Myths of central banking

The Bank of Canada has been in the news lately – or, more precisely, the news has been full of other well-placed people telling our central bankers what to do. In an interview on CTV this past weekend, Jim Flaherty made comments (later retracted) that Canada’s central bank will be pressured to raise interest rates sooner rather than later. On Tuesday, the influential, pro-business Conference Board of Canada also came out with some advice. A Globe and Mail editorial written its chief economist suggested, somewhat surprisingly, that the Bank should target a higher level of inflation, up to 4% from the current 2%.

Predictably, these pronouncements, especially Flaherty’s, spawned a chorus of criticism from conservative commentators. They lambasted the Minister of Finance for potentially undermining the central bank’s independence. Such attacks from the right were to be expected; however, even the NDP chimed in, calling the Minister’s comments “inappropriate”.

One reason for such universal criticism of any perceived meddling in central bank matters is that central banks are some of the most mythologized institutions of contemporary capitalism. They are often the subject of pious reverence on the part of media, politicians and economists. There is broad consensus that central banks should be independent and target low inflation (which, for many economies in the North has meant about 2%). This is why it was particularly odd to hear conservative voices question both of these assumptions: Flaherty, independence, and the Conference Board, low inflation.

In reality, however, both of these assumptions should be open to discussion and questioning. First, take the central bank’s independence. While we have many institutions that should be at arms-length from the government, these are largely bodies that hold government accountable and ensure that it is correctly carrying out its mandate – whether in terms of environmental protection, child welfare or accounting principles. The central bank is, however, not this kind of institution.

Economic policy is a multi-faceted enterprise and one that is politically-charged regardless of how it is presented. As Joseph Stiglitz has pointed out, arms-length and seemingly independent central bankers can be subject to bias, pressure and capture by financial interests. Indeed, for various reasons – not the least of which is the revolving door between financial institutions and central banks – central banks often end up promoting the interests of a narrow economic sector at the expense of others.

Is it better to have Flaherty rather than a financial sector technocrat calling the shots on monetary policy? Let’s call it a draw…but at least we have an opportunity to vote Flaherty out of office. Furthermore, to question the absolute independence of the central bank is not to argue for its subservience to every whim of government ministers. Most government institutions continue to be managed by bureaucrats carrying out the broad policy goals decided upon in the political process (although the Conservatives are trying to change this). There is a significant middle ground between independence and subservience; ground where the central bank and the government could work to further similar goals – decided politically – using fiscal and monetary policy in concert.

This leads naturally into the second central banking myth that we should be questioning: targeting low inflation to the exclusion of other policy goals. This is especially the case for the Bank of Canada, which, like the European Central Bank and a host of others, has an almost exclusive concern with inflation over other economic variables. Other central banks, such as the US Federal Reserve or the Reserve Bank of Australia, explicitly have employment or growth as policy goals in their mandates; however, even these institutions in practice often give primacy to inflation targeting.

The shift to a focus on low inflation in central bank practice has followed theoretical developments within economics. The Phillips curve, which purports to show a positive relationship between moderately higher inflation and lower unemployment, at least in the short term, is a theoretical stand-by of mainstream Keynesianism. The idea behind it is that people sometimes adjust their expectations slowly. Specifically, an upward surge in prices can lead firms to hire more as wage demands take longer to catch up to higher prices, which immediately raise revenues and profits. This gave theoretical backing to more flexible monetary policy that was not intent on low inflation at all costs.

Around the stagflation crisis of the 1970s and into the 1980s, the Phillips curve, like much Keynesian theory, came under attack and largely fell out of favour. It was displaced by rational expectations theory. This theory assumes that people adjust their expectations constantly and almost immediately react to policy changes. These theoretical superhumans are able to predict how changes in factors like monetary policy will affect future real income and are constantly adjusting their behaviour based on economic trends.

If one believes this theory, then both the traditional Phillips curve and attempts to influence growth or employment via monetary policy seem misguided. Indeed, the key becomes instead to keep the economy near the so-called NAIRU or “Non Accelerating Inflation Rate of Unemployment”. This is a level of unemployment (which can differ between countries and time periods) that is compatible with a stable and low level of inflation. Unemployment that is “too low”, or below the NAIRU level, will cause inflation to rise and disrupt the economy. Keeping inflation stable is thus seen as a means of keeping the economy stable and ensuring a “sufficient” level of unemployment.

