by Anis Chowdhury 10 January 2022
I begin by commending Mr. Mian Hameed for his excellent piece (South Asia Journal, 6 January, 2022) on the follies of recent legislation passed by Pakistan’s parliament granting independence of the State Bank of Pakistan (SBP), apparently at the behest of the International Monetary Fund (IMF). He is correct, “A true independent central bank is a myth”.
Myth debunked
None of the central banks even in developed countries are truly independent of their legislative bodies. For example, the Federal Reserve (FR) of the United States is accountable to the public and the U.S. Congress. Twice a year, the Federal Reserve submits an extensive report–the Monetary Policy Report–on recent economic developments and its plans for monetary policy to the Congress. The Board of Governors of the FR submits its annual report and regularly reports the results of supervisory stress tests of large banks to the Congress. In addition, the Chair and other Federal Reserve officials often testify before the Congress.
Similarly, the Bank of England’s democratic oversight is exercised via a number of formal and informal mechanisms, including parliamentary scrutiny, with the Governor and other Bank officials being called to testify in the front of the Treasury Committee (TSC), and reporting requirements, such as the obligation to publish the minutes of the meetings of the Monetary Policy Committee and the publication of the Bank’s Inflation Reports on a quarterly basis.
The European Central Bank (ECB), which is also regarded as a very strongly independent institution, has various mechanisms of democratic accountability.
Central banks do not operate in a political vacuum. The governors of the central bank are nominated by the executive and are accountable to parliament, which can decide in the last resort to revise the central bank’s statute.
Misleading arguments
Central bank independence is favoured by monetarists. However, Milton Friedman, the father of monetarism, believed “… money is too important to be left to the central bankers”.
Friedman elaborated his concerns as follows: “The political objections are perhaps more obvious than the economic ones. Is it acceptable in a democracy to have so much power concentrated in a body free from any direct political control? … One economic defect of an independent central bank … is that it almost invariably involves dispersal of responsibility… Another defect … is the extent to which policy is … made highly dependent on personalities… A third technical defect is that an independent central bank will almost invariably give undue emphasis to the point of view of bankers… The defects I have outlined constitute a strong technical argument against an independent central bank.
It is often argued that central bank independence is needed for monetary policy credibility to keep inflation low, which is needed for sustaining growth. However, there is no theoretical or empirical basis to support the claim that low inflation is helpful for economic growth as can be seen from Figure 1 which presents average inflation and per capita GDP growth in 177 countries covering 3 decades (1990-2020).
Figure 1: Average inflation and per capita GDP growth (1990-2020, 177 countries)
Source: World Bank online data
Three facts stand out: (a) inflation and per capita GDP growth are positively related for inflation up to 30%, (b) inflation-per capita GDP growth relation becomes negative when inflation exceeds 40%, and (c) growth rates can be high or low for inflation up to 20% (shown in the red circle).
Therefore, there is no solid empirical basis for the commonly used inflation targets of around 2-3% for developed and 5% for developing countries. Raising the question “Is inflation harmful to growth?”, and based on their cross-country econometric analysis, two senior World Bank economists, Michael Bruno and William Easterly, recently concluded that, “The ratio of fervent beliefs to tangible evidence seems unusually high on this topic”.
As the experience of fast-growing Asian economies shows, inflation and growth go hand-in-hand, except when there is a financial crisis (e.g., 1997 AFC) or external shocks (e.g., 1994 Tsunami). Just as a running machine causes frictions, and hence heat, a growing economy causes inflation. Too restrictive money and credit policies stifle an economy as businesses need access to finance to invest. Certain amount of inflation is also needed to induce structural change towards desirable and dynamic sectors. Higher prices signal where resource should move.
Higher inflation also means lower value of debt and hence benefits indebted poor. Higher inflation may not necessarily mean lower real wage or loss of employment if inflation is due to rapid growth and structural transformation. Thus, the relationship between inflation and poverty is complex and inflation does not necessarily harm poor as is commonly believed. Negative inflation-poverty relationships are influenced by extreme values or outliers, above 30%. Poverty can be high or low for inflation up to 20%.
