Home > Political Economy, The Economy > Tyranny of the Central Bankers

Tyranny of the Central Bankers

from Dean Baker

The European Central Bank (ECB) announced earlier this month that it was raising its overnight lending rate by a quarter of a percentage point to 1.25 percent. This is very bad news for people across the eurozone countries and possibly the rest of the world as well.

This action shows two things. First, the ECB is prepared to slow the eurozone economy and throw people out of work. This is the point of raising interest rates. The ECB targets two percent inflation with the current inflation rate in the eurozone around 2.5 percent.. The inflation rate is above the ECB target due to a jump in the price of oil and other commodities. These price rises in turn are primarily attributable to instability in the Middle East and increased demand from China, India and other fast-growing developing countries.

Raising interest rates in the eurozone will do little to reduce the prices of commodities. However if higher interest rates throw enough people out of work in the eurozone, it can place sufficient downward pressure on wages to offset the impact of higher commodity prices. If commodity prices rise by much more than two percent, then the ECB can make wages rise by less than two percent, thereby returning to its magic number and declaring ‘mission accomplished’.

This brings up the other fact demonstrated by the ECB’s action. It has learned nothing from the events of the last three years. Those who hoped that the worst economic downturn in 70 years might change the Bank’s behavior are sure to be disappointed. It continues to adhere to its goal of maintaining an inflation target oblivious to the costs in unemployment and lost output.

Unfortunately, the ECB is not alone in this respect. Most central banks are now controlled by inflation targetters who explicitly ignore the impact of the banks’ actions on output, employment and financial stability.

A deficit of democracy

The worst part of this story is that these fundamental decisions about economic policy are made by a small, secretive clique operating largely outside of the public’s purview. Central bank decisions on interest rates are likely to have far more impact on jobs and growth than any of the policies that are debated endlessly be elected parliaments. Yet, these decisions are made largely without democratic input.

In fairness, politicians bear much of the blame for this situation. They established institutional structures that largely place central banks beyond democratic control. There is probably no bank that is as insulated from the democratic process as the ECB, in large part because of its multinational structure, but all the central banks in wealthy countries now enjoy an extraordinary degree of independence from elected governments. In many countries they are even more independent than the judicial system.

Even worse, the politicians have actually mandated many central banks, like the ECB, to pursue an inflation target to the exclusion of other considerations. This gives the central bankers a license to throw millions of people out of work in order to chase their obsession with inflation.

Giving the central bankers free rein to chase inflation targets could perhaps be justified if they had a track record of success, but they don’t. The world economy stands to lose more than $10 trillion in output because of the central banks’ failure to stem the growth of the dangerous housing bubbles.

While the central bankers were congratulating themselves for hitting their inflation targets, the bubbles were growing ever larger, and the financial system was becoming more highly leveraged. All they could express when the bubble finally collapsed in 2008 was their surprise.

In other professions, people would have been fired for such a momentous failure. However if any central banker lost their job due to this disaster, the firing was kept very quiet.

The economic crisis should have taught central banks that it is not sufficient to pursue an inflation target; maintaining high levels of employment and overall financial and economic stability are also important – and failure to meet these challenges should result in replacing the current crop of central bankers.

Processes must also be in place to hold the central bankers accountable to elected governments. The choices they make involve issues on which the public should have input, particularly the tradeoff between higher unemployment and the risk of more inflation.

Naturally, different actors will take different positions on this tradeoff. The financial firms, who tend to be close to the central bankers, are unlikely to be very concerned about the cost of unemployment. However, they will view the risk of higher inflation with enormous trepidation because it will typically lead to large losses for the industry.

The larger public is likely to take the opposite position, as moderately higher rates of inflation pose little cost. This choice should be the sort of topic that arises in political campaigns, since it is likely to have far more consequence for the public than whatever tax or spending policies the competing parties are promoting.

None of this means that we want politicians deciding interest rates. However, the people who do decide them should be answerable to politicians in a way that is not true today. In this way central banks should be like any other regulatory agency. For example, politicians do not decide which drugs the US Food and Drug Administration approves. However if it goes five years without approving any drugs – or approves a number of them that cause sickness and death – serious problems ensue.

In short, this is simply a question of restoring accountability to the central bankers for their management of the economy. The days of the central bank as a church beyond the reach of the commoners should be brought to an end.

See article on original website

  1. April 20, 2011 at 4:35 pm

    The mistake the central bank makes is that it is assuming that the inflation is currently “demand-pull”. Whereas is in fact cost push due to the increase in the price of petroleum, other primary commodities and food.

    The increase in the interest rate in fact adds to the cost push inflation at the same time reduces aggregate demand leading to further excess capacity, thus further increases in unit production cost.

  2. Podargus
    April 20, 2011 at 7:49 pm

    “None of this means that we want politicains deciding interest rates.”
    To the contrary,politicians should be ultimately responsible fo all aspects of the economy as they are accountable to the citizens at the ballot box,at least in theory.As in other matters they could and should take advice from various people both in and out of government.

    In Australia,my country,the creation of the Reserve Bank as an independent entity is a comparitively recent occurence and was much touted at the time as a great improvement by those who expected to gain by the change,including the politicians who could then distance themselves from responsibility.

    The resulting economic performance has hardly been outstanding.

  3. April 20, 2011 at 10:52 pm


    From the mouth of the chief economist for S&P, speaking for himself, not for S&P:

    “My feeling – and understand I speak for myself, not necessarily for S&P, is that we need to reduce the deficit more urgently than we need to spur growth…”

    It hurts to laugh so much.

    • Alice
      April 21, 2011 at 10:49 am

      “My feeling – and understand I speak for myself, not necessarily for S&P, is that we need to reduce the deficit more urgently than we need to spur growth…”

      Good luck with that one.

  4. April 21, 2011 at 1:05 pm

    The explanation is not hard to find.

    Inflation hits holders of financial assets hardest. (By contrast, it increases the relative value of real assets.)

    87% of financial assets are held by the top 20% of households (by income).

    An extra point of inflation costs each of those households about $22,000 a year. (That money is effectively transferred to holders of real assets.) Far more for the top holders, the ones who actually have some influence on policy…

    • April 21, 2011 at 1:12 pm

      Just did the arithmetic for the top 10% of households (who hold 67% of financial assets): an extra point of inflation costs them (on average) about $32K a year.

    • April 21, 2011 at 1:33 pm

      Yep, which is why I like to put the polemical counter-point: The “sound-money” doctrine (Ryan, Heritage, etc.) is to finance what cost-of-living increases are to labor. So if a guaranteed future real standard of living is good for anyone who plays by the rules, it is good for everyone who plays by the rules. If the rules cannot accommodate that, then something isn’t fair about the rules….

      • Alice
        April 22, 2011 at 10:16 am

        which we already know Dave. Something isnt fair about the rules because fair istelf is being stretched into rapidly growing inequality. So either its the message behind the policy or the rules or both that isnt fair.

  5. Alice
    April 22, 2011 at 10:18 am

    so in summary – Central banks work for the already rich whilst pretending to work for all?

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