The case for central bank independence

Even though right-wing Turkish citizens have supported him ever since he started his political career more than three decades ago, President Recep Tayyip Erdoğan has never been popular with left-leaning Turks.

He may have found a way to lure them as well. Two of my readers, who often send me Marxist economics articles, recently wrote to me, arguing that central banks should not be independent. “Governments should control central banks in democracies. That why they are elected. If they screw up, at least they can be unelected,” claimed one.

This argument is not new, but it is based on the false premise that central banks are all-powerful entities that can determine the fate of countries by lowering or raising interest rates. While the impact of monetary policy on the real economy is debatable, almost all respectable economists would agree that central banks have limited tools at their disposal to jumpstart or fine-tune the economy.

I said “almost all” on purpose. Joseph Stiglitz challenged that widely-held notion by noting in early 2013 that “in the crisis, countries with less independent central banks, including China, India and Brazil, did far, far better than countries with more independent central banks like Europe and the United States.”

It is tough to argue with a Nobel Prize laureate, but this observation ignores the fact that the global economic crisis erupted from countries with more independent central banks in the first place. In any case, these countries have done much better since then. The timing of Stiglitz’s statement is particularly unfortunate. China’s economic imbalances, some driven by loose monetary policy, have emerged since then.

Central banks are most suited to controlling inflation and providing financial stability. And independent central banks can deal with the former effectively by anchoring inflation expectations. Governments’ promise to lower inflation would not be credible because of the attractiveness of high inflation for “inflating away” domestic debt or the short-term costs of lowering inflation, such as the rise in unemployment. But the public understands this and doesn’t decrease its inflation expectations, making lowering inflation more difficult in the first place.

When you think about it, this simple framework, which was first developed by Robert Barro and David Gordon based on Finn Kydland and Edward Prescott’s Nobel-winning idea of “time inconsistency,” is exactly what is going on in Turkey at the moment: Despite the longer-term benefits of bringing Turkey’s inflation to levels comparable to peers, Erdoğan cannot accept the short-run cost in growth of higher interest rates needed to lower inflation, especially before the critical June elections.

Not even pretending to be impartial, he is trying to win enough seats to change the Constitution – so that he can legally become an all-powerful president. He doesn’t care that even in the unlikely scenario that consumption surges in response to lower rates, Turkey’s economic vulnerabilities would be rekindled: Imports would rise, and the dependence on capital inflows would continue.

As you can see, there is a strong economic argument for the Central Bank of Turkey to remain independent. But the real case to be made is that it would be run by someone who believes that, contrary to common economic wisdom, higher interest rates beget higher inflation.