Public institutions: Independence against or performance within the elected governments?

As law-makers of elected governments cannot do everything by themselves to manage the economy and society in democratic systems, several layers of public service operate within the government. The central bank is one of them. All are contributing to the macroeconomy and no any one entity other than the government can claim the ownership for the macroeconomic stability

By P. Samarasiri

The article is intended to provide a set of views on the subject of independence of central banks in the context of some of views expressed by W.A. Wijewardena in his article published in the Daily Financial Times.

Opening words

The central bank is one of the public institutions whose independence and performance are much debated around the world. At the top of the debate, the independence of central banks has been a concept presented by central bankers along with their network of economists. 

In general, this independence is referred to as the freedom from the government to print the state money/legal tender or broadly to carry out the state money-based monetary policy for the society as the top bureaucracy of central banks believes as desirable. This is because they believe that the central bank is the only game in town who can keep the country’s economy in perfect shape of the stability through their monetary policy. 

How we have got central banks

Central banks did not come from heaven to perform perfectly. They were invented by the private sector in the 18th century to serve as bankers’ banks to facilitate the early banking business and help resolve money and banking crises during the private multi-currency systems. 

State central banks were established in the 20th century to unify such private multi-currency systems with the state legal tender with a view to prevent banking and financial crises. Accordingly, the monopoly power to print state money and regulate banks were assigned to state central banks in order to secure stable monetary and financial systems on behalf of the government.

Later, macroeconomic and monetary concepts entered in central banking laws with undefined mandates of economic stability, price stability, maximum employment, high standards of living of the public, long term low interest rates, etc., assigned to central banks by believing a divine-like power of the money machine, which is not considered as a factor of production but as a magical factor. 

As a result, central banks started interpreting their monetary policy actions to be driven on fixed or flexible or crawling targets of various macroeconomic variables such as inflation, unemployment, economic growth, money supply growth, credit growth and exchange rate from time to time at their discretion with any justification they preferred. As a result, anything under the sun came within their purview for printing money.

The old economic theory of money that central banks have been following to justify their monetary policy is the theoretical effect of the money supply or stock of money on the level of aggregate demand in the economy. If the money stock is unnecessarily higher than the demand for money, commodity prices rise causing inflation as people will spend the additional money. In contrast, if the economy suffers low growth and high unemployment due to insufficient aggregate demand, increase in money stock will push the aggregate demand which would raise production and employment without causing inflation. 

Central banks believe that they easily can control the money stock through the monetary policy to fine-tune the aggregate demand for securing any one or combination of macroeconomic variables at their choice and, therefore, they demand that they be given the freedom to control the money stock at the levels they think desirable for the macroeconomic stability. 

Hawks, doves, swingers, pigeons and other types of possible creatures are different schools of monetary policy intellectuals divided across the choice of macroeconomic variables for the conduct of the monetary policy.  However, none of them has been able to prove the relationship of the monetary policy with those macroeconomic variables, despite the use of modern statistical techniques. 

Good governance in state macroeconomic management

As law-makers of elected governments cannot do everything by themselves to manage the economy and society in democratic systems, several layers of public service operate within the government. The central bank is one of them. All are contributing to the macroeconomy and no any one entity other than the government can claim the ownership for the macroeconomic stability. 

State central banking is a part of good macroeconomic management system created to separate the state’s money spending arm (Treasury) from the state’s money printing arm (central bank). This is another concept that central banks demand independence so as not to mix up the printing of money with the funding of the fiscal spending and to keep them at arm’s length. 

Central banks forget that, during economic recessions, it is the fiscal policy that saves economies while the monetary policy has no role at terribly low interest rates unless it accommodates the fiscal policy as in the case of the great depression in 1930s and the last decade’s recovery from the global financial crisis. 

Leading economists argue that Western central banks are now not in a position to prevent the next economic downturn possible from 2020 when the fiscal stimulus is over as they do not have a monetary policy space to cut interest rates by about 300-500 basis points normally required to survive a downturn.

Unelected powers of central banks

Central banking is essentially a type of national banking carried through the printing of money. Therefore, they have immense influence in the public lives through interest rates, exchange rates, credit, monetary liquidity and bank oversight as part of their national banking carried through lending, taking deposits and buying and selling of foreign exchange, government securities and private securities at prices and quantities they determine which set the ground for the rest of the monetary and financial pyramid to facilitate the real economy. 

This is where the top bureaucracy of central banks claims that they do a privilege job in the country although some analysts claim that some central banks have virtually become bankrupt state enterprises in their financial conduct.

