Question

An opinion column in the Wall Street Journal noted, "In a democracy, the tradeoff for a central bank's independence is accountability to the nation's elected leadership." a. Why would a country want to grant its central bank more independence than it grants, say, its department of agriculture or department of education? b. In the United States, how is the Fed held accountable to the nation's elected leadership? Source: David Wessel, "Explaining 'Audit the Fed," Wall Street Journal, February 17, 2015 .

Short answer

A country would grant its Central Bank more independence because it enables the bank to make decisions that are in the best long-term interests of the country's economy, irrespective of political pressures. In the United States, the Federal Reserve (the central bank) is accountable to Congress and is subject to regulation and oversight, ensuring it adheres to its mandates.

Step-by-step solution

Understanding Central Bank Independence

Central Bank independence means that it's free from political influence to make its own policies. This independence is beneficial for any country because it allows the Central Bank to focus on long-term economic goals, like controlling inflation, stabilizing the financial system, and maintaining economic growth. It is generally granted more independence than other departments because its decisions affect the entire economy and should be free from political pressures.

Benefits of Central Bank Independence

Independent Central Banks can shape monetary policies that prioritize the health of the economy as a whole over short-term political gain. This helps insulate the economy from political volatility and reduce the risk of harmful policy decisions. For instance, decisions about interest rates are often better made with a focus on long-term stability, rather than short-term situational benefits.

Accountability of the Central Bank

While the Central Bank operates independently, it is held accountable by various mechanisms to ensure it meets its mandate and operates in the best interest of the nation. In the United States, the Federal Reserve, also known as 'The Fed', is accountable to Congress. They submit regular reports, testify before Congress, and are subject to audit. This ensures transparency, accountability, and adherence to the mandates given by Congress.

Why Other Departments Don't Need Such Independence

Departments like the Department of Agriculture or Education work on more specific sectors and are typically more closely linked to the political framework. They implement policies in line with the ruling government’s agenda, and their decisions and operations are usually under the direct regulation of the elected government. Thus, there may not be a need for the same level of operational independence as that enjoyed by a central bank.

Key concepts

Monetary Policy

At the heart of central bank independence is the concept of monetary policy, the process by which a central bank manages a country's money supply to achieve specific economic goals, such as controlling inflation, minimizing unemployment, and stabilizing currency. It is crucial to understand this since the autonomy of the central bank enables it to execute monetary policy effectively, without the interference of short-term political agendas.

For instance, when the central bank perceives inflation to be a threat, it might increase interest rates to cool off an overheating economy. This is the kind of decision that can be unpopular in the short run since it can slow economic growth and increase borrowing costs. However, it may be necessary for long-term economic health. By being independent, the central bank can take such measures, even though they may conflict with the political objectives of the government in power.

Economic Stability

Economic stability is a primary objective for any nation, characterized by a steady growth rate, low unemployment, and controlled inflation. Central bank independence contributes significantly to this stability. Without independence, there might be a temptation for political actors to engage in 'politically expedient' monetary policies such as manipulating interest rates to boost economic growth ahead of elections, which could lead to a boom-and-bust cycle.

An independent central bank, with a clear mandate to prioritize long-term economic stability, can mitigate such risks. It can maintain consistency in monetary policy across various political administrations, providing a stable financial environment for businesses and investors. This, in turn, can bolster confidence in the economy, encouraging investment and supporting sustained economic growth.

Federal Reserve Accountability

While a high degree of independence is desirable for the Federal Reserve to conduct monetary policy effectively, it cannot operate in a vacuum. The Fed is held accountable to the public and the nation's elected leadership through several mechanisms. For example, the Chair and other members of the Federal Reserve Board of Governors are nominated by the President and confirmed by the Senate.

The Federal Reserve also must report to Congress and testimonies are often provided by the Chair, detailing the state of the economy and policy intentions. This process ensures oversight and enables elected officials to ask questions and provide feedback. Moreover, the Fed's actions are also audited in various ways, ensuring that their operations remain transparent and responsible to the taxpayer, safeguarding against misuse of monetary powers.

Political Influence on Economy

The profound impact of political decisions on the economy cannot be underestimated. Political influence can manifest in fiscal policies such as taxation and government spending, which are highly visible and directly affect voters. Yet, it's essential to minimize such influence over monetary policy to protect the economy from becoming a tool for short-term political gains.

When politicians exert influence over central banking decisions, it can lead to policy choices that favor immediate results over long-term health, such as pushing for low interest rates to boost economic activity despite the risk of inflation. By keeping the central bank independent, a buffer is maintained against such politically motivated influences, preserving the integrity of economic management and ensuring that fiscal policy complements rather than conflicts with monetary policy for the overall benefit of the nation’s economy.