21 May 2024

Project Syndicate's Skidelsky: The Myth of Central-Bank Independence

The BoE’s failure to respond effectively to the worst inflation in four decades underscores the need to abandon the outdated notion that fiscal and monetary policy can be kept separate. If governments are to be held responsible for investment and employment, they should also control interest rates.

The United Kingdom’s economic policy is adrift. That was the main conclusion from the House of Lords Economic Affairs Committee’s inquiry into the Bank of England’s failure to predict the worst inflation in 40 years. In a recent report, the Committee criticized the BOE’s internal culture and forecasting models, casting doubt on its ability to get inflation back to the 2% target by 2025.

The UK’s annual inflation rate reached a four-decade high of 11.1% in October 2022, while overall prices have increased 22% over the past three years. The House of Lords report attributed the BOE’s mistakes to “groupthink” among officials, an increasingly vague mandate (which now includes considerations like climate change), and “inadequate” forecasting tools. Former US Federal Reserve Chair Ben Bernanke, commissioned by the BOE to review its performance, highlighted the Bank’s obsolete software. The Committee also raised valid concerns about central bankers’ “unelected power.” In 1997, then-Chancellor of the Exchequer Gordon Brown set the UK’s annual inflation target at 2.5% (later reduced to 2%) and gave the BOE “operational independence” to achieve it. Since then, the Bank has taken even greater control over economic policy, pumping £875 billion ($1.1 trillion) into the British economy through its quantitative easing program in response to the 2008-09 global financial crisis. As Economic Affairs Committee Chair George Bridges observed, this outsourcing of macroeconomic policy from government to central bankers – now standard practice in developed economies – represented “an enormous transfer of power from elected representatives to unelected officials.” Given that interest rates affect not just the value of money but also unemployment, growth, and distribution, it could be argued that monetary policy, like fiscal policy, should be managed by governments accountable to voters. Yet, despite the criticism of the BOE’s performance, the report did not question the principle of central-bank independence. Instead, they focused on ways to align the Bank’s freedom to set interest rates “independent of political pressure” with government accountability for economic policy.

The notion that central-bank independence is sacrosanct can be traced back to Milton Friedman’s monetarist counterrevolution in the 1970s, which ended the hegemony of Keynesian social democracy. Friedman argued that market economies are “countercyclically stable” at their “natural rate of unemployment,” provided that market participants are not deceived by variable inflation rates. This argument effectively narrows the scope of macroeconomic policy to maintaining price stability.

Since monetary policy, like fiscal policy, affects economic activity with “long and variable lags,” entrusting inflation control to independent central banks – insulated from political interference and operating according to mechanical rules – would prevent politicians from manipulating the money supply.

Bankers and economic-policy wonks were quick to embrace Friedman’s monetarist gospel. In a 1984 speech, then-Chancellor of the Exchequer Nigel Lawson turned the previous Keynesian orthodoxy on its head. The objective of macroeconomic policy, he asserted, should be “the conquest of inflation,” not “the pursuit of growth and employment.” Conversely, microeconomic policy should focus on “the creation of conditions conducive to growth and employment,” rather than on suppressing inflation....

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