by Nicholas Torres
A central bank, put simply, is the institution within a country that manages that country’s currency, money supply, and interest rates. These three factors have a profound influence on the broader economy. Therefore, the function of a central bank is something to take seriously. However, there has been an unfortunate rise in the politicization of the role of central banks; in turn, grave ramifications have followed. In order to analyze this phenomenon and the wider context that surrounds the politicization of central banks, we first need to briefly explore the economic history and theory underpinning monetary policy. From there, we will discuss the economic crisis occurring in Turkey and relate this crisis to the thesis of this essay. Finally, we are going to explore what this encroachment on central bank independence means for those of us in the United States.
History of Monetary Policy
Early practices of monetary policy go back as far as Ancient Egypt where it is said the value of goods were measured with a central unit called a shat.1 However, the modern way of conducting monetary policy can be traced back to the 17th century Dutch Republic where, during this time period, the monetary system was both coin-based and heavily decentralized. The decentralization of currency-issuance led to a number of problems, the main one being the inability for the Bank of Amsterdam to issue coinage without it differing in value from coins outside of Amsterdam.2 The solution would be for the government to put in place regulations on coinage. Central banks constructed in the mold of the Bank of Amsterdam would take on even more complex roles. Most notably, the Bank of England (BoE) was formed to issue bank notes (government bonds) to investors in order to pay for political engagements that England had embarked upon (e.g. Nine Years’ War with France) 3
Similarly, the United States’ central banking system, adopting heavily from the BoE, formulated under times of warfare. The American Revolution needed to be financed and thus led to the Continental Congress issuing paper currency called “continentals.” The First Bank of the United States (1791-1811), an idea concocted by Alexander Hamilton himself, was constructed to help the nation pay off massive debt accrued from the Revolutionary War and to invest in American industry. The Second Bank of the United States (1816 – 1836) was chartered by Congress in response to the country’s rising debt brought upon by the War of 1812. 4
The Bank would be crippled and eventually liquidated after President Andrew Jackson refused to renew its charter in 1832 due to his political preference for a decentralized and less regulated banking system; this would lead to several “bank panics” and subsequent recessions in the decades to come. In 1913, the Federal Reserve Act was passed by Congress, creating the Federal Reserve system we have today; the impetus for this system stemmed simply from the faults of the old “free banks” system.
Modern Monetary Policy
Today, the Federal Reserve, or “Fed,” conducts monetary policy by controlling the money supply, or simply, the number of bank notes in circulation. A way it can do this is by buying and selling Treasury bonds on the open market. Buying bonds held by private institutions and individuals increases the amount of money in circulation and selling bonds to private institutions and individuals decreases the amount of money in circulation. Furthermore, buying bonds effectively decreases interest rates while selling bonds increases interest rates. With all that said, it should not come as a surprise the amount of influence a country’s central bank can have on its economy. In order to examine this more closely, we will look at the unraveling economic crisis occurring in Turkey.
Currently, Turkey is experiencing a lot of inflation due to its emerging market economy—specifically, a lot of Turkish companies are growing, and they are borrowing money from foreign entities (e.g. foreign governments and financial institutions) to continue this growth, thereby leading to inflationary pressures. The entities investing in Turkish companies are buying “corporate bonds,” a kind of debt issued by companies whose amount is to be repaid in full along with any interest attached to the bond. Because foreign investors hold these Turkish corporate bonds, they expect interest rates to increase as inflation within the country increases. 5
In June of this year, when the Turkish central bank decided it would not increase interest rates, the Turkish lira decreased by 3% in value against the US dollar, reflecting investors dissatisfaction with the Bank’s move to leave interest rates unchanged. However, this move was brought on by pressures coming from Turkish president Recep Tayyip Erdogan to keep the Turkish economy running at full steam in order to keep interest rates low.5 Fortunately, this past September, the Turkish central bank decided to sharply increase interest rates from 17.75% to 24%, citing the need to curtail the out-of-control inflation, manifesting throughout the Turkish economy. 6 Even with the interest rate hike, investors remain wary of the central bank’s independence, and how Turkey will come away from this unraveling currency crisis remains to be foreseen.
