Since the beginning of his term, Prime Minister Benjamin Netanyahu has been demanded of several times to explain extreme statements made by members of his government to the world media. Usually, these statements relate to the conduct of the war in Gaza, but at the beginning of February last year, the prime minister was asked about a completely different issue: the independence of Israel’s central bank.
“Under my leadership, The Bank of Israel law that guarantees the independence of the monetary committee headed by the governor in determining the interest rate was passed. Nothing will change it,” Netanyahu posted on the social media platform X, in both Hebrew and English. Then-Foreign Minister Eli Cohen, who sparked the storm by criticizing the Bank of Israel’s interest rate hike, was also made to clarify his remarks and declare his support for the independence of the central bank.
Cohen’s remarks, along with criticism by Finance Committee Chair Moshe Gafni, were strongly criticized by the Israeli economic establishment. But in the global economic field, there are also other opinions, which may not fully match Cohen and Gafni’s criticisms but which certainly challenge one of the sacred cows of the Israeli economic consensus.
“The idea of central bank independence is based on the false claim that interest rate policy is effective in fighting inflation,” Canadian economist Louis-Philippe Rochon told Davar. “If interest rate policy doesn’t work as central bankers claim, then why do central banks need independence?”
Rochon is part of a group of thinkers who criticize orthodox economics. He has written and edited nearly 40 books on economic theory and the history of economic thought. Along with economists such as Nobel laureate Joseph Stiglitz and Claudia Sahm, he opposes the serial interest rate hikes by central banks around the world, led by the US Federal Reserve. In an interview with Davar, Rochon explained why raising interest rates is ineffective in fighting inflation and harms the most vulnerable, and why the idea of central bank independence should be abandoned.
Why are you against using interest rates to fight inflation?
Rochon: The use of interest rates is intended to lower the level of consumption and investment, and is based on the assumption that inflation is caused by excess demand. If this were true, the use of interest could be justified, but I do not accept this assumption. I think inflation was caused by other reasons. I also reject the view that inflation of 8-9%, as we saw after the coronavirus pandemic, is the worst thing that can happen to the economy.
Aren’t price increases a serious problem?
Rochon: Price increases certainly are a problem—following the recent increases, many are finding it difficult to buy food products. But I don’t think inflation at 8-9% is worse than unemployment. In my view, unemployment and inequality are far more serious problems, and high interest rates exacerbate inequality and create unemployment. The policies used against inflation are far more harmful than inflation itself. Not for nothing, the economist John Maynard Keynes said that using interest rates against inflation would cure the disease but kill the patient, that is, the economy.
How does interest rate policy relate to the idea of central bank independence?
Rochon: The independence of the central bank and interest rate policy are part of the same approach. It’s an old concept, but it only came to maturity after the inflation of the 1970s and early 1980s. The idea is to protect central banks from political pressure, so they can set interest rates at the right level for fighting inflation. It’s based on the argument that politicians are not interested in fighting inflation but in winning the next election and therefore they may fear high interest rates, which will hurt their chances in those elections.
And is this an agreed-upon view?
Rochon: It absolutely is a consensus. I think the overwhelming majority of central bankers, analysts, economists, and politicians believe in the idea of central bank independence. The reason is probably a desire to avoid a repeat of the high inflation that existed in the 1970s.
What do studies say about the effectiveness of central bank independence?
Rochon: In order to examine the connection between the independence of the central bank and inflation, we need to define what that independence is. The studies that do this start with the assumption that inflation is the biggest threat to the economy and therefore a central bank that fights inflation is good, that is, independent. But what about unemployment or inequality? This is basically circular reasoning, as it is assumed that inflation is the great evil, and therefore fighting it is good.
But even setting that aside, there is no empirical support for the claim that central bank independence leads to a reduction in inflation. Even economists who support this approach will admit that the evidence is weak and far from conclusive. The reason many studies do not find a link between the independence of the central bank and inflation is that interest rate policy is ineffective in fighting inflation. The central bank model doesn’t work. I’m not saying monetary policy isn't effective at all, just not for fighting inflation.
Why does the model not work?
