2008 “stewardship era,” which was one of interdependence between politicians and central bankers. In this state of affairs, politicians required the central bank to ensure price and financial stability and intervene in bond markets when necessary, and central banks required the cooperation of their respective political authorities.

The 2008 crisis proved that the idea of central bank independence was at least partially a myth. When push came to shove, states and central banks would work in a coordinated fashion to ensure the stability of the financial system. But in times of protracted crisis, cooperation, too, goes out the window.

The social crises provoked by the austerity measures of the 2010s had terrible consequences for domestic politics, which became increasingly unstable. Economic crises amplify the power disparities within societies and between states, and in doing so, erode the very political coordination required to resolve them.

In the United States, President Barack Obama attempted to respond to the 2008 crisis by passing an adequately sized stimulus package. This effort was thwarted by Democratic and Republican opposition. In the eurozone, the member states, divided as creditor and debtor nations, failed to agree on any lasting reform to the bloc’s fiscal rules, a set of constraints on government debt and spending.

This contributed to the harsh austerity programs across Europe and prevented the establishment of a stabilization fund for stricken European lenders. As a result, Greece, the greatest victim of European mismanagement, witnessed a fall in living standards comparable to the Great Depression. Likewise, in the United Kingdom, the Conservative Party–led government of David Cameron embarked on one of the harshest and most protracted austerity programs on record.

Thus, while interdependence remained a fact, central banks could only maintain price stability if states intervened to prevent firms and citizens from becoming insolvent, which they frequently did not. This position is what political economists Waltraud Schelkle and Deborah Mabbett have termed the “loneliness” of central banks, echoing the words of Tommaso Padoa-Schioppa, architect of the European Central Bank (ECB), who wrote that “only superficial thinking could view the lack of political union as strengthening the central bank and making it freer to fulfill its mission.”

The result was that the world’s major central banks (such as the Federal Reserve Bank, European Central Bank, and Bank of England), having become the reluctant stewards of much of the world economy, devised ways to stabilize the system without the aid of governments. They did this by devising methods to pump ever more liquidity into the financial system, that is to say ensuring that banks and other financial actors had access to short-term and long-term financing and that the buying and selling of financial assets would remain relatively undisrupted, especially on the market for government debt. The main objective, though rarely explicit, was to keep bond yields (thereby government borrowing costs) low, and, in the eurozone in particular, to prevent spreads between the yields of different countries’ bonds from widening.

The methods included a whole suite of asset-purchasing programs (collectively referred to as QE, or quantitative easing) and various other refinancing operations. While the exact design of these programs differed from country to country, they largely involved either targeted loans to financial institutions or a kind of “asset swap,” in which the central bank would receive bonds (or other similar assets) from banks in return for central bank reserves. Because credit creation is linked (though not strictly) to the quantity of reserves, the idea was that banks would be able to lend more to the real economy and that the prices of other assets would rise, further allowing other actors to borrow and invest.

All of these various “unconventional monetary policies” were set up and expanded against the backdrop of historically unprecedented ultralow interest rates.

While these policies kept the financial system afloat, they neither solved the underlying issues nor, since the channels through which they affect the real economy are circuitous and weak, did they compensate for the lack of adequate government spending across the North Atlantic. The result was a persistent shortfall of aggregate demand, lackluster wage growth in the UK and EU, stagnating prime-age employment in the United States, and high youth unemployment in the EU. This was a perfect breeding ground for populism of the left- and right-wing variants.

The consequences for central banks were paradoxical: they became exalted technocrats; at press conferences journalists treated their every word as having world-historical import; and they were praised for their decisive actions while being viciously criticized for overreaching and for distorting the economy. In other words, the political and financial conditions that provided them with more autonomy from government control also undermined their ability to obtain the political cooperation on which the maintenance of their power rested.

One major driver of this dynamic was the distributional consequences of low interest rates and asset-purchase programs on which the central banks were forced to embark. These programs favored banks and the owners of financial assets at the expense of savers and pensioners. Further, due to effective policy of keeping yields low, central banks in the eurozone were accused by right-wing populists within richer creditor nations such as Germany and the Netherlands of “bailing out” profligate governments such as Greece, Spain, or Italy. In tandem with the perceived legal overreach of central bankers and the (false) perception they were risking runaway inflation, these distributional issues caused lasting political backlash.

In the eurozone, in particular, the ECB was subject to successive challenges by the German Constitutional Court, acting in response to lawsuits filed by right-wing euroskeptic political constituencies. Its situation was and remains particularly precarious given that the ECB’s mandate is uniquely limited to price stability, how it lacks a corresponding European sovereign, and how its more recent asset-purchase programs constitute some form of debt monetization in substance if not in name, this being prohibited in the European treaties.

As a result, the ECB, wary of having to overstep its mandate in ever more creative ways, would frequently engage national policymakers in games of chicken, and suspend or threaten to suspend its bond purchasing programs, in a likely effort to force European leaders to agree on the necessary reform to the monetary union.

The Federal Reserve, too, has been wary of being accused of doing politics. A potent example of this reluctance can be found in the establishment of the Municipal Liquidity Facility (MLF) in April 2020. At the height of the pandemic, the Fed had been exploring ways to provide a credit backstop to ailing municipalities (states, cities, counties, certain government agencies) by committing to buy newly issued municipal bonds.

