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Central Banking in Contemporary Capitalism: Monetary Policy and its Limits

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 R E S E A RC H O N M O N E Y
AND FINANCE

Discussion Paper no 5

Central Banking in Contemporary Capitalism:

Inflation Targeting and Financial Crises

Demophanes Papadatos
Department of Economics, School of Oriental and African Studies

15 February 2009

Research on Money and Finance Discussion Papers

RMF invites discussion papers that may be in political economy, heterodox economics, and
economic sociology. We welcome theoretical and empirical analysis without preference for
particular topics. Our aim is to accumulate a body of work that provides insight into the
development of contemporary capitalism. We also welcome literature reviews and critical
analyses of mainstream economics provided they have a bearing on economic and social
development.

Submissions are refereed by a panel of three. Publication in the RMF series does not preclude
submission to journals. However, authors are encouraged independently to check journal policy.
Demophanes Papadatos Address: Department of Economics, Soas, Thornhaugh Street,
Russell Square, London, WC1H 0XG, Britain. Email: [email protected]

Research on Money and Finance is a network of political economists that have a track
record in researching money and finance. It aims to generate analytical work on the
development of the monetary and the financial system in recent years. A further aim is to
produce synthetic work on the transformation of the capitalist economy, the rise of
financialisation and the resulting intensification of crises. RMF carries research on both
developed and developing countries and welcomes contributions that draw on all currents
of political economy.

Research on Money and Finance

Department of Economics, SOAS
Thornhaugh Street, Russell Square
London, WC1H 0XG
Britain

www.soas.ac.uk/rmf

Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 2
 Abstract

This paper examines central banking in contemporary capitalism,

particularly the role of inflation targeting and central bank
independence. Emphasis is laid on the consequences of financial
instability in light of the various episodes of the 1990s as well as the
current sub‐prime mortgage market crisis. A Marxist political economy
framework of monetary policy and financial instability is employed to
show the limits of contemporary monetary policy. The paper stresses
the importance of the various social and political aspects of central
banking and their relation to class interests. It is established that the
recent financial crisis shows the class dimension of inflation targeting,
particularly its defence of financial interests. Central banks have used
their power to protect financial profits while socialising financial losses
at the expense of the vast majority of society.

Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 3
1. Introduction

Financialisation is the result of the transformation of real accumulation in recent years,

which has also led to the transformation of the financial system. Real accumulation
witnessed a regime shift in 1973‐74, during the so‐called first oil shock that signalled the end
of the long post WW II boom. This regime shift was accompanied by a profound
institutional and political reaction as a response to the failure of official Keynesianism to
deal with the stagflationary crises of the 1970s. The recent wave of financial globalisation
started in the mid‐1980s, with rising cross‐border financial flows among industrial
economies and between industrial and developing economies. This has in turn promoted
financial innovation, such as the introduction of increasingly sophisticated financial assets
and the growth of new financial players.

Against this background the financial sector has been entirely transformed through rapid
growth, deregulation, global expansion, introduction of new technology, institutional
change and financial innovation. The weight of the financial sector has grown markedly in
developed countries in terms of employment, profits, size of institutions and markets.
Finance now penetrates every aspect of society in developed countries, and is becoming
increasingly important in the developing world (Lapavitsas, 2009).

However, with the surge in financial flows came a spate of currency and financial crises in
the late 1980s and 1990s. The importance of the central bank has increased as bubbles and
financial crises have become a regular feature of financialised capitalism, particularly since
their nature has varied significantly from the turmoil of the mid‐70s due to the
transformation of the financial system. Nevertheless, much ambiguity and confusion
surrounds the operations of the central bank in the new environment, even as it aims to
preserve the interests and social dominance of the capitalist class.

A first response to these trends by economic policymakers was to strengthen the monopoly
of the central bank over legal tender. The financial system became even more dependent on
using central bank money as obligatory means of payment for the settlement of debts. At
the same time, inflation targeting and central bank independence were also adopted.1 Since
the early 1990s inflation targeting has become the dominant (‘best practice’) monetary
policy paradigm in several high‐ and middle‐income countries.2 In addition to countries
that follow fully‐fledged inflation targeting policies, several dozen countries have adopted it
informally or implicitly, for example, by pursuing ‘inflation caps’ (maximum desired
inflation rates) in the context of IMF programmes. Such ‘caps’ are insufficient to define these
policy regimes as inflation targeting, but they are evidence of a medium‐term move towards
inflation targeting.

Moreover, the macroeconomic performance of most OECD countries improved in terms of

inflation, unemployment, output volatility and interest rates during the last ten to fifteen
years. This is the so‐called ‘Great Moderation’, which has been attributed by mainstream
theorists to neo‐liberal policies. In this context, monetary policy has become even more
prominent, further strengthening the tendency towards adopting inflation targeting
(Bernanke, 2004).

1 On how the central banks have strengthened their monopoly of legal tender in the era of financialisation, see Kneeshaw,
J.T. and Van den Bergh 1989.

