Beware of Central Bank Independentists. Let us find the truth.

 

Since the middle of the last year, the world has been facing historically high inflationary pressures, despite the mandates of central banks with so-called independence to preserve the price stability, among other objectives such as financial system stability, high real income and maximum employment. 

Governments in developed countries with greater market-based economies, while worrying about the rising cost of living of the general public, finger at central banks by calling that it is the duty of central banks to control inflation and that the central bank independence to bring the inflation under control is respected. Meanwhile, Governments in developing countries are confronting political instability as the economies are largely state controlled where central bank monetary policies exist largely on state funding.

However, as Governments and economists generally treat central banks as independent from the Government fiscal policies and their prime objective of operations as the price stability, a grave public issue arises as to why such galloping inflationary pressures are contagious across the globe in front of central banks. Therefore, the question arises as to whether central banks are independent, or their policy models or mandates are unable to preserve the price stability as required.

Further, the incumbent Sri Lankan Central Bank Governor immediately after accepting the post stated on April 8 that he would independently and professionally reduce the money printing and control the inflation caused by the excessive money printing undertaken by the two former Governors. 

However, some political leaders and social media who even do not understand the functions of the Central Bank and its level of independence seek the reappointment of the incumbent Governor for the new term of 6 years from July 1 while the Governor himself is heavily involved in a campaign as seen in the social media to preserve this esteemed public position.

This also cast doubts whether the Sri Lankan Central Bank possesses the so-called independence as the word "independence" is being sold to make the appointment political. In that context, six persons have held the post of the Governor during the last two terms (12 years).

Therefore, this article is intended to present a summarized technical note that the central bank independence is only a non-existent notion believed by some people that causes immense instabilities and uncertainties to economies and public across the globe.

What is meant by the central bank independence?

During the last century, Governments have expanded their control over the economic life of the public to a great extent through the state budget and the state monopoly of printing and regulating money. The state budget which has been very old is known as the fiscal policy handled by the Treasury. The state money printing which is new from the beginning of the 20^th century is known as the monetary policy.

The difference here is the nationalization of the money printing with the central bank (fiat currency system) and kept it outside the Treasury on paper. Unlike the fiscal policy invented by the Governments in the interest of their sustainability, money, money printing and central banking have been invented by markets in the interest of economic transactions.

Therefore, the central bank independence is meant to be the independence of the monetary policy from the fiscal policy. This means that central banks should have the freedom to carry on the monetary policy in order to achieve their targets without regard to fiscal policies in place. 

However, central banks are owned by the Government and central bank officials also are public officials remunerated from the public or state funds. Therefore, central bank managers whoever get appointed from time to time do not have the luxury of behaving independently in the mind of managing their own property independent from the state intervention because what they manage are the money which is a liability of the state. It is noted here that even private properties have to managed in compliance with the state laws in place.

Therefore, managing the money or the monetary policy by central banks has to be in line with the state fiscal policy from time to time where central bank managers are not in a position to resist the fiscal policy by citing the monetary policy independence. In times of the resistance by such independentists, not only the central banks will lose its internal administrative independence, but also the economy and the general public will confront catastrophic crises as there is no evidence that central banks alone can fulfil their mandates as stipulated on paper without the support of the Government.

For example, present Sri Lankan crisis is largely a result of the failure of managing the central bank by such independentists to serve the statuary functions, primarily the preservation of its foreign currency reserve and the exchange rate stabilization within the monetary policy and the public debt management as set out in the Monetary Law Act (MLA) and other statutes. The global economic literature also is full of such crisis episodes caused by central banks in other countries.

Why central banks cannot implement monetary policies independently?

Whatever said and done by central bank independentists, central banks in fact operate on inputs provided by the fiscal policy. Therefore, in the event the Government runs a balanced budget or becomes bankrupt not being able to borrow or repay, the central bank also will find extremely difficult to exist with usual monetary operations. This position is justified from the following 10 facts relating to central bank operations in general.

1. Money in Trust of the Government

In the monetary policy, central banks print money as a public good on the monopoly license given by the Government on behalf of the Government. Accordingly, the currency is accepted by the public for transactions in trust of the Government as the currency is not guaranteed by any specific asset at par value, similar to gold standard in the past.

2. Printing Money on Purchase of Government Securities

Assets that most central banks purchase for printing money are primarily the Government securities issued by the Government to borrow from the market for financing the budget deficit. Most central bank statutes consider Government securities as credit risk free assets. Even though some central banks are authorized to acquire private securities, they are generally not inclined to buy or trade private securities in the monetary policy due to their high-risk profile.

