Do central banks control the business cycle? Should price stability be their only monetary policy goal? Do politicians give up a degree of power and gain nothing personally when they grant central banks independence? This Commentary argues that none of these widely held notions is true. The Commentary is based on a speech presented to participants at the conference on the Origins and Evolution of Central Banking, sponsored by the Central Bank Institute of the Federal Reserve Bank of Cleveland, in May 2001.Banks and banking, Central

Geoffrey P. Miller

English

Research Papers in Economics

United States was also very concerned
that Japan not do anything to destabilize
its stock market, given the perception
after October 1987 that U.S. equity 
markets were fragile.
Finally, the BOJ had to deal with power-
ful figures inside Japan who were profit-
ing enormously from the bubble econ-
omy. Anyone who owned land in Tokyo,
and later throughout the country, saw his
paper wealth skyrocket during this
period. Investors got rich on stock mar-
ket profits. People in industries such as
construction, real estate development,
securities brokerage, and so on earned
fabulous sums and were quite liberal
with campaign contributions. Some
politicians also earned large amounts in
the stock market. And nearly everyone
felt buoyed by the enthusiasm that
accompanied the climb in the Nikkei.
Faced with these conditions, the BOJ, 
I think, was not really in a position to
take strong action against the bubble
economy. While the experience of the
BOJ does not translate directly to
November 2002
Federal Reserve Bank of Cleveland
Three Myths about Central Banks
by Geoffrey P. Miller
ISSN 0428-1276
Do central banks control the business
cycle? Should price stability be their
only monetary policy goal? Do politi-
cians give up a degree of power and
gain nothing personally when they
grant central banks independence?
This Commentary argues that none of
these widely held notions is true. The
Commentary is based on a speech pre-
sented to participants at the conference
on the Origins and Evolution of Cen-
tral Banking, sponsored by the Central
Bank Institute of the Federal Reserve
Bank of Cleveland, in May 2001.
Over the past decade, central banks
have emerged from relative obscurity 
to global recognition as one of the most
powerful institutions in the world—
powerful not only economically, but 
also politically, socially, and as forces
for cultural and historical change. 
Associated with this new image are 
several ideas about central banks that,
while often not clearly expressed, are
nevertheless widely held. These ideas
circulate in a sort of folklore or oral 
tradition. They exercise a significant
influence on how central banks are 
perceived. 
■ Central Bank Omnipotence
The first of these ideas is that of central
bank omnipotence. There seems to be a
general public perception that a central
bank is responsible for controlling the
business cycle and for ensuring an end-
less stream of prosperity. This isn’t a
view that is held by central bankers
themselves, although they benefit to
some extent if the public holds them in a
sort of awed semiadulation.
We see this idea at play today. In the
United States, for example, the Federal
Reserve System is credited for the
period of economic expansion and price
stability that we have enjoyed for many
of the past years. The Fed is also blamed
for the recent economic slowdown; if
only the central bank had loosened
credit earlier, we hear, we would not
have faced the layoffs, lack of consumer
confidence, deteriorating corporate prof-
its, and so on that were grist for business
news over the past few years. But is the
Fed really so powerful?
We can’t easily determine the degree of
central bank influence. No controlled
experiments are available. However,
there’s reason to believe that central
bank powers, although very large, are
still significantly limited. 
One object lesson on this is the role of
the Bank of Japan (BOJ) over the past 
15 years. Many have criticized the BOJ
for contributing to, even creating, the
bubble economy of 1987–1990, whose
collapse was followed by more than a
decade of economic stagnation in that
country. A governor of the BOJ even
accepted blame for the failure.
Yet my research suggests the Bank was
not nearly as responsible as many think
(see “The Role of a Central Bank in a
Bubble Economy,” by Geoffrey P.
Miller, in the Cardozo Law Review,
1996). It was highly constrained in its
ability to act against the bubble econ-
omy, for several reasons. It wasn’t clear,
at least in the early years, that Japan was,
in fact, in the midst of a speculative 
bubble; many argued that the upsurge in
Japanese equity and real estate prices
was due to economic fundamentals. 
The bubble economy didn’t show up in
the wholesale or retail price indexes, so
the Bank could not easily justify inter-
vention as an inflation-control measure. 
Tools of monetary policy were too broad
in scope to deal effectively with sectoral
phenomena; the Bank’s intervention was
going to affect the economy as a whole
rather than the limited areas of stock
market and real estate prices. The Bank
also had to take foreign relations into
account, especially relations with the
United States. BOJ credit tightening
would have been seen by the United
States as inconsistent with commitments
the Japanese government had made to
stimulate domestic spending in order to
increase demand for U.S. goods. Thelessons for the Fed, the two central
banks do play a largely similar role in
their respective economies. I would
guess, however, that the Fed’s powers, 
if not as constrained as the BOJ’s during
