The author opinions that unlike in the periods of the global inflation of the 1970s and 1980s, the case for central bank independence will not nearly be as strong in the post-pandemic era, with the US Federal Reserve for one at risk of coming under over political control.
The coronavirus crisis is quite likely to void the contract under which the U.S. Federal Reserve and the world’s other main central banks have operated for decades. As the full costs of the pandemic emerge, the main idea in this contract — that central banking can and should stay politically neutral — might have to be abandoned.
This wouldn’t be the most dramatic result of the COVID-19 emergency, but in the end it could be one of the most consequential.
An earlier crisis — the global inflation of the 1970s and 1980s — first stamped the case for central-bank independence on conventional economic wisdom. This new crisis will demand, at the very least, much closer coordination between governments and central banks. But it will probably demand more, perhaps bringing central banks, including the Federal Reserve, under overt political control.
The case for central-bank independence went largely unquestioned for years. The logic was straightforward. It assumed that politicians think short-term, and make decisions for political reasons. At full or close-to-full employment, expansionary monetary policy might briefly juice the economy but, after a delay, it causes inflation. If the delay is enough to get the government through the next election, policy will have an inflationary bias. If you keep monetary policy at arm’s length from politics by making it the responsibility of an independent central bank, you avoid the problem.
That’s not all. According to the conventional view, there’s no lasting tradeoff between inflation and employment. Tolerating higher inflation doesn’t lower unemployment, and it probably reduces growth. Maintaining low inflation therefore doesn’t pit winners against losers; it helps everybody. Monetary policy then becomes a largely technical matter, suitable for delegation to experts with no direct accountability to voters.
Looking back, it’s nothing short of remarkable how widely this thinking was accepted. In the U.S. today, every choice of policy (and much else besides) is rendered in intensely partisan terms, and for the past three years President Donald Trump has assaulted the principle of central-bank independence with all the tweets at his command. Despite this, the Fed has simply carried on, largely shrugging off the threat of political entanglement. No doubt it helped that, up until 2008 at least, the results were pretty good. The Fed had bought itself a lot of room for maneuver.
Even before the pandemic, though, the recession and the subsequent slow recovery had changed things. The prospect of persistently slow growth — “secular stagnation” — had already called the Fed’s policies into question. The risk of higher inflation seemed remote. To many, a more expansionary stance of fiscal and monetary policy looked desirable.
Compounding the problem, with interest rates at or close to zero, the conventional tools of monetary policy were no longer much use. To support demand, the Fed and other central banks had to resort to bond-buying on an enormous scale — a policy that blurs the line between monetary and (more explicitly political) fiscal policy.
In effect, after 2008, central banks faced a dilemma. They could either be restrained and stand accused of letting their economies stagnate; or they could be bold and inch into the fiscal and political realm. They inched. The coronavirus emergency will push them much farther over that line.
So far, the Fed has responded to the pandemic quickly and comprehensively — much more smoothly than Congress or the administration, a display of technocratic energy and expertise at its best.
It has cut the policy interest rate to a range of 0% to 0.25% and promised that rates would stay low indefinitely (“until we’re confident the economy has weathered recent events”). It announced a new open-ended bond-buying program and broadened the range of eligible securities. It relaxed some regulatory requirements. It revived and expanded lending programs developed after the crash in 2008 to support banks, financial markets, corporate borrowers and households. It has acted to help states and cities under financial pressure. Last week, it announced a new $600 billion Main Street Lending Program that will buy 95% of qualifying loans made by banks to small and middle-sized companies.
Despite their remarkable scale, these measures still fit the apolitical template tolerably well. They can be seen as technical initiatives to keep financial markets up and running while maintaining the flow of credit to the economy. Renewed bond-buying is a partial exception. This does test the political boundary, but not too severely, since it’s widely seen as necessary and by now it’s familiar.
The Fed’s new political problem will arise later — because of the size of the fiscal interventions that are just getting under way. The president recently signed a stimulus bill proposing some $2 trillion of new spending, roughly half a trillion more than the combined measures passed in response to the crash. And this is unlikely to be enough. With luck, the coronavirus emergency might come to an end within a few months, and the subsequent recovery could be strong as well, but in the short run the economy is going to shrink dramatically.
The shutdown seems certain to cause the biggest short-term drop in output the economy has ever experienced, and the pace of the subsequent recovery is hard to guess. On the view that public spending should rise to protect the millions of workers who are being laid off or furloughed, the outlays in the new relief bill won’t go far. Congress is already debating further measures. Later, supporting the recovery once the epidemic is under control will require additional public spending, and tax increases to cover the cost of what’s already being spent will most likely need to be delayed. After the recession of 2008, and before the pandemic struck, net U.S. public debt increased from 38 percent of gross domestic product to 79 percent. Over the coming year, and maybe beyond, it will surge again.
In policy terms, this will not be just more of the same — because this time, public spending will have to do it all. With short-term interest rates already back at zero, conventional monetary policy can’t provide any new macroeconomic support. Quantitative easing can continue, but there’s limited scope for bond-buying to work through the intended channel of lower long-term rates, because they too are very low. One of the lessons learned since 2008 is that QE faces diminishing returns.
So the big question is how far public borrowing can expand before lenders take fright at the rapid and potentially indefinite issuing of additional public debt. Closely related to that is another question: How long can central banks insist that their quantitative easing is a temporary expedient, that their bond purchases will be unwound in due course, and that taxpayers will therefore, sooner or later, have to service the government’s debts?
The alternative to maintaining that posture — to claiming, in other words, that monetary policy is still distinct from fiscal policy — would be for central banks to simply erase the addition to public debt and directly finance the needed public spending. Thanks to the pandemic, an eventual recourse to direct monetary financing, which fully merges monetary and fiscal policy, is possible and perhaps even probable.
It could be done in a variety of ways, involving much less drama than the term “helicopter money” suggests. The simplest from an accounting point of view would be to announce that some of the bonds acquired by the central bank would henceforth be interest-free and irredeemable. The monetary expansion provided by the bond purchases would then be permanent, and future taxes wouldn’t need to rise to cover the government’s debt-service costs.
One risk in this approach to fiscal-and-monetary expansion, needless to say, is inflation. But let’s assume that danger can be avoided by judiciously limiting the scale of any such expansion. The other risk, regardless of scale, is that it requires such close cooperation between a government and a central bank that the distinction between the two would be erased along with some portion of the public debt.
Either the central bank becomes entirely passive, financing whatever amount of public debt the government believes is necessary; or, at a minimum, it becomes the government’s partner in designing the size of the needed monetary-and-fiscal intervention. In the first case, it no longer has any say in monetary policy; in the second, it cannot expect to remain above the political fray.
In either case, its independence is over, and a new post-pandemic era of central banking will have begun.