by E Balls · 2018 — The crisis demonstrated that a focus on price stability alone is too narrow: effective macroeconomic policy cannot ignore the financial sector, and requires
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Mossavar – Rahmani Center for Business & Government Weil Hall | Harvard Kennedy School | M – RCBG Associate Working Paper Series | No. 8 7 The views expressed in the M – RCBG Associate Working Paper Series are those of the author(s) and do not necessarily reflect those of the Mossavar – Rahmani Center for Business & Government or of Harvard University. The p apers in this series have not underg one formal review and app roval; they are presented to elicit feedback and to encourage debate on important public policy challenges. Copyright belongs to the author(s). Papers may be downloaded for personal use only. Central Bank Independence Revisited: After the financial crisis, what should a model central bank look like? Ed Balls, James Howat, Anna Stansbury April 2018

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1 Ed Balls Research Fellow, Mossavar – Rahmani Center for Business and Government, John F Kennedy School of Government, Harvard University & Visiting Professor, London James Howat John F Kennedy School of Government, Harvard University Anna Stansbury John F Kennedy School of Government & Economics Department, Harvard University A n earlier version of this paper was published in September 2016 as a working paper by the Mossavar – Rahmani Center for Business and Government at Harvard University. It was largely written during Ed as Senior Fellow at the M – RCBG, during which James was an MPP student and before Anna began her PhD course. Earlier versions of this paper were presented at a Harvard – wide panel event on 27 th March 2017, at the Feldstein – Friedman Macroeconomic Policy Semi nar in the Department of Economics, Harvard University on 1 st March 2016 and to the Senior Fellows Meeting at the Mossavar – Rahmani Center for Business and Government, Harvard Kennedy School in February 2016 . The ideas in the paper were discussed at the Ba The authors are grateful to Shasha Mohd Rizdam Deva , Jon Newton , Alexander Harris and Nyasha Weinberg for help with the case studies and Larry Summers, Alberto Alesina, Tim Geithner, Martin Feldstein and Ben Friedman, Andrei Shleifer , Michael Walton , Christopher Crowe, Chris Giles, Charles Goodhart, Jens Henriksson, Donato Masciandaro, Kevin , Alan Taylor, Sir Nicholas MacPherson, Sir Charlie Bean and Andy Halden, for support and comments. All comments are gratefully received.

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2 Summary After the financial crisis , countries around the world significantly expanded the objectives and powers of central banks . As central banks have acquired more powers, the trade – off between independence and accountability has become more complex and as a result , the pre – crisis academic consensus around central bank independence has broken down. Popular discontent towards central banks is growing. A new model of central bank independence is needed. We first investigate the traditional case for central bank independence. Extending work from the 1980s and 1990s to the present, we show that op erational independence of central banks the ability to choose an instrument to achieve inflation goals – has been associated with significant improvements in price stability. But in advanced economies at least, political independence the absence of the possibility for politicians to influence central bank goals or personnel has not been correlated with inflationary outcomes. This suggests that c entral banks in advanced economies can sacrifice some political independence without undermining the operati onal independence that is important in both their monetary policy and financial stability functions . In light of this distinction between political and operational independence , we then evaluate the new powers that central banks have taken on over recent years , focusing on advanced economies . We develop a framework which examines how to maximize the benefits of locating new powers inside the central bank, while minimizing potential conflicts with monetary policy and limiting political threats to the legiti macy of operational independence. Based on this framework, we recommend a set of principles to guide central bank structural reform. First, we recommend the institution of formal monetary – fiscal coordination mechanisms, provided that they are limited to the zero lower bound, triggered by the central bank and protect democratic control over fiscal policy. Second, we recommend that systemic risk oversight and prioritization is carried out by a multi – member body comprising the central bank and financial regulators and chaired by government, b ut that macro – prudential policy – making is operationally independent from government. Third, we recommend that crisis management efforts are led by government, but that there should be few restrictions on central bank liquidity provis ion. Finally, we argue that there is a case for and against the central bank as bank supervisor, but that the central bank should not be responsible for policing financial conduct. Viewed in light of our framework, no single country has yet settled the question about how a moder n central bank should be structured. The approach taken by major economies all have strengths a nd weaknesses: t hey would benefit from learning from each other . For example , i n the US, the central bank lacks the macro – prudential tools required to fight ris ks to the – new powers from the government. T he UK shou ld also look to the US for lessons. After the centralisation of prudential regulation both of the micro and macro variety and systemic risk monitoring inside the Bank of England, there is a danger that the UK money – credit constitution is too concentrat ed in the central bank, leading to the possibility of groupthink, a lack of oversight and ultimately political risks to central bank independence. I n Europe, the ECB has made progress building up its macro – prudential toolkit. But it still lacks powers to i nfluence the non – bank financial sector and this macro – prudential policy capacity is fractured across several different institutions without effective

