National Post
Tuesday, September 19, 2000


The vote standard
Something as crucial as Bank of Canada policy should be subject to direct democratic control. Elect the Governor, argues Andrew Coyne

Some time in the next few weeks, the government will appoint a new Governor of the Bank of Canada. The decision is supposed to be made on the recommendation of the Bank's board of directors; at the same time, they are not likely to recommend anyone not to the government's liking.

This saw-off is in keeping with the Bank's ambiguous, quasi-independent role. Yet of late the Bank's independence seems more quasi- than ever. Not only is it under pressure from the Finance department to allow faster economic growth than the present Governor thinks wise, but the former deputy minister of Finance is reputed to be a leading candidate to replace him. The erosion of the Bank's autonomy that began with the forced departure of John Crow is in peril of becoming a wholesale takeover by Finance.

Once again, the age-old debates over central-bank independence resurface. It is a battle that never seems to be resolved. The roundheads in this conflict, invoking democratic principle, insist central banks must be accountable to some elected authority. The royalists defend the divine right of central banks to set policy independently. Monetary policy, on this view, would inevitably lean to inflation if left to the vagaries of democratic politics. A politicized central bank would find it harder to take unpopular but necessary steps to maintain price stability.

Royalists argue an independent central bank is still accountable, in the end. Central bankers are, after all, appointed by elected officials. Still, this ought to give democrats some pause. The analogy is frequently drawn with the Supreme Court, which is also "unaccountable." But that's because the Court must often protect minorities from the tyranny of the majority. The implication here is rather that the majority must be protected from itself.

Must we choose between democracy and stable prices? Isn't there some middle ground here? Yes there is: Elect the Governor.

The whole issue of whether the Bank should be "independent" or "accountable" stems from a failure to define our terms: Accountable to whom? Independent of what? Let's not blame the people for the sins of their leaders. It isn't democracy that monetary policy must be protected from, but government. It's perfectly legitimate that something as critical in its effects on the economy as monetary policy should be subject to democratic control. But it should be direct control.

The case for keeping the money supply out of government hands is grounded not in aristocratic distrust of democracy, but in the classical liberal ideal of separation of powers -- in this case, fiscal and monetary. The historic reason for this was to prevent the government from welching on its debts by debasing the currency in which they are to be repaid. To deny government this power is in keeping with our oldest democratic traditions: Inflation is a tax that can be levied without consent, even without warning.

Or at least, it could. In theory, the Bank can do this by engineering a larger amount of inflation than bond markets anticipate -- as it did for a time in the 1970s, when real interest rates actually fell below zero. To fool the markets again, however, would take some doing: These days, bond prices drop like mine canaries at the first whiff of inflation. And of course, to achieve any lasting reduction in real rates, the Bank would have to go on fooling them, over and over and over again.

This may seem to indicate inflation is no longer a threat. The simultaneous judgment of millions of investors around the world imposes a ruthless discipline on national monetary policies. But just because a thing is impossible doesn't mean governments won't try it. And so long as there is any doubt about the authorities' intentions, the potential for damaging missteps remains. In a world of "rational expectations," the case for central bank independence is stronger than ever. This bears some explanation.

Bond markets are not the only ones who make bets on inflation. Monetary policy engages the whole of society in an intricate exchange of expectations. The public scrutinizes the authorities, trying to guess future policy moves; the authorities in turn try to factor the public's response to policy changes into their own economic projections. If economic agents expects higher inflation, they will ask for higher prices, wages, and interest rates to keep pace. If policy instead tightens, and inflation falls, it will catch the public offside. Lower inflation plus higher nominal wages and interest rates means real wages and interest rates jump. Result: higher unemployment, and recession.

So if governments wish to reduce inflation without recession, it's vital that people understand the policy they intend to pursue. Just as important, they must believe the announced policy will really be carried out. This is the central paradox of monetary policy. The greater the public's conviction that the authorities are determined to tighten policy, no matter what the costs, the less those costs are likely to be: Inflation expectations would adjust to keep wages and prices in line.

On the other hand, if the public knows, or suspects, that the monetary authorities will do anything to stave off a recession, they will be encouraged to behave in ways that invite one. Wages and prices would spiral, on the calculation that, whatever it might say to the contrary, the Bank would always stand ready to pump up demand enough to accommodate them. Expectations of ease would in this way prove self-fulfilling: until at last, with inflation spinning out of control, the Bank was forced to disappoint them.

It's important, then, not to let the Bank's credibility become an issue in the first place. Why would an independent Bank be more credible than one more directly accountable to government? Because, royalists have always answered, it bears no responsibility for the fiscal consequences. It would not then be tempted to use the printing press to escape its debts. But this is only another way of saying that it is not democratically accountable. Which in the end is not, well, credible.

It's all very well just to pass a law stating that the central bank is autonomous. But if true, this is undemocratic, and if false, it is worthless. In practice, the latter has more often been the case: Central banks have proven not to be so independent as all that, easing policy in election years and tightening afterward. It could not be otherwise. No central bank, however independent it may be on paper, has the legitimacy to defy a democratically elected government determined to get its way. The issue, then, is not whether the central bank should be "independent" or "accountable": If it's not accountable, it won't be independent.

The same applies to all those other means proposed from time to time to tie central banks to the straight and narrow: steady-growth rules, gold standards, fixed exchange rates, even privately issued currencies. All of them, without exception, beg the question of political will: Any government that could summon the nerve to put itself on the gold standard, much less privatize the mint, would have no trouble running a stable monetary policy.

Political will derives from popular will. The express preference of the people for stable prices is ultimately the sole assurance of the authorities' resolve. For that matter, inflation is not only a matter of meddling by wastrel politicians: Historically, it has often been unclear whether the central bank itself is wholly devoted to stable prices. Central bank independence is therefore a necessary but not sufficient condition for honest money. A clear, unambiguous mandate for stable prices would be as instructive to the Bank as to the government.

The solution follows. Put monetary policy, not on the gold standard, but the vote standard. Elect the Governor.

I hear the skeptics. Would the people vote for honest money? Or would they be swayed by a sweet-talking soft-money salesman? Maybe they would -- once. But the best advertising in the world won't sell a bad product a second time. Monetary policy is undoubtedly a complex issue. But if you want voters to make responsible choices, you have to give them responsibility. They'll educate themselves soon enough.

A democratic Bank would have to talk openly with the public, making less likely any miscalculation as to its intentions. And the public could in turn speak more clearly. Inflation does not usually become an election issue until it is already out of hand. In an election strictly on monetary policy, the public's preferences would be known from the start.

Moreover, this conversation would be eavesdropped by a third party: capital markets. If a candidate promising loose money were leading in the polls, interest rates would rise sharply; if the tight money candidate then pulled ahead, they would immediately ease. The lesson, that the way to lower interest rates is through low inflation, could not be brought home more forcefully.

Perhaps people would still vote for the loose money candidate, notwithstanding the markets' alarm. But I doubt it. The evidence is that inflation, like protectionism, is not the vote-getter it is imagined to be. That's why, when inflation began to climb exponentially in the late 1970s and early 1980s, the public in country after country turned to politicians with the will to control it. The process was painful. But the same leaders were re-elected time and again.

It comes down to this: Either people want honest money, or they don't. If they do, they haven't had much of it, and they won't until they have the means to tell both governments and central bankers that that's what they want. If they don't, if what they really want is inflation, let them have it. That, after all, is democracy.

Andrew Coyne is national affairs columnist for the National Post.