Money and Politics

Carmen Reinhart on Why the Central Bankers Will Eventually Be Tempted to Inflate

As the government debt gets higher, it's harder for the central bank to raise interest rates

Carmen Reinhart has a very good, very sobering interview with Spiegel about government debt and central bank independence:

No central bank will admit it is keeping rates low to help governments out of their debt crises. But in fact they are bending over backwards to help governments to finance their deficits. This is nothing new in history. After World War II, there was a long phase in which central banks were subservient to governments. It has only been since the 1970s that they have become politically more independent. The pendulum seems to be swinging back as a result of the financial crisis.

She adds:

But it is certainly more difficult for a central banker to raise interest rates with a debt to gross domestic product ratio of over 100 percent than it is when this ratio stands at 39 percent. Therefore, I believe the shift towards less independence of monetary policy is not just a temporary change.

The disasters of the 1930s pushed central banks towards an inflationary bias. The disasters of the 1970s revealed the follies of that, and for forty years, we've trended towards central bankers who operate independently of their governments. To a first approximation, modern politicians would always prefer inflation now, austerity later; the inflation gives a boost to the economy, and some other politician has to live with the aftermath.

The solution to that was for central bankers to loudly proclaim that they didn't care what the politicians who appointed them wanted--and prove it, by costing a few of them an election. (Jimmy Carter was arguably one of these.) As a result, we had a nice long period of low inflation, during which most of us forgot what it was like when prices went up by 10% or so every year.

Reinhart is arguing that this period is probably over. One way or another, all the debt we've taken on has to be dealt with. And the least painful way, at least in the short term, is for central bankers to keep their hands on the interest rate levers--and their eyes on the government debt.