Since the beginning of his term, Prime Minister Benjamin Netanyahu has had to explain several times to the world media extreme statements by members of his government. These are usually statements regarding the conduct of the war in Gaza, but at the beginning of February last year, the Prime Minister was required to address a completely different issue: the independence of the Central Bank.
“The Bank of Israel law guarantees independence… the governor sets the interest rate. Nothing will change that,” Netanyahu wrote on his Twitter account in a tweet that was also translated into English. Even the then foreign minister, Eli Cohen, who ignited the storm, was required to clarify his words, and to declare his support for the independence of the central bank.
His words, along with a criticism of the Chairman of the Finance Committee, Moshe Gafni, on the conduct of the Bank of Israel, received sharp criticism from the Israeli economic establishment. However, in the global economic field, there are also other opinions, which may not fully correspond to Cohen and Gafni’s criticism of the institution, but are certainly challenging. You are one of the sacred violations of the Israeli economic consensus.
“The idea of central bank independence is based on the incorrect claim that interest rate policy is effective in fighting inflation,” Canadian economist Louis-Philippe Rochon tells ‘Davar’. “If interest rate policy does not work as central bankers claim, then why do central banks need independence?”
Roshon is part of a group of economists that criticizes the orthodox economic approach. He wrote and edited almost 40 books dealing with economic theory and the history of economic thought. Along with economists such as Nobel laureate Joseph Stieglitz and Claudia Saham, he opposed the series of interest rate hikes taken by central banks around the world led by the US Federal Reserve. In an interview with ‘Davar’, he explains why raising interest rates is ineffective in fighting inflation and hurts the weakest and why the idea of central bank independence should be abandoned.
Why are you opposed to using interest to fight inflation?
“The use of interest is intended to lower the level of consumption and investment, and it is based on the assumption that inflation results from excess demand. If this were true, it would be possible to justify the use of interest, but I do not accept this assumption. I think that inflation was caused by other reasons. I also reject The approach that inflation of 8-9 percent, as we saw after the corona virus, is the worst thing that can happen to the economy.”
Are price increases not a serious problem?
“Certainly the price increases are a problem – following the recent increases, many find it difficult to buy food products. But I don’t think that inflation at the level of 8-9 percent is worse than unemployment. Unemployment and inequality are, in my view, much more serious problems, and the high interest rate exacerbates inequality and creates Unemployment. The policy used against inflation is much more harmful than inflation itself. Not for nothing, the economist John Maynard Keynes said that using interest rates against inflation will cure the disease, that is, the economy.”
Economist Louis-Philippe Rochon (photo courtesy of the photographer)
How is interest rate policy related to the idea of central bank independence?
“The independence of the central bank and the interest rate policy are part of the same approach. This is an old concept, but it only reached maturity after the inflation of the 1970s and early 1980s. The idea is to protect the central banks from political pressures, so that they can set the interest rate at the right level for the fight against inflation. It is based on the claim that politicians are not interested in fighting inflation but in winning the next election and therefore they may fear high interest rates, which will harm their chances in the elections.”
Is this an agreed upon concept?
“It’s definitely a consensus. I think a vast majority of central bankers, analysts, economists and politicians believe in the idea of central bank independence. The reason is probably a desire to avoid a repeat of the high inflation that was in the 1970s.”
What do the studies say about the effectiveness of central bank independence?
“In order to test the relationship between the independence of the central bank and inflation, you need to define what that independence is. The studies that do this begin with the assumption that inflation is the greatest threat to the economy, and therefore a central bank that fights inflation is good, i.e. independent. But what about unemployment or inequality? This is actually A circular argument, it is assumed that inflation is the great evil, therefore fighting it is good.
“But even if we put the issue of definition aside, there is no empirical support for the claim that central bank independence leads to a decrease in inflation. Even economists who support this approach will admit that the evidence is weak and far from conclusive. The reason many studies do not find a connection between central bank independence and inflation is that interest rate policy is ineffective In fighting inflation, the central banks’ model does not work. I am not saying that monetary policy is not effective at all, just not for fighting inflation.”
Why is the model not working?
