A recent spat between the government and new Reserve Bank Governor, Dr Anna Breman, brought the issue of central bank independence into the spotlight again. We need the debate.
There has been a consensus since the monetary reforms of the 1980s that monetary policy should be off-limits to politicians and monetary policy (transmitted through the financial system) and fiscal policy (government spending) should ‘travel in their own lanes’.
To understand the issues, it’s worth starting with some history to show how the government and its central bank used to engage and what changed.
In New Zealand, the Reserve Bank has had a high degree of operational independence ever since its formation in 1934. It operated with little fanfare as a department of government, with a strong independent streak in the free and frank advice and pushback it gave to its minister.
While the government could set the strategic direction through the political process, the bank was largely left to decide operational matters, using monetary policy tools to support the government’s goals while maintaining sound money.
That changed after 1989 when a new Reserve Bank Act gave the bank a level of statutory independence from the government that was unusual in the world at the time. Among other things, the Act narrowed the bank’s strategic goals to just two: financial stability (a sound banking system) and price stability (low and stable inflation). A narrow remit was the trade-off for handing so much power to unelected bureaucrats. To support the price stability goal, we got another Kiwi innovation, inflation targeting, with its prescriptive target for inflation and a focus on interest rates to achieve it.
The bank pursued its two goals as it saw fit and any requests to support other goals could be ignored.
The changes put the Reserve Bank on a pedestal and made its governor a public celebrity; criticism or discussion of how monetary policy could help the government’s aims were off-limits to our elected representatives; and inflation targeting turned interest rate watching into a national sport.
The changes suited the banking lobby who only had to deal with bureaucrats, largely out of the public eye with little chance of political challenge. And for a while, politicians were winners, too, as they dodged responsibility for inflation and leaned on the bank’s looser credit policies to shrink government spending.
So what were some of the policy areas that the bank was no longer obliged to support?
One of them was industrial policy (‘picking winners’ as it pejoratively came to be known). Previously, the government had identified certain industries as of strategic importance and the Reserve Bank accommodated these goals. It did this through both direct and indirect means. Direct support included Reserve Bank credit lines for producer boards like the Dairy Board, and support for industrial development banks such as the Development Finance Corporation (DFC). Indirect support included guidance to the banks to encourage lending to favoured sectors.
Under its new remit, the bank ceased direct accommodation and set its own direction for banking rules and credit allocation and leaving banks to decide where and how much credit to extend. (Spoiler alert: it was ‘housing’ and ‘a lot’.)
Another former goal that now fell outside the bank’s remit was the massive infrastructure programme that followed the Depression and war years. Reserve Bank support included underwriting and in some cases directly financing government bond issues.
Time for a change of consensus
While strong operational independence needs to stay in place, the strategic terrain where it can operate needs to expand and be more open to democratic scrutiny.
Around the world, many of the old policy approaches that had successfully leaned on their central banks for support are coming back into vogue. Our problems today increasingly resemble those of our nation-building grandparents and great-grandparents—a massive need for public infrastructure investment, seeding new industries and nurturing development in regions where markets alone have failed, and taking a more active role in providing good jobs to new and displaced workers.
At the same time, the inflation targeting approach at the core of the current arrangement is coming under pressure. Its negative side-effects such as wealth inequality, household debt stress, and housing unaffordability can no longer be ignored.
In a speech given by Dr Breman in her former role with the Swedish central bank, she acknowledged major shifts taking place in the world of money, and the need for central banks to broaden their toolkits beyond interest rates for dealing with them. She said:
“Fiscal policy will probably play a greater role for stability in the economy going forward, something that I would welcome….Being open to adapting monetary policy to new challenges obviously involves being open to and prepared for other scenarios.”
Among the new tools Dr Breman highlighted was direct monetary financing, the subject of our petition calling for a return to its use to help finance public infrastructure. It is currently before parliament’s Finance and Expenditure Select Committee.
As Dr Breman describes monetary financing in her speech:
“This is also an old tool used throughout history which is now being revived. The idea is that the government implements fiscal policy stimulus as it normally does in a recession, but instead of financing this by increasing the sovereign debt, it enlists the help of the central bank, which creates new money.”
You can read our own paper proposing direct monetary financing for infrastructure here, or our proposal showing how it can help councils to finance water infrastructure.
With plenty of big and urgent challenges ahead, it’s time for some fresh thinking and leadership to bring change to New Zealand’s creaky, aging consensus on monetary policy.