A novel discourse on ‘central bank independence’ has begun. This is in the backdrop of Central Bank of Sri Lanka (CBSL), a distinguished former employer of mine, becoming the source to perhaps the biggest controversy during the Yahapalana two years.
It’s not clear when the debate started. To me, a statement by minister of finance at a post-budget seminar organised by the Institute of Certified Management Accountants of Sri Lanka appears to be the starting point. I may be wrong, though.“The Central Bank has failed miserably on many fronts. It was set up by the Constitution to carry out certain monetary measures, but they have been politicised.”
That was verbatim what Minister of Finance Ravi Karunanayake said. Such words are provocative – coming from anybody. But, excuse me, this is not anybody, but the Minister of Finance. No previous finance minister has publicly accused the Central Bank of being political. Yes, that was the first time we heard such a statement in the 66-year history of the bank. The CBSL kept mum. Obviously it cannot publicly confront the minister of finance.
However, its thoughts might have been echoed in the writing of W A Wijewardena, an ex-Central Banker, having retired as its Deputy Governor. Wijewardena wrote: “The Central Bank of Sri Lanka has been criticised in the past on grounds that it is subservient to the ministry of finance. As such, although it had independence in deciding monetary policy, critics charged that top officials in the ministry of finance had, in reality, dictated its policies. This has been made possible by the presence of the secretary to the ministry of finance on the Monetary Board, the policy deciding body of the Central Bank, with voting powers. John Exter, the architect of the present Central Bank, had clarified in the report that he submitted to the government on the establishment of a Central Bank in Ceylon, known as the Exter Report, why this arrangement had been made in the structure of the Central Bank. But over the years, Exter was defeated by some of the officials who had occupied the top-most positions in the ministry, paving the way for critics to justify their charge of having a subservient Central Bank.
Wijewardena went on claiming that central banks should be ‘independent’. According to him, that is the best way to ensure that a central bank does not over print money (or, in better terms, ‘increase money supply’), leading to inflation.
Agreed, one key obligation of central banks is to control inflation. For example, in the UK, where the very concept of central banking originated, the governor of the Bank of England has to officially inform and defend the recovery strategy to the parliament if the inflation rate crosses 2%. His resignation letter will follow, if no improvement is seen for two quarters without an apparent external reason.
The Central Bank of Sri Lanka has no such obligations. No governor has resigned over high inflation, even when the rates were above 10% for considerable periods during some war years. For one quarter, it was 28%. Still, nothing happened. One can argue that this is the direct consequence of the inherent political nature of our Central Bank. A more ‘independent’ central bank might have prevented such a development.
[pullquote]Is ‘central bank independence’ a must? Or, on the other hand, will a bit of flexibility offer a better environment for a government to operate?[/pullquote]
On the other hand, one can also argue that high inflation rates were a necessary evil – a price to pay for ending the war. The flexibility of handling economics the way the government wanted contributed to ending the war. Were there a so-called ‘independent’ central bank, we would still be fighting the North-East war. Fighting inflation is important, but that is not the sole priority of a government. A politically-conscious central bank against an ‘independent’ one allows the necessary space to place inflation control at a right point among multiple self-conflicting priorities.
This prompts the questions: Is ‘central bank independence’ a must? Or, on the other hand, will a bit of flexibility offer a better environment for a government to operate?
One who analysed the issue comprehensively was Milton Friedman, Nobel Prize winning American economist for his research on consumption analysis, monetary history and theory, and the complexity of the stabilisation policy.
Friedman typically believed in a limited government. Still, his views on this subject have been different. He firmly believed the Federal Reserve, what comes closest to a central bank in the American context, should be subordinate to the treasury. A single locus of power on monetary and fiscal policies, he said, would establish accountability for mistakes in policy that otherwise leaves each institution free to blame the other for policy errors. Even if there were a central bank that had independence to the furthest extent, said Friedman further, it would still be independent only if it had no conflict with the rest of the government. Were there a conflict, the bank would unquestionably give way to fiscal authority. The best local example would have been the ‘independent central bank’, if it existed in 2008-2009, placing its interests behind the nation’s interest of ending the conflict. Inflation is bad; war is far worse. Any sane individual selects the former over the latter.
Friedman goes even further, stating that even if a fully independent bank could be established, it would not be desirable to do so for political and technical reasons. The political reason is that, in a democracy, it would be wrong and foolish to place such concentrated power in a group free from any kind of direct political control. Technically, an independent central bank may not fully take its responsibility in times of uncertainty and difficulty, fostering instability, and can be subjected to undue influence to the opinions of bankers. None are acceptable in the interest of the nation.
However, in the case of any regulator, moving to the other extreme isn’t a solution. For example, if they were to serve as the lender of last resort, as leading central banks did during the recent financial crisis, they must have some degree of independence. In particular, the central bank practically cannot be open in its lending. They must delay disclosure about the recipients of its funds. If not, some banks may be seen as fragile, leading to the freezing of interbank funding, perpetuating financial system liquidity and panic. At the same time, the central bank must not lend to insolvent banks; otherwise, the stigma associated with borrowing will discourage solvent but illiquid banks from seeking funds. These are not tasks a state institution can normally carry out in an open environment.
So it is imperative that both parties, the central bank and the treasury, understand that the relationship between the two should lie somewhere between complete independence and complete control. The interesting question would be where the line can be drawn, but certainly it cannot be at one extreme.