Independent central banks, a model that has proven to be successful, are under massive pressure in many countries and must defend themselves against short-term political interests, writes Andreas Vetsch in his exclusive essay for finews.first.

This article is published on finews.first, a forum for authors specialized in economic and financial topics.

Historically, central banks emerged from banks that were founded to finance the state and, in particular, to finance wars. The existence of bankers dates back to the Middle Ages, for example, the Fugger family in Augsburg, who provided loans to princes who were ailing financially.

At the end of the 17th century, a number of English bankers decided to found the Bank of England (BoE), which served to finance the English throne. The linkages between central banks and elected governments were very strong at that time. The banks were misused as an extended arm of the state to wage costly wars or better manage economic crises.

«If monetary policy is in the hands of the government or parliament, the result is often high inflation»

The independence of central banks in their current form only came into being starting from the middle of the 20th century. In the U.S., this was enshrined in the Treasury-Fed Accord of 1951, which resulted in the separation of tax and monetary authorities. The German Bundesbank has been independent since 1957.

Due to the high inflation during the 1970s and the realization that independent central banks are an important instrument for controlling inflation, more and more countries began to adopt this model. If monetary policy is in the hands of the government or parliament, the result is often high inflation. The inverse relationship between central bank independence and inflation has been confirmed in numerous empirical studies.

«US President Donald Trump, for example, described the U.S. central bankers around Jerome Powell as fools»

But what does independence mean for a central bank? Generally speaking, a central bank is considered independent if it can make its monetary policy decisions without the influence of a government, parliament or other institutions. Independence is divided into three levels: political independence, financial independence and independence with regard to personnel. Political independence is when a central bank can itself determine the ultimate objective and which instruments are required to that end.

A central bank is financially independent if it is not forced, either directly or indirectly, to finance the national debt. Independence with regard to personnel relates to the procedures for the appointment or dismissal of people who make monetary policy decisions as well as the determination of the term of office of such people. It should be noted here, that political influence is possible in particular in the case of appointments.

However, this independence is increasingly being called into question. Critical comments and political influence are on the rise and are almost the order of the day. U.S. President Donald Trump, for example, described the U.S. central bankers around Jerome Powell as «fools» and «naive». For months, he has been criticizing the Fed's policy and demanding lower interest rates.

«Left-wing populists are calling for closer integration between the government and the central bank»

In his view, central bank policy is preventing additional growth and stifling the stock market boom. And the criticism is not just coming from the right-wing. Left-wing populists who advocate the ideas of Modern Monetary Theory (MMT) are calling for closer integration between the government and the central bank.

And the U.S. is by no means a one-off. Shortly after taking office, Japanese Prime Minister Shinzo Abe appointed a central bank governor who has since supported the government’s Abenomics policies. In India, the head of the central bank resigned in December 2018 after being increasingly pressured by the government to loosen the rules for lending. In Turkey, Recep Erdogan fired his central bank governor in July because he increased interest rates to fight inflation. Erdogan, in contrast, had called for interest rate cuts.

«Such high expectations, however, entail enormous risks for the reputation»

These examples show that politicians are repeatedly tempted to allow for inflation. Increased money issuance helps to finance public spending, reduce debt or bring about a temporary economic upswing. To prevent central banks from becoming a pawn in political interests, it is important to establish the right framework conditions. Clear goals are of paramount importance, although a broad spectrum of objectives is not always better.

The Federal Reserve's dual mandate to ensure stable prices and maximum employment does not necessarily lead to improved confidence building. Focusing on meeting a clear objective such as price stability can be advantageous. However, this clear mandate is often at odds with the expectations of governments and the general public.

It requires central banks to ensure good economic growth or a secure financial system in addition to price stability and maximum employment. Such high expectations, however, entail enormous risks for the reputation and legitimacy of an independent institution.

«It is difficult to defend independence and currency stability vis-à-vis a society with excessive demands»

At this time, therefore, it seems all the more important to preserve the legal foundations of an independent central bank and to adjust expectations. Independence has contributed to high monetary stability in recent decades and should continue to withstand political attacks in the future. A clear mandate is a basis on which a central bank can pursue a strategy that builds trust and credibility. In addition to clear legal bases, the public’s expectations are also key.

