Testing the RBA’s DNA

Published in Business Spectator (Melbourne), 5 January 2012

With the relentless stream of bad news somewhat easing over the holiday break, it’s a good time to study lessons for Australia emanating from Europe’s troubles.

Much has already been written about obvious issues, such as the size of the state and the reliance on deficits to finance it. Instead of repeating them, I would like to make some observations regarding the cultural aspects of central banks that can be applied to Australia’s Reserve Bank.

Both the Bank of England and the German Bundesbank enjoy formal independence, but this independence looks and feels very different in practice. One can be free of all vices without having a single virtue. In the same way, central banks can be formally independent without adding to economic and financial stability.

The issue is not only the way in which politicians and the public treat a central bank but also how the bank conducts itself. Does it regard itself as part of the economic governance of a country? Or does it take the role of an umpire whose main role is ensuring price stability?

Two news items from recent days illustrate the difference between the British and German central banking cultures. First, a new report released by London-based think tank Policy Exchange criticised the Bank of England’s newly established macro-prudential Financial Policy Committee for its perceived lack of independence. In particular, the report objected to a Treasury official having a seat on the FPC and only a minority of external appointments. Both make the FPC look unduly political.

Second, German newsmagazine Der Spiegel featured a long interview with Bundesbank board member Andreas Dombret. What he had to say about monetary policy was traditional Bundesbank orthodoxy: A sound ‘nein’ to credit easing, a rejection of an ECB bazooka, and demands to European governments to further consolidate their budgets. So no surprises there – except that Dombret was born in the United States and holds both German and US citizenships. He also worked for JP Morgan and Bank of America for many years and only joined the Bundesbank in May 2010. However, the interview demonstrates how quickly one can become acculturised within the Bundesbank.

Perhaps an even better example of how the culture of a central bank shapes those working within it is Dombret’s boss, Bundesbank President Jens Weidmann. When his predecessor, Axel Weber, resigned last year in protest against the ECB’s bond buying activities, Weidmann appeared to be an odd choice to head the ferociously independent Bundesbank. That was because Weidmann came straight out of the chancellery, where he had worked closely with Angela Merkel as her chief economic advisor.

Given this background, many observers feared the Bundesbank would turn into a de facto government department. However, Weidmann’s first few months in office have proven that the institution of the Bundesbank is stronger than his personal affiliations with the chancellor.

Just like his predecessors, Weidmann became a public advocate of orthodox monetary policy and did not hesitate to criticise the government for a lack of fiscal discipline. Under his leadership, the Bundesbank continues to publish critical assessments of the European Union’s management of the financial crisis. In many ways, the Bundesbank has taken over the role of the political opposition. Merkel and her government certainly have to fear the Bundesbank much more than the hapless parliamentary opposition.

There is no doubt the Bundesbank is much further removed from the political process than the Bank of England. Ever since its foundation in 1949, independence from political machinations has always been at the core of the Bundesbank – a government official sitting on any Bundesbank committee is unthinkable.

Over the decades, the bank has continued to defend itself against even the slightest and most indirect political interferences. As Dutch central banker Wim Duisenberg once said, the Bundesbank is “like cream; the more you whip it the harder it gets.” This solidified the bank’s almost mythical reputation as an institution outside the political sphere, an institution to which inflation-wary Germans happily trusted their money. Former European Commission President Jacques Delors famously remarked, “Not all Germans believe in God, but they all believe in the Bundesbank.”

In contrast, such independence is relatively new to the Bank of England: Chancellor Gordon Brown only awarded it in 1997. But for such independence to work, it needs time to sink into the collective subconscious. As long as politicians comment on the bank’s every decision, as long as they publicly demand support for their own policies, and as long as they keep reminding the bank of its (supposed) objectives, independence may not be worth the paper it is written on.

Though Mervyn King, the Bank of England governor, occasionally comments on economic policy issues in a critical but usually conciliatory tone, it is unthinkable for the bank to be as forthright against the government as the Bundesbank. Maybe it is also a matter of proximity: central bankers are part of the political establishment in London, whereas the Bundesbank in Frankfurt is quite distant from the political action in Berlin.

These reflections on the difference between token independence and the intrinsic independence within a bank’s DNA are worth considering in Australia.

The Reserve Bank of Australia sits somewhere in between the Bank of England and the Bundesbank. Unlike the Bundesbank, the RBA had always included economic goals along with monetary stability in its mandate. But unlike the Bank of England, the RBA has also established itself as a more independent institution, probably aided by not being based in Canberra but predominantly in Sydney. This independence was confirmed, for example, by the interest rate hike during the 2007 election campaign.

The real test of the RBA’s independence is yet to come. Only in times of sharp economic downturns can one see the actual worth and metier of a central bank. For this reason, Canberra should consider strengthening the RBA’s political independence by withdrawing the Secretary to the Treasury from its board and removing the appointments process from the Treasurer.

As a practical first step towards more RBA independence, perhaps politicians of all parties could refrain from both applauding and criticising RBA decisions. It is none of their business.