Elections Impact on Bank of Canadas Independence

The independence of central banks from the democratic process has been a bedrock of economic policy for decades. The Bank of Canada is no exception , maintaining distance from elected officials to ensure monetary policy is free from political pressures.

However, a clear division between central bank and government could be tested with Mark Carney, former governor of both the Bank of Canada and the Bank of England who's running for leadership of the Liberal Party and, in turn, the role of prime minister.

His bid raises concerns about how central bank independence might be perceived under a Carney-led government. Could his tenure as a central banker result in the Bank of Canada's independence being clawed back? After all, he has demonstrated his ability to manage monetary policy at the highest levels.

The answer, if we want to preserve the economic benefits of central bank independence, is clear: the Bank of Canada's independence must be preserved. And Carney, who has championed the importance of politically neutral monetary policy, would likely agree.

Incentives, not ignorance

The idea that central banks should operate independently of the democratic process is a widely held view among economists and central bankers. This is largely because there is an extremely low likelihood of elected officials committing to implement monetary policy that produces low inflation and stable prices.

If elected officials controlled monetary policy, incumbent governments would be tempted to "juice" the economy with "loose money" by reducing the interest rates right before elections.

In the short run, this would reduce unemployment, raise wages and potentially boost the chances of incumbent governments being re-elected. But, in the long run, citizens would pay the price in the form of inflation.

With repeated political interference, market entities would no longer react to injections of loose-money by investing in capital and labour and low interest rates would no longer produce the desired short-term benefits of more jobs and higher wages. But inflation would still persist. As economist Garrett Jones puts it, it would be "all hangover, no buzz."

Empirical evidence bears this out. Central banks that with greater independence tend to have more price stability and less inflation.

This is why governments delegate monetary policy to independent central banks. Central bankers are able to implement monetary policy without the temptation to manipulate the economy for electoral gain.

It's worth noting that the need for central bank independence is not exclusively due to politicians' ignorance about managing monetary policy. Rather, it's because the electoral incentives they face prevents them from being trusted to pull the levers of monetary power effectively.

This principle applies even to someone like Carney. If he were to become prime minister, he would face the same incentives as all other incumbent governments. Despite his expertise, he would still need independent central bankers to ensure monetary policy remains insulated from the political cycle.

Central bank independence in Canada

Central bank independence is not a binary, but exists on a spectrum. When studying the effects of independence, central banks are usually scored on a number of indicators , including whether central bankers can be fired by elected officials, how long central bankers' terms are, and the extent to which they can be instructed by democratically elected bodies.

Widespread support for central bank independence among economists only began in the mid-1980s . Prior to that, central banks often gained their independence due to political and legal circumstances, rather then a deliberate attempt to adhere to a principle of independence. Both the Federal Reserve and the Bank of Canada have this in common.

The independence of the Bank of Canada had a tumultuous 25 years after its establishment in 1935 . When pressed, finance ministers could not answer whether they or the Bank of Canada were ultimately responsible for the country's monetary policy, often giving conflicting answers.

It would not be until 1961 that this uncertainty would come to a head during the Coyne Affair . Prime Minister John Diefenbaker wanted James Coyne, governor of the Bank of Canada at the time, fired for embarrassing his government and taking a hefty pension. The House of Commons passed a one-line bill that fired Coyne, but the Senate refused to pass it. Coyne resigned the next day.

After the Coyne Affair, central bank independence grew into the de facto status quo. In 1985, the Bank of Canada Act was passed, setting some limits on the power of the governor and their responsibility to the finance minister. As a result, Canada's central bank independence falls somewhere in the middle of the spectrum compared to other wealthy, western nations.

Carney on central bank independence

In 2022, Conservative Party leader Pierre Poilievre threatened to fire the governor of the Bank of Canada , Tiff Macklem, if he became prime minister.

While the Bank of Canada Act does permit this through a formal procedure , setting the precedent that cabinets can and will fire governors could undermine central bank independence. It would risk making central bankers more beholden to the political aims of incumbent governments and more likely to produce inflationary monetary policy.

Compared to Poilievre, Carney is the conservative choice, likely aiming to maintain the status quo by leaving central bankers alone. During and after his time as a central banker, Carney has favoured central bank independence . And, as it stands, it doesn't appear that he's changed his mind now that he's running for Liberal leader.

So, what would a Carney government mean for the Bank of Canada's independence? Likely, not much - and from a monetary economic perspective, that's a good thing. Preserving the status quo would ensure the Bank of Canada remains insulated from political interference, allowing it to focus on long-term price stability.

Andrew Allison receives funding from the Social Sciences and Humanities Research Council.