This last factor demonstrates how crucial the distribution of bargaining power between workers and capital is to the conduct of monetary policy. If workers are able to bargain for higher wages and have the institutional context to do (sufficient unemployment insurance, stricter labour laws and so on) then moderate inflation is not so problematic and need not negatively impact growth. Indeed, a central bank can have policy goals beyond just inflation levels.

The NAIRU theory upon which inflation targeting is based turns this on its head. Lower inflationary pressures require lower wages, weaker worker protections and greater job insecurity to simultaneously allow for low unemployment. A lower NAIRU means that workers are weaker; low inflation is compatible with low unemployment only at poor working conditions, low wages and high job uncertainty. More of the gains of growth are realized as profits. A more unequal distribution of income that results from high profits and low wages is thus combined with low interest rates. These not only keep inflation down, but they also encourage borrowing to make up for the lower labour income and can easily spiral into the kind of asset bubble that preceded the last financial crisis.

Indeed, outside of crises, maintaining asset prices is precisely one of the other reasons to keep inflation low. Economic theory often describes inflation as a tax. This is accurate albeit what economists often fail to mention is that inflation can be a very progressive tax. Like many economic phenomena, the negative effects of higher inflation are unequally distributed depending on wealth – however, not necessarily in the direction to which we are accustomed. Low inflation is instrumental in maintaining the value of assets, especially financial assets. For example, if a bond will pay a certain sum in 10 years, then the return on this bond will be lower if that sum at the end of the 10 years due to higher inflation. Higher inflation can actually hurt the wealthy to a disproportionate degree because they hold a far greater number of assets than the rest of us.

If you are spending most or all of what you earn and are able to increase your wages relatively frequently to keep pace with inflation, then it does not matter as much if both your earnings and prices of the items you consume are growing by 2% or 8% per year. Similarly, if you have a debt to pay off, then higher inflation means you will ultimately be paying less in real terms over the term of the loan. If, on the other hand, you hold assets or are a creditor, then higher inflation eats away at your future income.

While many central banks across the world, both in the North and South, have tried to maintain an inflation target below 5%, and often in the proximity of 2%, a widely-publicized study published by the IMF in 2010 concluded that moderate inflation is not detrimental to growth. In fact, emerging economies can experience sustained inflation up to 10% per year before rising prices start to significantly impact growth. This upper threshold was found to be lower for developed countries and also near 10% for oil exporters. As Canada falls into the developed and oil-exporting camps, its threshold is likely somewhere between the current 1 to 3% target and 10%.

Indeed, IMF economists have explicitly argued for higher inflation targets since the latest financial crisis, citing higher risks of stagnation and deflation with current targets. This is also the position of the Conference Board, which sees higher targets as a means of restarting growth. Some are prepared to go further, however, and as Stiglitz has questioned central bank independence, a few prominent economists have begun to question inflation targeting itself as the correct policy goal for central banks.

Such deeper questioning of the myths of central banking is important because it begins to move the debate towards the fundamental problem that the banking and financial sector as a whole is not responsive to the needs of the majority. For the moment, financial flows chase after profits rather than work to further the well-being of society. Low wages and cheap credit are seen as instrumental to maintaining the conditions for economic stability. This all serves to increase instability, producing asset bubbles and further redistribution of wealth towards the top.

A solution that truly goes beyond the myths is a nationalized banking sector that acknowledges finance as a public utility rather than as a tool that ultimately serves to further enrich a wealthy minority and disempower workers. In some ways of course the dollars flowing through the economy are very different from the power flowing through our electricity grids or the water flowing through our hydraulic mains. In another sense, however, the fundamental idea is the same. Each example, including finance, involves the question of how and on what grounds we distribute a key resource necessary for the economy to function and potentially benefit all.

Public banking would also greatly reduce worries about the place of central banking. A democratically-controlled banking sector would still require a central bank to ensure the stability of currency and help manage the creation of financial flows. Such a central bank would, however, be embedded within an entire political and economic framework of socially-useful finance. This is quite different from today’s framework that requires myth to keep us from looking too closely under the hood.