IMES DISCUSSION PAPER SERIES

Institutional Innovation and Central Bank Independence 2.0

Kenneth S. Rogoff
Discussion Paper No. 2022-E-9

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IMES Discussion Paper Series 2022-E-9
July 2022

Institutional Innovation and Central Bank Independence 2.0
Kenneth S. Rogoff Introduction
It is great honor to give the 2022 Mayekawa Lecture at the Bank of Japan. My topic today is how
central bank independence has been challenged in the zero-bound era, and how it is likely to bechallenged further in the coming if contemporary trends in deglobalization are sustained. Central
bank independence, of course, is the bedrock of modern inflation targeting, which itself is a wayof asserting and reinforcing independence.1 Too much analysis of central bank policy takes
independence as given, focusing solely on technical issues, and ignoring underlying political
economy issues that have become far more acute in an era where the zero bound has radicallycurtailed conventional monetary policy, and populism has created enormous pressures formission creep.
If, as a great many academics and commentators have opined, fiscal policy should be
responsible for much more of the burden of routine macroeconomic stabilization (not just in
severe crises such as the pandemic), that too will create new political economy pressures that do
not exist to the same degree in a regime where fiscal policy governs the long-term direction of
the economy, and monetary policy handles short-term stabilization. The modern idea that fiscal
policy can be made as technocratic as central bank interest rate policy (for example, using
precision-calibrated countercyclical transfer payments) is, in my view, highly dubious in today’s
divisive political environment.
I will suggest that if the global real interest rates – and therefore presumably the theoreticalabstract of the neutral real policy interest rate – remain at incredibly low levels as the postpandemic-era inflation abates, important innovation is needed to restore the efficacy of normalinterest rate policy. Without a meaningfully independent instrument, central bank independence
itself becomes more difficult to maintain, as the experience of the past decade has shown.
 Professor of Economics and Maurits C. Boas Chair of International Economics, Harvard University (E-mail:krogoff@harvard.edu).
This is an extended version of the May 25 lecture to be published (with minor revisions) by the Bank of Japan.
All views are those of the author. The author is grateful to Veronica De Falco and Pierfrancesco Mei for helpfulcomments on an earlier version.
1

The idea of having an independent central bank to deal with political economy pressures was first advanced in
Kenneth Rogoff, 1985, “The Optimal Degree of Commitment to an Intermediate Target,” Quarterly Journal of
Economics, 100, November, pp. 1169-89. The paper, which in general analyzes the tradeoff between commitment
and flexibility in choosing an intermediate monetary target, considers optimal inflation targeting among otherapproaches.

1

On the other hand, the trend towards deglobalization, which has the potential to be a massive
ongoing negative supply shock, puts tremendous pressure on central banks to allow higher
inflation, certainly in the short run but also potentially in the long-run if deglobalization
fundamentally impacts the political economy pressures on the central bank, for example byincreasing the monopoly power of firms and unions, or by making prices less flexible.
Interplaying with all these issues, and almost certainly having major implications for central
bank independence is the rise of digital currencies. For emerging markets and possibly small,advanced economies, digital currencies – especially advanced economy central bank digitalcurrencies – could exacerbate problems in maintaining monetary autonomy. Crypto currencies
are already having an impact in emerging markets. Advanced-economy central banks havefundamental decisions to make with respect to regulation that could profoundly alter their status
within the society and within the government.
Political Pressures on the Central Bank: The Recent Example of the United States
Before I turn to the more academic themes, and to underscore the point that political economy
influences on monetary policy may be on the rise, it might be helpful to consider the recent
experience of the United States Federal Reserve, which may or may not smoothly dig its way out
the difficult current adverse inflation dynamic.
Many commentators view the sharp rise in inflation since early 2021 as a profound failure ofmonetary policy. (The April 23rd cover of the Economist magazine trumpets “The Fed that
Failed.”) In their view, an inflation-targeting central bank should have realized, far sooner that
the Fed did, that by spring 2021, the post-pandemic recovery was well underway. Overstimulated
by a 1.9 trillion-dollar stimulus package in March 2021, coming on top of several earlier roundsof trillion-dollar stimulus packages, it was easy to see that sustained inflation inevitable.
Supposedly distracted by pressures to address the environment, inequality and social justice, theFed responded much too slowly and much too meekly. By insisting for too long that inflation
was mainly driven by temporary supply shortages and likely to recede, the Fed painted itself into
a corner where it is now forced to respond more aggressively, even to supply shocks, than might
normally be called for.
While having important elements of truth, this simplistic view understates how much political
economy pressures on the US central bank have ramped up in recent years. It also denies themassive uncertainty in the economics profession about the long-term trajectory of “neutral”
interest rates as well as the determinants of inflation. And it does not assign nearly enoughresponsibility to policy economists and academics who argued for a much larger role forcountercyclical fiscal policy, particularly at the zero bound, without giving clear guidelines ofany sort to how it might be calibrated. Relatedly, the argument that debt to GDP ratios can beraised substantially in most advanced economies, without any need to raise future taxes(including the inflation tax), has also played a significant role in encouraging maximalist fiscal
policy without concern for potential effects on resilience.
Consider an alternative view. From the perspective of 2019, inflation seemed to have beenconquered worldwide, with downward pressures from globalization making deflation a far bigger
2