2The following countries are full‐fledged inflation‐targeters: Australia, Brazil, Canada, Chile, Colombia, Czech Republic,
Hungary, Iceland, Israel, Mexico, New Zealand, Norway, Peru, Philippines, Poland, South Africa, Republic of Korea,
Sweden, Thailand and the United Kingdom (see Carare and Stone 2003 and Stone and Bhundia 2004).
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 4
This paper discusses these developments by adopting a Marxist approach which stresses the
social and political aspects of central banking and their relation to class interests. It is shown
that the current financial crisis has also become a crisis of the monetary policy regime, while
revealing the class dimension of inflation targeting. Essentially, inflation targeting has been
an attempt to preserve financial interests at the expense of the vast majority of society. The
same underlying aims characterise recent mainstream proposals to move central bank policy
beyond inflation targeting. Devised partly in response to the current crisis, these proposals
stress the central bank’s function as lender of last resort and complement it by the novel
function of ‘market‐maker of last resort’. Such policies aim at using the power of the central
bank to socialise financial losses while defending private profits.

The paper first analyses the inflation targeting framework while advancing a political
economy critique of mainstream views of inflationary phenomena. It then analyses the
social relations characteristic of central banking by adopting a Marxist approach.
Specifically, the theory of central banking as “contested terrain” of class and intra‐class
conflict is subjected to critical analysis. Further, capital/labour and finance/industry
relations are examined in light of developments in the era of financialisation under the neo‐
liberal agenda. Finally, financialisation is analysed with regard to financial bubbles,
establishing connections between bubble‐bursting and sudden changes in monetary policy,
while demonstrating the relation of monetary policy changes to social and political interests.

2. The Rise and Fall of Inflation Targeting

2.1 The trajectory and effectiveness of inflation targeting

Inflation targeting has been the dominant, ‘best practice’ monetary policy paradigm for
nearly two decades and until the emergence of the subprime mortgage crisis. Things have
now changed and several policymakers and economists argue that central banks must move
beyond inflation targeting.

Early indications of the demise of inflation targeting can also be detected in the previous
period. Thus, until the Asian crisis of 1997‐8, inflation targeting was implemented in its
original form, the primary focus of which was price stability. However, after the financial
crises of the 1990s, financial stability began to be considered as a goal for monetary policy of
equal, if not greater, importance to price stability. This contributed to a gradual weakening
of the exclusive focus towards price stability (Siklos, 2002, p.8). This gradual weakening of
the primary focus on price stability has encouraged a theoretical critique of inflation
targeting, which has supplemented older empirical critiques of its effectiveness.

Problems for inflation targeting appeared already in the early period of its implementation,
when conflicting conclusions came out of efforts empirically to measure its effectiveness.
Several studies identified presumed gains regarding the rate, volatility and inertia of
inflation, improved expectations, faster absorption of adverse shocks, lower sacrifice ratio
(the output cost of reducing inflation), output stabilisation, and convergence of poorly
performing towards well performing countries.3 However, other studies were more critical
of the effectiveness of inflation targeting. They claimed that there is no convincing evidence
that inflation targeting improves economic performance as measured by the behaviour of

3See, for example, Bernanke, B.S. and M. Gertler 1999a , Debelle, G. Masson, P. Savastano, M, Sharma S 1998, Mishkin and
Schmitt‐Hebbel 2001.
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 5
inflation, output or interest rates, and it may even lead to a deterioration of some indicators,
especially unemployment.4

These conflicting conclusions are partly due to the different approaches and econometric
methodologies used in various studies. Yet, the divergence of assessment is also due to
deeper reasons. There are strong indications that the performance of most OECD countries
has improved in terms of inflation, unemployment, output volatility and interest rates
during the last ten to fifteen years. These improvements are evident in both inflation
targeting and non‐inflation targeting countries, which suggests that the underlying cause is
something other than inflation targeting.

In the words of Arestis and Sawyer (2006, p.24): “Both inflation targeting and non‐inflation
targeting countries performed over the inflation targeting period equally well. The average
rate of inflation and its variance have been reduced in both periods. This is true for both
inflation targeting and non‐ inflation targeting countries … We may conclude … by
suggesting that on the basis of the average inflation and GDP growth rates performance,
there is not much difference between inflation targeting and non‐ inflation targeting
countries … Consequently, inflation targeting has been a great deal of fuss about really very
little!”

2.2 The framework of inflation targeting

According to its advocates, “fully‐fledged” inflation targeting consists of five components:

absence of other nominal anchors for the economy, such as exchange rates or nominal GDP;
no fiscal dominance; policy (instrument) independence; policy transparency and policy
accountability.5 In practical terms, the central bank announces that it will strive to hold
inflation within a specified target range ‐ rather than a plain number ‐ typically established
for horizons between one and four years. “Price stability” is usually defined as 2% inflation
(Bernanke and Mishkin, 1997, p.99).

The degree to which the central bank is formally accountable for meeting this target varies.
In New Zealand, for example, the law links the tenure of the central bank governor to the
inflation target whereas in other countries there are no legal or explicit sanctions. At the
institutional level, inflation targeting is usually associated with changes in the law, which
enhance the independence of the central bank from the elected government.6 Some
economists draw a distinction between goal independence and instrument independence
(Debelle, Guy, and Stanley Fisher, 1996). This distinction may not mean very much in
practice because the two kinds of independence are complementary – enhancing one kind of
independence necessarily implies enhancing the other (Bernanke and Mishkin, 1997, p.102).