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3 oversight, a concern for political accountability especially in a union representing many different countr ies and political systems. In the US, the UK and the Eurozone over recent years , there have been calls to reduce or eradicate central bank independence from both politicians and the public . But we are clear that this is no time to throw the baby out with the bathwater . We do argue for a more nuanced approach to central bank independence, with political accountability in terms of mandate – setting and appointment of officials, and oversight of wider financial stabil ity powers. Nonetheless, we reiterate that the case for operational independence in both monetary and macro – prudential policy is strong: to retreat on this now would be a serious mistake.

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4 1. Introduction Prior to the financial crisis, a consensus had develo ped around the model of an ideal central bank: independent from government, with a focus on price stability through an inflation target 1 , with primary responsibility for moderating macroeconomic fluctuations . This consensus was supported by theoretical and empirical evidence demonstrating that central bank independence was important in reducing inflation without a negative impact on growth or employment. Central banks in advanced and emerging economies converged upon this model of central bank independence , and i n many countries, central institutions to enable to central bank to focus on its core monetary policy responsibility. In the wake of the global fi nancial crisis, however, this model of a central bank is being challenged. In . President Trump has criticized the Federal Reserve and its independence, and broke with precedent in not re – appointing Fed Chair Janet Yellen to a second term , replacing her with new Fed Chair Jerome Powell . The opposition Labour Party in the UK launched a review of the Bank of England and its leader Jeremy Corbyn previously called force it to fund public projects . Bank of England Governor Mark Carney has also come under criticism from senior Conservative politicians . The ECB has been criticized by senior Eurozone politicians including most notably the then German Finance Minister Wolfgang Sch ä uble. It has been alleged that g overnments in Brazil and India have recently tried to curtail the independence of their central banks. Challenges to the pre – crisis consensus do not just come from politics. Even mainstream academic voices have begun breaking long – held taboos by calling for monetary financing of governments ( ), scrapping inflation targeting , and questioning the value of central bank independenc e. This backlash reflects important shortcomings in the traditional model of a central bank. The crisis demonstrated that a focus on price stability alone is too narrow: effective macroeconomic policy cannot ignore the financial sector, and requires coord ination between monetary and fiscal policy when at the zero lower bound. New trade – offs have been revealed between stable inflation, full employment and financial stability. For some, c entral bank independence itself designed to prevent inflation from be coming too high may no longer be useful when monetary policy is constrained and the central challenge is inflation being too low 2 . As a result, models of central banking have diverged since the crisis , with countries overhauling their monetary and regulatory architecture in markedly different ways. Central banks have accumulated a much wider range of powers than was common at the time the consensus around central bank independence was built, in areas o f unconventional monetary policy, crisis response and financial stability. and powers challenge the previous academic consensus that their independence is an unalloyed good. Unlike monetary policy, these new po wers may require the central bank to coordinate closely with the government and other regulatory institutions, and to venture 1 And, in some, cases, the maintenance of full employment. In the case of the Fed, these two goals were equally weighted; the ECB and the Bank of England, among others, had primary weighting on price stability. 2 See, for example, Kocherlakota (2017)

