US Federal Reserve Chairman Jerome ‘Jay’ Powell opened a window on the central bank’s new monetary-policy strategy in August 2020 by stressing that he was focused on the Fed’s ‘core constituency, the American people’. A few days later, the Dutch central-bank governor, Klaas Knot, gave a speech in Amsterdam to underscore that the job of the central-banking community is ‘to manage the risks that normal people have to face’. This was no coincidence. Both men were responding to a call made in 2019 by the Australian central-bank governor Philip Lowe for monetary policymakers to ‘talk in stories people can connect with’. If former Fed chair Alan Greenspan could once pride himself on being incomprehensible, that time is over. Central bankers need to be understood – and quickly.
The splendid isolation of monetary policymakers has ended, because ‘the people’ are no longer happy with central bankers who seem only to care about the financial community. They are also unhappy with central bankers who seem to act outside of political control. In May 2020, the German Constitutional Court challenged the way the European Central Bank (ECB) takes its decisions without political oversight. The court accused the German federal government of failing in its duties to protect the German people by not paying closer attention to how the ECB works. That ruling was a wake-up call.
Central banks have a legitimacy problem. They are too important to be left out of the democratic conversation and too complex to be included. There is nothing new about this dilemma. Arguments about the excessive power that central banks can wield are as old as central banks themselves. Indeed, such arguments explain why the United States tried to live without a central bank for much of the 19th century and part of the 20th century. That ‘national banking’ period nearly ended in disaster. But if we cannot learn to live without central banks, we had better learn to live with them. That means striking a new balance in central banking between politics and economics. The best way to do that will be to start recruiting more diverse – and representative – central bankers.
Central banks are necessary
The long period during which the United States did not have a central bank came to an end shortly after the 1907 financial crisis. The big financial institutions of the day narrowly saved the US economy from collapse, but the bankers realised they could not play that role forever. Hence, they insisted that the federal government create a central bank for the US. The Federal Reserve System in place today is the result. The Great Depression of the 1930s showed the wisdom of that decision, even if the Fed did not cover itself with glory at the start of the crisis. By the end of the Second World War, just about every country had a central bank of sorts – and most of those were publicly controlled.
Public control turned out to be a mixed blessing. Central banks are complicated. They look like banks, accepting deposits and lending money, but their influence over how the economy works operates on many different levels and through a variety of different channels: financial, economic and psychological. Central banks create money, set interest rates, influence exchange rates and play an important role in making sure that commercial banks do not take on excessive risks. Doing all this at the same time means juggling complex trade-offs between inflation and unemployment, financial stability and investment.
These trade-offs are politically important. The essence of politics is making decisions about who gets what, when, where and how. Democratic politics rests on the idea that politicians as decision-makers are acting on behalf of the electorate. Alas, politicians tend to be poor at matching the activities of central banks with the desires of democratic electorates. During the 1960s and 1970s, for example, politicians instructed central banks to lower interest rates and stimulate the economy; the result was both more inflation and higher unemployment. Nobody voted for this kind of stagflation. That is why economists made the case for central banks to have ‘political independence’: politicians could set the broad objectives, but the central bankers would have control over how they achieved those goals, setting interest rates and other instruments without political interference.
Crises are not normal
The argument for letting central bankers work without political interference makes a lot of sense in normal times. So long as the politicians can agree on the broad objectives and the experts can agree on how to use central-banking instruments, people working in financial markets can predict what central bankers are going to do under most circumstances. This means that central bankers can shape market expectations in ways that will deliver the kind of performance that voters expect. In other words, politically independent central banks can deliver on the promises made by democratically elected politicians.