Nonetheless, policymakers should be watchful, especially against wage-price spiral, i.e., giving in to demands for higher wages because of higher inflation. In such circumstances, higher wages are passed on to higher prices, and thus can create a vicious circle of inflation-wage demand-inflation.
There are alternative measures to deal with inflation and wage demand, for example, subsidised provisioning of services, such as child-care, health-care, education and public transport. Collectively, they can be termed as “social wage”, made possible by supportive fiscal policy.
The role of central banks in economic development
Historically, central banks have played developmental roles, e.g., by financing public investment. Even though many statutes are not explicit about developmental roles, the two oldest central banks – the Bank of England and Sweden’s Riksbank – are not prohibited from vigorously promoting priorities.
The Bank of England pioneered the idea and creation of specialised development institutions, e.g., the Industrial and Commercial Finance Corporation, the Finance Corporation for Industry, and the Bankers’ Industrial Development Company. The Riksbank actively promoted housing for all in Sweden.
The US Federal Reserve Act is committed to realise “the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates…in furtherance of the purposes of the Full Employment and Balanced Growth Act of 1948.”
Central banks of Italy, Germany, Japan and the Netherlands have used various means to finance areas underserved by credit markets. These include lowering bank reserve requirements and lending for priorities such as housing, agriculture, exports, small business and underdeveloped regions.
Central banks have also played an important role in development by easing the constraint of access to credit for firms through credit allocation policies. Subsidised bank loans (known as ‘policy loans’) were a vital instrument for the implementation of the strategy of the Republic of Korea for promoting heavy and chemical industries. In the United States, the Community Reinvestment Act of 1977 tasks regulators, including the Fed, with ensuring that low- and moderate-income families have adequate access to credit.
In India, a decisive shift in credit deployment in favour of the agricultural sector took place in the 1970s and 1980s. The Bangladesh Bank adopted a sustainable finance policy in 2011 to promote green investment and sustainable agriculture. Ninety developing country central banks have signed the Maya Declaration to promote financial inclusion since 2011.
Developmental objectives are explicit in many developing countries’ central bank statutes. The statutes of some central banks established in the 1970s and 1980s with IMF technical assistance have specific provisions for developmental roles, e.g., in Bhutan, Botswana, Fiji, Maldives, Solomon Islands, Swaziland and Vanuatu
Goal versus operational independence
Therefore, central bank’s development goals have to be mandated by the elected representatives. However, a distinction has to be made between ‘goal independence’ and ‘operational independence’ of the monetary authority. International experience shows that monetary policy tends to be more effective in supporting stable prices, sustained economic growth and strong employment when it is shielded from short-term political influence.
Thus, while the short- and medium-term targets for mandated goals – e.g., ‘maximum’ decent employment and ‘reasonable’ price stability should be decided in consultation with the government, central banks should have ‘operational independence’ to choose and apply appropriate tools to achieve these targets.
Concluding remarks
In a democratic society it is appropriate that central bank’s ‘operational independence’ is paired with central bank’s accountability to the public and its elected representatives. Greater central bank ‘goal independence’ in recent decades has undermined macroeconomic policy coordination, preventing them from directly financing government’s development projects.
The IMF’s mantra of keeping inflation low and central banks independent is driven by ideology, ignoring other policy goals. Supposedly for central bank and monetary policy credibility, such priorities actually serve financial investors, especially speculators.
But with ‘unconventional monetary policies’ after the 2008 global financial crisis, central bank lending to governments has become more acceptable. Many rich country governments have since turned to their central banks for fiscal space and other finance.
With little affordable finance available from both private and official sources, some developing countries, such as Indonesia, have suspended laws preventing direct borrowing from its central bank to deal with the on-going pandemic. Others, e.g., the Philippines, have amended legislation to allow its central bank to directly lend to governments.
Thus, how countries emerge from short-term economic downturns, and transform their economies to achieve progress in the longer term, critically depends on effective cooperation between central banks and governments.