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5 into politically treacherous areas with first – order distributional consequences such as housing policy. Some fear that central ban ks have become too independent and insufficiently accountable to the – won independence in monetary policy, diluting their focus on inflation targeting . The following section of this paper explores in greater depth the failure of the pre – crisis conception of central bank independence and the backlash that it has unleashed. A brief overview of the diversity of responses to these problems reveals that t he pre – crisis cons e nsus about the structure of a central bank regime has broken down . The third section investigates what of the pre – crisis conception of central bank independence is worth saving. To do so, it tests the relationship between different types of independenc e focusing on the distinction between operational and political independence and inflation outcomes. It also examines whether these results differ between developed and emerging economies and, given the threat of a lower bound on nominal interest rates means for the effectiveness of central bank independence. In light of these conclusions, as well as insights from economics, public choice theory and politics , the fourth section of the paper create s a framework to system at ically evaluate whether the different powers and responsibilities that have been thrust on central banks should indeed be housed in that institution. This framework is designed to maximise the effective implementation of these tool s, while minimising potential conflicts with monetary policy and limiting threats to central bank independence. Using this framework, the fifth section draws up an ideal template for the modern central bank. In particular, it evaluates the appropriate ins titutional structures for coordination between monetary and fiscal policy, systemic risk supervision, macro – prudential policy, financial supervision and conduct, and crisis management. The final section brings together our recommendations and offers sugge stions for further research. In an annex to the paper (Annex D) , we construct an index tha t measures countries against this template for a modern central bank. Traditional indices of central bank independence such as Grilli, Masciandaro, & Tabellini (1991) and Cukierman, Neyapti & Webb (1992) financial stability mandates, they actually penali s e central banks for taking on financial stability objectives and the tools required to meet them. We use our scoring system , which reflects the broader mandate of modern central banks, to evaluate the new functions of the central bank in 1 0 countries 7 develop ed and 3 emerging economies based on case studies attached in Annex C . While the first section s of our paper explore empirical relationships, the latter sections are more normative. As a result, there will inevitably be disagreements about our template . But given the lack of consensus in academic and practitioner discussions, and highly divergent reforms in the real world, we hope that our proposals can move forward the debate on how, post financial crisis, a modern central bank should look and operate.

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7 The global financial crisis revealed significant weaknesses in each component of this framework. i. In order to meet their inflation targets, central banks needed to dramatically expand their toolkits beyond their policy rates . In some cases t he convenient d ivine coincidence appeared to break down central bankers might now need to choose between inflation at target and the economy at full capacity . Particularly at the zero lower bound, monetary policy alone could not guarantee price stability or return the economy to full employment and so fiscal policy once again had a key role to play in demand management, suggesting the need for coordination between the government and the central bank 5 policy tools such as quant itative easing had fiscal implications , involv ing consolidated balance sheet and affect ing the management of gover nment debt (Greenwood, Hansen, Rudolph, & Summers, 2014) . The crisis demonstrated that financial conditions matter greatly for the transmission of monetary policy financial policy. ii. crisis demonstrated that the modern complex financial system is vulnerable to systemic risks that can be and were missed by micro – prudential regulators focused on specific institutions. Such risks might build up over time : for example herding behaviour can lead to pro – cyclical investment strategies. Systemic risks might also be cross – sectional as firms develop complex exposures to risks that micro – prudential supervisors, looking only at individual firms, might miss. Supervisors lacked adequate macro – prudential tools system – wide changes to capital and liquidity requirements, market structures and permissible terms of lending to respond to such risks. iii. The increasing size and complexity of the financial sector forced central banks to expand dramatically their lender of last resort facilities. Contrary to Bagehot, they lent at subsidised rates, on the basis of hard – to – value collateral and to a wide range of counterparties. In fact, some central banks even acted as market – makers – of – last – resort. iv. could not stem a crisis. Governments have pumped large amounts of fiscal resources into re – capitalising failed institutions in order to prevent financial contagion. Many jurisdictions have also set up new resolution mechanisms for large inter – connected financial institutions and new bodies that are responsible for fighting risks to financial stability at the system – level or that, in a crisis, could coordinate the central bank, different regulators and the government. Meanwhile, financial and monetary policies have become increasingly international, involving trade – offs between domestic and foreign interests. The response to cross – border financial crises requires the close cooperation of multiple jurisdictions. Monetary policy has become increasingly inter – depen dent across countries. H é l è ne Rey, for example, has argued that unless a country imposes restrictions on its capital account, it cannot pursue a monetary policy fully independent of the global financial cycle (Rey, 2013) . Some eme rging market central bankers, such as Raghuram Rajan during his tenure as Governor of the Reserve Bank of India , have advocated for advanced economies to take greater consideration of 5 An idea coming from the original Keynesian models, and developed more recently by Krugman (1998), Feldstein (20 Correia, Farhi, Nicolini, & Teles (2011) among others.

