Reply #39: Central Banks Should Steer Clear of Politics By SIMON NIXON [View All]

[Demeter]

http://online.wsj.com/article/SB10001424052748704635204575242400983963766.html?mod=dist_smartbrief



The principle of central-bank independence, a mainstay of economic orthodoxy for two decades, has taken a battering over the past week. Investors should be on their guard.

Thirteen years after Gordon Brown gave the Bank of England its independence on his first day as U.K. Chancellor of the Exchequer, his successor, George Osborne, used his first day to seek the public endorsement of BOE Governor Mervyn King for his budget plans. That breaches the principle that central bankers don't comment on fiscal policy. Days earlier, the European Central Bank bowed to political pressure to start buying government bonds to help ease the euro-zone debt crisis, a step toward monetization.

Allowing central banks freedom to set interest rates without political interference is the best way to anchor inflation expectations, reduce borrowing costs and deliver faster growth. Independence is arguably even more important in a crisis, when markets need reassurance that governments won't attempt to inflate away debts. But independence also allows central banks huge powers with limited accountability. That makes it even more vital they don't politicize their roles by straying into policy areas beyond their mandates, such as fiscal policy, and thereby risk forfeiting public support.

On this score, Mr. King's endorsement of Mr. Osborne's budget plans was unwise so soon after an election, when the timing of spending cuts was a key issue. Does he plan to offer a running commentary on fiscal policy? Will other Monetary Policy Committee members now be free to offer their views on fiscal policy? Will Mr. King continue to offer Mr. Osborne public support if the policy proves politically unpopular? Doesn't Mr. Osborne's wish to "coordinate" monetary and fiscal policy implicitly cut both ways?

The ECB's decision to start buying government debt is even more troubling. It says it is responding to "dysfunctional" bond markets. But how does it define dysfunctional? How does it know that high government borrowing costs reflect liquidity problems rather than legitimate solvency fears that will expose the central bank to losses? How does the ECB balance the need to maintain financial stability with the goal of price stability? Might its decision to buy bonds increase moral hazard, removing the incentive for governments to tackle their deficits—and increasing pressure on the ECB to monetize their debts?

In fairness, the financial crisis has muddied the line between monetary and fiscal policy. With government borrowing so high, fiscal policy is having a direct impact on the yield curve, a key concern of monetary policy. Both the BOE and ECB insist they won't be deflected from their price stability objective—and their mandates make it very difficult for them to pursue inflationary policies. But both central banks have crossed the line this week into political territory. They shouldn't stray any further.