The current economic tumult in Turkey has led to a particular response from here in the United States. President Trump’s initial reaction was to increase the import tariffs on Turkish steel and aluminum from 20% to 50% in order to mitigate the beneficial effects of the depreciating Turkish lira on the previously imposed tariffs. 7 Turkey is America’s sixth largest foreign supplier of steel, so one can imagine how an increase in import tariffs can have devastating effects on American companies who rely on Turkish steel.
Looking at the situation politically, there is also a lot to take away. President Trump has not shied away from praising “strong leaders” like Turkey’s Erdogan; therefore, it should not come as a surprise that the President has also not been hesitant to criticize the Fed’s interest rate hikes. In an interview with CNBC, President Trump declared that he was unhappy with the Federal Reserve raising interest rates, clearly diverging from the idea that policies put forth by central banks should remain independent from the politics of other branches of government. President Trump later tweeted that hikes in interest rates have
“hurt all that we have done” and “The US should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt are coming due & we are raising interest rates—Really?” 8
To clarify, the President is referring to an idea that higher interest rates will negatively impact the United States’ ability to export goods because higher interest rates lead to a higher US dollar.
However, there is another side to this that the President is missing (or purposefully neglecting), and it is that lower interest rates eventually lead to high amounts of inflation and, even more severely, a credit crisis, just as we see in Turkey. The President’s desire to keep interest rates low is one of a political nature and not one that is firmly grounded in economic theory. One of President Trump’s political missions has been to improve America’s international trading stance, so, from a political standpoint, it makes sense that he advocates for economic policy that appears to advance his political agenda.
All in all, though President Trump’s comments may appear not all that serious on the surface, they can lead to negative economic ramifications if such a precedent is set—that is, if the Federal Reserve simply caves to spurious political sentiments coming from influential government officials; then the central bank may indeed take on a monetary policy approach that leads us straight into another economic crisis. It is high time we take this seriously and, for the sake of this country’s economy and the global economy, call for the political independence of our central bank.
1Vantieghem, Charlotte. 1991. “Monetary practices in ancient Egypt.” National Bank of Belgium. October 13. http://www.nbbmuseum.be/en/2012/05/nederlands-geldgebruik-in-het-oude-egypte.htm
2Quinn, Stephen, and William Roberds. “The Bank of Amsterdam and the Leap to Central Bank Money.” The American Economic Review 97, no. 2 (2007): 262-65. http://www.jstor.org/stable/30034457
3Andréadès, A. 1924. “History of the Bank of England” Translated by Christabel Meredith. https://socialsciences.mcmaster.ca/econ/ugcm/3ll3/andreades/HistoryBankEngland.pdf
4Federal Reserve Bank of Minneapolis. “The History of Central Banking in the United States.” https://www.minneapolisfed.org/about/more-about-the-fed/history-of-the-fed/history-of-central-banking
5Gauthier-Villars, David, and Christopher Whittall. 2018. “Turkish Lira’s Plunge Prompts Concern About a Currency Crisis.” https://www.wsj.com/articles/turkish-lira-falls-after-central-bank-defiantly-leaves-rates-unchanged-1532433561
6Gauthier-Villars, David, and Jon Sindreu. 2018. “Turkey Takes Action on Strained Economy with Big Rate Rise.” https://www.wsj.com/articles/erdogan-moves-to-support-turkeys-embattled-lira-with-new-measures-1536826634
7Philips, Matt, Ana Swanson and Jim Tankersley. 2018. “Trump Hits Turkey When It’s Down, Doubling Tariffs.” https://www.nytimes.com/2018/08/10/us/politics/trump-turkey-tariffs-currency.html
8Timiraos, Nick. 2018 “Trump Criticizes Fed Rate Increase Again, but Says He Hasn’t Spoken to Fed Chair Powell.” https://www.wsj.com/articles/donald-trump-repeats-complaints-that-the-fed-is-raising-interest-rates-too-fast-1539119455