3. Maintenance of Foreign Currency Reserve from Government Foreign Borrowing

The major source of money printing by central banks in developing countries who confront BOP deficits are the proceeds of the Government foreign borrowing where central banks buy such foreign currency proceeds directly from Governments and provide them with the equivalent amount of local currency. In general, 60%-80% of central bank assets in these countries is the foreign currency reserve funded by the Government foreign borrowing. It is this foreign currency reserve that central banks use to control or stabilize the exchange rates. The present Sri Lankan foreign currency-induced economic crisis is the result of the Central Bank's heavy dependence on the Government foreign borrowing for the conduct of the monetary policy.

4. Conduct of OMO through Trade of Government Securities

In open market operations (OMO) conducted for the purpose of regulating the market liquidity and interest rates, central banks trade Government securities and control the yield curve relating Government securities. As such, the monetary policy in some central banks in some periods becomes explicitly yield curve control based, for example, Central Bank of Japan at present to keep the 10 year Government bond in the secondary market around zero. 

In Sri Lanka, Treasury bill yield rates are heavily controlled by the Central Bank through the purchase of Treasury bills outside the weekly auctions. Therefore, in times of rising fiscal deficits and borrowings, central banks are compelled to buy government securities to keep market interest rates within the monetary policy targets. Therefore, central banks have no options but to fund the fiscal deficits if they are to keep market interest rates under control.

5. Fiscal Support for Resolution of Financial Crises

In times of financial crises, central banks seek the Government support for the resolution of the crises. The fiscal instruments mostly used to boost the public trust in banks and the financial system in such crisis times are the Government guarantees, bailouts through injection of funds by asset purchases and ownerships of troubled financial institutions, nationalization of troubled banks, fiscal incentives to affected businesses and new legislations. Such fiscal instruments are necessary as central bank lender of last resort (LOLR) and existing regulatory measures are not adequate for new crisis resolutions.

6. LOLR and Liquidity through Government Securities

Even for the fondly LOLR of central banks used in the interest of banking stability, loans are given on collaterals of Government securities. Further, bank liquidity regulations also require banks to hold Government securities as liquid assets where the composition permitted for private securities and other assets is limited.

7. Dealing with the Global Corona Pandemic

It is in common knowledge that varying economic risks consequent to the pandemic were dealt with world over by the fiscal instruments through rising budget deficits and debt at historic levels. In this context, central banks relaxed monetary policies at historic levels in order for Governments to raise funds at low interest rates. Therefore, the monetary policy was only a conduit that assisted the fiscal policy to deal with the severe economic risks of the pandemic.

8. Dealing with Effects of Inflation on the General Public

The increase in the cost of living of the general public or fixed income earners while their real income falling is the widespread public issue confronted by the state policymakers. In this regard, it is the fiscal policy that can implement targeted relief to the affected public. However, the effectiveness of controlling inflationary pressures by the present market based monetary policy models is not established yet as the policy transmission mechanism is not empirically identifiable.

Central banks advocate monetary tightening mainly through the gradual policy rate hikes until the inflationary pressures disappear in the medium to long-term term. However, it is accepted that risks of economic downturns and recessions caused by the monetary policy by cutting the growth of interest sensitive demand sectors are harmful to the economies and societies as central banks are unable to manage the policy balance between the inflation and economic growth.

In this context, Governments are compelled to implement fiscal relief measure to support persons getting unemployed by the economic downturns while providing cost of living support to households in general. However, as Governments in many developing countries do not have the fiscal resources to provide unemployment benefits during the economic downturns, the resulting social and political unrest may even destabilize the economies and societies as now being experienced in many countries including Sri Lanka. 

This position is to accelerate to historic levels in the near-term as central banks have embarked on a global front of raising interest rates faster to control rising inflationary pressures. Therefore, fiscal authorities are required to protect the general public from the next round of the global economic downturn and recession in 2023/24 projected from the current cycle of the monetary policy tightening.

9. Government Agency Functions

Central banks with various agency functions of the Government even confront day-to-day administrative interventions from the Government as the most of such operations requires the state approvals and concurrence. For example, Central Bank of Sri Lanka undertakes debt management, fiscal agent, foreign exchange control, provident fund management, etc., for the Government and these operations have direct impact on the country's monetary conditions and monetary policy. In fact, the evidence is available that the Central Bank have been accustomed to use those operations to support the monetary policy in conflict of interests. 