the Japanese bubble economy, are 
considerably more limited than might
appear at first glance. Central banks are
indeed powerful, but they are not
omnipotent, and the popular belief that
attributes excessive powers to them is
not supported by the evidence.
■ The Talisman of Price-
Level Control
A second popularly held belief about
central banks is that their only function
with respect to monetary policy should
be maintaining price stability. The
belief rests on the observation that there
are essentially no benefits to inflation,
and from this observation it is surmised
that a central bank should be charged
with a nondiscretionary responsibility
to keep the price level steady or within
a narrow range. 
If we take this idea of rule-based price
stability to its extreme, we can engage
in the following thought experiment:  
In place of the central bank, we build a
supercomputer, program it to achieve
price stability in all circumstances with-
out exception, and then throw away the
password. We even install an internal
nuclear power supply so we can’t pull
the plug. We have an absolute, rule-
based commitment to price stability.
But I don’t think a country would, or
should, adopt this strategy, even if it
were technologically feasible. Price 
stability is a very important goal, but not
necessarily the only goal. There may be
emergency political or social conditions
in which this goal should give way to
overriding objectives. The government
may urgently need to raise funds
quickly to accomplish these objectives.
In such cases, an inflation tax, although
not desirable under ordinary conditions,
might be a useful tool.
An obvious example of such an emer-
gency condition is a threat to national
security. If a country faces a sudden,
extreme threat from outside, it may have
good reason to elect to fund the necessary
response through inflation rather than
through the slower, although otherwise
more desirable, means of the explicit tax
system. For another example, we might
look to the Bundesbank’s approach to
German reunification. Even though the
German central bank was perhaps the
world’s most famous inflation hawk, its
leaders perceived that reunification was a
priority important to the nation’s essential
identity. The very large costs of unifica-
tion, which involved huge subsidies for
the East, were in part funded by inflation.
The problem, as a matter of institutional
design, is how to know when rules
should give way to discretion, and how
to ensure that short-term temptations 
do not erode the value of a rule-based
system. This is a matter to which law can
contribute—although we have always to
remember that laws are just pieces of
paper, and what counts is what people
actually do.
For an example of a legal response to the
design problem, we can look at how U.S.
law deals with the problem of regulatory
forbearance, that is, when the govern-
ment permits an economically failed
bank to remain open because it is “too
big to fail” or permits the FDIC to extend
de facto guarantees to uninsured deposi-
tors and nondeposit creditors during the
resolution of a closed bank. It might be
tempting for government officials to offer
this kind of assistance, both to cover
themselves against criticism and to cater
to powerful constituents. 
The 1991 Federal Deposit Insurance
Corporation Improvement Act created a
filter—the systemic risk exemption—to
ensure that forbearance is extended only
when really needed. The FDIC can res-
cue uninsured depositors and creditors of
a closed bank or allow an insolvent bank
deemed “too big to fail” to remain open
only if the following conditions are met.
The board of directors of the FDIC and
the Board of Governors of the Federal
Reserve System must each pass by two-
thirds vote a resolution recommending
the rescue. And the secretary of the trea-
sury, in consultation with the president
of the United States, must determine that
not rescuing the institution “would have
serious adverse effects on economic con-
ditions or financial stability” and that the
planned assistance “would avoid or miti-
gate such adverse effects” (12 U.S.C.
Sec. 1823(c)(4)(G)). Moreover, any
FDIC losses must be expeditiously
recovered out of a special assessment,
and any rescue must be investigated by
the General Accounting Office. 
Whether a similar approach should be
used for central bank monetary policy
responsibilities is another interesting
question of institutional design (some
countries, such as the United Kingdom
and New Zealand, already direct their
central banks to meet specific price-
level targets). In the event of a crisis or
other compelling need, the central bank
would be allowed to deviate from these
targets, but usually only after consulta-
tion with, and ultimately with the
approval of, specified other government
officials or agencies. How to best design
such a system would depend on the 
constitutional and legal structure of the
particular country.
■ Why an Independent
Central Bank?
My final example of central bank folk-
lore is that central bank independence is
simply a matter of good government.
There are persuasive theoretical reasons
to believe that independent central
banks represent a desirable social policy.
When we look at the fact that central
bank independence has been upgraded
in country after country around the
world, we might conclude that leaders
are persuaded by the theory and are
implementing the recommendations out
of a sense of social responsibility.
Undoubtedly, political leaders are often
motivated to improve the welfare of citi-
zens, and this incentive plays a signifi-
cant role in the establishment of inde-
pendent central banks. But it would be