Rochon: The central bank model says that if inflation is higher than the central bank’s target, the interest rate should be raised. Raising the interest rate reduces consumption and investment, that is, demand. Low demand expands unemployment, and high unemployment rate reduces inflation. The problem is that empirical studies have shown that the effect of interest rates on demand is negligible and that the effect of unemployment on inflation does not exist.
Consumption and investment do not respond to small increases in interest rates. I can quote the Federal Reserve, the International Monetary Fund, the World Bank, and a host of other respected economic institutions, that the impact of incremental interest rate hikes is negligible. Of course, after 11 increases in interest rates, as was done in the US, there will be a response in demand to the high interest rate, but we don’t know how many increases will be required.
What about unemployment and inflation?
Rochon: The second part of the mechanism is that high unemployment will lead to lower inflation—also known as the Phillips curve. The Phillips curve represents a negative relationship between unemployment and inflation—when unemployment rises, inflation decreases. Again, the problem is that in the last 50 years, the curve has become a flat line: There is no connection between inflation and unemployment. Here, too, we can quote economists and senior institutions about this. This is a consensus.
In summary, the impact of interest rates on demand and therefore on unemployment is small, and so is the impact on inflation, so the entire model collapses. When central banks see that raising interest rates do not have an impact, they raise it again and hope that it will have an impact. But it doesn’t, so they raise interest rates again and again, 11 times, until eventually the system collapses under the high interest rate.
And still, even now the US economy enjoys healthy growth and a low unemployment rate.
Rochon: The US economy is growing despite 11 interest rate hikes because of Biden’s massive fiscal stimulus. You always have to address the full picture. But in many other countries, such as Canada, England, Germany, among others, the economy has slowed significantly following a series of interest rate hikes.
Independence from government, but not from capital
In another criticism, Rochon argues that the independent central bank is free of government influences but not financial markets.
Rochon: When inflation was just starting to rise after COVID-19, the Federal Reserve said inflation was likely to be temporary so there was no need to raise interest rates. They started raising interest rates because the markets told them they were behaving irresponsibly and were starting to lose confidence in the markets.
What do you mean by “the markets told them”?
Rochon: There have been a lot of criticisms from economists of financial companies, such as hedge funds, that have raised concerns about the credibility of the Federal Reserve. If there’s one thing central banks are afraid of, it’s their loss of credibility, and that’s why they’ve started raising interest rates.
Why are they worried about losing credibility?
Rochon: They want to be in a position where people trust what they say. They don’t want to appear weak or idle in the face of inflation, even though they themselves said it would be temporary. I, along with economists such as [Joseph] Stiglitz and [Claudia] Sahm, argued from the outset that this inflation is temporary and therefore there is no reason to raise interest rates, and this diagnosis turned out to be correct. We explained that when the real problems that caused inflation were solved, inflation would come down, and that's what happened.
Where does central bankers’ sensitivity to financial markets come from?
Rochon: Economist Gerald Epstein said that central bankers make decisions through the lens of the financial market. Central bankers often come with some history in financial markets. They want to make sure that the markets are healthy, that the rentiers—people whose income comes from assets—earn well. That’s why it’s very important to them what the financial markets think.
Do you object to the central bank taking care of the health of the financial markets and system?
Rochon: Absolutely not. I’m just pointing out the hypocrisy of saying that the central bank is independent. There are people like Stiglitz and others who contend that in order for the argument for central banks’ independence to be acceptable, they also need to be independent of the markets.
What were the real causes of inflation?
Rochon: Rising prices for oil, wheat, and other commodities, rising transportation costs, and bottlenecks. These things have to do with COVID-19 and the war in Ukraine. The other reason is profit inflation, in which corporations have taken advantage of all the problems I’ve talked about to expand their profit margins. When transport and energy prices fell, inflation was contained.
These things happened at the same time as the interest rate increased. How do you know that interest had no role in that?
Rochon: The interest rate hikes have nothing to do with that. According to the Federal Reserve, as well as other sources, interest rates take about a year and a half to have an effect, but inflation began to decline two or three months after the rate increases. That is, the timing is completely incompatible. There is no basis for the claim that monetary policy solved inflation.
What are the disadvantages of the interest rate policy?
