Changing times for central banks

For much of the last 30 years, it has been a good time to be a senior central banker.  Over that period central banks have grown in stature, prominence and power, and the very top central bankers have become household names.  And, in the process, fabulously well paid for public officials too:  at well over £800,000 a year, Mark Carney’s remuneration when he became Governor of the Bank of England in 2013 was some four times in real terms Robin Leigh Pemberton’s salary 30 years earlier[1].

It has been a long process, in which they won their spurs by defeating the chronic inflation of the 1970s and early 1980s, then perfected the methodology of inflation targeting, and finally in the late 1990s and early 2000s presided over a decade of solid non-inflationary growth and rising living standards.   Grateful governments offered them more and more independence, not only over the operation of policy but also in some cases (eg the ECB) over the setting of targets as well, and the aura of omnipotence that surrounded them and the respect of the general public were by no means entirely unwarranted.

After the Global Financial Crisis in 2007-09, the cult of the central banker grew even further, as they moved from respected technicians almost to the status of revered superstars.  For fully 10 years, central banks often seemed to be the only game in town, solving the financial woes of society single-handed while governments looked on impotently.  As Angela Merkel is reputed to have said to ECB President Mario Draghi as the euro crisis unfolded in 2012, “It’s up to you Mario, you deal with this – you’re the one with the money”.

And central bankers played along with this – who, after all, does not enjoy being seen as the knight in shining armour, fearlessly acting to save us all.  Never mind awkward questions over how much of the 2007-09 crisis was the fault of central banks and supervisors being asleep at the regulatory switch;  such questions were deemed impertinent while there was work to be done to save the world.  And over the decade central bankers began to believe that they really were able to solve society’s problems single-handed, and took more and more of the recovery work onto their shoulders.

In retrospect, it might have been better if central banks had been both more humble about what monetary policy can achieve, and more forceful in pushing back against governments and making them share the policy burden[2].  But having taken on the task of restoring the world to economic health, the result was a decade-long experiment in managing and controlling modern economies almost exclusively through monetary policy.  And in the process, it is fair to say that monetary policy was pushed to its very limits.

In essence, monetary policy is the way that a central bank influences and seeks to control the economy’s access to and use of money.  They do this through operations affecting both its price (interest rates) and its quantity (the money supply).  The central bank can clearly set official interest rates where it wishes, and it can influence the amount of money in the economy by operations on its balance sheet – buying and selling securities in the market.

During the decade of recovery from the Global Financial Crisis, both the price and the quantity of money were set at levels never seen before, in fact not just outside previous experience but way outside anything even imaginable to earlier generations of central bankers[3].  First, interest rates were reduced to near and in some countries even below zero.  Then, with interest rates not able to go any lower, central bank balance sheets were expanded many-fold in successive rounds of what became known as Quantitative Easing – QE.  Just as to someone with a hammer, every problem looks like a nail, so to a central banker with a flexible monetary policy, every challenge called for lower interest rates, more QE.

Einstein is said to have observed that “The definition of insanity is doing the same thing over and over again and expecting a different result” – though there is in fact no evidence that he ever actually said it.  But whether central banks in the 2010s were insane or merely insistent, they certainly tested to destruction the idea that monetary policy can solve all society’s problems.  And by the end of the decade the consensus was growing that exclusive reliance of monetary policy not only cannot solve all our problems, but it creates a few of its own.  Sky high asset prices, reduced central bank flexibility and ammunition for new crises, growing inequality between the haves and the have nots – the list of unfortunate side effects was becoming non-negligible.

And then the pandemic struck.  And the error of over-reliance on just one policy tool and running the monetary tank right down to empty became clear – central banks had little to offer as economies fell off a cliff.  Fortunately the need for fiscal action was so obvious, so urgent that even the most tight-fisted of finance ministries accepted the need to open the spending taps – even Germany abandoned its previously rigid and ideological adherence to balanced budgets with barely a second thought.

The main result has been a rapid and serendipitous rebalancing of official policy, from over-reliance on just monetary policy to a proper share of the task once again being carried by fiscal policy.  This is in our view a good thing:  it is not just a matter of two parts of officialdom both pulling their weight, but a recognition that monetary policy and fiscal policy work in different ways and through different parts of the economy (in a nutshell, and very simplistically, easier monetary policy aims to encourage the private sector to take on extra debt to get the economy going, while fiscal policy works through the public sector doing so), and a balanced recovery and balanced economy is easier to achieve with balanced policy mix, with both arms of the state playing their part.

But the second result of countries switching to aggressive fiscal policy action has been to puncture some of the air of indispensability and infallibility of central banks.  They are clearly having to work with their newly invigorated treasury counterparts, and equally clearly they are very much playing second fiddle to them.  And this in turn is calling into question that sacrosanct belief of the last 30 years:  that central banks should be free of political oversight, and indeed in many people’s eyes, the more autonomous they are, the better.

In short, as well as testing to destruction the idea that monetary policy could solve all our problems, recent experience has also perhaps called into question the idea of central bank independence.  Central bankers are having to accept that in the world of pandemics and government spending, they have a new and less exalted position.  Their task is not to save the world single-handed, but to work with governments – and often, that will mean working for them, under their closer direction.

The more thoughtful central bankers are far from averse to this.  The position of sole guardian of the economy’s well-being and saviour of the world is not an easy one, and several senior central bankers have long queried how an independent and in some countries almost entirely unaccountable central bank legitimately fits into the structure of a democratic society.  Nearly three years ago former Deputy Governor of the Bank Sir Paul Tucker explored just this in detail in his magisterial work “Unelected Power”[4];  nothing he wrote then has been found wanting by recent events.

Central banks have had a glorious 30 years.  The next ten look like being less easy – they face resurgent finance ministries, a possible return of inflation, and the difficult question of when to start raising interest rates.  They do so with unbalanced and overblown balance sheets (many of which are not only far larger than is ideal but also running significant maturity and interest rate mismatches), and very limited policy ammunition.   And whereas their immediate predecessors were masters of all they surveyed, the current cohort of central bank governors may have to be more accommodating towards the politicians, and may have to re-learn the art of working with their finance ministry colleagues.

And they may even have to accept slightly less eye-watering salaries.


[1]              Which, as more than one former central banking colleague has observed to me, causes its own problems when central bankers try to admonish commercial bankers for their sky-high remuneration.

[2]              I accept though that asking anyone in the same sentence to be both “more humble” and “more forceful” sets quite a challenge!

[3]              In the Bank of England’s first 300 years, Bank rate, in its various guises, was never set below 2%.  In the last 10 years it has not been above 0.75% (and is currently 0.1%).

[4]              See