Given the monetary and financial powers of central banks, governments have initially trusted unknown central banks too much and assigned the majority of financial related public services to central banks from time to time. Public debt management, foreign exchange management, state pension fund management, state depository, regulation of financial institutions, financial crime prevention (anti-money laundering) and government’s fiscal and financial adviser are some of them. 

This is an example of governments using central banks as the scapegoat without establishing specialised lines of public services. As a result, governments have been able to use central banks to help their favourites as well as to punish some others. 

Central banks cannot perform without the government and fiscal policy

Although central banks claim for independence, they in fact function on the economic and monetary space created by and solvency of the fiscal policy/government. First, the legal tender/money printed by central banks is the liability of the government and not of the central banks. Therefore, in all catastrophic situations of the monetary systems, either galloping inflation or banking crises or currency crises, it is the government that saves both the system and central banks. During such times, no central bankers have big talks of independence.

Second, central banks have chosen to print the majority of money through purchase of safer assets, i.e., the purchase of government securities (in the primary market or secondary market) and foreign exchange received on the fiscal policy support to foreign trade and sovereign borrowings. 

If governments run fiscal surpluses and no foreign borrowings, central banks cannot carry on desk-top monetary policy as they will run out of secured sources of money printing. Even central banks’ interest rate policies are guided by the yield curve on government securities where they even try to reshape the yield curve to run the monetary policy in the direction they wish. 

In countries where central banks manage public debt, they even do not let the government securities market to develop in the broader market mechanism and administratively control the market through the use of their other powers such as pension fund management and exchange controls to have yield rates at levels they prefer while keeping the government securities markets out of public transparency without any yield curve recognised in modern finance.

Third, in economic downturns/recessions caused by the collapse of spending with low interest rates, central banks have to depend on the fiscal policy to push the aggregate demand through fiscal spending financed by borrowing. Even monetarists believe that the monetary policy fails when interest rates are close to absolute low levels (liquidity traps). This is the latest experience during the past decade where zero or negative interest rates of global central banks even along with huge fiscal stimulus took a decade to recover from the last global financial crisis. 

Highly academic and independent central banks in the advanced market economies could follow ultra-loose monetary policies of the century by printing money to buy the most of government securities issued for the required fiscal expansion. If governments had let central banks to serve their macroeconomic and financial stability duty without fiscal policy, the world would have needed another 10 years to boost the aggregate demand through the monetary policy even at zero or negative central bank interest rates.

Fourth, no central bank can rescue the public from banking and financial crises as the history throughout shows. Irrespective of independence and technical/professional expertise, no central bank can prevent banking and financial crises, despite their nicely worded broad mandates and powers as they fail to fix the fundamental problem of dominance of the private bank money created with insufficient reserves/legal tender that causes systemic liquidity risks and bank runs. 

As seen in the past era of private monetary systems without state central banks, it is the government that has to rescue monetary and financial systems during crisis times. Central banks are unable to pull the trigger timely even on their conventional instrument of lender of last resort due to lack of their knowledge on the monetary front and the inter-connectedness of the financial pyramid to money and banking. 

All past financial cries including the last global financial crisis are the established evidence for this. Even failures of a small financial institution cannot be resolved by central banks without the government support even after several years due to lethargic bureaucracy and conflicts of interest.

Grave failures in performance of central banks

Before discussing on the god-like independence, we need to assess whether central banks have performed their mandates in vanilla. All state central banks have failed in delivering their stability mandates. 

Countries and world have confronted banking and financial crises as happened in the past private central banking era. The cycles or bubbles of inflation, interest rates, economic growth and unemployment have become the routine of the public. No country is free from these bubbles and bursts, despite the macroeconomic stability role of central banks.

Inflation and interest rates which are the bread and butter of central banks who seek to keep them low and stable in the long run in order to anchor inflation expectations have been in unbelievable cycles of each five to 10 years with wider fluctuations where the long-run never starts or ends. Western central banks have been unable to firmly push the inflation to their target of 2% even after a decade. As policy-makers have terribly failed in price controls in markets, any attempt to control inflation also is a failing job.

Central banks have failed in their other state agency functions too. The public debt has become the number one national threat, despite some central banks being the public debt managers. However, failed mangers are not fired or do not step down. In fact, central banks have increased public debt from foreign sources to claim that they manage a high level of foreign reserves by purchasing foreign proceeds of such foreign debt and countries have now got into foreign debt trap and resulting currency crises. 

State fund management is eternally in the media on allegations of mismanagement and abuses. Bureaucratic foreign exchange management has deprived of the inflow of foreign savings and businesses which are much needed to promote economic development of the countries although central banks talk about flexible exchange rates and foreign investments.

