When the next crisis comes, don’t blame the central bankers

President Trump recently tweeted his outrage at what was going on in the rarefied world of central banking. First he attacked the European Central Bank’s outgoing boss Mario Draghi for ‘unfairly’ promising more monetary stimulus to the Eurozone countries. He followed this up by condemning the ‘insane’ monetary policies of Jerome ‘Jay’ Powell, the man he had appointed to run the USA’s equivalent central-banking institution, the Federal Reserve. To add insult to injury, he suggested Draghi would be a better person to head the Fed.

Trump’s tweets often bring into the open some of the truths of modern politics – things that his predecessors were rather more guarded about. In so many areas, Trump has simply been much more candid in spelling out approaches that have defined Western governing for many years, from the use of tariff and non-tariff protectionism to subsidising domestic businesses to the toleration of public-deficit spending. In all these areas, Trump has been following the status-quo path set by his predecessors, propping up a fundamentally anaemic system of production.

Trump’s problem with the Fed is that it made the damaging mistake of raising interest rates too fast and too far. His immediate irritation is that this removed some of the wind behind rising US stock markets, one of Trump’s favourite measures to praise his own ‘fantastic’ presidency. At the same time, the Fed’s tighter (though still historically very loose) monetary policy, relative to other advanced countries, has been lifting the dollar.

Higher interest rates make dollar-denominated financial investments more attractive by comparison, sustaining the currency. Trump lambasted the resulting downside, that a higher dollar boosts the competitiveness of imports into the US, while aggravating the competitiveness of its exports. The Fed has supposedly been ‘killing’ jobs. He wants it to become a leader again in easing monetary policy.

Leaving aside their hyperbole, Trump’s tweets do draw attention to how prominent central banking has become over recent decades. Central banking’s high profile today marks a significant shift from earlier times. Central banking used to be regarded as a necessary activity that most people knew existed, but few could get that excited about. It was the macroeconomic equivalent of your plumbing at home. Indispensable for household sanitation, but not something you spent much time thinking about.

Except, that is, when it breaks down. When a water-related crisis strikes at home we turn to a (hopefully) competent, practiced technician, a plumber, to fix things and get us back to normal. Similarly, that’s how politicians used to regard central bankers – as experts with usually mundane jobs who are turned to in times of economic crisis, and whose actions (hopefully) restore economic normality.

Jimmy Carter, for instance, appointed Paul Volcker head of the US Federal Reserve in 1979 to crack down on the rampant inflation of the late 1970s. Volcker pushed up official interest rates to around 20 per cent. This precipitated the harsh recessions of the early 1980s that broke the inflationary cycle at the cost of rocketing unemployment and stagnant wages.

This ‘Volcker Shock’ exemplified the traditional way politicians turned to central banks to help out in exigent times. But with hindsight, it also marked the closing of an era of conventional central banking. Volcker’s successor in 1987, Alan Greenspan, became associated with a more prominent ongoing role for central banking, not only in the US but across the mature industrial countries. This had nothing to do with changes to the calibre of central bankers, or to the development of new banking techniques. Instead, it was primarily a response to the exhaustion of Western politics that became more evident from the second half of the 1980s.

Trump’s tweets about the Fed, therefore, acknowledge the contemporary role of central banking and monetary policy. In denouncing the ‘bad job’ done by Powell, Trump points to three important features of central banking in modern mature economies. First, the misleading fallacy of central bank ‘independence’. Second, the associated sheltering of politicians from responsibility for the economy. And third, the waning efficacy of central banking.

Central bank ‘independence’, which has been widely promoted since the final years of the Volcker era, has been much more a concept than a practical reality. The new enthusiasm for bank ‘independence’ in advanced countries expressed the hollowing-out of conventional politics. Politicians from both left and right adopted approaches that conveyed their abandonment of previous aspirations to create a better society. Instead we had the ‘Third Way’ mélange that openly embraced the fundamentals of the market system.

Politicians once offered distinct political programmes for economic progress. More recently, they have tried to present themselves as the most competent in market management. This has gone alongside a faltering political belief in the effectiveness of economic policy: from so-called ‘Keynesian’ fiscal policies to industrial policies, that had been subsidising lame-duck industries, to the Friedmanite monetarism applied in the 1980s. As a result, politicians since then have increasingly preferred outsourcing their economic responsibilities to technocrats, and in particular to independent central banks.

The idea was that independent central banks, detached from the electoral cycle, could use monetary policy to stabilise the economy, mainly through adjusting interest rates to control inflation. After Volcker’s apparent success in taming rapidly rising prices, the conventional assumption grew that targeting an inflation rate of around two per cent was best for business and for the economy. Such inflation targeting became the usual mandate for central banks. Pricing stability was seen as the means to financial stability, a goal that increasingly morphed into the assumption that central banks were vital for economic stability, too.

Central bank independence is actually not a new concept, but the meaning has changed since earlier in the 20th century. Historically, bank independence from the government wing of the state reflected a simple recognition that running a national bank and implementing monetary policy is an area for expertise. Central banking is technocratic in the descriptive sense, in that it relies on specialised technical skills that are not often found within the political class. Hence, the assumed benefit to society of a division of labour between elected politicians and expert central bankers.

