A revisit to central bank independence: It is the unprincipled agents who are at fault

Central bank independence becoming a hot topic

The independence of central banks has become a hot topic after the world was hit by COVID-19 pandemic. Before that, there was generally a consensus among academics about the independence of central banks to carry on the mission assigned to them by people. That mission was to preserve the value of money they have created – known as price stability or keeping inflation at near zero level. When I delivered the Central Bank’s Anniversary Oration in 2018 on the subject, I concluded that governments and central banks should have a cordial relationship to serve their principals, namely, the public (available at: https://www.cbsl.gov.lk/sites/default/files/cbslweb _ documents/press/pr/speech _ 20180828_68th _ Anniversary_ Oration_e.pdf ). 

But after the onslaught of the pandemic crippling the entire global economy, a section of academics has begun to question the validity of this proposition. For them, a central bank cannot divorce itself from its ‘creator’ and should work according to its directions. Echoing this view publicly, the present Governor of the Central Bank, Deshamanya Professor W.D. Lakshman is reported to have pronounced that “The Central Bank as a representative agency of the Government, as part of it, has to do certain things on behalf of the Government” (available at: https://economynext.com/sri-lanka-central-bank-controversy-with-president-erupted-without-prior-discussion-governor-71846/). What this means is that the Central Bank should act in accordance with the wishes and dictates of the Government in power.

Government is simply an agent of the State

To assess the validity of this statement, it is necessary to understand the difference between the State and the Government. The State is the legally constituted political organisation made up of all the people living in a given geographical area. In general usage, this is loosely referred to as the Nation. What the State does is therefore acts done in national interest. To activate the national interest phenomenon, the State appoints agents with different missions. One such agent is the Government which has to protect, preserve and prosper the nation. Another agent is the Central Bank which has to provide the means of exchange and preserve its value over the time. 

Money creation brings social benefits and is desired by the people. In economics, such desirable products are known as goods. But if money is created excessively, it brings in inflation and entails social costs on people. Therefore, the excessive money production is undesired. Such undesired products are called bads. The dictate of the nation is that the central bank should produce goods and avoid producing bads. But governments can force central banks to produce excessive money and cause inflation leading to the production of bads. 

Hence, nations have created central banks as independent institutions whose policies relating to money creation – known as monetary or price stability policies – are made independent of the control of the respective governments. It is this right of central banks which has been given to them by the State which is now being challenged. 

Independence depends on the stature of people heading a central bank

In September 2019, delivering the Central Bank’s monthly lecture, I drew the attention of the audience to the need for recognising the following fundamental principles relating to central banking. First, both the Central Bank and the Government are just two agencies created by the nation to serve the nation. Therefore, they should carry on their respective missions by the nation in collaboration with each other. Second, the argument that a central bank cannot exist as a sovereign institution under a sovereign government is fallacious. That is because it is not the government which is sovereign but the State which has created both agencies. Third, central bank’s independence cannot be ensured by mere laws. What happens if the central bank is legally independent but the top people at the bank and the members of the Monetary Board are meek people? Hence, independence of a central bank depends wholly on the stature of the people who hold those high positions in the bank. 

Fourth, certain provisions in the current central banking law in Sri Lanka, the Monetary Law Act, that tend to compromise the bank’s independence should be revisited. They are the provisions relating to the Secretary to the Ministry of Finance serving on the Monetary Board as a vote carrying member, central bank’s obligation to extend provisional advances to the government and facility provided for the central bank to invest in the primary issues of Treasury bills. I argued that the civil society should stand up to protect the independence of the central bank because it is the civil society that stands to gain from it (available at: https://youtu.be/IIO6UWkqrZw ).

SARB Governor arguing for independent central banks 

These views were more formally presented by the Governor of the South African Reserve Bank or SARB, Lesetja Kganyago (pronounced as Lesetia Khanyaho) when he delivered the annual oration of the Washington DC based Peterson Institute for International Economics, abbreviated to PIIE, in April 2019 (available at: https://www.piie.com/system/files/documents/niarchos-prepared-remarks2019-04-15.pdf). The title of his oration, ‘Principled Agents: Reflections on Central Bank Independence’ contains a pun. To preserve the independence of central banks, those who run them should be ‘principled people’. By the same token, if they are unprincipled, then, the independence of a central bank is at high stakes. The pun is that central banks are agents who have to work for their principals who are the members of the public. In between the central bank and the public, there is another agent, the government, which should work in collaboration with the central bank. What Kganyago meant was that those agents should be principled if they are to serve their principal, the public. 