issue for advanced economy central banks than inflation. In 1992, over forty countries had
inflation over 40%; but by 2015 that number had fallen to less than a handful. Central banks
were convinced they knew how to fight high inflation but were far less sure how to fight therelatively new problem of excessively low inflation, particularly given the apparent collapse of
equilibrium real interest rates. As policy rates sat longer and longer at the effective lower bound,markets implicitly came to believe that central bank target rates would be significantly negative,
if that were possible. Thus, the likelihood of interest rates being raised into positive territory was
extremely low for the foreseeable future. As the zero-bound era persisted, long-term interest
rates collapsed across the advanced economies.
With conventional monetary policy stymied, and the effectiveness of alternative monetary
instruments fading sharply over time, central banks came under two types of pressures. The firstwas to spend much more their time addressing other issues where they lacked competence andeffective targeted instruments. The second pressure was far less subtle: if risk of high inflation isdead or at least deeply dormant, and short-term real interest rates zero, why not have the central
bank cede a much larger share of stabilization policy to the fiscal authorities? Central banks canjust play a supporting role by buying up government debt (which in the United States still had asignificant positive interest rate) and substitute short-term bank reserves, which paid near zero.
Modern Monetary Theory is, of course, an extreme caricature of this viewpoint,2 but theoverwhelming thrust of the post financial crisis literature has also pointed in this direction.
It is this context that during 2019, the Federal Reserve held a review of its monetary framework;
several other central banks have engaged in similar exercises. Importantly, open-ended negative
nominal interest rate policy (which would require a novel approach to dealing with paper
currency), was apparently viewed as too political and basically taken off the table. (Here thepolitical pressure comes mainly from the right.) The academic reviews the Fed commissioned,on balance, generally painted a somewhat rosy picture of the effectiveness of alternative
monetary instruments, especially given the disappointing results around the world in fighting
deflation in an exceptionally low real interest rate environment. The ultimate result of the review,is as well known, was a new asymmetric framework that squarely treated today’s core monetary
policy challenge as fighting deflation, not inflation (because it presumed the latter problem wassolved). I need not go into the details here.3
Let us now fast forward through the pandemic – where the Fed’s creative and aggressiveinterventions into private markets (“fiscal quantitative easing”) are rightly credited with holding
down long-term scarring, and arrive at early 2021, when the seeds of inflation were starting tosprout. With 20-20 hindsight, it is now clear that an omniscient (and fully independent) Fedshould already have started at least gently hiking interest rates by mid-year. But what was thereality of the intellectual and political pressures it faced?

2

The MMT view is laid out in Stephanie Kelton, The Deficit Myth: Modern Monetary Theory and the Birth of thePeople’s Economy, Washington: Public Affairs, 2020.
3“2020 Statement on Longer-Run Goals and Monetary Strategy,” Federal Open Market Committee, August 27,
2020.

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The political side is clear. In January 2021, progressives (the left) had swept into Washington,believing they had a mandate for major change. The progressive’s main idea for financing new
programs and expenditures was to radically increase taxes on upper-income Americans, which if
implemented fully might well have proved both sustainable and non-inflationary (albeit withlikely negative effects on trend growth, which was considered a fully acceptable trade-off).
However, it was understood that sharply raising taxes on high-income Americans would require
overcoming strong entrenched interests, an insurmountable challenge since the “mandate” forchange was backed only by razor-thin majorities. However, deficit finance was viewed as areasonable second-best alternative if the obstacles to higher taxes proved too great. Given
apparent success of successive debt-financed pandemic stimulus programs, continuing ultra-low
interest rates, and the lax attitude in both parties towards deficits, the fallback position became
the leading idea.4
When the March 2021 stimulus bill came along, what should the Federal Reserve have done?
Mostly importantly, even if a few prominent economists (most notably an exceptionallyprescient Lawrence Summers) were warning it might cause inflation, the general view was thatthe risks were small. After all, United States had not seen elevated inflation in decades. In theacademic literature, there was growing debate over the empirical relevance of the Phillips curve,
and little consensus over the neutral real policy interest rate. Both factors, made it difficult toassess just how much monetary stimulus there was in the system. Uncertainty over the effects ofyears of quantitative easing compounded this uncertainty.
Given still exceptionally low inflation and legitimate concerns about inequality, didn’t
progressives deserve a chance to implement the policies they had been elected to champion
without having the Fed interfere, especially when so many believed that inflation would either
not be a problem or would develop so slowly it would prove easily manageable? It would nothave been so easy for the Fed to stand in the way. Recall that the Japanese experience was heldout as showing there was enormous running room for debt and deficits without inflation.5(Although holding Japan as example that a legacy of extremely high debt is not a problem for
future growth is another issue; overwhelming academic consensus is now that debt is a drag.
Being able to borrow is good for growth, inheriting extremely high debt is most definitely not.6)