“The model of the central banks says that if inflation is higher than the central bank’s target (1%-3% in Israel, G.R.), the interest rate should be increased. The increase in the interest rate reduces consumption and investments, i.e. demand. Low demand expands unemployment, and the high unemployment rate reduces inflation. The problem is that empirical studies have shown that the effect of interest on demand is negligible and that the effect of unemployment on inflation does not exist.”
“Consumption and investments do not respond to increases in small steps in the interest rate. I can quote the Federal Reserve, the International Monetary Fund, the World Bank, a host of respected economic institutions, that the effect of an incremental interest rate increase is negligible. Of course, after 11 increases, as was done in the USA” B, there will be a demand reaction to the high interest rate, but we don’t know how many increases will be required.”
What about unemployment and inflation?
“The second part of the mechanism is that high unemployment will lead to lower inflation – the Phillips curve. The Phillips curve represents a negative relationship between unemployment and inflation – when unemployment increases, inflation decreases. Again, the problem is that in the last 50 years, the curve has become a flat line; there is no relationship between inflation For unemployment. Here too, you can quote senior economists and institutions regarding this, it is a consensus.
“To conclude, the effect of the interest rate on demand and therefore on unemployment is small, and so is the effect on inflation and the whole model collapses. When the central banks see that raising the interest rate has no effect, they raise it again and hope that it will have an effect. But it doesn’t, so they raise the interest rate again and again, 11 times , until in the end the system collapses under the high interest rate.”
Still, even now the American economy is enjoying healthy growth and a low unemployment rate.
“The American economy is growing despite 11 interest rate hikes due to Biden’s massive fiscal stimulus. You always have to consider the full picture. But in many other countries, such as Canada, England, Germany and other countries, the economy has slowed significantly following a series of interest rate hikes.”
Independence from the government, but not from capital
In another criticism, Rushon claims that the independent central bank is free from government influences but not from the financial markets.
“When inflation just started to rise after the corona virus, the Federal Reserve said that inflation is expected to be temporary and therefore there is no need to raise interest rates. They started raising interest rates because the markets told them that they were behaving irresponsibly and were starting to lose the confidence of the markets.”
What do the markets mean?
“There’s been a lot of criticism from economists of financial companies, for example hedge funds, who have raised concerns about the credibility of the Federal Reserve. If there’s one thing central banks fear, it’s the loss of their credibility, so they’ve started raising interest rates.”
Why do they fear the loss of credibility?
“They want to be in a position where what they say is trusted. They don’t want to appear weak or helpless in the face of inflation, even though they themselves said it would be temporary. I, along with economists like Stieglitz and Saham, argued from the very beginning that this inflation is temporary and therefore there is no reason to increase the interest rate, and this diagnosis turned out to be correct. We explained that when the real problems that caused inflation were solved, inflation would go down, and so it did.”
Where does the central bankers’ sensitivity to the financial markets come from?
“Economist Gerald Epstein said that central bankers make decisions through the lens of the financial market. Central bankers often come with some background in the financial markets. They want to make sure that the markets are healthy, that the rentiers (people whose income comes from property) earn well. That’s why it’s very important to them what you think in the financial markets.”
Are you opposed to the central bank taking care of the health of the markets and the financial system?
“Absolutely not. I’m just pointing out the hypocrisy in saying that the central bank is independent. There are people like Stieglitz and others who argued that in order for the argument about the independence of central banks to be acceptable, they should also be independent from the markets.”
What were the real causes of inflation?
“The increase in the prices of oil, wheat and other commodities, an increase in transportation costs and bottlenecks. These things are related to Corona and the war in Ukraine. The other reason is profit inflation, in the context of which corporations took advantage of all the problems I talked about to expand their profit margins. When transportation and energy prices fell, inflation was curbed. “
These things happened at the same time as the interest rate increases. How do you know interest had no role in it?
“The interest rate hikes have nothing to do with this. According to the Federal Reserve, and also according to other sources, the interest rate takes about a year and a half to have an effect, but inflation began to decrease two to three months after the interest rate hikes. In other words, the timing is completely inconsistent. There is no basis for the claim that the monetary policy is the one that solved the inflation .”
“Monetary policy is ineffective in fighting inflation, but beneficial to the rich”
What are the disadvantages of the interest rate policy?