Unfortunately, the influence of central banks expands even further in times of crisis. This is a design feature, not a bug. Recall that in 1907 the US had no central bank; in the 1930s it did. Central banks exist to ensure that banks (and often also governments) have access to money in times of distress. In the last crisis, central banks were the ‘only game in town’ – to quote Egyptian fund manager, analyst and commentator Mohammed El-Erian, who used the phrase because no other policymakers outside of central banks appeared either willing or equipped to respond to the crisis in an effective manner. During the current crisis brought on by the novel-coronavirus pandemic – a worse crisis than the last one – central banks are necessary just to keep the game going. Central banks everywhere are doing things they have never done before and on an unprecedented scale, and yet even this may not be enough without help from other policymakers – particularly those who can lower taxes and spend more money.
The justification for allowing central bankers to use their monetary-policy instruments independently is harder to make in moments of crisis. The trade-offs that arise when central banks play an emergency role become more obvious and more important insofar as central bankers often have to decide which commercial banks are allowed to continue and which need to be wound up. Worse, if the crisis is severe enough and if the conditions are unfamiliar – which is an accurate description of both the last crisis and the current one – central bankers may find themselves working beyond their expertise. As they experiment with new policies, they create winners and losers across society with no guarantee that the policies will work to achieve some pre-determined political objective.
The last crisis is a good illustration of this dramatic expansion at work, something that central bankers would be the first to admit. As Lowe put it in his speech, central bankers need to ‘tell stories about the trade-offs [they] face and how [they] are managing those trade-offs’. The purpose of Knot’s speech in Amsterdam was to remind listeners that ‘the work of central bankers has a direct influence on your life and on everyone else’s’. Powell took care in his own speech to emphasise the importance of hearing directly from the American people about ‘how their everyday lives are affected by our policies’.
The huge growth in the balance sheets of the major central banks is further proof that something out of the ordinary has happened. Central banks bought government bonds, commercial paper, mortgages and more complex securities to ensure that banks (and often also governments) had access to money; such actions were a boon to the people who held those assets but came at a cost for people who relied on the interest from their savings.
Of course, the trade-offs faced by central bankers are more complex than they may appear. People who complain about the low rate of interest on their savings would probably not prefer that their bank fail, their job disappear or their country’s economy collapse. The point is simply that when the experts start experimenting, the case for making central banks ‘politically independent’ gets weaker. Politicians are no better at using central banks to achieve political objectives in crisis situations than they are in normal times, but the advantage of entrusting experts with the awesome powers that central banks can wield is less compelling. Unlike bankers, politicians at least have the virtue of having been elected.
The trouble with speaking to the people
Central bankers were quick to recognise this dilemma during the last crisis. Devising a solution was more difficult. Adopting a fixed rule for central bankers to follow was not a viable option because every crisis is different, even if the inevitability of crisis remains the same. Worse, the performance of the economy between crises has been changing as well. Rates of output and productivity growth are slower, as is the pace of inflation. Interest rates are also lower. The relationship between unemployment and prices has changed as well. Market participants are growing used to these new circumstances and resetting their expectations to match. The result is an increase in the demands on central bankers paired with a reduction in their room for manoeuvre.
Central bankers have realised that they are politically exposed. Because they are unelected, they have no natural constituents or supporters. Politicians can raise expectations about what central bankers can accomplish and then hide from the consequences when the policies fail. When that happens, the political independence of central bankers is a vulnerability, not a strength. The criticism central bankers faced in some countries during the last crisis was withering; many were forced from office, and some, like Panicos Demetriades in Cyprus, left under threat of violence.
Because of this, central bankers have looked for ways to connect both to politicians – in ways that require them to accept greater responsibility for economic performance, particularly in moments of crisis – and to the electorate – to help citizens understand what central banks can and cannot accomplish. Unfortunately, this kind of connection can be difficult to establish, because ‘the people’ are not the only ones who listen when central bankers speak. Financial-market participants are listening as well, and often become confused by new messages – with important consequences for economic performance.