4

Even aside from Modern Monetary Theory, the academic literature increasingly, if not quite unanimously, argued
for greater use of debt finance leading and not to be concerned with rising debt levels, given ultra-low real interest
rates. Indeed, in his widely praised 2019 American Economic Association presidential address, Olivier Blanchard
argued that given that growth rates appeared likely to exceed interest rates for an exceptionally long time, debt could
be much higher without having to raise taxes or inflate it away. These arguments had a major influence on
politicians worldwide.
5
The claim that excess demand automatically leads to inflation must be qualified by the fact the United States is an
open economy. The theoretical case for how excessive fiscal stimulus leads to inflation is not as airtight assometimes presented. In normal times, price pressures due to excessive fiscal stimulus might at least in part be
relieved through a larger current account deficit. In the event, of course, global supply pressures limited thatchannel.
6
See the literature reviews in Abbas, S. Ali, Alex Pienkowski, and Kenneth Rogoff, 2019, Sovereign Debt: A Guide
for Economists and Practitioners, Oxford University Press.

4

Had the Fed that tightened before inflation had convincingly taken hold, it would have been both
politically and intellectually vulnerable. I am not simply referring to fact that the New YorkTimes was still publishing puff pieces about Modern Monetary Theory as late as February 2022,
but that the mantra of the academic papers selected for the Fed’s 2019 review emphasized,
repeatedly, not to move to quickly to stamp out inflation for fear of being faced with moredifficult to tackle deflation, and worst of all, recession. Indeed, has the Fed raised interest rates
even slightly, it would own any subsequent recession, whatever the main cause.
As the year 2021 progressed, another consideration began to loom large on the horizon. Newlyelected President Biden had to fill several seats on the Federal Reserve, as well as appoint thechair within the year. Of course, even this would not be enough to dismantle the strong culture ofindependence at the Fed, but it was still a powerful influence. Had the Fed followed the newconsensus advice and raised interest rates much sooner, it seems unlikely the incumbent chair
would have been reappointed. Surely, any replacement would have been a policymaker withknown more “dovish” views. Markets would have quickly realized this, muting the effects of thetightening cycle on longer term interest rates. President Biden chose not to resolve thisuncertainty until late November 2021.
The Political Economy of Macroeconomic Stabilization Policy in an Environment of More
Activist Fiscal Policy
This bring us to another critical issue. Central bankers and monetary policy analysts are often
asked if there is a risk that current elevated inflation could morph into a more sustained anddifficult to tame 1970s style inflation. The common answer, intended to be reassuring, is that thisis highly unlikely. Inflation expectations are far better anchored. Central bankers understand how
to deal with supply shocks much better than they did in the 1970s. Central banks are now
independent. This all rings true. However, it omits to consider the reassertion of fiscal policy as
co-equal partner in stabilization policy. While it is fair to say that more is known about fiscal
policy than fifty years ago, theory and practice are far less developed than for monetary policy.
The idea of laying out a technocratic fiscal rule with anywhere near the degree of consensus asaround monetary policy is, at least in the United States, nothing short of ludicrous. The
politicization of fiscal policy is baked into the democratic process.
In two papers written four decades ago, Alesina and Tabellini (1990) and Persson and Svensson(1989)7 argued that democracies with competing political parties inevitably have a strong debt
bias. Overspending (under-taxing) is not only a way of taking advantage of what might be atransitory period in power, but also a way of constraining the opposition party when it comes
into power. Translated into United States politics, Republicans do not mind running deficits ifthey are to fund new tax cuts or spend more on the military. Democrats are happy to run deficits
if the money is spent on social programs and middle-class entitlement programs. Invariably, the7

Alberto Alesina and Guido Tabellini, 1990, “A Positive Theory of Fiscal Deficits and Government Debt,” Review
of Economic Studies, 57 (3), July, pp. 403-414. Torsten Persson and Lars Svensson, 1989, “Why a Stubborn
Conservative would Run a Deficit: Policy with Time-Inconsistent Preferences,” The Quarterly Journal of
Economics, 104(2), May, pp. 325-345.