SARB is one of the few privately owned central banks

Kganyago was best suited to deliver this oration because he heads one of the few wholly private sector owned central banks in the world. Despite its private ownership, the government of South Africa has control over its affairs. Accordingly, the government appoints eight of the 15-member board of directors, the counterpart of Sri Lanka’s Monetary Board; the eight includes Governor, and three Deputy Governors. The balance seven are appointed by the shareholders. 

Therefore, the government’s control over SARB is delicately balanced with only Governor’s casting vote giving the government a majority in the board. Thus, Kganyago has to satisfy two masters, like an acrobat walking on a tight rope. If he tilts over to either side, he falls off the rope; along with him falls the independence of the bank as well. Hence, as Governor, he and the other three deputy governors on the board should be extremely ‘principled’ if SARB is to serve its principals, namely, the public. 

Central banks action may be bitter to some

Central banks throughout the globe have come under criticism for speaking a language that is not spoken by powerful groups in society. For instance, Bank of England came under severe criticism when it calculated the cost of Brexit and announced it before the referendum on whether to stay or leave EU. This has angered 50+a little more of voters who had voted for Brexit. This has been common to SARB too. He, therefore, qualifies his claim to deliver the oration: ‘And of course in South Africa, the independence of the Reserve Bank has also come under threat in recent years, which must be why you think I’m the person to discuss this subject’

Kganyago has attributed the loss of independence of a central bank to failure on account of two matters. 

Brach of policy consistency

One arises from the policy inconsistency dynamics associated with those responsible for policy. This arises from a paper published by the Norwegian economist Finn E. Kydland and American economist Edward C. Prescott in 1977 in the Journal of Political Economy under the title ‘Rules rather than Discretion: The Inconsistency of Optimal Plans’. Going by this policy inconsistency view, Kganyago says that politicians, an important agent in the system, promise before the election that they would bring down inflation which they allege that their political rivals have created. 

Instead of sticking to this policy consistently, politicians after getting into power would go on having a loose monetary policy and inflating the economy. The central bank is at the receiving end here. If it does not yield to the demand of politicians to relax monetary policy and help them finance their expenditure programs, the central bank comes under threat. According to Kganyago, if the politicians and central bank’s top managers are principled people, there would not be a problem for the bank’s independence. But the problem arises when they become unprincipled. Then, both get together, increase money supply and inflate the economy. 

If anyone wants proof of this, they should look at Sri Lanka’s track record of inflation and money supply growth since independence. As I have presented in a previous article in this series (available at: http://www.ft.lk/columns/The-fuss-about-money-printing-How-far-is-this-charge-valid/4-705981 ), Sri Lanka’s consumer price index, when prorated, has increased from 100 in 1952 to 11900 at end-August 2020. What it means is that the value of a rupee in 1952 is worth less than a cent today. 

The need for principled agents to tackle the principal-agent problem

The second argument of Kganyago on the violation of the concept of principled agents relate to ‘principal-agent problem’ in economics. In this problem, principals appoint agents to carry out duties to satisfy their objectives. However, the agents who have an inherent wish to have their own objectives satisfied, will deviate from their mandate and work for their own wellbeing. The principals in this case are all citizens in a sovereign state. They have created two agents to carry out programs to satisfy their own goals. Those two agents are the government on one side and the central bank on the other. 

Instead of working for the satisfaction of the objectives of their principals, these two agents would work for satisfying their own needs. But in the process, the central bank’s independence is compromised. Then the issue boils down to, according to Kganyago, a fundamental political governance challenge. That is, how societies could get their political leaders to look after the public interest instead of their own short-term private interests.

Public myopia has helped political leaders

However, what we have observed is that the political leaders choose to justify their intervention in central banks on the pretext of acting in public interest. That is because they believe, and public also tends to accept the same, that they have been created by their principal, the State, to work for public interest. The members of the public are unable to distinguish between what is to be done in public interest and what is being done in private interest. This is because there is a veil before the eyes of the public that prompts them to see only the narrow picture of what they can see immediately. The broad picture displaying all the possible consequences – good or bad – is not visible to them. 