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8 international financial implications when setting monetary conditions (Misra & Rajan, 2016) ; while Blanchard (2016) has argued that the scope for international monetary coordination is limited . Finally, with weak financial systems and over – leveraged private sect ors undermining transmission of m onetary policy to the real economy, some allege that central banks have become thy neighbo u . As a result of all this , it has become increasingly important for central banks to coordinate with their peers abroad. In response to these institutional shortcomings revealed by the crisis, countries around the world overhauled their regulatory frameworks. Governments ext ended central bank mandates to include explicit financial stability goals and equipped central banks with varying degrees of macro – prudential tools to achieve them, ranging from counter – cyclical capital buffers to loan – to – value ratios. While the powers of almost all central banks have increased, they have done so in very different ways. structures. For example, the Bank of England is now explicitly re sponsible for financial stability and has been equipped with an extensive macro – prudential toolkit to achieve this mandate. But in Sweden, the financial regulator, which sits outside of the Riksbank, controls the macro – prudential levers. In the US, the Tr easury Secretary can veto recommendations by the Financial Stability Oversight Council that monitors systemic risks. But national governments have no representation on the equivalent euro – zone body, the European Systemic Risk Board. And in perhaps the bigg est challenge to the pre – crisis conception of central bank independence, the Bank of England worked with the government to coordinate monetary policy and debt management, as well as using fiscal resources to boost lending to the real economy through its Fu nding for Lending Scheme. Table 1. Financial stability powers of ten central banks Y = Yes, ~ = Somewhat, N = No CB has financial stability mandate? CB has formal macro – prudential powers? Systemic risk monitoring body? Monetary policy/debt management coordination? Bank supervision in CB? Australia Y ~ Y ~ N Canada ~ N ~ N N China ~ N Y N N ECB N ~ ~ N Y India ~ Y Y Y Y Japan ~ N ~ N N Malaysia Y Y Y N Y Sweden N N Y N N UK Y Y Y ~ Y US ~ N Y N ~ (Table based on individual country case studies attached in the Annex.)