The idea gained further momentum as a way to underwrite much-needed large-scale green investment. Uptake, however, was low. Only Illinois and New York’s MTA made limited use of the MLF. Powell and other Fed officials had stressed that this was a feature not a bug and that it was strictly meant as a backstop only, while repeatedly voicing concerns about supplanting the function of Congress and front-running elected public officials.

The Specter of Financial Dominance

What put central banks in this strange position of stewards of a system they could not entirely influence was austerity, and the crippling damage it inflicted on states across the globe. In that sense, fiscal dominance — the idea that monetary policy is constrained by the fiscal stance of the government — is not a contemporary specter but a matter-of-fact description of how the world has been for a while.

What is more, fiscal dominance is not a coherent concept to begin with. For one, it implies the clean separation of fiscal and monetary affairs, which is only true if inflation is, in the words of Friedman, “always and everywhere a monetary phenomenon” — that is, the result of too much money. The Pandemic-induced inflation, which was the result of supply shocks, should have put this theory to bed.

It is further misleading to claim that fiscal policy is the only thing that has held sway over central banks. In fact, it seems like some governments are subordinating their fiscal policies to them. If, as is largely true, central banks set interest rates, including those on sovereign bonds, then any government that calibrates its budget based on where interest rates are (or are expected to be in the short run) is effectively relinquishing discretionary fiscal policy to central banks.

Nowhere is this clearer than in the United Kingdom, where the incumbent government has painted itself into a corner. Rachel Reeves, the country’s chancellor of the Exchequer, has contrived fiscal rules that make her government unable to spend enough to lift its growth trajectory, while facing frequent runs on the pound and rising yields when it doesn’t consolidate enough.

The Bank of England, meanwhile, has refused to cooperate with Keir Starmer and Reeves by lowering borrowing costs to provide the Labour government with more fiscal leeway. In a defining moment during the short-lived Liz Truss government, the announcement of an expansionary budget plan sparked a large sell-off in the sterling and gilts (UK government bonds), reverberating through global debt markets. Evidently, the Truss government had expected the bank to at least raise interest rates to forestall any fears about the budget’s inflationary effects.

But what moved the bank to intervene was the financial panic, which, as it happens, had much more to do with the financial risk that had built up in the UK’s large pension sector and the bank’s own overly hasty tightening of monetary conditions.

If anything, this indicates that central banks are more responsive to the instability generated by the enormous, highly leveraged market-based financial system than they are to the fiscal needs of the sovereign. Far from technocratic deities, they act responsively and defensively. This was clear in the bond market panic of 2020, when the global liquidity provision by the Federal Reserve in the US Treasury market reached new heights.

Powell’s steadfast refusal to accommodate the inflationary and fiscally imprudent macroeconomic policies of Trump can also be seen in this context. Central banks face both fiscal and financial pressures but are more responsive to the latter. Perhaps by necessity. Even former ECB president Mario Draghi’s famous “whatever it takes” speech in 2012, widely credited with calming European bond markets at the height of the euro crisis, can be seen not as an assertion of technocratic might but as the mute compulsion of market-based finance at work.

Don’t Bet Against the Sovereign

All of this raises the question of alternative arrangements. The case for a competent central bank that doesn’t serve every whim of whatever government currently holds office makes itself. But reverting to the era in which central banks exercised outsize power to the detriment of the general populace and with too few political constraints is equally undesirable. The political left in particular should not, goaded by Trump, throw in their lot with the proponents of central bank independence.

Perhaps one could learn from the most innovative central bank, namely the Bank of Japan, which pioneered the “unconventional monetary policies” of recent decades, and, in close cooperation with state officials, has successfully guided Japan’s macroeconomic fortunes through very choppy waters. Japan, despite experiencing one of the largest financial crises in history, remained a high-employment, highly developed industrial economy. In this context, one should also ask whether “fiscal dominance,” of which the Bank of Japan’s monetary financing is an extreme example, is really something over which to lose much sleep.

What should instead be feared is the apparatus of the most important central bank falling into the hands of a thuggish, criminal, and maliciously incompetent regime such as that of Donald Trump. This is the type of political subordination that central banks could find themselves subjected to if their hierarchy of concerns remains as it is. This would not be a story of Icarian hubris, with Powell and others flying too close to the sun. Rather, the recent story of the central banker coerced into a lonely role that sets him on a path of confrontation with his master calls to memory the fate of Thomas Becket and his friend and King, Henry II of England in the tenth century.

Becket initially served as Lord Chancellor, the King’s right-hand man, equivalent to a vizier in the Ottoman Empire or a majordomo in the Merovingian dynasty, and analogous to an ideal version of the relationship between central banks and elected governments.

Tiring of opposition from the church and faced with challenging financial circumstances, Henry made his pal Becket Archbishop of Canterbury. But in his new, powerful position, lacking the King’s cooperation when it came to opposing the other powerful feudal lords within the court, Archbishop Becket’s duties ended up at cross purposes with the interests of his king. In 1170 AD, he lay slain on the floor of his cathedral.

In the struggle between clerical and secular power, the latter has always come to prevail. And while it is true that as a market actor you should “never bet against the Fed,” when it comes to the Fed squaring up against the executive: don’t bet against the state.