Central Bank Independence and Fiscal Rules in the Periphery

 

Reading Keynes in Buenos Aires

This week I participated (virtually) in a conference in Colombia organized by the finance ministry, alongside a remarkable group of participants, including Rafael Correa, Isabella Weber, and Daniela Gabor. The focus of the discussion was the ongoing dispute between the government of Gustavo Petro and the Colombian central bank over the persistence of relatively high interest rates, and the broader question of central bank independence.

None of this, of course, is new. Variants of this conflict have played out repeatedly, including in the United States, where Donald Trump has openly criticized the Federal Reserve for maintaining interest rates he considers too high, and has clashed with Jerome Powell, as I have discussed here. But the Latin American context adds an important layer that is often missing from these debates.

The first point worth stressing is historical. The notion of an independent central bank is a relatively recent invention. Central banks have existed for centuries, but their functions have evolved significantly. Early central banks, even before institutions like the Bank of England (see here and here), were deeply intertwined with the fiscal needs of the state. They acted as fiscal agents, helping to finance public debt, often at levels that would alarm today’s orthodox commentators. In Britain, public debt during the Industrial Revolution exceeded 100 percent of GDP, with significant portions effectively absorbed by the central bank.

In this context, I suggested an analogy with Ha-Joon Chang’s argument about kicking away the ladder. Chang shows that today’s advanced economies relied heavily on protectionism and industrial policy during their own development, only to later promote free trade as the universal path, effectively denying developing countries the same tools. Something similar can be said about central banking. Historically, advanced economies used their central banks as instruments of development and as fiscal agents of the state, helping to finance large public debts and support economic transformation. Once they achieved development, they moved toward promoting central bank independence as a general principle, thereby limiting the ability of developing countries to use similar financial tools. In that sense, one could say that they also kicked away the financial ladder.

The idea that central banks should operate according to fixed rules, insulated from political pressures, is more closely associated with the gold standard era and the late nineteenth century. Even then, this rule-based framework reflected specific historical conditions rather than a timeless principle. And, as is well known, it broke down in the interwar period, when governments, faced with high unemployment, and the crisis of British hegemony, abandoned orthodoxy in favor of more active coordination between central banks and treasuries.

The US experience is illustrative. Under Marriner Eccles during the New Deal and World War II, the Federal Reserve worked closely with the Treasury, including maintaining low interest rates on government debt. It was only with the Treasury–Fed Accord of 1951 that the modern notion of central bank independence took shape. Even then, the separation was never as clean as the textbooks suggest.

This is because, at a more fundamental level, the central bank and the Treasury cannot be meaningfully separated. The central bank still acts as the fiscal agent of the state. Government spending creates money, whether through keystrokes in digital accounts, as emphasized recently by Modern Money Theory authors, or more traditional mechanisms. The idea that governments can run out of money (domestic issued money) in a technical sense is a useful fiction, one that obscures the real constraints, which are not financial but material. As John Maynard Keynes famously suggested, if it can be done, financing can be arranged.

This brings us to the present conjuncture. The recent inflationary episode in the United States was not primarily the result of excessive demand, but of supply-side disruptions, pandemic-related bottlenecks and energy price shocks (I wrote many posts on that; see this one). As these factors subsided, inflation fell. The Federal Reserve’s aggressive interest rate hikes were, at best, incidental to this process, and at worst risked pushing the economy into recession. What prevented that outcome was not monetary policy, but fiscal expansion, particularly the initial stimulus enacted by the Biden administration, the one that Larry Summers referred to as the worst economic mistake of the last 40 years (it's worth remembering).

If this is the case at the center, the implications for the periphery are even more significant. In Latin central bank independence is even more recent than in the US. It results from institutional arrangements that have evolved particularly in the wake of the debt crises of the 1980s and the imposition of the Washington Consensus, but that have been fully accepted by left of center governments in the region (note that most central banks in the region were created to deal with development issues in the aftermath of the 1930s crisis; this is represented by Prebisch, reading Keynes in Buenos Aires, in the figure above*).

The debate in Colombia mirrors similar tensions in Brazil, where Luiz Inácio Lula da Silva has criticized high interest rates maintained by the central bank under the previous chairman, appointed by Jair Bolsonaro, Roberto Campos Neto.  Interest rates, which remain high with the current president of the Brazilian Central Bank, Gabriel Galípolo, have not precluded growth, which depended on fiscal expansion and higher wages. True, Brazil has returned to growth, but it has done so more slowly than it could have, but not as a result of the interest rate policy. Instead, the slower pace of growth results from the self-imposed fiscal limits (see this by Haluska, Serrano and Summa).

