Why Should Central Banks Be Independent?

Last month Donald Trump fueled a debate when he called the Fed “crazy.” Political accusations started flying all across the media. However, it raised a very important point. The world realized that Donald Trump is not in control of the Federal Reserve which is the central bank of the United States. To the financially savvy, this was no revelation at all. However, a majority of the people believe that central banks are in complete control of their government.

However, this is not the reality, at least, not in recent times. For instance, the Bank of England had been controlled by the government to a large extent until the year 1997. After 300 hundred years of its existence, the Bank of England was finally able to become an independent body in 1997. It was the not the only central bank to do so. Ever since the 1970’s, central banks all over the world had been lobbying for financial independence. The OPEC shocks of the 1960’s and 1970’s had exposed the weakness of the central banks. All throughout, the 1960’s and 1970’s, inflation was running at double digits in Europe. Central banks needed greater autonomy to fix this problem. They were given this autonomy. As a result, almost all the central banks in the world are free from political influence. This policy has its pros and cons. In this article, we have described the advantages and disadvantages of having an independent central bank.

Advantages

Having an apolitical central bank obviously has many advantages. Some of them have been listed below.

  • Political Cycle vs. Business Cycle: Politicians all over the world are only concerned with staying in power. They will do whatever it takes as long as they can stay in control. Hence, it can be said that the actions of the politicians are controlled by political cycles. They become extremely generous and accommodating during the pre-election years.

    The business, on the other hand, operates based on business cycles. It is not necessary that periods of boom and bust will coincide with the political cycles. Also, if they do, politicians may have a conflict of interest. For instance, if there is too much inflation during an election year, politicians might simply skip the necessary but unpopular decision of implementing rate hikes. Hence, it is likely that the politicians will end up jeopardizing the entire economy for selfish gains. This is the reason why central banks need to be independent. They can take tough decisions regardless of the election cycle. The economy and elections are not naturally correlated. Hence, it is imperative that the decisions regarding the economy be taken independently.

  • Inflation: Controlling inflation is the primary objective of any central bank. In order to do so, they need to control the money spent by the government. If decisions regarding the economy can be taken by the government, they will take only populist decisions. For instance, governments may decide to provide free health care and retirement benefits even though they don’t have the financial wherewithal to implement such decisions. The bottom line is that if the government is given control of the economy, they might resort to indiscriminate money printing which will ultimately lead to economic collapse. This is what has happened in many ancient civilizations including Rome. Hence, to prevent this, central banks have been made independent of government authority.
  • Deficit Spending: Governments all over the world are fond of undertaking populist projects even though such projects are not supported by economic fundamentals. Consider the case of sports stadiums built for the Olympics in Greece and for FIFA World Cup in Brazil. In both cases, the government should not have indulged in deficit spending, but it did. These instances would become more common if the government had full control of the monetary policy. Hence, it is important to keep the monetary policy separate from the government in order to maintain the financial health of the state.

Disadvantages

Separating the central bank from the state has many advantages that have been listed above. However, there are some disadvantages as well.

  • Secretive: The biggest criticism against the central bank is that their operations are very secretive. Many times their actions are completely unexpected. Many financial crises in the past have only taken place because the central bank took unexpected action. To prevent this from happening again, central banks need to ensure smooth transitions. Their policies should not be secretive and should not shock the economy.
  • In Favor of Big Banks: Many analysts are of the opinion that all the policies created by central banks are in favor of big banks and not in favor of the common people. For instance, their biggest goal is to reduce inflation. However, after the 2008 crash, they followed a policy of quantitative easing to save the big banks. This has ended up creating more inflation than any government policy ever has.

In summary, one can say that there are pros as well as cons to having independent central banks. However, the pros seem to be outnumbering the cons as of now. This is the reason why central banks across the world have witnessed increased autonomy.


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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.


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