Central banks are curious and wonderful beasts. I love studying them. And not just because it is a necessary duty in my day job of managing short-term portfolios. Central banks are the sinew of modern day societies founded on the dual, but competing , foundations of democracy and capitalism. Indeed, central banks are often viewed as a de facto fourth branch of government, notably here in the United States, with only slightly less power than the executive, legislative, and judicial branches. And as a practical matter, that view is not too far from the truth, even though it is categorically not the truth in a constitutional sense in the United States: Congress, and only Congress, has the constitutionally-granted power "to coin Money [and] regulate the Value thereof." Congress also has the constitutional power "to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States." Thus, as a constitutional matter, both monetary and fiscal policy are the responsibility of the legislative branch, which is co-equal with the executive and judicial branches. It's a very cool arrangement; America's founding fathers were really, really bright dudes who created an enduring framework for democratic capitalism:


  • Government by the people, founded on the principle of one person, one vote.
  • Commerce in the markets, founded on the principle of one dollar, one vote.

Property rights are the nexus between the competing foundations of democracy and capitalism: we the people, as both citizens and economic agents, agreeing to adjudicate disputes over who owns what by the "rule of law." We the people, of course, can and do change our laws continuously, through the political processes of democracy. Thus, the sanctity of the "rule of law" is not founded on a particular set of laws, but rather on our collective decision to live by whatever laws that we democratically embrace.

It's All About Property Rights
Under the umbrella of democratic capitalism, there can be no immutable line of demarcation between private and public property, but only an evolving zone, with its boundaries defined by the evolving will of we the people. This is nowhere more clear than in fiscal policy: the power of the public sector, granted by the outcome of the democratic process, to transfer private property from one segment of the electorate to others. Fiscal policy is not, to be sure, usually described in such a fashion, but that is its essence: the power to tax is nothing more than the power of government to lay claim to private sector property rights.

Most of us grasped this concept as youngsters the very first time we worked in the above-ground economy: the difference between your gross paycheck and your net paycheck! Mowing Ms. Jones' lawn for $2 an hour in cash was a $2 property right; flipping Ms. Jones' burger at McDonald's for $2 an hour was not a $2 property right. The government had a minority property right in that $2, we found, and it thoroughly annoyed us: just what the heck were these things called FICA taxes!?! It was our duty to pay them, we were told, so that Grandma could receive a Social Security check every month, which was a good thing (particularly since she put a $5 bill in your birthday card every year!).

Yes, the power of government to tax and spend, granted by we the people, is a part of democratic capitalism. Civilized societies must be founded on a mix of individual property rights and collective property rights. Civilized societies must also be smart enough to recognize the inherent conflicts between democracy and capitalism, and to put in place checks and balances to prevent arbitrary and capricious abuses by either the will of the people or the will of the markets.

The Printing Press is a Property Right
Which brings us to the matter of monetary policy (finally, you say!). The Constitution explicitly grants Congress the power to "coin Money [and] regulate the Value thereof." And that is an awesome property right: the power to declare what is, and isn't, "legal tender" and monopoly ownership of the presses to print whatever government declares to be "legal tender" (yes, counterfeiting is illegal!). To me, this monetary power is far greater than the fiscal power to explicitly "tax and spend," because the fiat power to print money determines the real value - claims on real resources! - represented by nominal taxes laid and nominal expenditures made by Congress.

Indeed, until the 16th Amendment was ratified in 1913, explicitly granting Congress the power to impose an income tax, 1 there was no fiscal "policy" as we know it today. Instead, monetary policy was the economic battle ground for the democratic political process, defining how we the people defined the gray zone between our individual property rights and our collective property rights. Monetary policy was openly understood as a political debate, with the outcome determining the relative property rights of creditors and borrowers. Creditors want to be paid in hard money, of course, preserving if not increasing the real value of monies owed to them; debtors naturally want soft money, diluting the volume of real resources they need to surrender to honor their nominal debts. And there was a time when the political process in America openly addressed this question, with presidential elections serving as the preeminent forum for the democratic determination of whether it was better to be a creditor or a debtor.

President Andrew Jackson's 1832 veto of legislation to keep alive the National Bank of the United States, an ersatz central bank run by the "monied" classes, was a defining political (populist) event for the next forty years. In turn, President Hayes' decision in 1879 to retire the fiat-backed "greenbacks" issued during the Civil War with gold-backed money was a defining political event in the opposite direction for the next forty years. And that secular reversal to "hard" money was tested three times in presidential elections, with the silver-tongued populist Williams Jennings Bryan losing in 1896, 1900, and 1908. In the 19th century all three branches of the government, and the electorate, took very seriously the power of monetary policy to define and shape property rights, the nexus between the private and public sectors.

