Stiglitz is wrong to dismiss central bank independence

Joseph Stiglitz has recently questioned the orthodoxy of central bank independence, arguing that there is little evidence to suggest correlation between independence and economic performance.

Australian economists and financial-market regulators would agree with much of Nobel Laureate Joseph Stiglitz’s recent speech to the Reserve Bank of India. The complexities of formulating useful models of financial markets where participants have incomplete information are well known, and Stiglitz has made important theoretical contributions in this field.

More controversial is Stiglitz’s widely cited claim that countries with less independent central banks weathered the global financial crisis better than in Europe and the United States. Central bank independence, he argues, is a mirage: the European Central Bank and the US Federal Reserve were ‘captured’ by the sectional interests of the financial institutions they were supposed to be regulating. He also argues they should have paid more attention to effective regulation and the effects of their decisions on employment and growth.

Australia’s central bank is seen as independent. Furthermore, some countries with independent central banks — Australia included — did better than the Europe and the United States. Commodity exporters with less central bank independence, such as Brazil, were helped by a boost to the terms of trade. Casual empiricism is hardly likely to clinch the argument.

To what extent do Stiglitz’s criticisms apply to Australian monetary arrangements?

Independence

Here a distinction can be made between “goal” and “instrument” independence.

Since 1996, the goals of the Reserve Bank of Australia (RBA) have been formalised in the Statement on the Conduct of Monetary Policy, prepared jointly by the Treasurer and the Governor of the RBA.

The Statement recognises a trade-off between short-term effects of monetary policy on employment and output, and the medium-term target of keeping annual inflation (on average) between 2 and 3%. The vigour with which the RBA pursues its medium-term inflation target is moderated by the outlook for unemployment and economic activity generally.

While the RBA does not have goal independence, it does have instrument independence. Government bond issues are managed by public tender, and there is no requirement for the RBA to participate. Decisions on short-term interest rates are made by the RBA board at its monthly meetings, and intervention in foreign exchange markets is made at the discretion of the Bank.

But even this degree of independence is somewhat limited. The RBA Act provides that in exceptional circumstances the Treasurer’s view shall prevail if there is a disagreement between the Treasurer and the Board over the direction of monetary policy.

Who funds bailouts?

Stiglitz argues forcefully that central banks, which may be captive to sectional interests of financial markets, should not be able to engage in bailouts of the institutions for which they have regulatory responsibility.

Observers of the partisan way in which the US Congress makes fiscal policy decisions may well wonder whether it is less captive to sectional interests than the unelected Federal Reserve.

Be that as it may, Stiglitz’s criticism does not apply to Australia. Responsibility for prudential regulation of individual banks rests with the Australian Prudential Regulation Authority, not the RBA. Measures to support Australian financial markets in the GFC were instituted by the Treasurer, not the RBA. These measures included the insurance scheme for individual deposits, and the government’s borrowing guarantee for banks to access wholesale funding markets. Premia paid under these insurance arrangements are paid into consolidated revenue in the same way as taxes.

Inflation targeting

Monetary policy decisions have differential impacts in a number of dimensions. A high exchange rate, for instance, affects some regions of Australia more than others. Low interest rates help home buyers but penalise self-funded retirees. In hard times, small businesses may find it harder to access credit than larger firms.

Stiglitz argues that these differential impacts should be considered when setting monetary policy.

Clearly, it is not possible to pursue multiple objectives with just one instrument of monetary policy – the short-term interest rate. But even if more instruments were available, it is not clear that the RBA should be making what are, in effect, fiscal transfers from one group to another. This is properly the task of Parliament and the Treasurer even if, as with the minerals resource rent tax (MRRT), sectional interests can derail the decisions of elected representatives.

Australian implementation of inflation targeting is, nevertheless, sensitive to some distributional considerations. For example, the RBA did not tighten policy in response to the rise in CPI inflation consequent on the start of carbon emissions pricing last July.

The bottom line

In Australia, regulation of individual banks is the domain of the Australian Prudential Regulation Authority (APRA), while systemic stability is the responsibility of the RBA. Central bank independence in setting monetary policy is not at issue here. Small, open, financial markets such as Australia’s need to play by the international regulatory rules set by the Basel committee. Basel’s ‘rules of the game’ have been toughened since the GFC, but the best insurance against mismanagement is well-informed, hands-on supervision by APRA. Thus far, Australia has been well served by its regulators.

On independence, the RBA is rightly protective of its reputation for independence in pursuit of its medium-term inflation target. Stiglitz’s remarks provide no justification to change those arrangements.