“Monetary policy has a huge meaning regarding inequality. When you raise interest rates, you actually transfer income from workers to rentiers – those whose income comes from property ownership. Workers pay more interest and property owners enjoy a higher interest rate (return), and we see it in the data. Since the crisis Financially, central banks have begun to admit that monetary policy affects inequality, and a consensus appears to have emerged regarding the issue.
“If you understand that monetary policy is not effective in fighting inflation but enriches the rich, a big question arises regarding it: what does this policy do and are there better ways to use it?”
What is optimal monetary policy in your opinion?
“First of all, it is important to note that central banks were not founded to fight inflation but for other reasons. One reason is to support government spending, for example to facilitate the financing of wars, by lowering the interest rate on bonds. The second reason is to improve and stabilize the payments system. In essence, the banks The central ones were created to stabilize the financial system and the idea that their job is to fight inflation came much later; I would say in the 1960s.
“Because there is no clear connection between interest and inflation, I see no logic in a system of inflation targets. The central banks should set a relatively low interest rate and keep it more or less constant. Thus, the central bank is free to ensure the stability of the financial system through supervision and safeguarding of the financial markets.
“The 2008 crisis, for example, broke out largely due to the lack of supervision, but in response to it the central banks poured huge amounts of money into the system and thus prevented a much bigger crisis from developing. This should be their role. Low interest rates also reduce the inequality in the distribution of income between a minority that owns a huge amount of assets to the majority of the public.”
And what about inflation and growth?
“Fiscal policy should be used to deal with issues of growth, inflation, unemployment, ecology and environment, inequality, gender inequality, etc. A low interest rate allows the government greater fiscal space because the cost of a deficit and public debt is low. This is what happened in the crisis Corona when interest rates were absolutely zero, maybe even too low.”
Do you propose to steer the economy through government policy?
“True, we need to lean less on monetary policy and much more on fiscal policy, as happened in the decades after World War II until the 1960s. Then growth was faster, unemployment and inflation were lower, and inequality was less acute. No It’s just that we call these years the ‘Golden Age of Capitalism’.”
But this period ended with an inflationary crisis.
“Yes, but inflation in the 1970s did not break out because of fiscal policy, but just like today, because of oil crises, in 1973 and 1979. Even then, inflation was temporary, in 1981 it had already begun to decrease in the US and Europe and in 1982 It was already quite low.”
Even if you accept the claim that monetary policy is ineffective, a central bank in a small economy like Israel, and also in larger but less advanced economies, depends on the interest rates on the important currencies, primarily the dollar. If the Federal Reserve raises the interest rate on the dollar and the Bank of Israel maintains a low interest rate, investors will transfer their capital to the US where the yield is higher. Can the central banks that are not at the top of the economic food chain maintain an independent interest rate policy?
“This is an important point. The fear is that in the case of interest rate differentials in favor of the dollar, for example, capital flight will lead to a weakening of the currency and this will lead to inflation (because it makes imports more expensive, G.R). This should be examined for each economy individually. Japan did not raise the interest rate accordingly The Federal Reserve has indeed weakened significantly against the dollar, but this has not led to inflation. In other countries, for example, this may happen. The return of controls on capital movements is a way to maintain monetary independence; the controls will moderate the reaction of capital to interest rates . East Asian countries have implemented controls on capital movements and it has worked wonderfully.”
Many in Israel as well as in other countries have lost faith in the political level in Israel and see the weakening and subjugation of the professional level, which includes the central bank, as a danger to the economy. Does this situation not justify the protection of the central bank?
“The idea of central bank independence puts the reins in the hands of monetary policy and limits the use of fiscal policy. One should not confuse the desire to limit the government as it is with opposition to a certain ideological government. I oppose Trump and think that his re-election would be very bad, but that does not mean that one should prevent from the government to take fiscal policy. Think of the policy that Biden led, which resulted in growth and low unemployment.”
You are part of an economic school that developed inspired by the theories of the British economist John Maynard Keynes. What did he think about the independence of the central bank?
“Keynes believed in the independence of the central bank, but only if it was intended to fight unemployment and not inflation. But I think that in the current context, it is impossible to separate the independence of the central bank from an approach of inflation first. As far as I understand, Keynes was talking about this in a completely different context. My argument is that if the interest rate policy does not work as the central banks claim, then there is no need for their independence.”
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2024-06-11 09:28:35