Advocates of inflation targeting insist that, at the level of the government, the policy
institutionalises ‘good’ (i.e., orthodox) monetary policies, while increasing the transparency
and accountability of the central bank and providing guidelines for other government
policies. 7 Apparently, inflation targeting also helps to shape private sector expectations,

4See, for example, Agenor 2001, Cecchetti and Ehrmann 1999, Chang and Grabel 2004, pp.183‐4, and Neuman and von Hagen
2002, pp. 149‐153.

5 See Mishkin and Schmidt‐Hebbel, 2001, p.3; Bernanke, Ben S., Thomas Laubach, Adam S. Posen and Frederic S. Mishkin
1999.

6 Bernanke and Mishkin, 1997, p.102; Mishkin and Schmidt‐Hebbel, 2001, p.8.

7 See however, Aybar S and Harris, L (1998, pp. 20‐38) for a critique from a radical political economy perspective.
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 6
thereby reducing uncertainty and the costs associated with the necessary adjustment to the
new, low inflation regime. The implication is that other economic policy objectives – such as
employment generation, economic growth and income distribution – should be
subordinated to inflation targeting. Inflation targeting, therefore, came to dominate all
economic policymaking for nearly two decades. It reinforced the neoliberal view that
government intervention in the economy is either useless or counterproductive, and that
inflation is largely due to fiscal deficits, adverse expectations and lack of policy credibility.

It is worth examining a little more closely the economic model that underpins inflation
targeting. The model is very simple and includes two key parameters: the inflation target
and expectations of inflation. The former is set by the government, while the latter arise
from the private sector. The model also includes one discretionary policy instrument: the
nominal interest rate. In this light, the main objective of the central bank is to eliminate the
difference between the rate of inflation and the inflation target at some point in the future
(the ‘policy horizon’, usually set at between one and three years).

The model presumes that inflation is jointly determined by the inflation expectations of the
private (mainly financial) sector and the output gap, explained below. The rate of
unemployment presumably fluctuates around the NAIRU: when unemployment is below
(above) the NAIRU, it leads to higher (lower) inflation.8 The output gap (expressed as the
difference between the current rate of unemployment and the NAIRU) is determined by the
level of real interest rates. High real interest rates raise the output gap, while low interest
rates stimulate economic activity and reduce the gap. Finally, the real interest rate is, by
definition equal to the nominal interest rate minus inflation expectations. The central bank
attempts to hit the inflation target by manipulating the nominal interest rate in order to
influence expectations and, at a further remove, fine tune the level of aggregate demand.

It follows that inflation control demands ‘credible’ macroeconomic policies, which in

essence means adopting the “orthodox” policy view. It also follows that monetary policy
discretion should be used within a tight framework of rules. Furthermore, there should be
liberalisation of the capital account and elimination of residual inflationary pressures
through import liberalisation. It goes without saying that direct and indirect wage
restrictions should also be removed. Finally, when inflation targeting is implemented by
independent central banks, it is supposed to ‘discipline the politicians’ by removing the
inflation bias that they are supposed to generate due to elections.

Thus, the model and its policy implications are based on two underlying claims. First, that
persistent unemployment is essentially voluntary (natural), since involuntary (true)
unemployment is a transitory phenomenon. Second, that attempts to lower unemployment
below its ‘natural’ rate will trigger inflation, and perhaps even create accelerating inflation.
In short, inflation targeting is based on the notion that there is an empirical trade‐off
between inflation and unemployment. Yet, there is little evidence that this is true.

Drawing on empirical evidence, Shaikh (1997) has made three points to the contrary. First,
for much of the post‐war period, the rise in average unemployment levels in OECD
countries was directly associated with a fall in average output growth rates. Second, there is
no general historical trade‐off between unemployment and inflation in OECD countries.

8The NAIRU (non‐accelerating inflation rate of unemployment) derives from the monetarist concept of the ‘natural rate of
unemployment’ (NRU).The NRU is the unemployment rate at which all markets, including the labour market, are in
equilibrium. The NAIRU is defined as the unemployment rate compatible with stable inflation in the long‐run (if the
economy is operating below the NAIRU, inflation will presumably accelerate and vice versa).
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 7
Such a trade‐off might have existed during 1975‐1991, but the very opposite pattern seems to
hold for the period 1964‐1974. Third, inflation appears to be related to economic growth,
namely lower growth is associated with higher inflation.

Shaikh’s Marxist critique is consistent with the views of other authors within Marxist
political economy.9 Inflationary trends exhibit little homogeneity within capitalist
economies, and are often associated with processes that the state cannot immediately and
effectively control. A fuller understanding of both inflation and inflation targeting from a
Marxist perspective, therefore, requires placing these phenomena within a specific social
and historical context.

3. Central banking and class interests

3.1 The historical context of inflation targeting

The regime of inflation targeting is a product of historical development. After the collapse
of the Bretton Woods system in the early 1970s the ability of the main central banks to
exercise discretionary power over the rate of interest increased greatly. Monetary policy
started to acquire its present historical significance because of the attenuation, or complete
absence, of foreign exchange reserve discipline on the central banks. The rate of interest has
acquired the character of an instrument of public policy, and a multitude of often
contradictory demands has been placed on central banks regarding interest rate
manipulation. Typically these demands have included price stability, a satisfactory level of
economic activity and a balance of payments outlook compatible with high growth and
employment. However, the absence of gold discipline, after the collapse of the Bretton‐
Woods system, only served to emphasise the anarchical nature of the international capitalist
system by encouraging exchange rate instability, price inflation and financial speculation.