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opposition party almost wants to scale back the size of deficits to have greater flexibility forwhen it is next in power.
For broadly similarly reasons, plans to create “automatic” broad-based transfer payments neglect
the fact that rent-seeking politicians have every incentive to undo their effects.8 The
Congressional Budget Office in the United States has managed, admirably, to retain its
reputation as an honest broker for budget cost and debt projections, but it is still sharply
constrained in how it can make its assessments (for example needing to take legislation
governing future spending and taxes are credible, even when it is not). And it cannot advise on
policy. As long as there are sharp divisions between two closely competing parties, long-term
fiscal credibility is necessarily sharply circumscribed.
The 2021-22 US experience underscores just how much the recent academic literature has failed
to incorporate political economy. For example, the standard prescription for stimulating the
economy at the zero bound is to use deficit-financed fiscal policy up to the point there is “liftoff” of interest rates. The idea is common to many papers and widely advocated in the policy
literature. An early full-blown New Keynesian reference is Christiano, Eichenbaum and Rebelo(2011).9 Importantly, Christiano et al. emphasize that if fiscal authorities cannot credibly commit
to taking their foot off the gas once lift-off is achieved, then it will be much less effective. Thatbasic point is also clear from the Krugman’s seminal 1998 two-period model10, where one canshow that a shock to government spending that is expected to be permanent does little to pushinterest rates away from the zero bound.11
The excessive stimulus during 2021 shows the pitfalls of the “maximal deficit spending until
liftoff from the zero-bound approach.” First, in a theoretical model, fiscal policy can be dripped
out, but in practice, major spending bills come in big chunks since they involve so much horsetrading to reach consensus; that is there are significant transactions delays, and large deadweightcosts. Second, the timing of expenditures themselves are difficult to calibrate. Fiscal policy is nota single variable, but the sum of vast spending and tax policies, each with their own
redistributive and idiosyncratic effects. No two fiscal stimulus programs are the same, and notwo can be expected to have the same impact and timing. Third, fiscal subsidies often create theirown constituencies that make them difficult to reverse, which if built into expectations, createsproblems with their initial efficacy as there is less effect on the interest rate as Christiano et al.
demonstrate. But perhaps most importantly, even if the central bank is charged with raisinginterest rates if fiscal stimulus is excessive, it is not necessarily easy to forecast when inflation
will rise, particularly if inflation expectations are firmly anchored. In sum, the equivalence of8

I am somewhat understating the progress internationally, where fiscal councils have evolved to try to depoliticize
certain elements of the fiscal process.
9
Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, 2011, “Why is the Government Spending Multiplier
Large?” Journal of Political Economy, 119(1), February, pp. 78-121.
10
Krugman, Paul R., 1998, “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on
Economic Activity, 2, pp. 137-205.
11
It is important to note the zero-bound literature has largely concentrated on the case of large, closed economies. Ina small open economy (say a smaller advanced economy), the real interest rate is primarily determined in global
markets, so a significant share of any stimulus will end up affect the current account deficit, not the interest rate.

6

fiscal and monetary policy stabilization policy that one gets in a simple IS-LM model (or a richer
New Keynesian model) fails to consider the nearly infinite dimensionality of fiscal policy (whopays and who receives), and the concomitant political issues that invariably arise. By contract,monetary policy is extremely narrowly focused.
Before the new weight given to fiscal policy in stabilization, the monetary rule could be designed
rather straightforwardly and still be somewhat resistant to fiscal volatility. That is no longer soclear in the United States. With fiscal policy aspiring to a more active role – and at the zerobound for interest rates, the lead role – the efficacy of simple monetary rules is no longer
clearcut. The problem is even more severe in a situation where, as in the United States after the
pandemic, there is fundamental disagreement over the model both within the government andwithin the academics, making the central bank’s choices far more difficult. Prior to the financial
crisis, the role of fiscal policy in a recession was to provide insurance and a strong social safety
net, if necessary running a large deficit. However, because of difficulties in timing and reachingconsensus, it was not given a lead role in short-term stabilization except, of course, in the case ofnatural catastrophes such as COVID-19 or war. In a world where politically-driven fiscal policy
has a co-equal or lead role in short-term stabilization policy, it is difficult to see how central bankcredibility can be maintained at the same level as in the past.
If there were an appetite to maintain central bank independence, of course there are manymeasures that can help reinforce it and there has been experimentation around the world; it is not
at all clear there is any appetite for that in the United States. Progressives, in fact, might want to
see the central bank become more institutionally subordinate to the Treasury, while someconservatives prefer having the Fed follow more algorithmic interest rate rules, taking away
discretion if not necessarily independence.
Innovation to Reboot Central Bank Independence: Higher Inflation Targets vs Effective
Negative Interest Rate Policy
The political roots of discontent with central bank independence run deep. The 2008-09 financial
crisis has produced a strong populist reaction against a broad range of orthodox economic
institutions and policies, from financial firms to globalization. But surely the zero bound on
interest rates has played a key role. If indeed large-scale purchases of government debt (which I
prefer to term “pure” QE as opposed to “fiscal QE” purchase of private assets) are effectively
just a form of maturity transformation, then treasuries and finance ministries can easily undertake
QE on their own. QE may have some effect given segmentation in market between entities that
can hold reserves (and therefore freely substitute with treasuries) and the general public. But thetight arbitrage between the rate of interest on bank reserves and one-week treasuries (which tend
to pay a slightly lower interest rate), not to mention extensive experience and empirical work,
reinforced the view that pure QE is a very weak instrument outside severe crisis episodes whenmarket functioning is impaired. For years, most central banks had difficulty bringing inflation
up to target from below even with massive quantitative easing policies.

