Central Bank Independence Faces Another Test

“Central bank independence throughout the world has replaced gold and silver as the guardian of the currency.”  That sentence, towards the end of William Silber’s new book on the downstream consequences of the Silver Purchase Act of 1934, made me pause.  I hadn’t seen it put quite so clearly before. It is true, I think, but what it means may not yet be widely understood .

I was reading The Story of Silver: How the White Metal Shaped America and the Modern World (Princeton, 2019) because the aftermath of 2008 convinced me that present-day macroeconomics is seriously out of focus.  Silber, a many-sided professor at New York University’s Stern School of Business, is a gifted story-teller. His book on the crisis that accompanied the outbreak of World War – When Washington Shut down Wall Street: The Great Financial Crisis of 1914 and the Origins of America’s Monetary Supremacyilluminated a critical turning point in America’s financial history.

The new book shows how the US Silver Purchase Act of 1934 led to American purchases that knocked China off its silver standard in 1935 and destabilize the rest of Asia, preparing the way for the Pacific half of World War II and adding an accelerant to the Communist Revolution in China that culminated in 1949. Nevada Sen. Key Pittman was chairman of the Foreign Relations Committee and leader of the Senate’s “Silver Bloc.”  Touted as recompense of “the Crime of ’73” (when the silver dollar was omitted from the Coinage Act), the ’34 Purchase Act was the price that Roosevelt paid for Pittman’s support of New Deal legislation. The latter-day speculations of Nelson Bunker Hunt and Warren Buffett are thrown into the book for good measure.

Silber naturally ends with the election of Donald Trump.  He warns that the president’s “America first” policy may cause similar unexpected damage many years from now. It’s entirely possible.  But I’m more interested in the recent controversy about Trump’s proposal to nominate two close allies as governors of the Federal Reserve Board .  That simple sentence that piqued my interest implied a hundred-year saga in which the lead actors are former Fed chairs Arthur Burn, Paul Volcker, Alan Greenspan, Ben Bernanke, and Janet Yellen; and Trump is so far just another bit player.

The pure paper money we have today, backed by fiat instead of any link to precious metal, emerged after August 1971, when President Nixon suspended the right of other central banks to convert dollars to gold under the Bretton Woods System.  The best account I know of how it happened is The Imbalances of the Bretton Woods System 1965-1973: The Elephant in the Room. by Michael Bordo, of Rutgers University.

The reason commonly given for Nixon’s actions was the conviction that exploding US balance of payments deficits, along with growing current account surpluses in Germany and the rest of Europe, and Japan, were harmful to the US competitive position and the general prosperity of the United States.  Nixon’s “New Economic Policy” had three principal struts: closing the gold window, to protect US reserves; a ten percent surcharge on all imports to force trading partners to revalue their currencies; and a ninety-day freeze on wages and prices to contain the US inflation rate.

In fact, writes Bordo, the real reason for the growing imbalances was the steadily rising US inflation rate since 1965, driven by expansionary monetary and fiscal policy, the guns and butter financing to the Vietnam War and various Great Society initiatives. For political and doctrinal reasons, he says, this misalignment was not addressed.

Instead, a 1968 tax surcharge was not extended and Nixon pressured Fed chairman Burns and his Federal Open Market Committee to ease monetary policy, fearing that permitting the 1970 recession to lengthen into 1971 and damage the chances of his own re-election in 1972. Burns accommodated the president’s demands; the wage-price freeze pushed the resulting inflation into the future. Nixon blamed other nations for problems of America’s ownmaking, and, by 1973, the Bretton Woods system had collapsed.

One virtue of Bordo’s account is that it is based partly on conversations with George Shultz, who was a crucial player in the events of 1969-1973, as well as other narratives the period. Shultz served as Secretary of Labor and Secretary of the Treasury in those years, and founded the Office of Management and Budget in between.  The relevance of “The Elephant in the Room,” which he wrote last year, was to certain similarities between the imbalances then and those that have developed since the financial crisis of 2008 – specifically a debt-to-GNP ratio that had risen to historically high levels.  Worries about the likelihood of a sovereign-debt crisis have diminished somewhat since then.  But Bordo’s account also make a strong case for the virtues of an independent central bank.

For as Silber points out, the post-Bretton Woods experiment with fiat money almost failed. It was only after Fed chairman Paul Volcker, appointed by President Jimmy Carter and supported by President Ronald Reagan, led a decisive campaign against inflationary expectations that the credibility of the monetary system was restored.

The analytic literature on the nature of central bank independence has blossomed since then. See, for instance, Macroeconomic Policy, Credibility, and Politics, by Torsten Persson, of the Institute for International Economic Studies, Stockholm, and Guido Tabellini, of the University of California at Los Angeles The old saw, attributed to William McChesney Martin, Fed chairman from 1951 until 1970, to the effect that the job of the central bank is to “take away the punch bowl just as the party is getting good,” has since the 1980s acquired a new pertinence.

This better understood role of central banks around the world is receiving renewed attention. President Trump, having previously nominated the widely-respected investment banker Jerome Powell to a four-year term as chairman of the seven-member Board of Governors of the Federal Reserve System, recently reversed course. He bruited his intention to nominate as governors two political allies who are equally widely viewed – at least by students of the Fed – as unqualified for the position.

The candidacy of Herman Cain, a Midwestern pizza chain entrepreneur and former Republican Party presidential hopeful, seems already to have been turned aside. Stephen Moore, a founder of the Club for Growth and one-time member of the Editorial Board of The Wall Street Journal, has yet to be nominated pending reports of unpaid taxes and alimony claims. His confirmation prospects may be better than those of Cain thanks to long years as a proponent of tax cuts.

Moore by himself as a governor would make little difference in the deliberations of the Fed’s twelve-member policy-setting Federal Open Market Committee.  But if Mr. Trump were elected to a second term with a still-complaisant Senate, he might seek to replace Chairman Powell with a more conventionally loyal ally.  As president, Mr. Trump has violated a lot of norms. Perhaps none is more important than his attacks on the central bank’s independence.

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