A great achievement of the late 20th century was the independence of the central banks in the western industrial nations. The US Federal Reserve has been independent since its foundation in 1913, and the Bundesbank, which succeeds the Bank deutscher Länder, was created in 1957. In the course of the 1990s, other European countries also released their central banks into independence under the Maastricht Treaty for the preparation of the euro zone. In 1998, the European Central Bank became an independent central bank. The Bank of England became independent as early as 1997, while the Bank of Japan has operated autonomously since 1998. This was not always the case. The older central banks in particular, such as the Bank of England, were actually only a downstream authority at the beginning of their establishment, mainly concerned with the supply of money to the economy.
Money creation taken out of the hands of politicians
Modern financial markets could hardly have been developed without the independence of the central banks. The creation of money and employment goals – the latter directly or indirectly – were taken out of the hands of politicians and transferred to an independent institution. This was accompanied by very basic inflation targets. The experience of hyperinflation in the 1920s, especially in Europe, made this goal very important. After the Second World War, the central banks succeeded in stabilizing the financial system. Of course, this took several decades and there were some crises to overcome. During this period, the gold standard was abolished and the Bretton Woods system, which tied Western currencies to the US dollar, collapsed. In addition, the central banks had to cope with two major oil crises, accompanied by high inflation and subsequent recessions. The financial repression in the USA after the Vietnam War was also a challenge that the Fed mastered, just as the Bundesbank managed monetary policy during the reunification of Germany. The central banks were important and fulfilled their mandate without much fuss. The financial markets were thus able to develop into a pillar of the real economy. At the same time, confidence increased in the central banks as an anchor of stability for the real economy and the financial markets. The Confidence became the most important currency of the central banks.
From 1992 onwards, the world economy gained considerable momentum. The eastward expansion of the EU and globalization had an immense impact on production processes in industry. The result was a noticeably closer and more complex international integration of production processes and, as a result, sustainable growth in world trade. A competition between established industrialized countries and emerging markets began. This competition had consequences for wages, which no longer rose as usual, and for productivity, which picked up noticeably. At the same time, the capital and banking markets grew together, exacerbating the effects of globalisation. These developments led to falling global inflation. It became relatively easy for the leading central banks to achieve their goals. In this generally declining inflation trend, there were of course phases of rising inflation, but relatively small interest rate hikes by the central banks were sufficient to counter sustained inflationary pressure. This was not solely due to the influence of the central banks, but probably more important was the overriding trend of globalization. Although the successes of rising financial stability and low inflation were probably only partly attributable to the central banks, confidence in the capabilities of the central banks grew. A kind of illusion of control prevailed in the central banks: There was agreement that relatively small changes in interest rates could have a lasting effect on the inflation of large economies.
„Haughtiness comes before the event“ – this is the sentence that could be used to summarize the financial crisis of 2007 and its consequences. Everything seemed to be going well. Globalization ensured stable growth with low inflation. The introduction of new products on the financial market broadened the distribution of risk and thus also the risk-bearing capacity of individual investors and apparently also of the entire financial market. Unlimited growth seemed possible. However, there is no perpetual motion machine, neither in physics nor on the financial market. The system collapsed, with far-reaching consequences for the global economy and the financial markets.
This had its own consequences for the central banks. Even during the financial crisis, the central banks were functioning institutions and – more importantly – they enjoyed the trust of the people. So it was politically easy to entrust the central banks with all the tasks they had to perform: banking supervision, global macroeconomic control – macroprudential supervision – and, of course, monetary policy, the actual task of the central banks. This undoubtedly gave them a great deal of power. The extent to which the individual tasks could lead to a conflict of interests was not discussed. In the case of monetary policy and banking supervision, this was actually obvious. In the financial markets, central banks have thus developed into super institutions that control and regulate all interests. This also raised the question of democratic legitimacy for the first time. To date, such powerful authorities have been subject to direct democratic control, but the central banks have withdrawn from this by virtue of their legitimate and actually important independence.
In recent years, central banks around the world have been struggling to keep inflation too low, without any notable success so far. The inflation trend appears to be beyond the central banks‘ ability to exert any influence. Negative key interest rates, buying bonds, steering the yield curve – all these instruments have been used, but without success to date. There is, however, no discussion about the efficiency of the instruments chosen, but rather the motto „Much helps much“. So if inflation does not react as desired to the measures taken, more of the same medicine is simply administered. This would be criticized in all other fields of research. However, not with the central banks.
These extreme monetary policy measures, combined with regulatory obligations and a broad portfolio of tasks, make central banks increasingly attractive to policymakers. The political desire to stimulate growth through low interest rates and/or to ease government debt through a central bank bond purchase program has probably always been present. In the past, however, this would have meant paying the price of rising inflation or financial market instability. This seems no longer to be the case due to the described globalization effects and new central bank instruments. From a political point of view, the attractive opportunities offered by the new banks give the impression that they have no negative consequences for the national economies. Accordingly, it is not surprising that attempts to exert political influence are increasing. Or, as in the case of the ECB, that central banks pursue political goals rather than purely monetary ones. Obviously, the political possibilities of central banks have become simply too lenient.
The central bank system of the industrialized countries is based on the trust of the citizens. Political influence, politically motivated actions or incomprehensible actions of the central banks undermine people’s trust and thus the efficiency of the central banks in the medium term. In the end, the central banks could lose their significance. Politicians and central banks are certainly aware of this. It remains to be seen whether one will nevertheless take the risk from subjectively overriding goals, but it seems to be increasingly the case. Like Hercules, the central banks are at a crossroads.
Economy follows cycles
In recent years, central bank communication has been noticeably further developed. In particular, the long-term commitment to a certain central bank policy (forward guidance) should be mentioned here. However, the central banks themselves restricted themselves in the process of creating expectations that would actually help to avoid unnecessary volatility on the capital markets. In my view, the central banks should move away from the forward guidance and place their view of the economic structure and its changes at the center of communication in order to de-politicize the entire process. In addition, one should again accept that economic growth follows cycles and that these can be dampened but not prevented.
With these modifications and the proper allocation of tasks, the central bank system can be stabilized again. However, if we continue along the path we have taken the capital markets will certainly be subject to significant distortions as soon as the loss of confidence becomes apparent. In the end, central banks and politicians will probably react to this loss of confidence. However, it would be good to avoid the welfare loss associated with a crisis in the central bank system.