The collapse of the Keynesian ideology of full‐employment and the emergence of rapid
inflation in the 1970s gradually made price stability the primary objective of monetary
policy. Thus, Dumenil (2007, p.7) notes that the structural crisis of capitalism, beginning in
the 1970s, created the conditions for the reassertion of the hegemony of finance. The rise of
finance was combined with a broad set of other practices: deregulation, direct confrontation
with the worker movement and unions, a policy favourable to large mergers, and new
methods of corporate governance favourable to the interests of shareholders. For Dumenil,
neoliberalism is a new phase of capitalism, also signalling the return of finance to
hegemony.

The state has played an instrumental role during these transformations. Historically there
have been two primary and one secondary function of the state in relation to capital
accumulation. The primary functions are, first, securing the labour system and, second,
securing the money system. The secondary function is mediating the contradictory interests
of different parts of capital. The primary functions are critical to accumulation but cannot
be guaranteed by capital itself (De Brunfoff, 1976). The necessity of the state to secure the
labour and the money system is due to the very nature of capitalism. On the other hand, the
state’s mediating role derives historically from the anarchy of market‐based interactions.10

9 See A. Saad‐Filho (2000), A. Saad‐Filho and M.R. Mollo (2002)

10Marx’s first mention of the state in Capital is in relation to the production and distribution of coin, which is “an attribute
proper to the state”. The same point is made in relation to paper currency (Marx 1976, p. 223, 227)
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 8
As a state (or semi‐state) institution, the central bank has varied greatly throughout history
depending on the structure of the financial system, its connections with real accumulation,
the social and political relations mediated by finance, and the past practice of interventions.
The role of the central bank during the Bretton Woods era, for example, was the historical
result of the great depression of the 1930s as well as the emergence of the Keynesian
ideology of full employment. In the period of neoliberalism, which signalled the reassertion
of the power of finance, the major event was the change of monetary policy in 1979,
targeting monetary policy overwhelmingly toward price stability. The Volcker coup in the
USA took place primarily because of the experience of the stagflationary period of the 1970s
(Mayer, 2003), and eventually led to the triumph of inflation targeting.

3.2 Central banking and the management of modern money

Since the collapse of the Bretton Woods system, contemporary money has become
overwhelmingly credit money resting on central bank money (banknotes and deposits)
which is in turn backed primarily by state instruments of debt. Central banks have been
freed from the need to guard their gold reserves. Consequently, they have acquired fuller
discretion in making loans, in issuing their own money and, above all, in determining
interest rates. Under these conditions, stability of the value of central bank money has come
to depend on two factors: first, on the central bank’s management of aggregate credit flows
and, second, on central bank money being legal tender for the settlement of commercial and
other debts.

The central bank’s monopoly over legal tender is a fundamental component of

contemporary finance. Modern central bank money (banknotes and deposits) functions as
obligatory means of payments, backed mostly by state debt. Consequently, it has clear
aspects of fiat money, that is, money with arbitrary circulation backed by the power of the
state. Nevertheless, modern central bank money is still issued by a bank, in other words, it is
fiat money that has mutated out of credit money. The management of modern fiat money
draws on the social power and trust invested in the central bank. In this light, central bank
management of modern credit money ‐ a continuous evolving process – can be seen
primarily as an effort to preserve the value of credit money.

3.3 Central banking as “contested terrain” of class and intra‐class conflict.

The Marxist approach proposed here has common features with radical post‐Keynesian
treatments of central banking. Post‐Keynesian economics pays particular attention to
conflicting interests and especially to class and intra‐class struggles as determinants of
central banking. Central banking is seen as “contested terrain” in economy and society. 11
Four key factors determine monetary policy, namely the structure of the labour market,
connections between finance and industry, the position of the national economy in the
world economy, and the position of the central bank in the state apparatus.

However, the interpretation of financialisation underpinning this article also differs

significantly from the post‐Keynesian analysis. Differences are pronounced with regard to
the structure of the financialised labour markets as well as the connections between finance
and industry and their effect on monetary policy. Contrary to post‐Keynesian analysis, the
central bank is primarily a defender of financial interests rather than ‘contested terrain. This

11 See Epstein and Schor (1986, 1988, 1989, 1990), and Epstein (1992).
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 9
approach sheds necessary light on the various crises during the era of financialisation,
including that of 2007‐9.

To be more specific, with regard to relations between capital and labour, Epstein (1992)
distinguishes between what he calls the “Kaleckian” and the “neo‐Marxian” approach.12 The
latter posits a negative relationship between employment, capacity utilisation and profit
shares. As the economy expands and unemployment falls, workers gain the power to raise
real wages, or to improve working conditions, with the result of lowering productivity. Thus,
as capacity utilisation increases, unit labour costs increase and industrial profit share falls.
In contrast, the “Kaleckian” approach suggests that increased capacity utilisation reduces
competition and gives firms market power, thus allowing firms to increase their mark‐ups.
Consequently, industrial profit share rises as capacity utilisation increases or, at worst,
remains constant. Thus, the “Kaleckian” labour market postulates a non‐negative relation
between employment, capacity utilisation and profit share.

