“Economic Consequences of the Banking Crisis: The Role and Optimal Independence of Central Banks,” Daniel Hansen, May 2022, American Political Science Review, Volume 116, Issue 2, pp. 453 – 469
The independence of central banks from the control of governments has been recognized as extremely important for achieving economic growth and stability. Economists strongly believe that people in government usually try to influence central bank officials to adopt easy monetary policy which is unfavorable for economic growth in the long run. After all, easy monetary policy helps governments to borrow money at lower interest rates for populist spending and also helps in easier availability of credit, which many consider to be important for economic growth. Together these two can cause prices to rise sharply which in turn can lead to a loss of confidence and seriously undermine economic growth.
predetermined inflation mandate
Furthermore, an independent central bank that primarily focuses on keeping inflation within a predetermined range would automatically keep other crises under control, it is believed. In short, the dominant view among economists today is that an independent central bank with an inflation mandate can spur economic growth by keeping inflation and banking crises under control at the same time.
“Economic Consequences of the Banking Crisis: The Role and Optimal Independence of Central Banks” by Carnegie Mellon University economist Daniel Hansen disagrees with current mainstream perspectives on the benefits of independent central banks. Henson argues that the benefits that independent central banks claim to provide in terms of controlling inflation may actually come at the cost of an overwhelming response to major crises. This, in turn, can lead to long-term unemployment and other economic costs that could have been avoided if central banks were not so focused on controlling price inflation. In particular, Hansen noted that during times of crisis such as the 2008 financial crisis, the response of central banks such as the Federal Reserve focused on keeping price inflation under control rather than solving the crisis.
He argues that such a short-sighted focus on price inflation diverted attention from the urgent need to bail out the financial system by diluting liquidity and leading to unemployment, economic contraction and other negative effects. According to Hansen, this resulted in economic costs that far outweighed the benefits of keeping price increases under control. Obviously, central bank independence can also have serious political consequences as difficult economic conditions can lead to political upheaval. They argue that economic contraction and high unemployment due to central bank independence can also lead to a populist reaction that further undermines economic growth. Many have argued that rising populism in the US led to a trade war between the US and China.
More importantly, Hansen believes that a real inflation mandate is not needed to achieve the goal of central bank independence. They argue that the independence of the central bank can only be achieved through laws that prohibit the politically motivated appointment/dismissal of central bank officials. If so, there is no need to make rules that would bind the central bank officials to keep the price inflation within a predetermined range.
Hansen’s critics argue that in the absence of a clear inflation mandate, central banks may tend to expand the money supply at a far more aggressive pace. This, in turn, can lead to business cycles marked by more severe economic contraction. Some might even argue that the idea of central bank independence is largely a myth as central bank officials are appointed in many cases by political officials. Even in cases where central bank officials enjoy complete independence from the executive wing of the government, there is no reasonable guarantee that they will act in the best interests of the larger economy. Central bank officials may collude with politicians in exchange for a variety of benefits. If so, a predetermined inflation mandate may provide at least some sort of protection from discretionary monetary policy actions.