Principles of central banking 1: Why should people place trust in central banks?

Sunday, 4 August 2013 23:01 -     - {{hitsCtrl.values.hits}}

In a recent training workshop for central bank officers of a neighbouring country, a participant raised a very important question: Why should people trust central banks and accept the money which those banks issue to people as something valuable and useful? When the question was posed to the audience, the answers given were of two types but closely related to each other. State ownership of central banks does not bring in trust One answer was that central banks are owned by sovereign governments and therefore the trust which people have in those governments is extended to the central banks as well. But when it was pointed out that South African Reserve Bank or SARB is a private bank owned by some 650 private shareholders, the argument was re-examined. It was mentioned that at the Annual General Meeting of SARB, its Governor delivers an address covering the economy, monetary policy and the operations of the Bank. He also presents a comprehensive annual report on the Bank for approval by shareholders which is similar to the annual reports presented by state owned central banks to their governments. In addition, central banks in Belgium, Italy, Japan, Switzerland, Turkey, Greece and the US are jointly owned by the respective governments and private people. Even Reserve Bank of New Zealand, Bank of Denmark and Bank of England were private central banks until they were nationalised in the first half of the previous century. Hence, the argument was finally modified that state ownership maybe useful but not necessary for a central bank to earn the trust of people. Legal powers not necessary for making money acceptable Another argument presented was closely related to the previous argument of public-ownership of central banks. That was that the governments by using their sovereign powers have made it legal for the acceptance of the monies issued by those central banks and illegal all other types of monies. Therefore, people do not have choice but to accept them for use in transactions. This is why monies issued by central banks on behalf of governments are called ‘fiat money’ because they come into existence as a result of a fiat or an order of the government. But history abounds cases of private people issuing coins for circulation among people. Even during Kautilya’s time in the 4th century BCE in India, coin issue was not a monopoly of the king and private people too were in the practice of issuing them. Hence, in order to maintain standards, Kautilya recommended to his king in his treatise on economics ‘The Arthashastra’ to appoint a special officer called the Examiner of Coins to certify the coins issued by private parties upon payment of a fee. Even in Sri Lanka, as documented by Osmund Bopearachchi and Rajah Wickremesinhe in their ‘Ruhuna: An Ancient Civilisation Revisited’, there have been many coins found in archaeological excavations in Tissamaharama area that have been issued by private parties in the period from 4th century BCE to 7th century CE. The legends in Brahmi in these coins had indicated that they had been issued by private parties like ‘Householder Gupta, Householder Majjima, Dutaka’s son Pussa, Siddhartha’s son Tissa, Municipal Officer Nakati and Lady Uttama’ and so on. These coins would have been issued by merchant families to back the trading transactions they had been carrying out during that period. Hence, once again, fiat maybe useful but not necessary for monies to win the trust of people and thereby gain acceptance. Maintenance of the value of money is the key If the state ownership or the state fiat does not bring in trust for a central bank, then, what would contribute to building it? It is nothing but a central bank’s ability to maintain the value of the money it issues for use by people over time. Money, unlike bread or rice, is simply a notional concept and does not gain value by itself. The value comes from money’s ability to acquire those valuable bread and rice which people can use for their benefit. Since people can use them as a final good or as an input for producing a further final good, they are called real goods. A man has to sacrifice one real good, say his labour, to acquire another type of real good, say rice, and hence it is only the real goods which people are interested in. Money is simply a facilitator of an exchange between these two real goods. For example, a man can sell his labour for money and then use that money to acquire rice he needs. When he sells his labour for money, he is promised that he could acquire a given quantity of rice with that money. If he can buy that quantity of rice, then, he is satisfied and the sale of labour for money will continue to take place. But if he could buy only a lesser quantity of rice with that money when he goes to the market, then, the promise given to him is not kept. There, the value of money has fallen and it is the duty of the central banks to maintain the value at a stable level. The American economist of the Austrian School fame Murray Rothbard called this ‘purchasing power of money’ in his 1993 book ‘The Mystery of Banking’. All central banks throughout the world, whether they are government owned or privately owned, have been mandated to fulfil that promise. As long as they honour that promise, they are trusted and people continue to accept the monies issued by them for their use in numerous transactions. In the event they fail, the people will go for alternative forms of money for use in transactions. Overproduce money and reap inflation But of course today’s economies are complex and in addition to the monies issued by central banks directly, there are other monies created by banking institutions in the form of deposits which are known as bank money. Finally, it is the supply of these monies in comparison to the demand for same that determines the value of money. If the supply is higher than the demand, as in the case of any other good, it leads to a decline in the value. Hence, those who manage central banks should see to it that there will not be an oversupply of money relative to its demand. In a central banking system, the creation of all these monies in an economy is dependent on one preliminary seed money created by a central bank known as base money which is used by other banks to create more money in the form of credit and deposits. Responsible central bankers are needed Very often central banks throughout the world have been prompted to increase the supply of this base money without considering the final level of money created by the banking system and whether such money will exceed the demand for same. They are prompted in this case by the belief that those monies will create wealth and prosperity in society. But the fundamental point is that wealth and prosperity are brought in by hard work of people and not by an increase in the quantity of the medium that facilitates the exchange of real goods. Societies have created central banks and staffed them with responsible professionals so that they would not become yielding hands of those in power to produce more money than necessary and thereby allow its value to fall in the market. Need for adhering to good governance practices in