It is notable that neither of these approaches sheds much light on labour markets in the
current regime of financialisation. Ultimately this is because Epstein (1992, p.7) defines the
structural characteristics of labour markets by focusing on a very narrow aspect of the
capital‐labour relationship, namely the effect of changes in capacity utilisation (and thus of
the “reserve army” of the unemployed) on capital’s profit share. But the structure of
contemporary “financialised” labour markets has been determined partly by technological
change, partly by regulatory change, and partly by bouts of unemployment at key junctures
of the period of financialisation.

In the course of financialisation, as Lapavitsas (2009) notes, there has been a rebalancing of
paid and unpaid labour, while information technology has encouraged the contraction of
private time as well as piece work and putting out practices. These changes have effectively
led to an increase in the working day. Moreover, it is also likely that labour has been
intensified. From the extensive literature on job satisfaction, for instance, it transpires that
work intensification associated with new technology is a key reason for dissatisfaction with
work in developed countries, together with loss of discretion over work choices counting for
a deterioration of their living standards. Finally, the process of work has also been critically
affected by institutional changes in the labour market. This includes casualisation of labour
and entry of women in the labour force which effectively increased the working population.
Thus, the fluidity of labour has increased at the cost of greater insecurity of workers.

In this environment it is hard to advocate either a “neo‐Marxian” or a “Kaleckian”

relationship between employment and capacity utilisation. Rather, new technology has
intensified competition even among firms which previously possessed significant market
power. In “financialised” labour markets, employment is positively associated with profit
rates, while being institutionally dissociated from the wage level.

Furthermore, post‐Keynesian analysis of the relationship between finance and industry

under current conditions suggests that finance holds a dominant position relative to
industry.13 The reason is, presumably, that financial institutions have the ability to continue
making profits even when real accumulation meets difficulties. As a result, in the current
regime of capitalist accumulation, finance plays a pivotal role in promoting capital

12 Neo‐Marxism includes authors such as, Boddy & Crotty 1975; Schor 1985;Goldstein 1986; Schor and Bowles 1987;
Weisskopf 1988; Bowles and Boyer 1989; Bowles, Gordon, and Weisskopf, 1989.

13 Very selectively, see Stockhammer 2002, 2007, Orhangazi 2007

Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 10
accumulation as a whole. However, this is a problematic view. In spite of its rising relative
autonomy, finance continues to comply broadly with the essential motion of capitalist
accumulation because its objective foundations continue to be found in idle money
generated by capitalist enterprises.

The importance of this point can also be seen in connection with the “contested terrain”
approach. According to that, the primary concern of the central bank is to keep monetary
policy out of the hands of labour. But it is also argued that, when industrial and financial
capitalists are strongly divided, central bank independence often serves to keep monetary
policy out of the hands of industrial capital. In this case, the central bank tends
disproportionately to favour financial, or ‘rentier, interests.14 This means that there is space
for political alliances between labour and the industrial fraction of the capitalist class to
defeat the financial fraction.

It is important to note that Epstein (2002, p.17) has recently argued that: “There seems to be
further evolution in these class interests. Increasingly, in the United States and, probably
Europe, rentier and industrial interests may be merging, but not as in the case of old
German and Japanese financial structures (Zysman, 1984; Pollin, 1995; Grabel, 1997) where
industrial interests dominate finance. Rather, it may increasingly be the case that with the
deregulation of financial markets ‐ that is, with financialisation ‐ industrial enterprises
themselves are beginning to be increasingly guided by rentier motives. In short,
“financialisation” may have changed the structure of class relations between industry and
finance, making their interests much more similar”

In this connection, Marxist work shows that the foundations of the “contested terrain” are
flawed and the analysis has to be reconsidered (Lapavitsas, 1997a, pp. 85‐106). First, it
implies the existence of pure ‘functioning’ capitalists who possess investment projects but
no money. This is an ideally abstract assumption: In practice borrowing capitalists typically
possess some of their own capital plus some that they borrow. Second, revenue in the form
of interest tends also to accrue to industrial and commercial capitalists, and it is not the
exclusive foundation of a separate social group, such as financial capitalists. The separate
and often opposing interests of lending and borrowing capitalists cannot be fully analysed in
terms of the functioning‐industrial section of the capitalist class confronting the financial‐
monied section.

Lapavitsas (2009) makes further relevant observations regarding the characteristics of

contemporary rentiers in financialised capitalism. These confirm the view that revenue in
the form of interest tends to accrue to industrial and commercial capitalists and cannot be
the exclusive foundation of a social group. Rentiers in the era of financialisation are able to
draw extraordinary incomes because of their position relative to the financial system, and
not through ownership of financial capital. It follows that financialisation ought to be
approached by treating the financial system as a structured whole that is connected
organically to real accumulation. The recent ascendancy of finance has systemic origins. Its
social outcomes are far more complex than rentiers squeezing industrialists. By the same
token, there is no reason for labour to support industry against finance.

To recap, financial institutions have continued to make profits despite the problems faced
by real accumulation during the period of financialisation. Consequently, the significance of
the financial system has increased enormously, since under such conditions finance has
become a source of profits for the capitalist class as a whole. Meanwhile, capital‐labour

14 See Epstein and Ferguson 1984, pp. 957‐983; Epstein 1992, pp. 1‐30.
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 11
relations have been rebalanced with an eye to keeping central bank “immune” from the
influence of class struggles. The implication is that, in the era of financialisation, the central
bank is not “contested terrain” but the primary defender of financial interests. This is clear
in the context of financial crises, considered below.