The delivery of credit and liquidity to the wider economy also has failed as the majority of the economy suffers from institutional credit. Central banks have withdrawn from sectoral credit and liquidity distribution policies and moved to open market operations-based monetary policy to manage overnight inter-bank liquidity as they estimate by thinking that the inter-bank liquidity is the economy’s liquidity. 

As a result, the monetary policy has become a policy to facilitate daily cash-flow management of banks on signals given by speculative money dealers although central banking laws specifically provide for the conduct of the monetary policy to fulfil the sectoral credit and liquidity needs of the wider economy.

Although inflation control is the bread and butter of central banks, they do not have an inflation-tracking measure in modern economies. The old commodity market-based consumer inflation of households which is driven by weather and shocks does not measure the inflation of the wider economy. The so-called core inflation that they call as the inflation responsive to the monetary policy is only a small sub-set of same consumer commodity basket without food and energy which also does not have a track-record or a target other than ad-hoc references. 

Key macroeconomic statistics that they use to track the economy’s performance and stability are not supported with standard data governance systems and internal controls where central banks themselves are the compiler of most of key statistics. These economic statistics are under constant criticism of creative accounting.

Central bank governance systems with strict confidentiality also have failed. According to some analysts, board members do not understand the concepts of reserve money, creation of money and money supply and, therefore, monetary policy decisions they take with or without independence are only rubber seals. There is no any assessment of fitness and propriety and conflicts of interests of those who govern many central banks in contrast to banks regulated by central banks. As a result, central banks have lost their policy independence even to markets they regulate.

When questioned, the fiscal deficits are cited the scapegoat for all macroeconomic ills and failures of central banks and, therefore, they demand not only monetary policy freedom, but also more legal powers and scaling-down of the fiscal policy to enable central banks to do their job. This recalls the saying “People who can’t dance blame the floor for not being even.” When the economies are in good shape, they claim all credits to so-called prudent monetary policies. It is hard to believe that present economic and democratic systems can survive without the fiscal policy.

Monetary system is beyond the central banks’ control

Although central banks have the legal money printing machine and monetary policy, banking and non-banking system creates money in their books a way beyond central banks print. Money created by banks alone is three to five times the amount of state/central bank printed money in circulation. Central banks have no means to estimate the total money created and accepted by the upper-end of the financial pyramid for economic transactions. 

In modern technology-based economies, software engineers too have invented more than 1,500 crypto currencies. Local communities across the globe have invented more than 10,000 local currencies. Even LGBT societies world-wide use their own branded money “pink currency” for the community’s self-financial and business identity. Therefore, the monetary policy has no way to control the total stock of money in circulation or the economy funded by the private moneys. 

All monetary and financial crises have been caused by the excessive creation of such money when the money machine goes out of order from time to time. Central banks so far have found no means to fix this fundamental problem of unsecured private money. Therefore, the next global economic and financial crisis too will be caused by the same problem, as in the past, but led by electronic money, and governments will have to use the fiscal policy to resolve it too.

John Exter did not advocate for independence against the government 

John Exter never recommended central banks to be fully independent. In fact, he articulated so well the difficulty to maintain such a theoretical independence and the need to work in close coordination and harmony with the government since the government is finally responsible for the policies of the central bank too (as written “there is no gain-saying that in the last analysis the government must assume responsibility for monetary policy as for other policies). 

 Therefore, while empowering the Monetary Board for the monetary policy, he also empowered the Minister of Finance to issue directions to the Monetary Board, in the instances when the Monetary Board and the Government are unable to reach an agreement as to whether the monetary policy of the Monetary Board is directed to the greatest advantage of the people of Sri Lanka, to adopt the policy of the government while the government accepts the responsibility for the policy. Powers also were vested with the Minister of Finance and the President to remove the Governor and Monetary Board members. Governors have been removed lawfully by smart governments in two instances. 

Therefore, until the Minister of Finance becomes smarter, the central bank is virtually independent in the conduct of the monetary policy. The government cannot try to wash its hand in the event of economic or monetary catastrophe by stating that it is the central bank and we do not intervene. 

Exter also proposed that the Governor be given a place on the Economic Council at Cabinet level to be set up in future to achieve an increased coordination of the government economic policies. He also empowered the Monetary Board to print money to incur all operational expenses of the central bank too outside the government budget in addition to money printing in the monetary policy, but the capital fully provided by the government. Therefore, those who govern the central bank do not need any layman business management skills as no problem exists on the central bank to run on accounting bankruptcy or losses. 

All these are not about the independence per se, it is about the contribution of the central bank as a highly powerful public entity to the country’s development. Exter also alerted the Monetary Board on the possible reaction of the government by changing the law if the central bank does not work in close harmony with the government. 

