What To Bank On - Dr Ashfaque H Khan

A country’s central bank is the most important institution, not only for the financial market but for the economy as a whole. The central bank’s actions affect the interest rates, the amount of credit and the money supply, all of which have a direct impact not only on financial markets but also on output and inflation. It is in this perspective that the autonomy or independence of this institution becomes crucial and comes under scrutiny quite often, particularly in developing countries.

The independence of the central bank is considered to be a prerequisite for the effectiveness of any monetary policy. Its independence has always been at the heart of the IMF programme. In the previous programme (November 2008), the government had committed to review the legal provisions related to the operational independence of the State Bank of Pakistan (SBP) – the country’s central bank.

Under the new IMF programme (September 2013), the government has once again committed to amend the SBP law by incorporating the recommendations of the IMF safeguards assessment with a view to “strengthening the autonomy of the SBP, including full operational independence in its pursuit of price stability by end March 2014 (structural benchmark)”. This “amendment will establish an independent decision-making monetary policy committee to design and implement monetary policy and prohibit any form of new direct lending from the SBP to the government”.

Going by the trend, the chances of amending the SBP law to grant operational independence and setting up an independent monetary policy committee appear bleak. What do we mean by an independent or autonomous central bank? Stanley Fischer, a former MIT professor as well as a former deputy managing director of the IMF has defined independence of central bank as instrument independence, that is, the ability of the central bank to choose the appropriate instrument to conduct monetary policy, and goal independence, that is, the ability of the central bank to set the goals of monetary policy. Many central banks of the industrialised world enjoy both types of independence.

There are two views on the independence of the central bank. The first view represents the opinion of the political leadership, which is not in favour of granting operational independence while the second view represents the opinion of professional economists as well as powerful academics who are in favour of independence.

The case against independence from politicians rests on the belief that it is undemocratic to have monetary policy controlled by an elite group that is responsible to none. The lack of accountability of the central bank has serious consequences: if the central bank performs badly, there is no provision for replacing the governor or its board of directors. People hold politicians responsible for the economic well-being of the country, yet they lack control over the central bank.

From the politician’s perspective, monetary policy must be coordinated with fiscal policy – that is, the central bank must coordinate with the Ministry of Finance (MoF) for promoting economic stability. Hence, by placing monetary policy under the control of the politicians who control fiscal policy (MOF) these two policies can be prevented from working at cross-purposes.

Yet another argument from the politicians is that an independent central bank has not always used its freedom successfully. Central banks failed miserably in preventing the Great Depression of the 1930s, the financial crisis in East Asia in 1996/97, the global economic meltdown of 2007/08, and the European debt crisis of 2010 etc.

Those who advocate for an independent central bank rest their argument on the fact that control of monetary policy is too important to be left to the politicians – a group that has repeatedly demonstrated a lack of understanding of economic issues. