M-RCBG Associate Working Paper No. 87

Central Bank Independence Revisited: After the financial crisis, what should a model central bank look like?

Ed Balls, James Howat, and Anna Stansbury



After the financial crisis, countries around the world significantly expanded the objectives and powers of central banks. As central banks have acquired more powers, the trade-off between independence and accountability has become more complex and as a result, the pre-crisis academic consensus around central bank independence has broken down. Popular discontent towards central banks is growing. A new model of central bank independence is needed. 

We first investigate the traditional case for central bank independence. Extending work from the 1980s and 1990s to the present, we show that operational independence of central banks – the ability to choose an instrument to achieve inflation goals - has been associated with significant improvements in price stability. But in advanced economies at least, political independence – the absence of the possibility for politicians to influence central bank goals or personnel – has not been correlated with inflationary outcomes. This suggests that central banks in advanced economies can sacrifice some political independence without undermining the operational independence that is important in both their monetary policy and financial stability functions.

In light of this distinction between political and operational independence, we then evaluate the new powers that central banks have taken on over recent years, focusing on advanced economies. We develop a framework which examines how to maximize the benefits of locating new powers inside the central bank, while minimizing potential conflicts with monetary policy and limiting political threats to the legitimacy of central banks’ operational independence. Based on this framework, we recommend a set of principles to guide central bank structural reform. First, we recommend the institution of formal monetary-fiscal coordination mechanisms, provided that they are limited to the zero lower bound, triggered by the central bank and protect democratic control over fiscal policy. Second, we recommend
that systemic risk oversight and prioritization is carried out by a multi-member body comprising the central bank and financial regulators and chaired by government, but that macro-prudential policymaking is operationally independent from government. Third, we recommend that crisis management efforts are led by government, but that there should be few restrictions on central bank liquidity provision. Finally, we argue that there is a case for and against the central bank as bank supervisor, but that the central bank should not be responsible for policing financial conduct.

Viewed in light of our framework, no single country has yet settled the question about how a modern central bank should be structured. The approach taken by major economies all have strengths and weaknesses: they would benefit from learning from each other. For example, in the US, the central bank lacks the macro-prudential tools required to fight risks to the country’s financial stability. The US should learn from the Bank of England’s more expansive macroprudential toolkit and the mechanism that the Bank’s Financial Policy Committee has in place to request new powers from the government. The UK should also look to the US for lessons. After the centralisation of prudential regulation – both of the micro and macro variety – and systemic risk monitoring inside the Bank of England, there is a danger that the UK money-credit constitution is too concentrated in the central bank, leading to the possibility of groupthink, a lack of oversight and ultimately political risks to central bank independence. In Europe, the ECB has made progress building up its macro-prudential toolkit. But it still lacks powers to influence the non-bank financial sector and this macro-prudential policy capacity is fractured across several different institutions without effective oversight, a concern for political accountability especially in a union representing many different countries and political systems.

The recent US Presidential election, and the resulting Republican control of Congress as well as the White House, are widely expected to lead to further criticism of the power and independence of the Federal Reserve. Meanwhile, over the past year, we have seen open political attacks on Bank of England Governor Mark Carney from Brexit supporters. But we are clear that this is no time to throw the baby out with the bathwater. We do argue for a more nuanced approach to central bank independence, with political accountability in terms of mandate-setting and appointment of officials, and oversight of wider financial stability powers. Nonetheless, we reiterate that the case for operational independence in both monetary and macro-prudential policy is strong: to retreat on this now would be a serious mistake.

Download the paper in PDF format