Why is the Reserve Bank independent from government, and why does it matter?

Source: The Conversation (Au and NZ) – By Henry Maher, Lecturer in Politics, Department of Government and International Relations, University of Sydney

Negotiations over reforms to the Reserve Bank of Australia this week took an unprecedented turn when the Greens demanded the government use its reserve powers to immediately cut interest rates.

Labor had initially hoped to pass the reforms with the support of the Coalition. However, after a year of negotiations, they decided against it. Labor’s attempts to salvage the reforms by negotiating with the Greens now seem doomed to failure.

The Greens’ proposal that the government immediately cut interest rates might sound attractive, especially to the millions of mortgage holders struggling to service loans amid a cost-of-living crisis.

Yet government taking direct control of setting interest rates would run contrary to both long-standing historical trends and international financial norms, including the independence of the central bank.

Where did this independence come from?

The idea of central bank independence has a long history.

The classical political economist David Riccardo warned as early as 1824 that:

government could not be safely entrusted with the power of issuing paper money; that it would most certainly abuse it.

Even the authoritarian French emperor Napoleon Bonaparte claimed in creating the Banque de France that:

I want the bank to be more in the hands of the government but not too much.

However, for most of the 20th century, the commonsense view was that monetary policy was an important tool for government management of the economy. According to the Keynesian worldview of the time, it would be absurd for governments to give up such an important economic lever as control over interest rates.

The prevailing wisdom began to change following the stagflation crisis of the 1970s. Stagflation is the term for high inflation at the same time as high unemployment.

Neoclassical economists such as Milton Friedman argued that only repeated and long-term increases to interest rates could end the stagflation crisis.

However, Friedman suggested governments could not be trusted to maintain high interest rates because they would also cause unemployment. Accordingly, an independent central bank was needed. It would be insulated from partisan political control and could do what was necessary to stabilise the economy.

What about in Australia?

In Australia, central bank independence emerged slowly and informally.

The Reserve Bank of Australia was separated from the Commonwealth Bank and started independent operations in 1960. It set up its headquarters in Sydney to increase its autonomy from politicians in Canberra.

The RBA gained de facto independence from the government following financial deregulation under the Hawke government in the early 1980s. Subsequent declarations from federal treasurers Peter Costello and Wayne Swan affirmed the government’s recognition of RBA independence.

The government still maintains the power to overrule the RBA on interest rates, but this “emergency power” has never been exercised.

Why independence matters

Though central bank independence is generally associated with lower inflation, the historical performance of independent central banks is not without blemish.

For example, unemployment rates in Australia were historically lower prior to RBA independence. This reflects the willingness of the RBA to use higher unemployment as an inflation-busting mechanism.

Independent central banks were also partly responsible for the outbreak of the global financial crisis in 2007. Many commentators have suggested the then US Federal Reserve Governor Alan Greenspan’s decision to hold interest rates at artificial lows was responsible for the US sub-prime housing bubble. That eventually unravelled into a global recession.

However, the Greens’ attempt to use an interest rate cut as a negotiating chip ironically reinforces the importance of central bank independence. Were governments to take direct control of setting interest rates, we might expect monetary policy to be influenced by short-term electoral concerns, rather than the long-term health of the economy.

Creating a precedent that interest rates could be cut to suit the government of the day would also have long-term inflationary effects.

Further, it would likely continue to drive up house prices. This would exacerbate the housing crisis.

In contrast, the initial reforms proposed by Labor look to strike a balance. They recognise the competing political interests involved in the development of monetary policy while avoiding partisan interference in the day-to-day running of the RBA.

Though the Coalition has raised concerns about Labor using the reforms to stack the RBA board, both the governor and board are already appointed by the government of the day, acting on the advice of the RBA.

Finding a workable compromise that improves the bank while preserving political independence should be possible.

If the alternative is the complete abrogation of central bank independence, the Coalition would do well to return to the negotiating table.

Henry Maher does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

– ref. Why is the Reserve Bank independent from government, and why does it matter? – https://theconversation.com/why-is-the-reserve-bank-independent-from-government-and-why-does-it-matter-239717