Here is where the Colombia and Latin America, more generally, diverge from the US case. In the periphery, central banks do not operate in a vacuum. Their policies are constrained by the global financial environment, particularly by the stance of US monetary policy. Higher interest rates in the United States put pressure on developing countries to maintain relatively high rates of their own, in order to stabilize nominal exchange rates and avoid capital outflows and depreciation. Currency depreciation is not only inflationary but also contractionary, making macroeconomic management far more difficult.**

This is why the question of central bank independence, while important, is ultimately secondary to the issue of fiscal rules. Even countries without severe external constraints, such as Colombia or Brazil, face self-imposed limits on their ability to use fiscal policy to expand demand and promote growth. These constraints are not natural. The challenge, then, is not simply to debate whether central banks should be independent or not and from whom (certainly from financial markets). It is to rethink the broader framework within which monetary and fiscal policy operate, particularly in the periphery.

The discussion in Colombia, therefore, is not just about the appropriate level of interest rates or the degree of central bank independence. It is about the broader question of how much room governments have to use fiscal policy as a tool for development.

* Yes, the figure is AI; and the 9 of July monument, the obelisk, which was completed in 1936, was designed by Raúl's brother, Alberto Prebisch.

** Hélène Rey refers to this as the dilemma (instead of trilemma), since countries, with fixed or flexible (and, I guess, anything in between) exchange rate regimes, loose monetary policy autonomy with greater capital mobility.

Chapter on the history of monetary policy for the Elgar Companion to the Economies of Latin America and the Caribbean

My paper with Esteban Pérez has been published and is available now here. From the abstract of our chapter:

Monetary policy in Latin America has evolved in five different phases. The first one is characterized by the establishment of the first central banks adhering to a gold standard. The second phase is marked by the abandonment of the gold standard and the adoption of discretionary over rules based monetary policy. The third phase consists in the generalized adoption of developmental and inward industrialization goals by central banks. The fourth phase places price stability as the key overriding objective of monetary policy. The last phase focusses on the adoption of inflation targeting within an open economy context. The evolution of monetary policy in the region is closely related to the developments in the external sector and with the needs associated with the integration with the global economy. The chapter will emphasize the relative difficulties of insulating the region from external monetary and financial volatility and the limitations faced by monetary institutions to promote economic development with price stability.

An earlier version can be read here. 

UNCTAD INET-YSI Summer School 2020

Register here. I will be talking about Myths about monetary policy, inflation targeting and central banks.

Heterodox Central Banking in the Periphery

Our paper with Esteban Pérez on Prebisch's missions as a Money Doctor during the Fed-led missions directed by Triffin to Paraguay and Dominican Republic has been publish in Research in the History of Economic Thought and Methodology. From the abstract:

Traditionally, monetary policy in Latin America followed the recommendations of the missions of the monetary “doctors” who defended an independent central bank and a pro-cyclical monetary policy, adhering to the automatic adjustment of the gold standard. A key function of central banks was to support fiscal stability. The effects of the Great Depression and its aftermath in the periphery countries questioned these recommendations and gave way to a shift in monetary policy. An illustrative example is provided by the creation of the Central Bank of the Argentina Republic (BCRA) under the auspices of Raúl Prebisch, and the technical assistance missions of the United States Federal Reserve to several Latin American countries some of which were led by Robert Triffin. Prebisch actively participated in mission to Paraguay and the Dominican Republic bringing the experience he had acquired as director of the BCRA and the tools devised to adapt monetary policy to a changing external context and circumstances. The use of the discount window and exchange controls, among other instruments, was seen in this new view as necessary to pursue counter-cyclical policies and to provide support for industrialization and full employment in the periphery.

Read rest here. 

Heterodox Currents in Latin America

Esteban Pérez Caldentey will be talking about the topic in the next conference of the central bank of Bolivia. Program, that includes also Luis Bértola speaking on heterodox (presumably the unconventional, but not heterodox as in not mainstream inspired) monetary policy, is available here.

Prebisch and Central Banking

You can read here the Power Point of our presentation at History of Economics Society conference on Prebisch and Central Banking and his role as a Money Doctor in the 1940s after he left the Central Bank of Argentina.