For example, evidence is available that the Central Bank of Sri Lanka used private placements of Treasury bonds to control the yield within the targets of the monetary policy whereas Employees' Provident Fund was used as the major conduit to route the private placements in large volumes at forced yield rates. Therefore, the Central Bank Annual Report 2016 indicated that the sole auction system of issuing bonds resulted in the inability of the Central Bank to control the long end of the yield curve. Further, the heavy use of the Government foreign borrowing by the Central Bank of Sri Lanka to maintain its foreign reserve is a well known fact where this has caused the debt trap and the default announced on last April 12.

As such agency functions have to be carried out in the interest of the Government, the Central Bank has to communicate on daily basis with the relevant Government officials.

10. Non-Independence of the Central Bank of Sri Lanka

The MLA and the Exter Report do not recognize the independence of the Central Bank. The MLA provides for issuance of directions by the Minister of Finance to the Monetary Board as to the conduct of the monetary policy beneficial to the people, the audit by the Auditor General with the full access to the information and the Minister of Finance to require the Auditor General to submit reports on examination of any operation of the Central Bank as specified by the Minister and the submission of reports to the Minister of Finance on various economic issues periodically as specified in the MLA.

The Exter Report requests persons involved in managing the Central Bank to have greater co-operation and coordination of the monetary policy with the fiscal policy as the Government ultimately has to accept the responsibility of the monetary policy too. This report emphasizes the possibility of changes to the MLA in the event such co-operation and coordination are not healthy.

Concluding Remarks

When the real-world operations of the fiscal policy and monetary policy are reviewed, it is seen that the monetary policy is the state arm of creation of monetary/financial wealth whereas the fiscal policy is the state arm for the distribution of such financial wealth across the economy with a safety net mechanism as determined to be desirable by the Government. Therefore, both fiscal and monetary policies in the current world run largely on Government debt and debt cycles where the private sector activities remain in the periphery dependent on fiscal volumes at the core. In nutshell, modern monetary economies are driven by the state finance.

That is why the new school of thoughts proposes the modern monetary theory to redesign the monetary policy within the fiscal policy to ensure that the public wellbeing is improved through the mobilization of resources and production capacity without any fear of monetarist inflation. According to them, current macroeconomic management is actually driven by the fiscal policy financed by the monetary policy through printing of money on Government debt in hindsight as pointed out above.

Therefore, the central bank independence is only a ghost living in the minds of monetary fundamentalists. In fact, countries are facing macroeconomic instabilities and crises because of policy prescriptions of such fundamentalist antagonized with the elected Governments. 

However, their network is so influential that the political leaders and high-ranking Government officials find extremely difficult to intervene in central banks to ensure that central banks are operated, not in the interest of satisfying the monetarists’ ghost, but  in the interest of the wider economic well-being of the general public.

Therefore, the public question that ultimately should be raised is what the rationale is for setting up of a state monopoly money printing house and vested it with a few private hands to run it in the way they want while the Government accepts the responsibility.

For example, the current economic crisis with the collapse of living standards of the public is the direct result of the failure of the central bank's monetary policy in managing the foreign currency reserve and the exchange rate of the Rupee as required in the MLA. However, while political leaders and fiscal officials confront the public anger and revenge for the crisis, relevant central bank officials responsible for the policy failure, for example, the incumbent Governor, are not only safe, but also seek new positions with the assistance of a set of same political leaders by claiming to manage the Central Bank independently in order to stabilize the economy. This no doubt will cause utter catastrophe to the general public, given the poor performance record of the recent past.

Therefore, it is the heightened public responsibility of the incumbent President and the Prime Minister/Finance Minister at this crisis time to stay away from looking for people who are responsible for the current economic crisis to be appointed as the Governor for the next 6 year term and, instead find a young person from within the Central Bank who knows the in and out of the Central Bank and can look forward to driving the Central Bank continuously at least for the next decade as the present economic crisis will not end in the medium-term.

Otherwise, given the board purview of the monetary and financial powers vested with the Central Bank and the Governor as provided for in the MLA, in the event a central bank independentist is appointed to the post of the Governor, there is certainty that the present Government as well as the prospective Governments will not long last due to the possible noise and conflict created between the fiscal policy and monetary policy.

Therefore, it is the public duty of the other political leaders and people who do not really know the central banking in Sri Lanka is to allow the relevant authorities to take the responsibility for the appointment of the next Governor for the 6 year term in due course without canvassing their favourites in pursuit their future political interest (See the article in this blog released on last 26 to justify non-suitability of the incumbent Governor).

(This article is released in the interest of participating in the professional dialogue to find out solutions to enormous economic difficulties presently confronted by the general public consequent to the global Corona pandemic and subsequent disruptions and shocks.)

(Next article will be on ineffectiveness of the present model of the monetary policy in modern economies operating in the global economy)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles published)