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9 Concerns about central bank independence have mounted Nearly everywhere, central banks have been given far more powers since the crisis. Their new responsibilities and powers have thrust them into politically contentious areas of policy and required them to work closely with other institutions, including the government. At the same time, many of the ave systematically undershot their inflation targets over extended periods of time because they struggled to reflate their economies . As a result, t here has been a backlash against central banks. Concerns that central banks have become too powerful and unaccountable are reflected in the media and in politics in many countries. In the US, the Senate only narrowly rejected Senator Rand Paul and Representative Thomas Massie , which would have significantly curtailed Fed independence by requiring the Fed to set interest rates according to a predefined rule and by making monetary policy decisions subject to Congressional review (Bernanke, 2016) . The bill was reintroduced in January 2017 and would allow P residential candidates including Marco Rubio and Bernie Sanders voted in favour of the bill, and President Donald Trump expressed support when he was the Republican candidate (La Monica, 2016) . President Trump in November 2017 broke with precedent in not re – appointing Fed Chair Janet Yellen to a second term , replacing her with new Fed Chair Jerome Powell . In the Eurozone, the ECB faced legal challenges over its Outright Monetary Transactions program, only settled in 2015 by a European Court of Justice ruling confirming that monetary policy was indeed the of the ECB (ECB, 2015) . Senior Eurozone politicians, most notably former German Finance Minister Wolfgang Sch ä uble, have frequently publicly commented on ECB policy decisions (Reuters, 2017) ; in April 2016, his comments were construed as implying that the ECB bears some responsibility for the rise of far – right party AfD in Germany (Jones, 2016) . In Switzerland, t referendum to require the Swiss National Bank to hold at least 20% of its reserves in gold (Bosley, 2014) . In the UK, former Foreign Secretary and former Leader of the C onservative Party William Hague wrote in (Hague, 2016) . Michael Howard and Iain Duncan Smith, former Conservative party leaders, and Nigel Lawson and Norman Lamont, two former Chancellors, criticized the Bank of England for its analysis in the run – up to the Brexit referendum, arguing that there eful failure on the part of the Bank of England, the Treasury and other official sources to present a fair and (Smith, Howard, Lamont, & Lawson, 2016) . Some have argued that policy proposals from Jeremy Corbyn, the Leader of the Opposition Labour party in the United Kingdom, would jeopardize the (Yates, 2015) . Economic commentators have also begun questioning the value of central bank independence. As some as monetary policy involves inherently political trade – offs (Munchau, 2017) ; in 2015 , Ryan Cooper wrote in The Week , arguing that independent central banks have not performed well since the crisis (Cooper, 2015) ; The Telegraph Ben

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10 about the distributional effects of monetary policy and the extent to which central bank powers have expanded without corresponding accountability an d oversight (Wright, 2014) ; and Chris Giles in the Financial Times – that the Bank of England had too little accountability (Giles, 2012) . Within this backlash and increased suspicion of central banks , there are two sets of concerns about central bank independence. Concern 1: central banks are too independent C oncerns that central banks are too independent typically focus on either macroeconomic policy effectiveness or the implications for democracy and accountability. S ome economists have argued that central bank independence is at best irrelevant and at worst damaging in economies wh ere the key macro – economic challenge is raising inflation, not lowering it. C entral bank independence was designed to reduce inflationary bias , y et no advanced economy in the world has experienced prolonged bouts of high inflation in many years . In fact, most central banks are strug gling to bring inflation up to the ir inflation target s . Fels (2016) under gover nment oversight, including allowing the central bank to finance the Treasury directly, could (Negative Interest Rate Policy) 6 T here are also concerns that it is too difficult to hold central banks democratically accountable for their new powers (Issing, 2011; Braun & Hoffmann – Axthelm, 2017) . S hifting pow er away from the political process to independent institutions is , by its nature , undemocratic . It should only be done both when there are large benefits to removing the decision – making from the political process and when it is relatively easy to hold the independent institution accountable for its decisions. In (conventional) monetary policy, this is the case. In financial policy , however , it is much more difficult to set up effective ifficult to define than price stability and the tools to achieve it, such as macro – prudential measures, are less well understood than conventional monetary policy tools such as interest rates . Given regulatory arbitrage in finance, it is a lso very difficult to delineate ex – ante the necessary toolkit to tackle risks to financial stability. In addition , social preferences about financial stability are often less clearly defined and first – order distributional effects are likely to be greater than with conventional monetary policy 7 . It is very difficult , for instance, to set up a welfare function that allows the central bank to optimise the trade – off between economic dynamism and financial stability. In the absence of a social consensus on the objectives of financial stability policy, an independent central bank may simply impose its preferences on society , 6 Macro economic 7 Either because the distributional effects net out over the economic cycle, or because the redistribution from savers to borr owers or vice versa is outweighed by the benefits to all as a result of improved economic growth and stable inflation (see, e.g. Nakajima 2015). Note that this may be less likely to hold if monetary policy becomes asymmetrical, for example in prolonged per iods at the zero lower bound, or under large changes in monetary policy stance (Doepke, Schneider and Selezevna 2015, Nakajima 2015).

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