''Despite the fact that, fundamentally, there can be no such thing as independence for the central bank, the institutional arrangements and characteristics now commonly grouped together under the “independence” label can be helpful in delivering better monetary and budgetary policies.''
''But misinterpretation of independence for central banks can lead to policy conflict and poorly designed and executed monetary and fiscal policies.''
These are among the conclusions of Professor Willem Buiter, writing in the Economic Journal. Throughout the article, which considers some recent developments in monetary theory and monetary policy, Buiter emphasises the nature of monetary policy as one component, small but not unimportant, in the fiscal-financial-monetary programme of the state – the sovereign. He describes a fallacy, a mirage, two ghosts, two eccentrics and a mythos.
The fallacy is the so-called fiscal theory of the price level (FTPL), a theory of the link between the government budget and the general price level that became popular in the 1990s. Its basic flaw was a confusion between budget constraints and equilibrium conditions. This resulted in ill-posed monetary general equilibrium models. Its central proposition was that it was possible to determine the equilibrium general price level sequence from the government''s intertemporal budget constraint (and, in the simplest case, from the government''s intertemporal budget constraint alone).
Until its recent demise, following the demonstration of its fatal analytical/logical flaws, it created widespread confusion about the important links that do exist, in well-posed dynamic monetary general equilibrium models, between the government''s fiscal-financial-monetary programme and the general price level. As remnants of the FTPL still linger, Buiter seeks to drive a commemorative stake through its heart.
The mirage is the vision of the future of government fiat money and monetary policy which holds that the combination of financial deregulation and technical change in the payments and settlements technologies (e-money, etc.), will cause monetary policy to lose its capacity to influence nominal, let alone real economic variables.
Buiter argues that this view fails to understand the unique capacity of the state (through its unique capacity to tax and to endow some of its liabilities with legal tender status) to provide liquidity when, because of systemic risk and certainty, the private provision of liquidity dries up.
The two ghosts are the venerable liquidity trap and the Pigou effect (or real balance effect). Both have resurfaced as issues to be studied by monetary theorists and macro statisticians, and as policy concerns of central bankers facing a deflationary environment and the reality or threat of the zero lower bound constraint on nominal interest rates.
The two eccentricities are the implementation of negative nominal interest rates and the theoretical rationale and practical modalities of performing a helicopter drop of irredeemable or inconvertible base money. These two unconventional policies can stimulate consumer demand even when Svensson''s ''foolproof'' methods fail, that is, when nominal interest rates, short and long, present and future, are all at their zero lower bound.
Finally, the mythos refers to the theoretical rationale for and institutional implementation of independent central banks. Buiter argues that all senses of the word ''mythos'' are applicable to central bank independence. These range from the negative (a fictitious story, person or thing; a fiction or half-truth, especially one that forms part of an ideology) through the neutral (a popular belief or story that has become associated with a person, institution, or occurrence, especially one considered to illustrate a cultural ideal) to the positive (the pattern of basic values and attitudes of a people, characteristically transmitted through myths and the arts). Buiter concludes that despite the fact that, fundamentally, there can be no such thing as (instrument- or target-) independence for the central bank, the institutional arrangements and characteristics now commonly grouped together under the `independence'' label can be helpful in delivering better monetary and budgetary policies. Misinterpretation of independence for central banks can lead to policy conflict and poorly designed and executed monetary and fiscal policies.
''New Developments in Monetary Economics: Two Ghosts, Two Eccentricities, a Fallacy, a Mirage and a Mythos'' by Willem Buiter is published in the March 2005 Economic Journal. Buiter is Chief Economist and Special Counsellor to the President at the European Bank for Reconstruction and Development