It is difficult to defend independence and currency stability vis-à-vis a society with excessive demands. It is important that even a clear mandate such as price stability always allows for a certain degree of flexibility and human intuition.

Andreas Vetsch is a hedge fund analyst at LGT Capital Partners. He specializes in trading strategies. Before joining LGT in 2012, he studied at the University of St. Gallen, where he received a master’s in banking and finance and an additional qualification in business journalism.

Previous contributions: Rudi Bogni, Peter Kurer, Oliver Berger, Rolf Banz, Dieter Ruloff, Werner Vogt, Walter Wittmann, Alfred Mettler, Peter Hody, Robert Holzach, Craig Murray, David Zollinger, Arthur Bolliger, Beat Kappeler, Chris Rowe, Stefan Gerlach, Marc Lussy, Nuno Fernandes, Richard Egger, Maurice Pedergnana, Marco Bargel, Steve Hanke, Urs Schoettli, Ursula Finsterwald, Stefan Kreuzkamp, Oliver Bussmann, Michael Benz, Peter Hody, Albert Steck, Martin Dahinden, Thomas Fedier, Alfred Mettler, Brigitte Strebel, Peter Hody, Mirjam Staub-Bisang, Nicolas Roth, Thorsten Polleit, Kim Iskyan, Stephen Dover, Denise Kenyon-Rouvinez, Christian Dreyer, Kinan Khadam-Al-Jame, Robert Hemmi, Anton Affentranger, Yves Mirabaud, Katharina Bart, Frédéric Papp, Hans-Martin Kraus, Gerard Guerdat, Mario Bassi, Stephen Thariyan, Dan Steinbock, Rino Borini, Bert Flossbach, Michael Hasenstab, Guido Schilling, Werner E. Rutsch, Dorte Bech Vizard, Adriano B. Lucatelli, Katharina Bart, Maya Bhandari, Jean Tirole, Hans Jakob Roth, Marco Martinelli, Thomas Sutter, Tom King, Werner Peyer, Thomas Kupfer, Peter Kurer, Arturo Bris, Frederic Papp, James Syme, Dennis Larsen, Bernd Kramer, Ralph Ebert, Marionna Wegenstein, Armin Jans, Nicolas Roth, Hans Ulrich Jost, Patrick Hunger, Fabrizio Quirighetti, Claire Shaw, Peter Fanconi, Alex Wolf, Dan Steinbock, Patrick Scheurle, Sandro Occhilupo, Will Ballard, Michael Bornhaeusser, Nicholas Yeo, Claude-Alain Margelisch, Jean-François Hirschel, Jens Pongratz, Samuel Gerber, Philipp Weckherlin, Anne Richards, Antoni Trenchev, Benoit Barbereau, Pascal R. Bersier, Shaul Lifshitz, Klaus Breiner, Ana Botín, Martin Gilbert, Jesper Koll, Ingo Rauser, Carlo Capaul, Claude Baumann, Markus Winkler, Konrad Hummler, Thomas Steinemann, Christina Boeck, Guillaume Compeyron, Miro Zivkovic, Alexander F. Wagner, Eric Heymann, Christoph Sax, Felix Brem, Jochen Moebert, Jacques-Aurélien Marcireau, Peter Hody, Ursula Finsterwald, Claudia Kraaz, Michel Longhini, Stefan Blum, Zsolt Kohalmi, Karin M. Klossek, Nicolas Ramelet, Søren Bjønness, Lamara von Albertini, Andreas Britt, Gilles Prince, Fabrizio Pagani, Darren Willams, Salman Ahmed, Stephane Monier, and Peter van der Welle, Swetha Ramachandran, Beat Wittmann, Ken Orchard, Michael Welti, Christian Gast, Didier Saint-Georges, Jeffrey Bohn, Juergen Braunstein, Jeff Voegeli, Gérard Piasko, Fiona Frick, Jean Keller, Teodoro Cocca, Stefan Schneider, Lars Jaeger, and Matthias Hunn.