simplistic to say that public-spirited
motivations fully explain the phenome-
non. Good government is undoubtedly
desirable, but it is not a hallmark of all
political systems. Independent central
banks are created by politicians, not
political scientists or economists, and
they operate within a political regime.
When we focus on politicians, the issue
of central bank independence becomes
puzzling. Control over price levels is
one of the most important powers of
government, and, historically, the source
of unlegislated revenue to the state.
Politicians usually want and desire
power. Why, then, do politicians vote in
favor of central bank independence, an
act that seems to give away a hugely
important amount of authority?
There are a number of answers to this
conundrum. Countries vie for prestige,
and having an independent central bankhas become a mark of status. For devel-
oping countries, the International Mone-
tary Fund and the World Bank support
enhanced central bank independence;
desire for funding from these and other
international agencies can provide an
incentive to enhance legal independence.
But what about the developed world?
Why have so many developed countries
moved toward establishing independent
central banks during the past several
decades? I’ll offer a speculation in this
regard, based on political and institu-
tional data that lawyers see in our pro-
fessional role and consistent with how
economists have modeled interactions
between the government and the public. 
Politicians want and need support from
interest groups. Interest groups typi-
cally want the politicians to enact legis-
lation that benefits their members eco-
nomically. But politicians know that
once the law is passed, the interest
group is satisfied, and the campaign
contributions and other support dry up.
In this context, inflation can work to the
advantage of politicians in a manner
that has not been fully recognized in the
literature to date. 
The interest group deals that get
enacted are often tied, implicitly or
explicitly, to price levels. Where deals
are tied to price levels, the politician, by
creating unanticipated inflation, can
effectively undo the deal previously
negotiated. A $100 per ton subsidy for a
commodity is worth only $50 if price
levels double. The producers of that
commodity are going to come back to
the politician for a new deal, and the
politician can extract more campaign
contributions. 
Taken by itself, this suggests that politi-
cians would not want an independent
central bank. Rather, they would want
to keep control over price levels so they
can renew their sources of campaign
contributions. However, we have to 
take expectations into account, just as
economists have learned to do in ana-
lyzing monetary and fiscal policy. If the
interest groups suspect that politicians
have power over price levels, they are
likely to reduce the contributions they
will give to obtain the deal in the first
place. They discount the present value
of the deal they are getting by the 
probability that inflation will undo it. 
The politician, however, has a short-
term time horizon. He or she wants to
get as much as possible in the way of
campaign contributions now, not in the
future. Politicians recognize the value of
offering a credible commitment to not
give in to the temptation to undo politi-
cal deals by creating inflation. This way,
the politician can offer durable deals
and thereby maximize campaign contri-
butions in the short run. The upshot of
this analysis is that politicians actually
have an incentive of self-interest to cre-
ate independent central banks. By doing
so, they offer a credible commitment
that the deals they are offering will be
durable, in the sense that they will not
be threatened by inflation. 
This interest group theory of central bank
independence has some plausibility, but
it has also to explain why politicians 
cannot accomplish the same objective
through other commitment devices such
as indexing. It could be the case that dif-
ferent interest groups demand different
forms of commitment; Social Security
payments in the United States, for exam-
ple, are indexed. Also, standing alone, the
interest group theory doesn’t provide a
full explanation for the rather remarkable
trend toward enhanced central bank 
independence we have seen around the
world in recent years. Still, it’s a useful
idea to keep in mind when we try to
understand the incentives operating on 
a central bank within a nation’s political
and economic system.
As I indicated at the outset, central
banks are now commonly regarded as
being among the most powerful institu-
tions in the world, capable of fostering
economic, political, and cultural
change. At the same time, research into
the design and functioning of central
banks has not been studied as much as
the significance of the institution would
suggest is worthwhile. I hope my
remarks indicate that I regard this line of
inquiry to be fruitful for legal scholars
and social scientists alike.Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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credited. Please send copies of reprinted
material to the editor.
Geoffrey Miller is the William T. and
Stuyvesant P. Comfort Professor of Law and
Director of the Center for the Study of 
Central Banks at New York University 
Law School. 
The views expressed here are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
Economic Commentary is published by the
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Three myths about central banks

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Three myths about central banks

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