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As already noted, one idea that has been widely advocated for restoring the efficacy of
conventional interest rate policy has been to raise the inflation target to 4%.12 If credible, the idea
would be to raise the general level of interest rates so there is more room to cut in a recession.
The idea has merits but also significant drawbacks, as noted in Rogoff (2016, 2017).13 First andforemost, having abandoned the 2% target deeply ingrained in expectations, it might provedifficult to re-anchor expectations, and to eliminate lingering uncertainty about whether further
changes might be coming. Very importantly, if the length of contract intervals remains the same,
there will per force be greater dispersion in prices, creating inefficiencies. On the other hand, if
recontracting is more frequent, or inflation indexing becomes more prevalent, then monetary
policy becomes less effective. Simply put, the central bank will need larger interest rate cuts toachieve the same effect, and much of the benefit of raising the inflation target will be lost.
Nakamura et al. (2018) find that during the 1970s price dispersion did not become larger, but ofcourse this would require more indexation or more frequent adjustment.14 (Unless wage andprice setting to become highly synchronized, which does not seem empirically likely except
perhaps for a highly unionized country with nationwide wage setting.) Perhaps mostimportantly, the central bank would almost surely hit hard against the zero bound in any deep
recession; the extra two percent rope would not be enough according to most estimates. (Again,
in a deep financial crisis or a pandemic, of course fiscal policy is especially important, but there
tend to be crisis situations when (at least limited) consensus is easier to achieve.)
A much more elegant way to restore the efficacy of monetary policy in an exceptionally low
interest rate environment would be to take the steps necessary to invoke deep negative interest
rate policy. Until now, no central bank has tried this, or come close to doing so. There arenumber of legal and institutional challenges, but by far the main one is how to prevent wholesale
arbitrage (e.g., by insurance firms, pension funds and banks) from all interest-bearing assets into
paper currency. Even the main complaint from the banking sector, that they cannot easily pass on
the costs, ultimately stems from the fact that customers have the option of substituting into zerointerest paper currency if rates become too negative. (Recent research does appear to suggest thatthe zero bound is not terribly meaningful for large depositors even in the current regime.)
Admittedly, given only limited experience, it is difficult to be certain whether interest rate policy
would have the same effects in negative territory that it does when policy rates are positive. The
limited amount of research that has been undertaken to date suggests that it does have similareffects, if perhaps muted (see, for example Altavilla et al. (2022), Bottero et al. (2019), Ulate

12

The first analytical paper to analyze a 4% inflation target is Fuhrer, Jeffrey, and Brian Madigan, 1997, “Monetary
Policy When Interest Rates Are Bounded at Zero,” Review of Economics and Statistics, 79, December, pp. 573-85.
Kenneth Rogoff, 1998, points to the earlier Fuhrer and Madigan paper in “Comment on Paul Krugman, ‘It’s Baaack:Japan’s Slump and the Return of the Liquidity Trap,’” Brookings Papers on Economic Activity, 2, pp. 194-99, andalso in Kenneth Rogoff, 2016, The Curse of Cash, Princeton University Press.
13
Kenneth Rogoff, 2016, The Curse of Cash, Princeton University Press and Kenneth Rogoff, 2017, “Dealing with
Monetary Paralysis at the Zero Bound,” Journal of Economic Perspectives, 31(3), pp. 47-66.
14
Emi Nakamura, Jón Steinsson, Patrick Sun, Daniel Villar, 2018, “The Elusive Costs of Inflation: Price Dispersion
during the U.S. Great Inflation,” Quarterly Journal of Economics, 133(4), pp. 1933-1980.