4. Central banks and financial crises

4.1 The false belief that low inflation guarantees financial stability

The policy of inflation targeting has been eventually rendered redundant by the emergence
of major financial instability in the course of financialisation. It has taken some time for this
development to become clear, including several episodes of financial instability in the 1990s
and the gigantic crisis of 2007‐9.

The period of rapid inflation in the 1970s and 1980s was followed by nearly two decades of
stability in terms of prices, output volatility and interest rates. The mainstream attributed
these outcomes to monetary policy that focused on inflation targeting (Bernanke 2004). It
did not take long for the false view to emerge that price stability also guaranteed general
financial stability. On this basis, the central bank only had to concern itself with keeping
inflation low, and the financial sector could look after itself.

Schwartz (1988, pp. 33‐62 1998, pp. 34‐41) has been the main advocate of the view that price
stability guarantees financial stability, also shared by Bernanke and Gertler (1999a, pp.
18‐51). Relying on earlier work with Friedman (Friedman and Schwartz 1963), Schwartz
argued that the major threat to financial stability, especially for the banking sector, comes
from unexpected changes in the rate of inflation. Therefore, by promoting price stability, the
central bank “will do more for financial stability than reforming deposit insurance or
reregulating” (Schwartz, 1998, p. 38). If the central bank focused on low inflation, it would
apparently reduce the chances of lending booms (induced by high inflation) and recessions
(induced by unexpected deflation or disinflation). The “Schwartz Hypothesis” has been
tested by mainstream economists, who found a positive “association”, not causation,
between price instability and financial instability (meaning bank panics).15

These views are transparently fallacious, but they rest on ideological and political
considerations. The inflationary crises of the 1970s and 1980s represented failure to defend
the value of credit money. That failure had social and political implications, at the very least
because rapid inflation meant losses for creditors and because wage bargaining was
disrupted as workers attempted to obtain compensating increases in money wages. The
adoption of inflation targeting and central bank independence was a sign of the ability of
the capitalist class to learn from this experience.

Thus, the convenient legal fiction of independent central banking was created, separating
the electoral process from monetary policy. The latter was apparently to be determined by
disinterested and class‐neutral experts on “objective technical grounds”. Financial interests
were assured that inflation – which is deeply damaging to them – would not be tolerated.
Financial bubbles, on the other hand, were seen as irrelevant to central banking, and even
declared unlikely if inflation was kept low. In effect, financial interests were told that the
central bank was not going to intervene in their speculations, while protecting them from
high inflation.

15 See Bordo, Dueker and Wheelock (2000) and Bordo and Wheelock (1998, pp. 41‐62).
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 12
4.2 The significance of bubbles and financial crises

The emergence and burst of financial bubbles in the 1990s has undermined inflation
targeting, while showing the limits of contemporary central banking. Bubbles are
unsustainable, continuous increases in financial asset prices. They result from a climate of
optimism, which is fostered by rises in financial prices and leads to further price rises, thus
creating the phenomenon of asset price inflation. In an asset price bubble, consumers and
enterprises tend to over‐borrow. Rises in asset prices may also lead to a misallocation of
resources through time. There might be excessive capital accumulation in the short term,
for example, followed by an extended period of overcapacity. In this context, it becomes very
difficult for the central bank to set monetary conditions in a way that deals with changing
expectations regarding to the future pace of capital accumulation. As a result, there is
greater risk of policy error.

Moreover, according to Shaikh’s (1997) Marxist critique of inflation targeting, there is no

homogeneity to inflationary phenomena in the context of the capitalist market process.
Contrary to mainstream beliefs, inflation does not result simply, or mostly, from
government policy but also from the activities of the private sector, which are sometimes
revealed as changes in asset prices. These activities could undermine the ability of monetary
authorities to meet inflation objectives. Consequently, it is mistaken to think that asset
prices can be ignored, allowing monetary policy to focus exclusively on inflation.

It is important to note that in all countries that suffered financial bubbles during the last
fifteen years, inflation was either low in absolute terms, or low relative to its earlier history
(King, 1999). In each case, the emergence of an asset price bubble was closely correlated
with apparent success in lowering inflation, an achievement much prized by the advocates

Figure 1 ‐ US and Japan Inflation Rates, 1980Q1 ‐ 2008Q4

16

14

12

10

‐2
1980Q1 1983Q1 1986Q1 1989Q1 1992Q1 1995Q1 1998Q1 2001Q12004Q1 2007Q2
US Japan
Source: Bloomberg

Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 13
of the so‐called ‘Great Moderation’. This is not to exclude the fact that sometimes low
inflation was only a temporary phenomenon associated with a beneficial external shock, for
instance, in the UK in the late 1980s (King, 1999, 10‐18). Still, bubbles tend to emerge in
conditions in which inflation remains under control.

Figure 2‐ Britain and Germany Inflation Rates, 1980Q1 ‐ 2008Q4

9
8
7
6
5
4
3
2
1
0
‐1
1992Q1 1994Q1 1996Q1 1998Q1 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1
Britain Germany
Source: Bloomberg

It is clear from Figure 1, for instance, that Japan’s inflation rate in the 1980s remained at very
low levels. Even when it rose toward the end of the decade, it remained lower than that of
Japan’s competitors. Put another way, for much of the late 1980s, Japan would have easily
met most of the inflation targets currently in use. Very low interest rates in Japan in the
second half of the 1980s went together with low and stable inflation as well as rapid rises in
equity and land prices.

