Behind the drama playing out over the US Federal Reserve lies a story about compromises made in every Western economy.
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As the saga over the US Federal Reserve’s independence plays out, it is hard to miss the almost teleological nature of public discussion. The current discourse makes central bank independence seem like a natural right, of sorts. There is hardly any mention of the political economy compromise that underpinned Fed independence and its long-term consequences for the larger economy.
The story of the evolution of central bank independence, especially the Fed, also carries with it the tale of the larger macroeconomy and the hidden costs. A version of the same story can be found across geographies.
In the immediate post-war era, the German Bundesbank was effectively the only independent central bank. On paper, the US Fed got its autonomy through the Treasury–Federal Reserve Accord of 1951. But for the next nearly three decades, this autonomy was more de jure than de facto.
In 1965, as inflation soared on the back of tax cuts, increasing social spending, and the Vietnam War, President Lyndon Johnson summoned Fed Chair McChesney Martin to his Texas residence to berate him into not hiking interest rates. Martin managed to push back, but gave in a few years later.
The next Fed Chair, Arthur Burns, dropped all pretence and facilitated a massive expansion of the money supply, coupled with wage-price controls – resulting in non-inflationary growth surge in perfect time for President Richard Nixon’s re-election bid in 1972. The inflation eventually arrived, however, and the OPEC shocks of the 70s made it irritatingly sticky.
Through the 1970s, similar inflationary spirals also wrecked other economies, such as United Kingdom, Italy, France, Australia, New Zealand, and Japan. Understandably, the 60s and 70s came to be known as the Great Inflation period, where macroeconomic policy was mostly about fiscal policy and monetary policy didn’t matter much, especially in the United States.
This changed radically in 1979 under Fed Chair Paul Volcker, who took interest rates well into double digits to finally tame inflation. His independence was anchored in the Fed’s 1977 dual mandate to foster growth and price stability. With the Volcker Shock came central bank independence as we understand it today and a deeper political economy consensus that inflation had to be kept low.
Financialisation had disastrous long-term ramifications for the average American. While wealth increased manifold, it was highly unequally distributed.
Soon, this consensus proliferated across the world. New Zealand was the first to adopt a price-stability mandate in 1989, followed by the Bank of England in 1997. The European Central Bank, established in 1998, would be designed to ensure central banking autonomy.
However, as Skanda Amarnath and Mike Konczal argued on Bloomberg’s Odd Lots podcast, the Volcker Shock also marked the beginning of the something equally consequential: neoliberalism.
Here, the term neoliberalism has a specific meaning. The rise of independent central banks shifted the economic orthodoxy, with governments now prioritising monetary over fiscal policy as the prime macroeconomic instrument. The global context was the gradual shift towards flexible exchange rates, and with the lifting of capital controls came the unprecedented globalisation of capital. This globalisation led to the buoyant 1990s and 2000s – a period referred to as the Great Moderation – and the neoliberal orthodoxy of monetary policy dominance.
The Great Moderation featured low inflation and low unemployment. And at the heart of this arrangement were superstar Western central banks, which now effectively ran macroeconomic policy by tinkering with short-term interest rates. There was a certain jubilance that, by outsourcing macroeconomic management to central banks, economists and politicians had eliminated business cycles.
Yet, there was a hidden cost. Persistent low interest rates inadvertently led to rapid financialisation of the US economy which severely disincentivized investment in the real economy, such as infrastructure and human capital. Financialisation also had disastrous long-term ramifications for the average American. While wealth increased manifold, it was highly unequally distributed.
Moreover, financialisation meant that the Fed now effectively had to maintain stability across both the domestic economy as well as financial markets. Thus, there was a hidden element in the dual-mandate: markets.
The Great Moderation ended abruptly with the 2008 financial crisis, but the neoliberal orthodoxy of preferring monetary over fiscal policy survived. While the US government initially responded with fiscal stimulus, it soon side-stepped. They quickly passed the baton to the Fed to undertake an expansionary monetary policy via nearly-zero interest rates, and themselves returned to deficit reduction.
Things were arguably worse across the Atlantic. UK Chancellor George Osborne unleashed the kind of fiscal austerity that not only made the de-industrialised English suffer in the aftermath of a once in a generation recession but also had dire long-term consequences for public services such health and railways. From there, Brexit was arguably the eventuality.
Across the Eurozone, the German government coerced the reeling economies of Southern Europe into crushing austerity, pushing average households into years of economic stagnation. In its own backyard, the German government’s austerity obsession has had dire repercussions for the country’s eastern regions, infrastructure, and national security.
In the West, the absence of an adequate fiscal response to the Great Recession ensured that the recovery was neither fast nor deep. Eventually, populism filled the gap.
Where the 2008 crisis didn’t succeed, twelve years later a pandemic did. In response to the pandemic, President Joe Biden unleashed a staggering $1.9 trillion stimulus, effectively marking the return of fiscal policy. In Europe, it would take a bit longer, and more specifically, the return of Donald Trump for a second term in the White House.
This commentary originally appeared in The Interpreter.
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Srijan Shukla is an Associate Fellow working with the geoeconomics and the forums team. His research focuses on domestic and international political economy. In the ...
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