The Political Economy of Central Bank Activism

Yet another call for limiting central bank intervention in order to keep up the pressure for “structural reform” in the Eurozone has me thinking about the larger context.

Item 1: This morning I am reading a piece by two Dutch economists arguing for restrictions on the ECB’s promise to support sovereign debt markets (OMT) on the grounds that significant costs in financing fiscal deficits are needed to push reluctant governments to make necessary structural reforms.

Item 2: There have been never-ending demands for the Fed to relent on QE.  The justifications keep changing but the demands remain the same.

I agree with Noah Smith’s hypothesis that the true motivation, or at least one of them, is to not let a crisis go to waste, and to use economic pain as leverage to achieve other goals—a smaller state, less regulation, etc.  This is a strategy that dare not speak its name.  Proponents don’t say “let’s hold governments and populations hostage through austerity in order to force them to pursue a neoliberal agenda”; that would not go over well.  But this is not to accuse them of deceit.  In their own minds they probably see neoliberal reforms as self-evidently beneficial to the point that there is no need to spell them out or argue for them: everyone they know understands that this has to be the solution.  (It’s communicated through adjectives, like the “bloated” civil service, the “unaffordable” welfare state, “rigid” labor markets, and so on.)

But let’s take a moment to think about the mechanism.  Exactly what sort of pressure is envisioned that would override democratic preferences and force governments to cut the safety net, promote greater inequality and take other unpopular acts?  The answer is the bond market.  Governments that defend redistribution and restrictions on the market are expected to be punished by higher interest rates on their debt.  This empowers the creditors, wealthy individuals and institutions, to impose their presumed preferences on democratic majorities.  The great sin of aggressive bond market intervention by central banks to support sovereign debt is that it blunts this instrument, supplying publicly created liquidity when private wealth is skeptical.

From an analytical point of view, there are several questions to ask.  (1) To what extent do the risk perceptions of private wealth-holders accurately reflect the true long run prospects of national economies and their governments?  (2) Do more generous or more regulatory governments face higher interest rates on sovereign debt in general?  (3) What basis is there for the assumption that the economic costs of welfare programs, regulations and other government policies are systematically undervalued in the political process, such that they have to be defended by bond markets?

My guess is that most opponents of central bank activism don’t ask these questions explicitly; they simply assume the answers—that bond markets are rational and make the right calls, that they punish governments that fail to respect the logic of free markets, and that the enemy of “reform” is electoral populism.  You could say that, intellectually, they have simply taken sides.