With the ascendancy of fiscal policy in the 20th century, undergirded by the 16th Amendment, monetary policy increasingly came to be viewed as too important to be left to the political process. Or perhaps more precisely, too dangerous to be left to the democratically-elected politicians, who must toil in a market place where one person gets one vote. For, you see, democracy is inherently inflationary: getting elected and getting re-elected incites politicians to promise more things to more people than the economy can be rationally expected to produce. Put differently, political campaigns are a democratic debate about how to distribute a bigger pie than the capitalist oven can be rationally expected to bake. Thus, popularly-elected politicians naturally (not cravenly!) are tempted to use the printing press to "cover" the gap between politically-inspired promises (to spend more, or to tax less) with printing press money.

That's not necessarily a bad thing. A positive inflation rate, with surprises on the upside, not the downside, is inherently consistent with both capitalism and democracy: a tilt toward entrepreneurs and borrowers, who are often one and the same, and who are inherently more forward-looking, innovative and risk-seeking than creditors. But, as with so many other things in life, too much of a good thing is a bad thing, and inflation becomes a bad thing when it redistributes property rights in a capricious fashion, offending democratic sensibilities and overwhelming the ability of markets to allocate resources efficiently (via the signaling of relative, rather than absolute, price changes).

Protecting Democracy From Its Inflationary Self
Out of this concern about the inflationary bias of democracy was born the idea of operationally-independent central banks: politically legitimized by laws passed by a democratically-elected legislature, but once so established, accorded the operational freedom to conduct monetary policy in a professional, non-political way. Not a fourth branch of government, to be sure: still an agency clearly subordinated to the constitutional powers granted to Congress, and subject to Congress changing its collective democratic mind. But as a practical matter, the notion of central bank "independence" is to remove the central bank from the real-time heat of the democratic political process, as a check against democracy's inherent inflationary bias.

This notion is well established in the United States, with the Federal Reserve operating as an "independent" central bank since the Accord of 1951 with the Treasury, which ended the Fed's singular World War II duty to be a buyer of last resort (some would say first resort!) of the fiscal authority's issuance of debt at capped interest rates. Ever since, the Fed has operated as a de facto fourth branch of government, with its duties last addressed legislatively in the Full Employment and Balanced Growth Act of 1978 (the Humphrey-Hawkins Act), which directed the Fed " to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

The Humphrey-Hawkins Act was passed during a period of "stagflation": high unemployment and high inflation at the same time. And monetary policy in real time has the opposite effect on those maladies: hard money exacerbates unemployment while tempering inflation, while soft money does the opposite. Thus, faced with both maladies at the same time, the Fed had to choose which was the greater evil. And the Fed did, decisively, under Paul Volcker who assumed the Fed chairmanship in August 1979: inflation control would be the preeminent goal.

And so it has been ever since, with central bank independence surfing an ever higher wave of intellectual/academic consensus that there is no long-term trade-off between unemployment and inflation, only a short-term trade-off (to wit, there is no secular Phillips Curve, only a cyclical Phillips Curve). Indeed, the case for central bank independence has "matured" in many circles into a belief that the Fed should be held politically responsible and accountable only for the one thing it putatively has the power to control in the long run: the inflation rate. Congress hasn't taken the bait, and the Fed's mandate under the Humphrey-Hawkins Act of 1978 remains in place. Legislation has been repeatedly floated, however, to make inflation control the Fed's sole legislated goal, most notably by North Carolina's Stephen Neal (now retired) and Florida's Connie Mack, with current Fed Chairman Greenspan musing wistfully in support.

Central Bank Independence Goes Global
Indeed, by the 1990s, central bank independence became the global holy grail of the macroeconomic intelligentsia, the stairway to heavenly policy "credibility" and presumably, economic stability. Some decisions are just too important to be left to the democratic whims of the people, it was argued, and monetary policy was deemed one of them. But without saying so explicitly, of course, so as to avoid offending democratic sensibilities. Out of this milieu was born the concept of "flexible inflation targeting" - implicit here in the United States and in Japan, and explicit in Europe and increasingly, much of the emerging-country universe. At the concept level, a democratically-elected legislative body should pick the inflation target, not the central bank. To wit, the choice of an inflation target should be a political act, not a bureaucratic act.

As a practical matter, however, this "pure" form of inflation targeting has not been employed in the G-3 block, only in smaller countries (both developed and developing). In the G-3, central bankers have chosen their own inflation targets, both explicit and implicit, and have also chosen whether or not to reveal them. Indeed, current Fed Chairman Greenspan resolutely resists efforts - even by his own Fed colleagues! - to "institutionalize" the Fed's implicit inflation-targeting regime by putting some hard numbers on the table. Like the Supreme Court's view on pornography, Mr. Greenspan asks Congress, and therefore we the people, to simply trust that he will know the target when he sees it.

