In august 1979, Jimmy Carter appointed Paul Volcker to head the US Federal Reserve. In October, Volcker raised interest rates from 11.5 per cent to 15.5 per cent. Inflation in the US fell from 13.5 per cent in 1980 to 3.2 per cent in 1983. In the meantime, the Fed had caused the severe recession of 1980, Carter had lost the presidential election, and much of the world had followed the US lead in shifting policy to fighting inflation. The idea that central bank independence improves economic performance had become conventional wisdom.
This new wisdom stated that the only objective of macroeconomic policy was inflation control and that, left to themselves with stable prices, free markets deliver the best outcomes. Central bank independence was meant to ensure that vote-seeking politicians would never disrupt market mechanisms with inflationary policies.
These views have now become axiomatic on left and right; they are embedded in the Maastricht treaty. But I dissent from them entirely. For Britain, central bank independence would be economically and socially destructive.
The case for independence is based on an assumption about a past error in economic policy. It was once believed that monetary policy could be used to reduce unemployment-that we could achieve permanently low unemployment if we tolerated higher inflation. Policy makers thus faced a choice: lower inflation or lower unemployment. We now realise, runs the argument, that no such trade-off exists. Unemployment was reduced only temporarily and at the expense of long term higher inflation. Where there appeared to be a political choice there was no choice and no issue on which reasonable people would disagree.
The next step in the argument is to claim that central bankers are uniquely qualified to achieve low inflation. The proposals vary (from the Bundesbank to the New Zealand model and Maastricht treaty), but they are all based on the assumption that whereas politicians set policy with electoral objectives in mind, bankers, free from such pressure, pursue the national interest.
This argument leaves numerous questions unanswered. Why should we trust British central bankers on monetary policy when their skill in bank supervision (BCCI and Barings) is being questioned? And why, at a time when other professionals (civil servants, academics), are being assessed more rigorously, should the performance of bankers seem to depend on immunity from penalty when they err? And err they certainly do. In his memoirs, Nigel Lawson, who supports independence, says that as his boom ran out of control in the late 1980s, the Bank of England gave no infla-tionary warning at all.
There is another oddity. Why should the cynical view of politicians as concerned only with electability focus on monetary policy rather than the more easily understood taxation? Why not make taxation and spending "independent"?
Perhaps a more important issue is whether central bankers really are immune to political interests. Imagine an election such as that of 1983. The alternatives are a Margaret Thatcher government, or one led by Michael Foot. The case for independent central banking is that the bankers will act in (what they consider to be) the long term interests of the country to achieve low inflation. Are we seriously being asked to believe that this makes them neutral between alternative governments?
In any case, is there evidence to support the case for independence? A few studies purport to show that inflation is lower in countries with independent central banks, but others show that it is not. The German example is often quoted but proves nothing. There are many differences between economic institutions in Germany and Britain which could account for Germany's low inflation. How do we know that it is due to the independence of the Bundesbank and not centralised wage bargaining, or the lending practices of German banks, or the attitudes of the German people?
But the greatest weakness of the argument for independence is the claim that fighting inflation hurts in the short run only, never in the long run. This is what gives plausibility to the view that it is always appropriate to seek to control inflation and that we must insulate such decisions from the political process.
But it is not difficult to identify long term, indeed more or less permanent, detrimental effects of anti-inflationary monetary policy. The results of Volcker's actions suggest three. Most obviously, the 1980 recession and the high interest rates that came with it, added to what was already a large government deficit. The debt accumulated in the early 1980s continues to burden the US today. Second, several less developed countries, most famously Mexico, were caught out in 1982 by Volcker's interest rate policy. The resulting Latin American debt crisis endangered the world banking system. In the event, disaster was averted, but the consequences of having to meet higher debt repayments were catastrophic for developing countries.