8

(2021)).15 But precisely because no central bank has taken steps to eliminate the effective zero
lower bound, existing results surely considerably understate what the effects would be if a rate
cutting cycle, once initiated, were not bounded.
Indeed, it is curious that with tens of dozens of papers published in top journals on how to deal
with the zero bound, including all kinds of out-of-the-box ideas, more attention is not given to
the relatively simple steps required simply to remove the zero bound. If this could be done, it
could potentially restore the efficacy of monetary policy in a low interest rate environment,
defuse calls for excessive reliance on difficult-to-calibrate fiscal policy, and help to refocus
central banks on monetary policy where they have competency and comparative advantage.
There are multiple ways to deal with cash arbitrage but two stand out as simplest and cleanest.
One is to gradually phase out paper currency except perhaps for small notes (which would makelarge-scale arbitrate into paper currency impractical). If one restricts attention to legal, fully-tax
compliant transactions, such a transition has been underway for decades. The second approacheffectively involves making the trade-in value of cash (at the central bank) depreciate over time,
at a rate calibrated to match the path of negative interest rates.16 (By the same token, the rate canbe made to appreciate during times reserves pay a positive interest rate.) Such a system would
create an exchange rate between electronic currency and cash, which would be controlled bycentral bank. (For the history of this idea, which goes back at least a century to Robert Eisler andin a cruder form to the treasury of Kublai Khan, see Rogoff (2016).17) With this simple
institutional change, the problem of paper currency arbitrage is virtually eliminated. Of course,
negative rates are indeed a tax on currency, but if designed symmetrically, they can also be a
subsidy to currency when rates are positive. If negative rates are part of a system that keeps
overall inflation low, then it is not at all obvious the real tax on cash would be any higher than if,
say, the inflation target were raised substantially.
Both approaches to dealing with cash arbitrage have their virtues, and the choice really depends
on the extent to which one believes it is important to preserve large denomination notes. I haveargued elsewhere that the net cost to society of large denomination notes is negative, but thedebate over negative interest rates should be entirely separate, since there exist perfectly
satisfactory approaches that do not involve scaling back cash usage at all.
Given the huge stakes, the profession’s lack of interest in engaging more seriously on how to
implement open-ended negative rates issue is puzzling indeed; the most casual objections are
15

See Carlo Altavilla, Lorenzo Burlon, Mariassunta Giannetti, and Sarah Holton, 2022, “Is there a zero lower
bound? The effects of negative policy rates on banks and firms,” Journal of Financial Economics, 144(3), June, pp.
885-907. See also Margherita Bottero, Camelia Minoiu, José-Luis Peydro, Andrea Polo, Andrea F. Presbitero, andEnrico Sette, 2019, “Negative Interest Rates and Portfolio Rebalancing: Evidence from Credit Register Data,” IMF
Working paper 19/44, February. See also Mauricio Ulate, 2021, “Going Negative at the Zero Bound: The Effects ofNegative Nominal Interest Rates,” American Economic Review, 111(1), pp. 1-40.
16
There can be a wedge between the rate of depreciation on physical currency and the rate of return on electronicbank money, because the two are not perfect substitutes, and the way central banks set the depreciation(appreciation) rate on cash needs to take this into account (Rogoff (2016)). However, in a negative interest rateenvironment, wholesale arbitrage will likely keep this wedge fairly low.
17
Kenneth Rogoff, 2016, The Curse of Cash, Princeton University Press.