In Japan, the Bank of Japan, having "achieved" its independence from the democratically-infested "political" Ministry of Finance only in 1998, has refused to commit to proactively seek a positive inflation rate, committing only to not tightening as long as the inflation rate is negative. To its credit, the European Central Bank does publicly declare its inflation target: 2% or less. But since the European Central Bank is the most politically independent developed-country central bank ever created, this is no surprise: no need to worry about offending democratic sensibilities when your very existence was birthed outside the one-person, one-vote democratic process!

Yep, central bank independence was the policy mantra of the 1990s, just as central bankers everywhere agreed that the global economy was "one recession away from secular price stability ." Politically-independent central banks became the cat's meow, and all central banks wanted to be cats, even as they agreed they were one recession away from a room full of deflationary rocking chairs. And, now they are in that room. The global economy has had - is still having?!? - that last "necessary" disinflationary recession.

Protecting Capitalism From Its Deflationary Self
Inflation has been whipped, secularly and cyclically. There is no reason whatsoever for a continuing war against inflation. Quite to the contrary, there is every reason for central banks to start a preemptive war against deflation. No, deflation is not the baseline scenario, at least here in the United States or in Europe. Deflation is , however, the risk case that policy makers should fight, even if the probability of it occurring is low. As the great Peter Bernstein teaches and preaches, it is not just the probability of an outcome that matters, but a concurrent consideration of the severity of its consequences that should be the foundation of prudent risk management.

I submit that the consequences of a deflationary spiral would be far more nefarious to democratic capitalism than a mild cyclical acceleration in inflation. Indeed, I believe that a mild cyclical increase in inflation is actually a necessary condition for the sustainability of democratic capitalism as we know it. Therefore, I believe the time has come to rethink just how independent central banks should be: rethinking by central bankers themselves, preferably; and if they refuse, by the democratic process.

This is nowhere more clear than in Japan right now, which faces the reality, not just the risk, of deflation. In the clutches of deflation, the only "good" credit is that of the sovereign, backed by a printing press. Put differently, fighting actual deflation requires socializing private sector debt. That is quintessentially a fiscal policy function, and the apparatus for doing so is deposit insurance: the sovereign's commitment to make bank deposits "money good" (trade at par!), when deflation is ravaging the nominal value of banks' assets.

We had our own experience with that exigency here in the United States over a decade ago, when we the people - after many years of denial by our democratically-elected representatives! - made good on the deposits of the Savings and Loan (S&L) industry, ravaged by post-bubble deflation in real estate prices. As a mechanical matter, Congress footed the bill, with the Treasury floating debt to pay the bill. The Federal Reserve kept its hands politically clean, staying away from direct monetization of S&L's "bad assets."

The Fed did, however, accommodate the whole exercise by slashing the Fed funds rate and holding it low for a long time, thereby "accommodating" increased Treasury issuance of debt while fostering a steep yield curve: a printing press platter (even better than Williams Jennings Bryan's wish for a silver platter!) for depository institutions to make money by running net long of duration risk, while they "cleaned up" their deflation-ravaged, credit risk-heavy balance sheets.

During that period, the Fed was de facto an agent of the fiscal authority, not a politically-independent bulwark against democracy's inflationary bias. And that was precisely what the Fed should have done. Some would argue, of course, that what the Fed should have done was to prevent the lax credit underwriting of S&Ls that was the proximate cause of the boom-bust in real estate prices at the heart of the S&L debacle. If the Fed had been the regulator of the S&L industry, I might agree with that. But the Fed wasn't the regulator for the S&L industry: that role was the providence of the Federal Home Loan Bank Board (America's equivalent of Japan's FSA?), a coddled creation of Congress. It was abolished in the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which "bailed out" the S&L industry. Nonetheless, when the deflationary stuff hit the S&L oscillator, it was the Fed's job to help unplug it. And the Fed did, unlike the Federal Reserve of the Great Depression.

Socializing bad, even fraudulent, private sector credit creation is a nasty exercise, wholly disagreeable to capitalistic sensibilities. Stopping capitalism's inherent boom-bust proclivities at a par price for bank deposits is, however, an even greater calling. It's a fiscal policy calling, and its companion must be a subordinated monetary policy that is explicitly reflationary. Such is the case in Japan at the moment. And most recently, the Bank of Japan seems ready to accept that it must explicitly behave as a subordinate of the fiscal policy authority, using the printing press owned by the democratic people of Japan on their anti-deflation behalf: the time has come for the Bank of Japan to monetize banks' deflated equity holdings.