Moreover, when asset prices started to fall, Japanese monetary authorities failed to recognise
the dangers this posed for the economy. Expectations of future growth collapsed, and
industrial enterprises were left with excessive debt levels that prompted a slow move toward
deflation. Yet, the relative stability of inflation at the time gave policymakers an unjustified
level of confidence in the underlying health of Japanese capitalism. The Japanese experience
shows that catastrophic asset price bubbles can be consistent with pursuing low inflation.
The US experience in the late 1990s and more recently is a similarly good example of this
phenomenon. On this basis, it is probable that financial bubbles tend to develop when
inflationary pressures are low and, as a result, central banks feel comfortable with levels of
interest rates that eventually prove too low.

Furthermore, bubbles tend to develop when periods of low inflation are accompanied by
strong expansion of the domestic money supply (see Figures 3, 4, and 5). A temporary

Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 14
absence of price pressures allows central banks to tolerate excess money growth for an
extended period of time. A common rationalisation is that monetary expansion is not
problematic, if it reflects financial innovation. Thus, strong growth of money could in
practice lead to rapidly rising asset prices which, in turn, enable borrowers to offer
increasing collateral on loans, apparently lowering risk for lenders.

Figure 3 ‐ US M3 Money Supply Year on Year Change (percent), 1980Q1 ‐ 2006Q1

16

14

12

10

‐2
1980Q1 1982Q4 1985Q4 1988Q4 1991Q3 1994Q2 1997Q11999Q4 2002Q4 2005Q4

Figure 5 ‐ British M4 Money Supply Year on Year Change (percent), 1983Q3 ‐ 2008Q4
20

16

12

0
1983Q3 1986Q2 1989Q1 1991Q4 1994Q3 1997Q2 2000Q1 2003Q12005Q4 2008Q4

Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 15
Figure 4 ‐ German Money Supply (M3) Year on Year Change (percent), 1980Q1 ‐ 2008Q4
16

14

12

10

‐2
1980Q1 1983Q1 1986Q1 1989Q1 1992Q1 1995Q1 1998Q1 2001Q12004Q1 2007Q2
Source: Bloomberg

Finally, it is common for traditional risk assessment and valuation models used by financial
institutions to break down in the course of a bubble. This phenomenon has been particular
pronounced during the US bubble of 2001‐7. Technological progress and financial
innovations made it possible for banks to manage their liabilities more efficiently and
therefore more profitably. Instruments such as derivatives, transactions of securities, money
trust, insurance, as well as a variety of other services related to open markets encouraged
banks to turn toward financial market mediation. Also other activities, such as lending for
mortgages, consumer loans, credit cards and so on, which turn banks toward the personal
revenue of workers, became very prominent (Lapavitsas, 2009). A climate of optimism
fostered a huge asset bubble, contributed to lack of proper risk assessment, and eventually
led to burst. Low inflation offered no protection against the ensuing disaster.

To mitigate the consequences of bubbles bursting, central banks have tended to shift their
focus pragmatically, effecting emergency changes in monetary policy. This practical
response has been prepared by analytical work, such as McGee (2000) and Bean (2003, pp.
787‐807), arguing that price stability offers no guarantee of financial stability. Along similar
lines, Borio and Lowe 2002 have claimed that, if financial imbalances in the economy are
pronounced, there is a strong possibility of financial instability triggered by price stability.
Therefore they proposed the so‐called ‘flexible approach to inflation targeting’. This has
found some support from Mervyn King, the Governor of the Bank of England, arguing that
monetary policy may need to be tightened in response to rising asset prices, even if inflation
is not rising significantly.

The problem is that in a capitalist economy it is very hard to distinguish at an early stage
between a bubble and a period of lasting improvements in productivity performance.
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 16
Moreover, technological revolutions are often used to justify extended gains in asset prices.
It is historically documented that technological revolutions often give rise to bubbles.16 This
means that an initial expansion in economic activity based on productivity growth can give
way to unsustainable bubbles as money supply begins to increase and asset prices rise to
exceptionally high levels.

A case in point is the response of the Federal Reserve under Alan Greenspan to the so‐called
New Economy stock market bubble and the subsequent housing bubble in the USA.
Greenspan chose to restrain neither the former nor the latter. He declared himself right not
prick the equity bubble of the 1990s, allowing it to burst by itself and then ‘mopping up’ the
mess through lower interest rates. Greenspan justified his action on the grounds that one
can never be sure that what looks like a bubble really is a bubble. Apparently, he could not
use interest rates to ‘prick’ the bubble, because interest rates affect the economy more like a
sledgehammer than a scalpel. A modest rise in interest rates would be unlikely to halt rising
prices, but an increase sufficient to pop the bubble would slow the whole economy and
could even cause a recession. On this basis Greenspan concluded that it was safer to wait for
a bubble to burst by itself and then to ease monetary policy to soften the downturn.

In practice, Greenspan allowed financial interests to make enormous profits during the
bubble in the hope that the costs of the burst would not be unmanageable. It was taken for
granted, of course, that these costs would be passed on to society as a whole. Thus, inflation
targeting has gradually come to acquire the aspect of protecting private profits in a bubble,
while socialising losses during the burst. This approach led to disaster in 2007‐9.