9easily dismissed. Perhaps it is because the study of financial plumbing is not as appealing tojournals. Of course, there is a completely legitimate concern that overly negative real interest
rates will lead to financial excess, uneconomic investments, and lead to financial crises. But
presumably central banks would only turn to negative interest rates in a sustained deflationary
environment where weak demand was significantly weighing on growth, or in a deep recession(such as caused by a financial crisis) where asset prices are already depressed. In electing to pushnominal interest rates into negative territory, the same considerations should apply as whencentral banks cut interest rates during times where the neutral real rate is nearer to historic norms
and inflation at or above trend.
To the extent there are justifications for why researchers have not been more open to studying
how to remove the zero bound, perhaps the most reasonable is the assertion that psychologically,
people would not accept having their currency go down in value in nominal terms. Obviously,
this places a huge weight on nominal illusion; the typical person is keenly aware that highinflation eats away at the value of their nominal assets including cash. They do not like it, but noone suggests it is politically impossible, even double-digit rates of inflation. Practical central
bankers, who have experimented with negative rates, cannot be blamed for failure ofexperimentation, they have been more imaginative than massive academic literature which treats
the zero bound as an immutable fact of nature. Of course, if the current high inflation turns into
the Second Great Inflation, and if real interest rates regress towards long-term trend, perhaps thisdebate can be temporarily deferred. To be clear, if central bank independence is to be restored, if
we are to have central bank independence 2.0, some approach to re-establishing normally interest
rate policy will have to be a part of it. In my view, despite the rather closed-minded reaction
from much of the academic profession, establishing open-ended negative interest rate is thepreferred solution.
Would the Federal Reserve have waited as long as did to raise interest rates in 2022, if it knew it
had an effective policy for reversing course if it overshot and put the economy into recession?
Perhaps the answer is still yes, given all the political pressures that were brought to be bear. But
the option of negative rate policy would have taken away one of the strongest arguments forhesitation. Lastly, I have not stated this, with in all-digital world (there can be some residual
smaller paper bills), there is simply no obstacle to taking policy interest rates deeply negative if
needed. It can work with a central bank digital currency, but there is absolutely no need for it.
Negative rate policy can work perfectly well within the current two-tier banking system.
De-Globalization and Global Inflation
I have already discussed how the zero bound and the ascendency of more forcefulcountercyclical fiscal policy create significant problems for central bank independence. Anotherfactor going forward is the potential for a retreat from globalization, as well as adverse
demographics. In their widely cited 2020 book, Goodhart and Pradhan emphasize two key
factors they argue may prove inflationary over the coming couple of decades. First, if one
accepts that the rise of China has been a huge deflationary force until now, then the rapid agingof the Chinese economy could turn this effect into reverse. China is expected to have two
hundred million less worker by the year 2040, and the population by 2100 is expected to shrink
10from 1.4 billion people today to less than one billion, and perhaps as little as eight hundred
million. If India and Africa are unable to substitute for China over the next couple of decades,
this amounts to a massive decline in global productivity. They argue this will mean much higher
inflation. Their argument is powerful except that it neglects a key element: regardless of realfactors (demographics, trade, etc.), the long-term inflation rate is completely controlled by thecentral bank. So, the Goodhart Pranab analysis begs the question of why exactly a reversal inglobalization should lead central banks to make different choices of the long run.
In fact, Rogoff (2004) addresses exactly this fundamental question.18 That paper tackled the priorquestion of why expanding globalization might be disinflationary, much as Goodhart and Pranab
argue that future falling globalization (mainly due to demographic trends) is likely to be
inflationary. To address this question, one needs to develop a model where political economy
factors can impinge on equilibrium inflation, a dynamic that has been largely assumed away inthe mainstream New Keynesian central bank literature but, as I argue here, may again be coming
to the fore. My 2004 paper developed such a model (albeit only a super-simple illustrative one)
to argue that if increasing globalization increased price flexibility and reduced monopoly power,
then it is quite plausible it would lower equilibrium inflation on a lasting basis. This argument(which would run in reverse with deglobalization) is critical. In essence, the period of rapid
globalization made it easier for central banks to credibly bring down inflation, making it appear
that simply announcing inflation targeting did all the work. Going forward, a retreat fromglobalization, if it transpires, will make the pressures on central banks greater and their jobs
harder. Obviously, there are severe limitations to making a political economy model of central
banking realistic. Nevertheless, the discipline of writing down such a model allows one to
sharpen the distinction between what kind of shocks and changes lead to lasting higher trend
inflation, and what kinds of shocks are likely to have only very short-term effects. (In the modelof Rogoff (2004), supply shocks that do not change the underlying structure of the economy do
not have a lasting impact on inflation even if long-lasting and sustained.)
Challenges to Central Bank Efficacy and Independence from Innovation in Digital Currencies
I have spent some time on the trends of the past 14 years that have undermined central bankindependence and suggested an important measure to deal with it. But in some ways even bigger
challenges may be around the corner, stemming from the proliferation of digital assets. This is ahuge and fast-evolving topic, which I covered in the final chapters of my 2016 book on the past,present and future of money. I do not have time in this lecture to devote nearly enough space tothis issue, but it is important to mention before concluding, precisely because it again shows how
important it is to keep political economy front and center in designing central bank frameworks
and policies.
A central thesis of my 2016 book is that if one looks at the long history of money, innovation
almost always comes from the private sector, but in time, the government always regulates, andoften appropriates. Standard coinage was in private use long before the King of Lydia issued the18

Rogoff, Kenneth, 2004, “Globalization and Global Disinflation,” Monetary Policy and Uncertainty: Adapting to a
Changing Economy, pp. 77-112, Federal Reserve Bank of Kansas City, Monetary Policy and Uncertainty
conference.

