Central Bank Independence and the Future of the Euro

Central banks are never independent from politics. The bankers who run those organizations may have the institutional power to define their own objectives, the technical capability to adjust the settings on their monetary instruments, and strong legal protections around the terms and conditions for their employment. But none of that is enough to insulate them from politics. Determined politicians will find a way to exercise influence, no matter what the obstacles. More often than not, such politicians will do so without even implicating the legislative process. They do not have to rewrite the laws to violate central bank independence. Politicians only need to take advantage of the fact that central bankers come from society, they (and their families) have to live somewhere, and eventually they will also retire.

This is the harsh reality that former Cypriot central bank governor Panicos Demetriades reveals in his analysis of central bank independence. His point is not to deny the very strong theoretical reasons for trying to create a division between politics, on the one hand, and monetary policy, on the other. Rather it is that any such arrangement is only as sound as the commitment among politicians to respect the divide. Once that commitment wavers or the respect is lost, then central bankers are no more independent from political influence than anyone else. They can be pressured, scapegoated, outnumbered, intimidated. Moreover, the smaller and more tightly-knit the society, the easier it is for politics to predominate.

Demetriades makes this argument by using his own experience as a case study. He is careful to note, however, that his experience is not unique. Central bankers in other countries have found themselves in similar situations – right down to the level of intimidation. And the more that experience has been repeated, the easier it has become for politicians to copy. If there was a consensus on the virtues of central bank independence, that consensus is now broken.

Demetriades’ argument has important implications for the euro area and the European System of Central Banks. Because Europe’s economic and monetary union includes a large number of very small countries, the European community of central bankers has many points of vulnerability. Cyprus is one example, but Hungary, Lithuania, Malta, Slovakia, and Slovenia are challenging conventional norms about central bank independence as well. Moreover, the problems do not only come from politicians. Central bankers are prone to overreach, particularly in moments of crisis. The last decade has left the central banking community exposed both in terms of responsibility and in terms of scrutiny. Now politicians are taking advantage of the vulnerability that exposure has created.

The solution, Demetriades argues, is to return to first principles. That means getting central banks out of activities that are inexorably political, like banking resolution. It also means ensuring that at least some central bank board members should come from other countries, which makes them less vulnerable to political influence. Demetriades has a number of other recommendations for insulating central banks from the politicians who seek to violate their independence. He is careful to note, however, that the goal is not to reinforce the privileged position of the central banking community. Rather it is to reinforce the ability of central bankers to deliver the policy outcomes for which they were appointed.

Central bank independence is an instrument to achieve the policy objective of stable macroeconomic performance. Such independence is no guarantee that the economy as a whole will prosper or that the financial system will avoid any crisis. But it is better than the alternative of giving politicians direct control over monetary policy instruments even if the political independence of central banks does not really exist. Demetriades’ argument is essential reading both for those who seek greater accountability within the central banking community and for those who worry how macroeconomic policymakers are likely to respond to the next crisis.

Central Bank Independence and the Future of the Euro. By Panicos Demetriades. London: Agenda Publishing, 2019.