Kicking Away the Ladder, Too: Inside Central Banks

Last January the Association for Evolutionary Economics (AFEE) sessions at the Allied Social Sciences Association (ASSA) meetings revolved around the theme of "Inside Institutions," meaning that within institutions there are many actors with different sets of interests, so one must look under the hood, so to speak, of the institution itself to understand its actions. My paper followed my previous discussion of the historical evolution of central banks, and a brief discussion within the Argentine Central Bank. From the abstract of my paper:

Central banks are evolving institutions. In developed countries, particularly in Britain, central banks were used as instruments of the state to finance government and to promote economic development. However, once they went up the economic ladder, advanced economies kicked it to preclude developing countries from climbing it, too. It is in this context that the modern independent central bank, concerned with inflation targeting alone, which harkens back to the Victorian era, should be interpreted. This paper analyzes the recent evolution of the Argentine central bank in this broad historical perspective.

Download full paper here.

PS: This are the proofs and there are some mistakes. And yes, it should say seventeenth century in the first paragraph.

Time machine: May 1935

The Argentine Central Bank was created 80 years ago. The New York Times had this short piece, in which Raúl Prebisch, who declined to be appointed president of the institution (he was too young, 34 or so), is cited. He was effectively in charge of policy. Some discussion of his policies can be found in this paper with Esteban Pérez here (final version published here).

"The Question of Confidence" According to Marriner Eccles

From an address at a Conference on "Debt, Taxation, and Inflation" organized by the Wharton Institute of the University of Pennsylvania in May 8, 1936, and held at the Waldorf-Astoria in New York. In his words:

"Leaving aside plans which involved fundamental and far-reaching changes in our whole economic organization, the solutions offered to the country in 1933 were of two main types. On the one hand there were those who contended that all that was needed was the restoration of confidence. They insisted that it was essential to balance the budget... On the other hand there were those who, like myself, felt that recovery in the present situation could only be achieved by bold and aggressive intervention by the government, largely through underpinning the entire private credit structure which had collapsed, and undertaking to restore purchasing power through relief, public expenditures and other measures.
...
What businessman would have added to his plant, when he already possessed a great amount of excess capacity, merely because he read that the budget had been balanced? It is difficult to understand why people would be expected to invest money in new enterprise when existing investments were becoming less profitable every day. It should not require any great insight to understand that a reduction of government expenditures while everybody else as a matter of self-protection was being forced to reduce expenditures, could only accentuate the processes of deflation by reducing buying power.
...
A belief that industry would have voluntarily entered upon capital expenditures in 1933 if the government had restricted its expenditures and raised taxes is unrealistic to the highest degree. It displays an utter miscomprehension of the considerations that influence a business man in planning expenditures. There must be reason to believe that capital expenditures can be profitably made before they are undertaken."

Note that this argument builds on a clear comprehension of the accelerator mechanism. Firms buy machines when  they expect demand to increase and, hence, higher profits. In this sense, the empirical evidence on the accelerator should be relevant not just to show that low interest rates are not sufficient for expanding demand, but also to put a nail in the coffin of the confidence fairy. Austerity hurts confidence and private investment.

Encyclopedia of Central Banking

So LP Rochon has edited this Encyclopedia, with Sergio Rossi.

LP sent me the entry on Bretton Woods Regime, by Omar Hamouda, as a teaser.

"Bretton Woods is a location, period of history, beginning of an era in the twentieth century, birth of an international organization, but, most of all, an international monetary system to regulate trade, peg currencies to one standard, and maintain a regime of fixed exchange- rate parity.

In July 1944 at Bretton Woods, New Hampshire, 44 nations under official British and American leadership set up economic measures for post- war reconstruction. The US dollar – pegged to gold – was approved as the new monetary standard. Two new insti tutions were also established with specific tasks: the Stabilization Fund (International Monetary Fund, IMF), a “special organization” (Horsefield, 1969, p. 39), to be a watchdog facilitating and promoting trade through monetary stabilization, and the International Bank for Reconstruction and Development (World Bank), with the role of providing member nations with “necessary capital not otherwise available except possibly on too costly terms” (ibid.)."

Read rest here.

Elizabeth Warren on Fed Appointments

Warren says that Obama should pick nominees for the Board of Governors vacancies that would "look out for Main Street, not big banks." More precisely:

"The five sitting governors have a variety of academic and industry experience, but not one came to the Fed with a meaningful background in overseeing or investigating big banks or any experience distinguishing between the greater risks posed by the biggest banks relative to community banks. By nominating people who have a strong track record in these areas and who have a demonstrated commitment to not backing down when they find problems, the administration can show that it is taking the Fed’s supervision problem seriously. Nominating Wall Street insiders for the Board of Governors would send the opposite message."

 I have a few names in mind.