central banks Thus, a central bank’s ability to maintain the value of the money it has issued at a stable level will depend in turn on its internal governance structure. The guiding principle of this governance structure is that those who run central banks should know that they have to serve the society which has brought the bank into existence and not the political masters who have appointed them. In the event they fail to appreciate this responsibility and choose to act contrary to it, the result will be the creation of more money than necessary causing its value to fall in the market. Eventually, the public will lose their trust in the central bank and the money it has issued. Hence, integrity, professionalism and adherence to good governance practices on the part of those who run central banks are key to earning the public’s trust and gaining credibility for central banks. Ludwig von Mises: All inflations are government-made It was the economists belonging to the Austrian school that raised these issues openly in early 20th century. Ludwig von Mises in his 1912 treatise on the subject titled ‘The Theory of Money and Credit’ blamed the irresponsible governments and hence the irresponsible central banks for reducing the real purchasing power of money through over-supply. In the Preface to the 1952 English edition of the book he declared: “The great inflations of our age are not acts of God. They are man-made or to say it bluntly, government-made. They are the off-shoots of doctrines that ascribe to governments the magic power of creating wealth out of nothing and of making people happy by raising the national income.” He also says that the ordinary people do not appreciate the long term adverse consequences of inflation and therefore will go along with governments and central banks which produce more and more money thinking that it would improve their welfare. But Mises says that the short term which people had enjoyed has now become long term with repeated bouts of increases in money in their hands. The results have been catastrophic since they all have now been pushed toward the agony of inflation sending the short-term booms up in smoke. What this means is that ordinary people and therefore the politicians who come to power through their votes do not regard long term consequences. But the professionals at central banks cannot ignore them and should always work toward the fulfilment of the responsibility which societies have cast upon them for protecting the wealth of people. In that enterprise, they should be guided by a long-term apolitical view that will do the best for the societies that have brought them to existence. Friedrich A. Hayek: Denationalise money supply Another economist of the Austrian school, Nobel Laureate Friedrich A. Hayek, in a publication in 1976 titled ‘Denationalisation of Money’ argued that governments have failed in their duty to protect the value of money and therefore, the monopoly power vested in the governments and hence in the central banks should be taken away by societies. He proposed for the creation of a competitive system of issuing money in an economy. The virtue of such a system, according to Hayek, was that there was inbuilt incentive in that system for parties that issue money to protect the value competitively. The argument simply asks the question that if the soap industry could maintain the quality of the soap produced by the industry competitively, why not the money producing industry? To enable the competition to take it over, the monopoly power vested with central banks should be abolished. Given the many number of coins issued by different private parties pertaining to ancient Lanka and found in excavations in Tissamaharama by Bopearchchi and Wickremesinhe as reported above, what is suggested by Hayek is not at all a pipedream of a twentieth century economist. There have been instances where economies with thriving international trade like ancient Lanka functioning well with coins issued by private parties. Additional ground conditions for building trust However, Nobel Laureate Milton Friedman of the Monetarist School fame doubting Hayek’s claim of the working of competitive currencies has suggested in a paper published in 1984 under the title ‘Currency Competition: A Skeptical View’ two ground requirements for a currency to gain acceptability and win the trust of its users. One was the ‘network effect’ and the other was the low ‘switching costs’ associated with money. If many accept money, then, it will survive What is meant by network effect is that when money issued by a particular party – whether it is a government or a private party it does not matter – if there is a wide network of people who accept that money, then, that money gains acceptability and wins the trust of people. It is like my having a telephone does not serve any purpose if my friends too do not have telephones. In other words, if only one person uses particular money, then, he cannot use that money for transactions because others do not accept that money in exchange. But if they do so, then, there is no difficulty in popularising that money in exchange. The digital money, Bitcoin, which has been issued recently, has passed this test: when many others started to use it, a network sprang up spontaneously and Bitcoins saw a wide proliferation within a very short period of time. However, for Bitcoins to earn that trust, it had adhered to a fundamental principle of issuing money which central banks have normally not adhered to. That principle is the limitation of the production of Bitcoins by the system itself or in other words, the prevention of excess production. Freedom to change into chosen forms of monies The low switching cost means that people who use one type of money should be able to switch to another type of money easily. This is important because when they observe that the value of a particular type of money they use is falling, they must be able to cut the losses by changing into another form of money. If there are substantial costs in doing so, they would not accept that particular money in the first instance. If both these requirements are met, Friedman argued that such money will gain acceptance as well as earn the trust of people. It is now recognised that maintaining purchasing power, having a wide network of users and low switching costs are the main ingredients of ensuring confidence and trust of people in a currency. Professionalism in central banks demands continuous learning and humility in intellectual debates For central banks to command these qualities, it is necessary that they should not overproduce money and allow all facilities to change into another form if the users find it necessary to cut their losses. That depends not on the state-ownership or the state statutes which have empowered central banks. On the contrary, it depends on the integrity, professionalism and true adherence to the governance principles by those who run central banks. Professionalism requires central bankers to place themselves on a continuing learning path, readiness to review and in necessary accept criticism from outside, humility and humbleness in intellectual debates and above all, respecting the rights of the critics to criticise the actions of central banks. (W.A. Wijewardena can be reached at