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first government coinage. Paper currency (“flying money”) was in private use centuries before
Marco Polo came to witness the “alchemy” of Kublai Khan’s Mongol treasury. The same story
repeats itself in other places and other times as money is invented and recurs as moresophisticated forms of exchange develop. I go on to argue that it is folly to forget that digitalcurrencies, and crypto currencies, will eventually be heavily regulated, and central banks may
well some day issue their own digital currencies.
This may all prove true, but history suggests that one must be cautious in predicting the time
dimension over which such changes will take place. Past private financial innovations havetypically taken decades, if not even centuries for governments to fully regulate, much less usurp.
What does this imply about the timing and long-run for cryptocurrencies? Well, I do believe thatin the long run, decentralized pseudonymous currencies will either be decrypted (in which casethey will be dominated by lower cost centralized alternatives), or else they will be banned inadvanced economies. By “banned,” I mean that they cannot be used in any legal transactions andattempts to use them without reporting would be vulnerable to same techniques governments use
to trace off the books cash transactions. In principle, and possibly also necessary, the government
could also ban holding cryptocurrencies. However, one must be careful to emphasize that even if
the United States and all advanced economies (and China) were to ban crypto, there would
almost surely be holdouts, at a minimum among rogue states, and quite possibly in developing
countries. Not all countries have same incentives, for reasons it is hardly necessary to explain
given the outbreak in 2022 of war in Europe.
However, even if a ban does eventually come, it could take years, even decades to work its way
through the political system. If Bitcoin can be used widely for say, another two or three decades,(to avoid taxes, capital controls and regulations) it can still have great value today given its latenttransaction uses (which I have documented in recent work with Reinhart and von Luckner).
Consider that fossil fuel companies have massive valuations even though their products may
some day be taxed into oblivion (at least in advanced economies).
One especially important reason the political system might take decades to come to a resolution
is that the industry has already been immensely powerful and influential, using its resources tolobby politicians for favorable regulatory treatment. Twenty percent of the advertising time forthe 2022 Super Bowl – was purchased by crypto-related companies. Given the balkanization ofregulatory law in the United States, and failure of Congress to address the problem, there iscompetition among states to become the most crypto friendly environment. Many pension funds
and banks are moving into crypto, making regulation that might drive down the price harder.
With exceedingly high returns in the crypto industry, regulators have a nearly impossible job
competing for talent. There are eerie parallels between the impact of financial engineering on
system risk in the last 1990s and early 2000s, and crypto today, with regulators being told thatthey lack the expertise to regulate and could not if they wanted to.
There is also a second element to crypto currency regulation which is arguably quite different
than previous transactions innovations, at least in degree. International cooperation is difficult toachieve in part because although the cooperative solution may involve strong regulation,individual countries may have an incentive to court the industry, even if the flourishing of the12industry in one country hits others with negative externalities. Indeed, we are already seeing thisacross emerging markets, where crypto has become a major problem for treasuries and financeministries, helping to facilitate tax avoidance and capital flight (I again refer to my work withReinhart and von Luckner)19. Of course, until the United States federal government takes
decisive action, a similar problem is at play across states. (White papers issued by the Biden
administration and the Federal Reserve to date clearly do not show any great movement incoming to grips with the problem.)
At present, many countries, from the United Kingdom to Singapore, are competing to become
capitals of crypto, the Switzerlands of the digital age. Some have argued that the United Statesshould toss its hat in the ring, dominating Web 3.0 as it has dominated the internet. One possible
future would be, instead of issuing a central bank digital currency, the US could allow a group of
regulated stable coins, backed by US issued securities, to thrive. Americans would be allowed touse the stable coins freely, effectively an alternative to conventional bank accounts, provided thestable coins issuers are required to conform to the usual AML and KYC information, andallowed the government to audit transactions in much the same way it can now audit debt andcredit card transactions.
What about central bank digital currencies? From the preceding discussion, we can see that the
incentives for smaller economies are vastly different than the incentives for issuers of major
currencies, such as the dollar, yen, euro and renminbi. For the major currencies, there may well
be a gain to issuing a wholesale digital currency to enhance operation of the financial system.
But it is far from obvious that a CBDC offers anything that cannot be achieved through an
evolution of the current system as real-time retail clearing becomes universal, and as Stablecoinsbecome more prevalent. For a small central bank, it is a completely different game, where thebenefits from establishing an internationally accepted cryptocurrency are considerable, and thecosts are mostly born outside the country.
Conclusion
Academic research in the inflation targeting era has taken central bank independence far too
much for granted. In fact, favorable tailwinds from globalization and technology made balancing
growth and inflation easier and reduced political economy pressures. Over the past decade,however, the effective lower bound on interest rates has undermined the effectiveness of the
instrument over which the central bank has the most independent control, which is also the mostpowerful instrument in their arsenal. Meanwhile, populism has intensified pressures on central
banks. Now, a retreat from globalization is turning tailwinds into headwinds, and could make thepolitical economy pressures on central banks considerably more intense, potentially leading tohigher (time-consistent) equilibrium inflation rates. Meanwhile, the rapid move towards digitalcurrencies also places pressures on the effectiveness of central bank instruments, pressures thatwill likely need to be met with a much stronger regulatory than most advanced economies haveseen so far. The world has arrived at a new era of political economy and having independent
19

Graf von Luckner, Clemens, Carmen M. Reinhart, and Kenneth S. Rogoff, 2021, “Decrypting New Age
International Capital Flows,” NBER Working Paper 29337, October.

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central bank has taken on new importance. But to deal with the significant political andtechnical changes that they are facing, central banks too need to innovate.

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