Esteban Pérez on Prebisch, Central Banking and Economic Dynamics

The video below (in Spanish) explains Prebisch's intellectual evolution from the creation of the Argentinean Central Bank (BCRA) to his Economic Dynamic Lectures at the Universidad de Buenos Aires (UBA).

A paper covering some of these issues is available here. The full video is here.

Central Banking in Historical Perspective

The whole talk here. I posted before about it, but there was no link to the talk back then. And yes do NOT read Hayek. It's a waste of time.

David Warsh on Marriner Eccles

David Warsh from Economic Principals has written a nice post on Marriner Eccles. I particularly think he hits the nail when he argues that:

"Eccles embodied a peculiarly Mormon ethic of public service, full of frontier practicality (as Boston often has represented Puritan ideals and Philadelphia Quakerly ways). His was a role reprised by Willard “Mitt” Romney, who, as governor of Massachusetts, put a mandatory health insurance reform in place, presumably as the model for a national plan. (Romney eventually buckled under Tea Party pressure and disavowed the aim.)"

Although it is not well-known early Mormon doctrine was closer to Socialism that one might think, with an emphasis in redistribution and cooperative work (see for example this paper on "Communism among Mormons"; subscription required).

For more on Eccles go here and here. For a discussion of the LDS social ethic of cooperation the classic book by Leonard Arrington, Building the City of God, is a must read.

Prebisch on Keynes and White's Plans*

White and Keynes at Bretton Woods

Prebisch realized that, in order to be useful, economics needed to include as some of its central features, those aspects that traditional theory had ignored such as a historical/institutional perspective. Further, he became more aware of the interrelation and interconnectivity between the different countries and regions, and in particular, in the asymmetric relationship between center and periphery and its corresponding and distinct role in the international division of labor. Prebisch’s first reference to center and periphery dates back to 1921, in his analysis of the differences in the colonization of the Río de la Plata and the United States. In other words, prior to the publication of the development Manifesto in 1949, Prebisch had developed a sophisticated conception of the process of historical development of capitalism. This allowed him to understand the problems of the international monetary system from the perspective of the relationship between the center and the periphery.

In 1944, after he left the Central Bank of Argentina, he published a review of Keynes and White's plans (here in Spanish; subscription required). Prebisch highly approved the countercyclical element in Keynes’s Clearing Union. He nonetheless expressed his reservations about the plan. This was due to the fact that, according to Prebisch the balances of the members of the Clearing Union were to be deposited in a single institution and these had the obligation to spend their balances on commercial transactions between themselves. As a result, it did not promote the creation of a balanced and equilibrated commercial system that would benefit in any way the countries of the periphery.

For Prebisch, Keynes’ plan suffered from the same flaws of the Gold Standard including, in particular, its automatism ‘that had so gravely hurt the universal Gold Standard.’ This automatism referred to the freedom of countries to use the credits granted within their respective quotas. Prebisch thought that this had an inherent inflationary bias and that this did not benefit the countries of the periphery.** Moreover, Prebisch believed in a directed system of credits and, thus, that these should be granted according to countries’ needs. All in all, in his final judgment on Keynes’s plan he asserted: “the very favorable [aspects] and other inconvenient aspects that are not difficult... to correct. This applies to the counter cyclical policy of Keynes’s plan, because if at the beginning of a depression countries have enough resources to equilibrate their balance of payments, they have no need to compress their imports and lead to a sharp contraction of their domestic economies.”

Notwithstanding his critical appraisal of Keynes’s proposal Prebisch reserved his harshest criticism for White’s plan. Prebisch argued that White’s plan was even less favorable to the periphery than that of Keynes. Moreover, in spite, of providing temporary relief to balance of payments disequilibrium, White’s plan ultimately contained a strong contractionary bias. This could have a strong and negative effect in the growth of output and employment in the countries of the periphery. And on this Prebisch was correct, as that was the eventual effect of the International Monetary Fund (IMF), which was mitigated for a while as a result of the Cold War and, in the case of Europe, by the Marshall Plan (in Japan and other geopolitical hotspots in Asia too assistance reversed the contractionary bias of the balance of payments adjustment process).

Prebisch proposed an alternative plan, a full employment plan in line with that of John H. Williams, Harvard professor (from a time before Excel; yes, meaning Reinhart and Rogoff) and advisor to the Fed (for his views go here; subscription required too; for critical analysis of Williams contributions go here). This consisted in that the governments of the countries belonging to the center (and in particular in the United States) compensate the fall in economic activity with increased public expenditure, including public works to sustain high levels of employment and output. This plan also contemplated directing the flow of credit to avoid unsustainable disequilibria. Even though Prebisch did not realize, his plan was consistent with Keynes' views regarding the need to sustain rather than abolishing expansions.