As Paul Tucker, former deputy governor at the Bank of England, notes in his recent book Unelected Power, the original justification for this delegation to independent agencies was that their professional expertise could improve the welfare of the people. Of course, being an expert doesn’t make you any more infallible than an elected politician, not least when one of the tasks you have been given is to manage inherently volatile financial markets. Nevertheless, in the past it seemed sensible that politicians should set the high-level banking objectives, such as the monetary-policy goals, and skilled financial administrators should implement them.

Since the 1980s, bank ‘independence’ has turned into something different: a way for politicians to distance themselves from what is happening in the economy. The old efficiency argument became an argument for insulating policy from politics, for independence from politics. Influenced by the peculiar post-Weimar, post-Nazi model of the (West) German Bundesbank, this shift removed a big chunk of economic policy from democratic accountability.

In Unelected Power, Tucker also notes the misgivings liberals have about democracy, both historically and today. He views the enhanced authority of central bankers as part of a disturbing ‘re-emergence of unelected power’, which he views as one of the ‘defining features of modern governance’. From his insider vantage point as a former central banker, Tucker is well positioned to call out ‘faux independence’.

This is not to say that politicians are behind the scenes pulling the bank’s strings. Mostly, they have washed their hands of monetary policy. Rather, central-bank independence is bogus because elected politicians and central bankers are both instruments of government. As different parts of the same state, they each want to protect the market system from mishaps. Now that promoting ambitious economic change has receded from mainstream politics, both wings share the same impulse to preserve the status quo.

But what this also means is that, when things go wrong, politicians can deflect responsibility on to central banks. In attacking the Fed, Trump, like his predecessors, wants to distance himself from a malfunctioning economy. The ‘independent’ central bank is a scapegoat for when economic conditions worsen. Trump knows as well as anyone that the short-term positive effect of his tax cuts may not last much longer, and that relying on the buoyancy of the shale-energy sector is not a sure bet for maintaining even modest growth rates. Facing the risk of renewed economic slowdown in the run-up to his re-election campaign, Trump wants someone else to blame.

In reality, far from ‘killing’ jobs, the Fed’s (still) easy monetary policies have been helping save jobs in zombie businesses. Low interest rates, negative in real terms for some borrowers, allow loss-making and low-profit firms to keep going and keep employing. The other big effect of torrents of central-bank liquidity has been financing rising asset prices, and an associated feelgood factor for those who own financial investments or their own homes. Trump is turning things upside down with his tirades against Powell.

Trump’s frustration with the Fed reflects a growing loss of faith in the capability of central banking to keep things rolling along. Since the last financial crisis, the ‘only game in town’ has been a favourite idiom for central banking. With the next crisis, central banking risks becoming associated with some less flattering idioms: ‘falling from grace’, ‘going to the dogs’, or even ‘a dead man walking’. This would open up the limitations of making central banks the principals of economic policy. They have played a vital role in facilitating our financialised economies, but they have minimal sway over the productive economy. In the near term, expansive monetary policy can add to the resilience of the market system, but it cannot ever restore economic strength.

This explains why central banks have been unable to engineer a decent recovery since the 2007/09 crisis. Instead we’ve had the absurdity of state banks responding to one debt crisis by fuelling the next one. Pumping liquidity into the economy hasn’t done anything to boost productive investment in technology and innovation. But it has helped inflate another debt mountain. This time corporate borrowings to keep businesses going, alongside the financing of government deficit spending, have been the main drivers. While the commercial banks were the fall guys last time, when the bubble next bursts it could be the central banks taking the rap.

Moreover, when the next crisis does arrive, central banks will be much less able to ride to the rescue, further irritating governments. Central-bank emergency measures used last time around – those ultra-low interest rates and huge balance sheets courtesy of quantitative easing – have become the new normal for monetary policy. In a recent speech, Powell acknowledged this when he suggested retiring the term ‘unconventional’ for the tools used after 2008. Because the tools themselves have not been retired and are still active, the banks may have less to call up to help the economy through the next crisis.

That concern was a big factor behind the Fed taking advantage of the temporary stimulus from Trump’s tax cuts in 2018 and raising interest rates in order to load a few bullets. This is also why Bank of England governor Mark Carney has wanted so much to increase British interest rates too, to give him something to cut when the next recession arrives. However, the dilemma facing Western central banks is that they also know that lifting interest rates in a heavily debt-dependent world itself risks precipitating the next financial crash and recession. They are trying to balance two contradictory scenarios. As a result British, European and Japanese official rates remain at historic lows, more than 10 years after the crash. Even in the US, with the official funds rates now up to 2.25-2.5 per cent, the Fed’s gun is less than half-loaded compared to the five-per-cent-or-more rates before the last three recessions.

Our wrath should be directed not at the central bankers, but at the politicians who have deserted the field of promoting growth. They have passed the buck for trying to sustain a broken economy on to financial organisations with extremely limited powers over the real economy. Most central bankers never sought the limelight that politicians thrust them into. However, this is unlikely to protect them from the anger of duplicitous politicians. When Western economies subside again, alongside the customary foreign scapegoats, governments may well seek to denounce someone at home too.

Phil Mullan’s latest book, Creative Destruction: How to Start an Economic Renaissance, is published by Policy Press.

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