4.4. Socialising losses to protect private profits

The crisis of 2007‐9 has thrown inflation targeting in turmoil. As was previously explained,
the policy can be characterised as the epitome of sophisticated monetarism, which emerged
primarily because of the experience of the stagflation of the 1970s (Mayer, 2003). The policy
limits the central bank to pursuing a low inflation target subject to broad rules, while
downplaying the traditional function of lender of last resort.

Imposing the rule of targeting inflation rule can be quite restraining on the central bank.17
Since the capitalist economy develops dynamically, any rule which limits discretion by the
central bank is necessarily static. The recent crisis has shown that the dynamic evolution of
finance in the era of financialisation has undermined what was considered the greatest
achievement of inflation targeting regimes, namely central bank credibility. Thus,
mainstream economists are at present advocating renewed emphasis on the function of
lender of last resort (De Grauwe, 2007, pp. 159‐161). Others have proposed complementing
that with market making of last resort (Buiter and Sibert, 2007).

The crisis of 2007‐9 has manifested itself primarily as turmoil in financial markets.
Uncertainty and fear, which easily extended to panic, meant that little or no trade occurred
in certain classes of financial instruments. Subprime‐backed Collateralised Debt
Obligations, for instance, were often impossible to trade as there was no market maker
capable of valuing the necessary funds credibly to establish buying and selling prices. Such
market failures occurred in different ways across financial assets, including exchange‐traded

16 See C.Kindleberger,1989, ‘Manias, Panics and Crashes’.

17Even when it is perceived as ‘constrained discretion’, as in the USA, which allows for stabilisation of output and
employment subject to a declared target range for inflation. See Bernanke, 2003.
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 17
and over‐the‐counter instruments. But a common solution has been suggested: the central
bank should be the market maker of last resort. The function of market maker of last resort,
could involve, first, outright purchases and sales of a wide range of private‐sector securities
and, second, acceptance of a wide range of private‐sector securities as collateral (Buiter and
Siebert, 2007, p. 171‐172).

But extending the function of the lender of last resort and complementing it with the
function of the market‐maker of last resort would be far from easy. First, severe moral
hazard problems could arise as central banks substituted public credit for bankrupt private
credit. On this basis, Vives (2008, p.99) has even argued that the outbreak of crises might be
desirable to maintain investment discipline. It is even postulated that some barely solvent
institutions should not be rescued.18 Second, it is possible that as central banks acquire
problematic private securities, their own solvency might become problematic (Buiter 2008).
Thus, it is proposed that the state (as national fiscal authority) should provide ultimate
support for the central bank acting as lender and market maker of last resort. One way of
doing this would be for the state explicitly to underwrite the balance sheet of the central
bank.

From the Marxist perspective adopted in this paper, the proposals are evidence of the
central bank being used to socialise losses in order to protect private profits. Central bank
independence and inflation targeting have allowed repeated bubbles to emerge, partly
because of low inflation rates. The ensuing disaster has led to renewed emphasis on lender
of last resort supplemented with the novel function of market maker of last resort.
Financialisation has turned central banks into the main agent protecting financial interests
at the expense of society as a whole.

4. Conclusion

The current period of capitalist development is characterised by an apparent paradox: the

political power of central banks continues to rise, while their economic power is in serious
doubt. This paradox is related to the role currently played by financial interests in
promoting capitalist accumulation as a whole. Thus, in the era of financialisation the central
bank has emerged as the primary protector of financial interests. The basis of the power of
the central bank is provided by its monopoly over legal tender, and this has been greatly
enhanced in the course of financialisation. But the inherent instability of the capitalist
economy, to which monetary and financial factors contribute strongly, sets limits on what
central banks can do. The relative autonomy of the credit system is an important factor in
explaining financial instability in mature capitalism. In the era of financialisation, during
which financial fragility has increased, the triggering of financial crises also has political
aspects. It is similarly subject to considerable inter‐class struggle between financially fragile
(and thus less competitive) capitals and financially strong (and more competitive) capitals.

Inflation targeting and central bank independence have aimed at promoting capitalist
accumulation at the expense of working people by “immunising” central bank from the
effects of class struggle. Inflation targeting and central bank independence have facilitated
extraction of private profits at the cost of increased financial instability with enormous
ensuing losses for society. Capitalist states now recognise that central banking must go
beyond inflation targeting to protect the capitalist system from itself, without however

18 From a different perspective Dickens (1990, pp. 1‐23 1999, pp. 379‐398) argued that financial instability is a problem
created by the dynamics of the capitalist market reflecting the contradictions of capitalist accumulation. Financial crises
are primarily due to political decisions and are political in nature.
Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 18
abandoning the neo‐liberal agenda. This has meant renewed emphasis on the function of
lender of last resort supplemented with the newly‐fangled function of market maker of last
resort. In practice this amounts to socialising financial losses in an effort to preserve private
financial profits. Nonetheless, the crisis of 2007‐9 has shown that there are limits to what
central banks can do to stabilise finance.

As the burden of financial instability has become greater for the vast majority of society, the
need for central banks to be subject to democratic control has become clearer. Through
social control, central banks should be made to reflect the broader interests of workers and
others, rather than primarily those of banks and finance. Central banking is often called an
art, but it should certainly not be an art for the benefit of the few.

Demophanes Papadatos ‐ Central Banking in Contemporary Capitalism: Inflation Targeting and Financial Crises 19
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