For Prebisch the benefits of a full employment plan were immensurable, yet, he was not overly optimistic that the more developed economies (i.e. the economies belonging to the center) would ever adopt full employment policies. This view point would endure as a crucial component of Prebisch’s thought even when he seemed, at the end of the 1940s, to shift his analysis towards the longer run problems of Latin America and the need to promote the industrialization of the periphery.

* Modified from the Spanish version of the paper linked here.
** Prebisch's views on inflation at this point were strictly conventional and based on the notion of forced savings (excess demand).

Heterodox Central Bankers

"Virtually every monetary economist believes that the CB [Central Bank] can control the monetary base and…the broader monetary aggregates as well. Almost all of those who have worked in a CB believe that this view is totally mistaken…"

Charles Goodhart (1994, p.1424).

Goodhart, C. A. E. (1994) "What should central banks do? What should be their macroeconomic objectives and operations," Economic Journal, 104, November, pp. 1424-36.

Heteredox Central Bankers and Systemic Crisis

Anwar Shaikh's talk at the Central Bank of Argentina is now available at Revista Circus (h/t Alejandro Fiorito). Anwar's talk, as suggested before, looks at the current crisis from a long term perspective suggesting that this is the first of the 'depressions' of this century, a phenomenon that is recurrent in capitalist societies.

Heterodox Central Bankers and Microcredit

Jayati Ghosh's presentation at the Central Bank of Argentina was a harsh critique of microcredit, which according to her has "gone from hero to zero" in less than a decade. Jayati relies on Bateman and Chang recent critique of microfinance, which suggests that microfinance is actually a barrier to economic growth and poverty reduction. A lot of the microcredit experience in India resembles a loan shark operation, with very high rates and heavy penalties, and is part of a broader drive to liberalize financial markets. It is important to note the perverse effects that fads in economic development might have on policy making.

Heterodox Central Bankers: Kicking Away the Ladder Too

Let me briefly comment on two additional and interrelated presentations at the Central Bank of Argentina's annual conference. Two of the presentations were important in dispelling the myth that central banks were historically only concerned with inflation, and not particularly relevant for economic growth. Jane Knodell presented a paper on the evolution of the US banking sector from the late 18th century up to the Civil War, including the First and Second Banks of the United States, which were in many ways like the Bank of England a quasi-central bank.

Jane's presentation very clearly shows that the main role of the First Bank of the United States was as a fiscal agent of the federal government, its liabilities used to collect revenue and meet federal payment obligations, including debt service, a similar role to the Second Bank. More importantly, she concludes that the closing of the Second Bank by Andrew Jackson had a positive effect on growth, since the evidence suggests that countries with central banks concerned with the Gold Standard, as they tended to be in the 19th century, grew less than the US.

Valerio Cerretano's presentation was on the little known, at least among economists, industrial intervention by the Bank of England and the Bank of Italy in the inter-war period. Both central banks became directly involved in the 1920s and 30s in the administration of industrial firms, through direct management or through participation in holding companies. In the case of Britain the Bank of England was essential for assisting reconstruction of traditional sectors (heavy industries and cotton) and development of innovative industries (man-made fibres, aluminium), some of which were crucial latter in the war effort.

In other words, central banks have been directly involved in the funding of the Treasury and the industrial sector in developed countries, but it seems that, as Ha-Joon Chang has suggested for the case of international trade, once they got up the ladder using their banks to promote development they kicked it, and argued that they should only promote price stability.

Heterodox Central Bankers

The annual conference of the Central Bank of Argentina was held this week. The theme was the role of the Central Bank in the process of development. Jamie Galbraith, the actual author of the draft of the Full Employment and Balanced Growth Act, also known as the Humphrey-Hawkins Act, which gives the Fed its triple mandate of full employment, growth, and reasonably stable prices, opened the conference after the talk by the president of the bank (the video of Jamie's talk is available here; h/t Revista Circus), Mercedes Marcó del Pont. Jamie warned against falling into the trap of assuming that the crisis has only one cause, and was very pessimistic about the possibilities of a more rapid and vibrant recovery in the developed world. Phil Arestis (presentation here) closed the conference, with more emphasis on regulation issues, and his assessment was equally pessimistic. If the policies of central banks, in particular the ECB, and the austerity measures in the developed world are not reversed soon a long period of stagnation might ensue, as Anwar Shaikh (shown above with Stuart Holland, Jamie, and the president of the central bank) reminded us.