The third long term consequence of Volcker's policy is its damage to US trade policy. The overvaluation of the dollar between 1982 and 1986-an effect of high interest rates-placed US exporters and import-competing firms at a disadvantage and encouraged the protectionist lobby which led to the 1988 Trade and Competitiveness Act. This act gives the US president the power to impose retaliatory protectionist measures when overseas competitors are deemed to be trading "unfairly." We may yet find that, far from being short term, the damaging effects of disinflation policy have hardly begun to be felt.
The anti-inflationary lobby will no doubt argue that in each case, something else is wrong: governments are insufficiently firm in controlling spending; third world governments borrow too much; abandoning free trade is foolish on its own account-so don't blame the central bank. But I do blame the central bank. I blame it for theorising about a perfect world and setting policy in the real one. The fact that economic policy making is subject to uncertainties generated by the political process (how strong will lobbying for protection be, how many people are we willing to throw into poverty to pay back our debt?) is not to be welcomed, but it must be acknowledged. Any number of unexpected circumstances may arise which, undesirable as they are, call for a moderation of policy.
I must also question the claim that control of inflation has no effect on employment. I do not believe that permanently higher inflation will lower unemployment, but it does not follow that monetary policy cannot do long term damage to employment. Indeed, a glance at the postwar record suggests that it has. In 1977, Britain was in the depths of its worst postwar recession. Unemployment was 6 per cent. There followed a mild recovery, then the Thatcher recession, then the Lawson boom, at the peak of which unemployment fell only as low as 7 per cent. It is astonishing that from the worst postwar recession in 1977 to the tremendous economic boom of the 1980s, unemployment rose.
How can this be explained? The answer is that the Thatcher recession did permanent damage to the labour market. The long term unemployed lost valuable skills. When growth returned, the skills did not, so they remained unemployed and wage inflation was triggered at a higher level of unemployment than before.
Advocates of an independent central bank tell a different story. The problem, they say, lies on the supply side, particularly in the labour market. Their claim has some merit, but as a way of explaining the events of the 1980s, it is ridiculous. What great supply-side deterioration was there during Thatcher's premiership? The in-troduction of market mechanisms, weaker unions, freer bargaining and greater incentives are all said to be supply-side improvements. Why did unemployment rise at a time of such great improvement?
There is more than a factual mistake here. We are faced with a political movement advancing under the cover of fake economic science. The movement for central bank independence is one for low inflation at whatever cost; this, in turn, is part of the free-market/deregulation movement which has worsened conditions for the disadvantaged and benefited those who profit from unfettered markets.
The real cost of this policy is unemployment, so if we are to judge the case for independence, we must be clear about the costs of unemployment. If we were to take account of these costs, I doubt whether we would still be concerned about inflation being just this or that side of 2.5 per cent. There is the economist's pedantic concern with lost output. But that is not all. There is the great human cost to the unemployed. These costs are subjective, psychological and difficult to fit into national income accounts, but they are real. Beyond them lies a host of indirect social costs. The crime rate is evidently related to unemployment. Fear of crime, too, is part of the cost of low inflation. Everyone who has walked home at night fearing attack is paying the price of macroeconomic policy failure.
The granting of independence to central banks is itself a significant shift in the balance of power between those who benefit from the free market and those who do not. So where does this leave us? Do I intend to disregard inflation? Am I advocating full employment come what may? No. A rejection of today's fashionable nostrum is not the acceptance of yesterday's failed policy. I am not saying that inflation must be welcomed, or ignored, or that its control should never be made a priority. The point is that good policy needs judgement and brave leaders, not sectional interests, in control.
In 1979 the world-not just the US-needed Volcker because it needed a determined effort to reduce inflation. But more than his policy, the world needed his leadership. Volcker's achievement was not to defy elected politicians, but to persuade a wide spectrum of American opinion that his policy was necessary. He was opposed because businesses were damaged, people's hopes were dashed. But inflation in the US was defeated because Volcker and Ronald Reagan led public opinion. Such leadership is a poli-tical phenomenon.
The role of democratic governments is to provide leadership guided by judgement and motivated by sympathy for all of society, and then to stand or fall by the results. To that end, the levers of power must remain in politicians' hands.
