Central Bank Autonomy: A Dangerous Mirage

Alejandro Nadal

The global financial crisis is breathing and evolving. In Europe it is treated as a sovereign debt crisis. But given the fact that the crisis exploded in the midst of the private financial sector, how did we get here?

Four decades ago, more precisely on January 3 1973, a new law on central banking was approved in France. The new statute for the Banque de France contained critical provisions for the independence of the monetary institute. Article 25 turns out to be particularly relevant for today’s debate on Europe’s crisis. It stated that the Treasury would not be able to resort to the Banque de France to borrow money.

This represented a historical transformation in public finance and left the State at the mercy of the private commercial banking system. Instead of using the money emission capacity of the central bank, the French government had now embarked on a new course, one that turned out to be a milestone in financial liberalization. Many other countries followed this example. Incidentally, when the law was passed Georges Pompidou was the President of France. He had been director of the Banque Rothschild between 1956-1962, a fact that generated suspicion as to the motivations of the Loi 73-7 of 1973.

The international environment that surrounded this event was marked by the decision of then President Nixon in 1971 to suspend all sales and purchases of gold. The days of dollar-gold convertibility were over. Soon after this, Treasury Secretary John Connally shocked European leaders worried about the export of American inflation with his famous quip, “It’s our currency but it’s your problem”. That of course did little to allay the fears of Europe’s financiers.

The collapse of the Bretton Woods system had critical implications for the financial sector. As it created new risks for investors who now had to meet the challenge of flexible exchange rates (the “privatization of exchange risk” as Eatwell and Taylor aptly describe this), it also opened new opportunities for speculation in the foreign exchange markets. Financial liberalization was needed for the arbitraging operations that capital required to take advantage of the opportunities flexible exchange rates offered. And while this was being considered and promoted on all fronts, the idea of central bank independence came to life.

In theory this move would separate monetary policy from the vagaries of political winds that could take an economy down the easy road of temporary economic growth at the risk of generating long-term inflationary pressures. This would also prevent monetization of the debt arising from irresponsible fiscal deficits and, at the same time, condemned monetary policy to a passive stance. Not only was monetary policy shielded from democratic processes, but it also became subordinated to the dictates of financial capital.

The French law for the central bank has since ceased to exist. It was substituted by Article 104 of the Treaty of Maastricht and later by article 123 of the Treaty of Lisbon that prohibit overdraft facilities or any type of credit facility in favor of central governments and regional or local public authorities. In summary, central banks are forbidden to openly finance government operations. Thus, in addition to the scandalous regime of private monetary creation by private banks (who create money out of thin air, lend it and charge interest), we also ended up with a situation in which the State’s finances depend entirely on commercial banking system.

This situation is not limited to European countries. An IMF study reveals that from a sample of 152 countries, about two-thirds either prohibit central banking lending to the government or restrict it to short-term loans (mostly to smooth out fluctuations in tax revenues). In the case of developed countries, as well as in countries with flexible exchange rate regimes, the restrictions on government financing are rather strong. Finally, when short-term loans are allowed, market interest rates are charged.

The main policy objective of central bank independence is price stability. This is not the same as macroeconomic stability, as we know. But it is the only rationale for the so-called independence of central banks. The result has been the colossal expansion of interest payments from governments to the private banks. Using Eurostat numbers, Simon Thorpe found interest payments for 2011 in the European Union amounted to 370.8 billion euros (11% more than in 2010). That’s a whopping 2.9% of the EU’s GDP.

As the recession hit Europe, tax revenues dropped and expenditures increased (as more unemployed people needed public support). Because of the prohibition to borrow interest-free from the central bank, governments had to go to the financial markets. Here they met with higher interest rates, as well as demands for changes in macroeconomic policies that led to increased austerity and a deeper recession. If governments could refinance their debt through their central banks they would instead save colossal amounts of money. Under present rules this is not possible. Central banks’ independence is a mirage covering their subordination to the world’s private banking system.

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