A clear illustration of this sort of confusion comes from Europe. ECB President Christine Lagarde is a staunch proponent of Lowe’s way of thinking about how central banks should connect with the public. Inadvertently, however, she demonstrated the pitfalls of plain speaking in March 2020, just as the coronavirus pandemic was sweeping across Europe. Lagarde responded to a question about whether the ECB’s policies benefit one government over another by insisting that picking winners and losers is not the central bank’s responsibility. From a narrative perspective, Lagarde’s response was correct. But financial-market participants heard something different, reacting to the possibility that the ECB would not put a floor under Italian bond prices – even though doing so was necessary for European monetary policy to function. Within a week, the ECB had to commit €750 billion in new purchases to correct that impression, an amount that has since grown to €1.35 trillion.
The US Federal Reserve took a different approach. Rather than telling stories, the Fed went on a listening tour. This is the strategy that Powell talked about in his August speech. He explained that the Fed learned a lot about the importance of employment for the lives of ordinary people. The bank also learned about the diminished risk of inflation. This kind of anecdotal evidence reinforced the message Fed economists had derived from their models and statistical analysis. As a result, the Fed now believes it should promote employment more aggressively as a ‘broad-based and inclusive goal’.
Here again, the challenge of plain speaking became apparent. Whether the Fed’s new phrasing of its objectives will result in greater effectiveness or broader support for monetary policy remains to be seen; meanwhile, the impact of the speech on financial markets was immediate, with the dollar weakening against other major currencies. This currency movement may wind up benefitting the Fed, but only at the expense of central banks in other countries. Indeed, voices around the ECB are already expressing concern that a strengthening of the euro against the dollar could complicate efforts to stabilise the European recovery from the economic consequences of the novel coronavirus. As Lagarde tried to explain away this problem during a 10 September press conference on monetary policy, the confusion only got worse.
What else can they do?
Plain speaking is no guarantee that a central bank will find popular support. When central bankers disagree, plain speaking may even make the legitimacy crisis of a central bank worse. This is a constant source of concern in Europe among those countries that have adopted the euro as a common currency. As Martin Feldstein warned shortly before the euro was created, divisions over monetary policy could undermine popular support for Europe’s common currency. Implicit in that warning is an awareness that even political independence does not mean the experts will agree.
A recent speech by German Bundesbank President Jens Weidmann is a good illustration. The ECB spent most of the spring and early summer stressing that it would do whatever it takes to stabilise the European economy. That coordinated media campaign quickly repaired the damage from Lagarde’s March press conference, and even papered over the threat posed by the German Constitutional Court’s ruling in May. As summer faded into autumn, the ECB appeared to be usefully united around the extraordinary support it was providing to the European economy. Weidmann’s speech drew that unity into question by suggesting that the ECB may have reached the limits of what it can accomplish, particularly with large-scale asset purchases. Now everyone is wondering when the divisions will re-emerge among Europe’s monetary policymakers, and what impact that will have on the European recovery.
There is no easy way to resolve this dilemma. Giving politicians stronger political oversight over central banks is not going to result in better policymaking. Central banks are still too powerful and too complicated to entrust to non-experts. Speaking in stories is not going to connect central banks to the people either, particularly when those stories send bad signals to markets. We have already ruled out the idea of rules, because it is hard to imagine a rule for all occasions. But if central banks cannot be subjected to stronger political oversight, or receive comprehensive instructions in advance, or talk their way into the hearts and minds of the people without creating confusion, there seem to be few other ways that this necessary institution can be made to appear more legitimate in the eyes of the electorate.
Perhaps the best way forward is to focus on the central bankers themselves. By picking experts who connect with the people, institutions as a whole might be made more representative. In that sense, central bankers should perhaps be treated less like members of a homogenous expert community and more like judicial appointments – particularly given that they tend to disagree on matters of importance. The challenge is to broaden the pool of candidates with the necessary skills to work effectively as central bankers. This may be easier in Europe than elsewhere, given the large number of countries that use the common currency. But diversifying the pool of qualified central bankers will be no less important in other territories where the legitimacy of central banks is in doubt.Follow @Erik_Jones_SAIS