Central Banking and the Rule of Law.

• Author: Tucker, Paul

Should there be a truly "independent" monetary authority? A fourth branch of the constitutional structure coordinate with the legislature, the executive, and the judiciary?

--Milton Friedman (1964)

Institutions [can] do the work of rules, and monetary rules should be avoided; instead, institutions should be drafted to solve time-inconsistency problems.

--Lawrence H. Summers (1991)

Most discussions, and especially justifications, of central bank independence are expressed entirely in the language of economics. I wrote Unelected Power partly because I think that is not remotely sufficient for finding a proper place for these institutions in healthy constitutional democracies. (1) At a high level, this goes to a methodological feature of economics, which proceeds by identifying a social welfare problem of some kind and works out how a benign social planner would cure the problem efficiently. All government functions are in the hands of the benign social planner, subject only to whether delegation can help to overcome any problems in credibly committing to the socially optimal plan. (2) By contrast, the starting point for much political and constitutional theory is that the greatest threat to the people's well-being is the possibility of arbitrary or oppressive government by an all-powerful unitary sovereign. The values of the rule of law and of constitutionalism, including in particular the separation of powers, are directed at keeping those problems at bay. In summary, one discipline, economics, positing a benign sovereign, sets out to achieve a flourishing society in which well-being is maximized (by the lights of its particular social welfare function), while the other, political and constitutional theory, alert to the possibility of a malign sovereign, aims to avoid tyranny. This tension bears on central banking to the extent that its powers and mandate risk creating an overmighty citizen beyond the checks and balances inherent in a decent constitutional order.

This point has not been entirely lost on economists. As Chicago's Henry Simons put it in the 1930s: "[Delegation] to administrative authorities with substantial discretionary power ... must be invoked sparingly ... if democratic institutions are to be preserved; and it is utterly inappropriate in the money field" (Simons 1936: 2-3). As it happens, I am going to depart somewhat from Simons, for reasons that run fairly deep, but he certainly raised serious points about the framing and constraining of a polity's monetary power. This is about legitimacy.

The legitimacy of institutions matters greatly because it is what holds things together when, inevitably in any field, public policy occasionally fails badly. While performance matters hugely, because welfare matters, it would be foolhardy to rely solely on continuously satisfactory outturns underpinning legitimacy. To be accepted as legitimate, a government institution's design and operation (in their broadest senses) must comport with a political society's deepest political values. For constitutional democracies, those include the values of democracy, constitutionalism (including, importantly, the separation of powers), and of the rule of law. Although this article will focus on the third of those, I will consider constitutionalism and democracy as well. (3)

The Power of Central Banks

Today's central banks are quite extraordinarily powerful. First, the power to create money is always latently a power of taxation, capable of redistributing resources across society and between generations through a burst of surprise inflation (or deflation). Second, as an economy's lender of last resort, they can potentially pick winners and losers. Third, through their choice of collateral, counterparties, and other things for their various financial operations, they can affect the allocation of credit in the economy. Fourth, acting as banking-system supervisors, they, like their regulatory peers in other fields, are effectively delegated lawmakers. With such powers, why should they be formally insulated from quotidian politics?

Constitutionalist Monetary Authority

A major step toward our modern system of constitutional governance was the insistence, in England hundreds of years ago, that a representative assembly formally approve a monarch's wish to levy extra taxes. That separation of powers would be undermined if, in today's democracies, the elected executive branch could use a power to print money as a substitute for legislated taxation. If the president, prime minister, or chancellor controlled the money-creation power, the executive would at the very least be able to defer any need to go to the legislature for extra supply, and at worst could inflate away the real burden of government debts to reduce the amount of taxation requiring congressional (or parliamentary) sanction. In other words, it could usurp the legislature's prerogatives. The conclusion is stark: the last people who should hold the monetary power are the elected executive.

We can think of the old gold standard as an earlier era's response to this problem; broadly, sterling went off (and later back onto) gold, during the 19th century's wars and financial crises, only with parliamentary approval. But that kind of regime is not viable under full-franchise democracy given the volatility entailed for jobs and economic activity. With commodity standards sidelined, today's solution has been to delegate the management of the currency's value to an agency designed to be immune from the imperatives and temptations of short-term popularity, but acting under and within a mandate framed by the assembly, and which can be rescinded or recast by the assembly. (4)

Seen thus, delegation to an independent monetary authority is a means to underpinning the separation of powers once fiat money has been adopted. The regime is derivative or a corollary of the higherlevel constitutional structure and the values behind it. Pace Milton Friedman, this is not a new fourth branch, but an institution that exists at the assembly's pleasure, shielded from day-to-day politics, precisely to uphold a constitutional system of government (see Tucker 2018a: chap. 12).

Preconditions for Delegation-with-Insulation to Work Functionally

This leaves hanging in the air the (positive) conditions necessary for such delegati on--with-imulation to work as intended. It is commonplace to say that a monetary institution should mimic a rule or, as Larry Summers (1991) put it, do the work of rules in overcoming time-inconsistency problems. There is something missing in each formulation. The gap in the literature inspired by Kydland and Prescott (1977) is an explanation for why anybody could be relied upon to stick to a rule: that is just assumed, and so wishes away the big problem. The alternative "institution to do the work of rules" formulation, which of course dominates within the central banking community itself, largely on the grounds that we do not know how to write down a complete state-contingent rule for the monetary instrument, similarly leaves invisible the mechanism via which the "institution" is incentivised to deliver the goods.

When combined with an ancient tradition within political theory, I believe the answer is implicit in the work on delegation by Alesina and Tabellini (2007). If the unelected technocrat derives public and professional (peer group) esteem from faithfully delivering a legislated mandate, and if appointees care about that esteem more than about short-term popularity or their next job or delivering their own view of the public good, they are more likely to stick to the...