Axel Leijonhufvud argues that political independence of central banks is "impossible to defend in a democratic society":
Shell game: Zero-interest policies as hidden subsidies to banks, by Axel Leijonhufvud, Vox EU: The two pioneers of modern monetary economics – Irving Fisher and Knut Wicksell – were passionately concerned to find monetary arrangements that would insure against arbitrary redistributions of income and wealth. They saw such distributive effects as offenses against social justice and consequently as a threat to social and political stability.
Fisher and Wicksell thought that price level stability was a sufficient condition for avoiding distributive effects. In this they were in error. A hundred years later, the motivating concern for their work has long since disappeared from monetary economics.
But the error survives. For example:
- The Fed is supplying the banks with reserves at a near-zero rate. Not much results in bank lending to business, but banks can buy Treasuries that pay 3% to 4%.
- This hefty subsidy to the banking system is ultimately borne by taxpayers. Neither the subsidy, nor the tax liability has been voted for by Congress.
The Fed policy drives down the interest rates paid to savers to some small fraction of 1%. At the same time, banks leverage their capital by a factor of 15 or so, thus earning a truly outstanding return from buying Treasuries with costless Fed money or very nearly costless deposits.
Wall Street bankers are then able once again to claim the bonuses they became used to in the good old days and to which they feel entitled because of the genius required to perform this operation. These bonuses are in effect transfers from tax-payers as well as from the mostly aged savers who cannot find alternative safe placements for their funds in retirement.
The shell game: “Now you see it, now you don’t.”
The Fed’s low-interest-rate policy has turned into a shell game for the general public who are unable to follow how the money flows from losers to gainers.
- The bailouts of the banks during the crisis were clear for all to see and caused widespread outrage; now the public is being told that they are being repaid at no cost to the taxpayer.
- What the public is not told is that the repayments come to a substantial extent out of revenues paid by taxpayers for the banks to hold Treasuries.
- Both parties supported the bailouts so neither party seems ready to protest the claim that they are being repaid at no cost to taxpayers.
The goals of monetary policy
Present monetary policy achieves two aims.
- One is to recapitalize the banks and to do so without the government taking an equity stake.
The authorities do not want to be charged with “nationalization” or “socialism.” So the banks have to be given the funds outright. Economists have agonized a lot lately about the zero lower bound to the interest rate as an obstacle to effective policy in the present circumstances. The agony seems misplaced. As long as the big banks are to be subsidized, why not just pay them to accept reserves from the friendly central bank?
- The second aim, of course, is to prevent the housing bubble from deflating all the way.
In this respect, the policy has had some effect. Homeowners whose houses are not “under water” can often refinance at long-term rates around 5% and sometimes even lower.
Miscalculation of economic values: Who pays?
Any financial crash reveals a large, collective miscalculation of economic values. The incidence of the losses resulting from such miscalculations has to be worked out before the economy can begin to function normally again. Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. In the present case, doing so would simply have led into another Great Depression.
This means political choices have to be made to determine who bears the losses from this collective miscalculation. Obviously such choices are terribly difficult. Yet, temporizing can prolong the period of subnormal economic performance indefinitely – as the history of Japan over the last 20 years illustrates. The shell game, as presently played, is in effect an attempt to settle a large part of the incidence problem “under the radar” of public opinion.
The risks of this quiet bank subsidy
Quite apart from its distributional effects, the policy is not without risk.
- To the extent that it succeeds in inducing the banks to load up on long-term, low-yield assets, a return to more normal rates will spell another round of banking troubles.
If the US were to suffer years of slow deflation, a return to higher rates will be long postponed. At present, strong deflationary pressures are kept at bay by equally strong inflationary policies. If the US escapes the Japanese syndrome, the Fed will sooner or later have to raise rates to stem inflation or to defend the dollar.
Central Bank independence?
For the last 20 or 30 years, political independence of central banks has been a popular idea among academic economists and, of course, heartily endorsed by central bankers. Such independence has not been much in evidence in the recent crisis. But central banks would very much like to restore their independence.
The independence doctrine, however, is predicated on the distributional neutrality of their policies. Once it is realized that monetary policy can have all sorts of distributional effects, the independence doctrine becomes impossible to defend in a democratic society.