Hence, if politicians get the central bank to print money and hand it over to people, those who receive it are happy. Those who have not got it are also happy in the expectation that they too would get it someday. This myopic behaviour on the part of people has helped politicians to continue to print money to finance their programs. 

Kganyago: Independence is a must

It is only a person who has worked in a central bank would realises the reality. In a very strongly worded statement, this was conveyed by Kganyago in his oration as follows: ‘Independence allowed us to deliver on our mandate, as set down in the constitution. Independence ensured that the tremendous powers of a central bank – such as printing money, or licensing and supervising banks – couldn’t be taken over by politically connected individuals bent on looting the state instead of serving the citizens. I’m not sure exactly how this should be modelled – how we could prove the point in a large empirical study, and get a peer-reviewed article out of it – but it has been my lived experience for some years now. There is a saying: there are no atheists in foxholes. We’ve been on the frontlines lately, the place where good and bad governance meet, and I promise you – in that situation, you really learn to believe in central bank independence’.

Appointment process to high posts in central banks should be streamlined

Those who come to a central bank from outside have not lived in this experience and hence would not be able to appreciate its value. They are easy to become yielding hands to political masters. Hence, political authorities, to facilitate carrying out their schemes presented under the pretext of public interest, are bent on appointing people from outside to head central banks. Society cannot expect them to be principled agents. To overcome the problem, many modern central banks have limited the powers of political authorities to act on their discretion when appointing governors or other senior officers to central banks. 

Laws governing central banks have been amended in this respect streamlining the selection criteria of these high officials who have to act as principled agents. For instance, when a governor is to retire, the selection of a suitable individual to the post would start at least one year before the impending date of retirement. A selection committee is appointed by the governing board of the central bank to receive nominations, appraise the candidates and recommend three names out of them to the political authority to appoint one person to the post. 

The announcement regarding the selected candidate is announced at least six months before he or she would take up the position. By streamlining the procedure, even those who come from outside are fully vetted to ensure that he or she would be principled to hold that position on behalf of the public.

An independent judiciary is also a must for democracy

Kganyago has emphasised the need for having an independent judiciary to support the independence of a central bank. When there is a conflict between the political leaders and the central bank, it is the judiciary which has to make the adjudication. Says he: ‘judiciaries are relevant because they too need to honour democracy while exercising unelected power. They are also confronted with the challenge from elected officials, “I’m elected and you’re not, so shut up and listen to me.”

In practice, judiciaries do not resolve this tension through a policy of maximum deference. Rather, they typically take direction from the rights and values embodied in their countries’ foundational laws, and they confront violations of these principles when they see them. They appreciate that there is more to government than having 50% plus 1 vote’. What he means is that political leaders who get majority power cannot and should not ignore the values, rights and morality embodied into the constitution of a country.

Majority power is not a power to ignore values, rights and morality problems

He has further elaborated this point as follows: ‘The lesson for central banks is, we can honour democracy without feeling obliged to define it in strictly majoritarian terms, in which only directly elected leaders have any legitimacy. Democracy ensures that government serves the interests of the people. It does not consist of elections only. One of the gravest threats facing any society is the ruler who is more powerful than anyone else and therefore cannot be stopped by anyone, even when he is acting against the interests of the principals, the people. 

Not all leaders are bad – I have met many good leaders, and some who would have behaved better in easier circumstances. But a small portion of leaders are bad, and if you understand probability, then you know sooner or later most countries will get a bad leader. There is nothing undemocratic about buying some insurance against this eventuality, and independent central banks, like judiciaries, are useful parts of those insurance policies’.

Modern Monetary Theorists in high positions in central banks

But what about the Modern Monetary Theorists who believe that central banks should not be worried about their independence and they should print money and supply it to society for its greater good. Kganyago has a comment on that too: ‘Indeed, the so-called Modern Monetary Theorists even think you can do away with independent central banks and tackle inflation with other tools. Well, if you build a maximum-security jail and there are no escapes, does that prove you didn’t need to build a jail? I think it proves you built it right’.

The danger of unprincipled agents 

Leaders, both at political authority and at the head of central banks, need be ‘principled agents’ if they are to serve society which has created them. Hence, the problem lies in unprincipled leaders who tend to compromise both the constitution and the independence of central banks.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)