The current government has long been talking of changing the Monetary Law Act to have a professional central bank and Public Commissions also have recommended it in view of grave concerns over central bank’s irregularities. There is no question of the economic wisdom of John Exter to propose such a principle-based publicly powerful central bank with wide discretionary policy powers to a country of low economic development in 1950s, given the natural resource base of the island economy. 

Exter wrote… “The Bank should not be hampered by rigid limitations which might prevent it from fulfilling its purpose. When a new central bank is being established it is impossible to predict the course of its development. This will depend upon the environment within which it works and upon those who, determine its policies. Many of its powers may go unused for long periods, because they are designed for particular situations, some of which may never arise. Others are intended for use only in crises or to forestall a crisis, but prudence dictates that they be included now, so that they will be at hand in case of need. It would be foolhardy to assume, with the record of the war—and depression—induced economic crises of the last 30 years plainly before us, that the Ceylon economy will somehow escape such crises in the future. The safer assumption is the one underlying the drafting of the present bill: it is better in an uncertain economic world to be prepared for any eventuality.”

People knowledgeable on the mandates and powers of the central bank can study whether the central bank has really used its public powers to solve economic and financial problems of the country as empowered by the Parliament as recommended by Exter. The issue at hand is whether the central bank intellectuals have been able to understand those principle-based powers in the due national interest and spirit and used their public powers to develop the country under any of their intellectual approach, flexible targets or fixed targets or doves or hawks. The recent literature shows that it has not been so. 

In that context, Sri Lanka would have been a fully developed country as a small island economy through international competitiveness if the Currency Board system had continued. If so, export development strategies and foreign reserve to be driven by the fiscal policy or independence or failure of the central bank would not be a subject today after 68 years of the central bank.

A possible solution

In view of facts stated above, central banks are too-big and too-powerful public institutions which are risky to the societies. Adamant behaviours of some central banks who do not want to listen to what the whole world says is also highly risky to democratic societies and elected governments. Their undefined wide mandates have potentials to even overthrow the elected governments or create immense disruptions to elected governments as shown in many countries. 

The independence they are calling is a form of an unelected economic government outside the elected governments which is not justified by their performance so far and wider democratic systems the world believes. In fact, the way central banks operate is that those who govern central banks have unelected powers to print money over simple phone calls when they are at home or in frequent foreign travels.

Therefore, as John Exter alerted, the time has come to amend central banking laws to narrow down and discipline central banks to do what they can do in public economic interest by leaving out their unelected behaviours. After the last global financial crisis being a sheer failure of global central banking fathers, governments have taken them under control. The US Fed known as the most independent central bank in the world has been publicly advised to fall under the national economic policy of the government. 

Everybody knows disruptions now being created to the world economy by the theoretical monetary policy of the Fed in pursuit of so-called normalisation of interest rates after a decade of close to zero interest rates. Turkish President has got the monetary policy under his control to settle the currency turmoil in last August created by western financial dealers who demand double digit interest rates from their central bank counterparts.

In this context, elected governments have to find a way to have all public institutions to do their public job aligned to the targets decided by the governments. Many countries have done it successfully and now enjoy higher standard of living, mostly out of poverty. Otherwise, if all unelected bureaucrats demand independence to behave in whatever manner they think good for the public, it is the general public who will suffer and it is the democracy that will fail. 

Everybody knows that all corners of the state economic management arm are deterrents to the private sector who is creating the economic well-being to the public. If the public entities quarrel with the government for independence for them to do whatever they think good, irrespective of the government’s overall public policy targets, the elected government will be nowhere.

The thoughts of James Madison, 4th US President known as the father of the US Constitution are worth noting here. “If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and the next place oblige it to control itself.”

A few Governors and Deputy Governors of leading central banks who confronted the last global financial crisis and macroeconomic disruptions with all their independent monetary and regulatory powers virtually dormant have written their stories frankly after the retirement to advise new central bankers who continue to believe that they are the only game in town to get out of town immediately as only little they can do in modern complex market economies. If not, the private sector will invent another monetary system at the next crisis in this century while the governments will save the system any way as in the past.

John Exter at the inaugural ceremony of the Central Bank in August 1950 stated, citing the reason for having a simple event, that “we are sobered by the thought of great responsibility which we now have towards the people of Ceylon. Shouldering this responsibility does not seem to us to call for any celebration. The time for celebration is 10 or 15 years later when the Central Bank of Ceylon looks back on its achievements. At this moment, we can only be filled with high hopes and great intentions.” Therefore, 68 years are not too long to save the central bank. 

(The writer is a recently retired public servant as a Deputy Governor of the Central Bank and a chairman and a member of several public Boards who has authored several books and articles on economic and financial subjects.)