The Myth of the Independent Central Bank

In today’s fiat money world, money has no ‘intrinsic’ value. People value fiat money because other people value it. As long as everyone agrees that fiat money has value, then it does have value: but if enough people suddenly decide that fiat money has no value, it becomes worthless.

In hyperinflationary episodes, confidence in a fiat currency evaporates and people dump it in favour of assets, commodities and even other fiat currencies. Printing more of it only makes matters worse.

Macroeconomic models involving (fiat) money are thus inherently models with multiple equilibria. In one equilibrium, the value of money is stable: but in another, inflationary dynamics become explosive and money becomes either worthless (hyperinflation) or infinitely valuable (Fisherian ‘debt deflation’).

In such models, the economy can suddenly jump to an explosively inflationary equilibrium without any change in policy. In effect, they imply that there can be a ‘run on the central bank’.

Central banks can, of course, always meet demand for their own currency, since they can create it ex nihilo. But if there is always the risk of a sudden switch to an explosively inflationary or deflationary equilibrium, they can’t guarantee its value.

Nobel Laureate Professor Christopher Sims argues that it is fiscal policy that guarantees the value of fiat money. Central banks thus can never be independent of government. The ‘independent central bank’ is a myth.

But what about the European Central Bank (ECB), whose independence from government is guaranteed by treaty? The original concept of the Eurosystem assumes that there is a sharp distinction between monetary and fiscal policy, and that monetary policy does not give rise to fiscal transfers.

We now know that all monetary policy actions have fiscal consequences: for example, interest rate rises shift wealth from countries with more debt towards countries with less. Buying government bonds according to a ‘capital key’ reduces the borrowing costs of larger and richer countries.

The euro’s very existence was threatened by fiscal distress in Eurozone countries, to which the ECB was forced to respond. Thus, even the ECB is entwined with government.

Not only are central banks not independent of government, but they are also dependent on governments running appropriate and plausible countercyclical fiscal policy. As Professor Sims says, ‘if people understand that fiscal policy will try to slow the expansion of deficits in periods of high inflation, and will expand deficits when interest rates are at or near the effective lower bound, sunspots and multiple equilibria are eliminated’.

The ‘fiscal theory of the price level’ says that to keep the value of fiat money stable and prevent switching to an unstable inflationary dynamic, fiscal policy must actively maintain the real value of government debt over the long term. The fiat money ‘confidence trick’, in which – like Tinkerbell – it has value as long as people believe in it, thus depends on the credibility of fiscal policy as much as monetary policy.

Central banks’ ability to act as lenders of last resort in a crisis depends on their fiscal backing. When a central bank is actively buying assets, it can become technically insolvent if those assets fall in value. Several central banks around the world currently have negative net worth at market prices: some of them (such as the Chilean central bank) have had negative net worth for a long time.

There has been a considerable debate about whether the solvency of central banks makes any difference to their credibility as lenders of last resort or their ability to control inflation. Arguably, it does not – provided fiscal authorities can support them.

Often, the net present value of future seigniorage receipts is sufficient to cover any asset and liability mismatches at market prices. But if seigniorage is insufficient, then tax receipts will be needed to plug any gaps. In practice, this implies that the net present value of projected future primary surpluses must be sufficient to recapitalise the central bank without increasing government debt.

What happens if the fiscal authority is unwilling to recapitalise its central bank? This would be unthinkable in countries such as the US, where the currency is backed by the ‘full faith’ of the US government.

But in the Eurozone, the central bank is not only fully independent of government, but there are also 19 governments of varying degrees of fiscal credibility. Maintaining the stability of the euro depends on the willingness of all these governments to recapitalise the ECB.

To be sure, their willingness has already been tested. Since the ‘whatever it takes’ remarks of ECB president Mario Draghi at the height of the Eurozone crisis in 2012, the ECB has been to some extent cast in the role of fiscal institution, actively buying the government debt of Eurozone countries to keep bond yields down.

Had it not done so, some of those countries would undoubtedly have been forced out of the euro. It has arguably done this at the price of its own solvency – yet there has been no ‘run on the ECB’, as might be expected if markets thought fiscal support for the ECB would be found wanting.

But the ECB could still be forced to buy the government debt of countries with ‘irresponsible’ fiscal policies, if not doing so meant partial unravelling of the euro. Some Eurozone countries might balk at recapitalising a central bank that in their view was actively supporting governments that were breaking fiscal rules, especially as the ECB lacks the democratic legitimacy to make such decisions.

The Eurozone thus still lives in a world of multiple equilibria, even though the likelihood of a sudden switch to explosive inflationary dynamics appears remote at present.

Professor Sims says it would be better if there were a democratically accountable, Eurozone-wide fiscal institution with the power to raise taxes, which could take over the buying and selling (or issuing) of government debt. ‘But I don’t know how you organise that,’ he concluded.

The US knows how you organise it. They call such an institution a ‘federal government’. Sadly, we seem to be some distance from introducing such an institution in the Eurozone. Multiple equilibria and sunspots seem likely to remain the order of the day for many years to come.