Rochon: Monetary policy has enormous implications for inequality. When you raise interest rates, you're actually transferring income from workers to rentiers—those whose income comes from owning assets. Workers pay more interest and property owners enjoy higher interest rates (returns), and you can see this in the data. Since the financial crisis, central banks have begun to admit that monetary policy affects inequality, and a consensus seems to have emerged on the issue.
If you understand that monetary policy is ineffective at fighting inflation but makes the rich richer, a big question arises: What does this policy do and are there better ways to use it?
In your opinion, what is optimal monetary policy?
Rochon: First of all, it is important to note that central banks were not established to fight inflation but for other reasons. One reason is to support government spending, for example to make it easier to finance wars, by lowering interest rates on bonds. The second reason is the improvement and stabilization of the payment system. In essence, central banks were created to stabilize the financial system and the idea that their job was to fight inflation came much later, I would say in the 1960s.
Because there is no clear link between interest rates and inflation, I don’t see the logic in an inflation targeting system. Central banks should set a relatively low interest rate and keep it more or less constant. Thus, the central bank is free to ensure the stability of the financial system through supervision and maintenance of the financial markets.
The 2008 crisis, for example, broke out largely due to a lack of supervision, but central banks responded by injecting huge funds into the system, thereby preventing a much larger crisis from developing. That should be their job. Low interest rates also reduce inequality in the distribution of income between a minority that owns a huge amount of assets and the majority of the public.
What about inflation and growth?
Rochon: Fiscal policy should be used to deal with issues of growth, inflation, unemployment, ecology and environment, inequality, gender inequality, etc. Low interest rates allow the government greater fiscal space because the cost of deficit and public debt is low. That’s what happened during the coronavirus crisis when interest rates were virtually zero, perhaps even too low.
Are you proposing to steer the economy through government policy?
Rochon: Correct. We need to rely less on monetary policy and much more on fiscal policy, as happened in the decades after World War II until the 1960s. Back then, growth was faster, unemployment and inflation were lower, and inequality was less acute. It's not for nothing that we call these years the golden age of capitalism.
But that period ended with an inflation crisis.
Rochon: Yes, but inflation in the 1970s didn’t start because of fiscal policy, but, just like today, because of oil crises, in 1973 and 1979. Even then, inflation was temporary: By 1981 it had already begun to decline in the US and Europe, and by 1982 it was quite low.
Even if one accepts the argument that monetary policy is ineffective, a central bank in a small economy like Israel, and also in larger but less advanced economies, depends on the interest rates of important currencies, led by the US dollar. If the Federal Reserve raises interest rates on the dollar and the Bank of Israel keeps interest rates low, investors will move their capital to the US where yields are higher. Can central banks that are not at the top of the economic food chain have independent interest rate policies?
Rochon: This is an important point. The fear is that in the event of interest rate differentials in favor of the dollar, for example, capital flight will weaken the currency and this will lead to inflation [because it makes imports more expensive]. This needs to be examined on a case-by-case basis. Japan did not raise interest rates in line with the Federal Reserve, and indeed the yen weakened significantly against the dollar, but that did not lead to inflation. In other countries, Mexico for example, this might happen. The restoration of control over capital flows is a way to solve the problem, that is, to maintain monetary independence. The Banking supervision department will moderate capital’s response to interest rate differentials. East Asian countries have implemented capital flow controls and it has worked wonderfully.
Many in Israel and in other countries have lost faith in the political echelon, and they see the weakening and subordination of the professional echelon, in which the central bank is included, as a danger to the economy. Doesn't this situation justify protecting the central bank?
Rochon: The idea of central bank independence puts the reins in the hands of monetary policy and limits the use of fiscal policy. One should not confuse the desire to limit the government as it is with opposition to a specific ideological government. I oppose Trump and think his reelection will be very bad, but that doesn’t mean the government should be prevented from pursuing fiscal policy. Think about the policies Biden led, which led to growth and low unemployment.
You are part of a school of economics inspired by the theories of British economist John Maynard Keynes. What did he think about the independence of the Central Bank?
Rochon: Keynes believed in central bank independence, but only if it was to fight unemployment rather than inflation. But I think that in the current context, you can’t separate the independence of the central bank from an inflation-first approach. As I understand it, Keynes was talking about this in a completely different context. My argument is that if interest rate policy doesn’t work as central banks claim, then there is no need for their independence.