Purists in the matter of central bank independence are, of course, having a jolly good time whining about how the Bank of Japan has lost its political virginity. To me, this is nonsense. When a central bank has failed to prevent and/or arrest deflation, it has lost any legitimate claim to its political independence. Put differently, fiscal policy must dominate monetary policy when monetary policy has failed, even if fiscal policy is similarly riddled with its own follies and failures. Deflation is the beast of burden that capitalism cannot bear alone, 2 and when deflation surfaces, it is democracy's job to take decidedly anticapitalist acts to save capitalism from its deflationary self. And the printing press is the right tool for the job.

The Fed (Sorta) Gets It; the ECB Does Not
Fortunately, neither the United States nor Euroland is anywhere near as close to the deflationary beast as Japan. But the beast will linger on the horizon, in my opinion, unless and until the Fed and the European Central Bank act to slay it. Accordingly, in order to preserve their political independence - a good and proper prophylactic against democracy's inflationary bias - both the Fed and the European Central Bank need to quit trying to prove their independence by thwarting fiscal policy authorities' natural - political! - instincts to (1) spend more than they tax, to (2) subsidize more than they penalize, and to (3) weave financial safety nets more than they rent them. All are inflationary tendencies of the fiscal authority, and all are appropriate when deflation, rather than accelerating inflation, is the dominant macroeconomic risk.

The Fed intuitively understands, I think, the deflationary limit to central bank independence, and is presently, and unashamedly, "accommodative." Alan Greenspan is the smartest political cat ever to reign over an ostensibly politically-independent central bank. He is committed to dodging the deflationary rocking chairs until August 2004, when his term expires (or is that matures?).

Could the Fed do more? Yes, in my view, notably in reducing the pro -cyclicality of its regulatory oversight of bank credit risk; 3 and further cuts in the Fed funds rate would be okay, too, even if likely to be a damp stimulative squib. More importantly, I think it would be extremely useful for Fed Chairman Greenspan to quit preaching at Congress about the need for fiscal discipline. 4 In the long run, fiscal discipline is a good thing, as a check against democracy's inflationary bias. If deflationary risks are allowed to grow roots, however, as in Japan, the long run is a very long run indeed, with the painful death of capitalism along the way.

But any quibble I may have with the Fed is truly a quibble relative to my disdain for the blatant deflationary bias of the European Central Bank, the most politically independent "major" central bank ever created. The Eurozone is a grand experiment in monetary union without political union and, therefore, there is limited scope for fiscal policy to lead monetary policy in a reflationary direction. Indeed, the so-called Stability Pact regarding limits to non-cyclically-adjusted fiscal deficits is an abomination against all known antideflation principles.

The Pact will, of course, prove to be non-binding in forcing pro-cyclical fiscal tightening, as the sovereign countries that adopted monetary union recognize that the Pact should not be a suicide pact. But the Pact's existence alongside the strident political independence of the European Central Bank are monstrous impediments to reflationary aggregate demand policies - yes, Keynesian, or even better, Minskyesque! - worthy of the name.

Conventional wisdom in European circles is that the European Central Bank can overtly take inflationary risks, circa the Fed, only after it has "earned credibility." To wit, that the European Central Bank could/can ease in the style of the Fed, only when it has "achieved" an inflation rate below its target. To me, this is utter poppycock. But as history teaches, and reality in Japan screams, nonsense is not necessarily a sufficient condition for forecasting a change in nonsensical policies. As Keynes intoned long ago, worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. The European Central Bank is wholly conventional. And, from a macroeconomic perspective, tearfully wrong.

Bottom Line
Democratic capitalism is a beautiful, but messy combination of systems, the worst possible arrangement, Winston Churchill once intoned, except for all other combinations! In the face of macroeconomic (not just microeconomic, the providence of capitalism!) deflationary risk, extremism in the pursuit of monetary ease is no vice; and moderation in the pursuit of fiscal ease is no virtue. The great Barry Goldwater's patriotism was not all misplaced! Including in the field of macroeconomics.

It is time for the central banks of the G-3 block - not the emerging block, sadly, who have little say in the matter - to find the reflationary pot. And if they refuse, it is time for a democratic laxative to ease central banks' disinflationary constipation. The beauty and the glory of the marriage of democracy and capitalism demands nothing less. Alternatively, in the words of the great lyricist Kris Kristofferson, central bankers will experience the ignominy of the freedom of nothing left to lose.

Paul A. McCulley
Managing Director
October 1, 2002

1 The Supreme Court had been wrapped 'round the legal axle for decades about whether an income tax was constitutional, because of varying interpretations as to whether it was a direct or indirect tax, subject to the rules of "apportionment."

2 See "Capitalism's Beast of Burden,"  Fed Focus, January, 2001.

3 See "Time to Roto Rooter the Lender-of-Last-Resort Function,"  Fed Focus, August, 2002.

4 See "Prisoners Of Our Own Domain,"  Fed Focus, June, 2001.


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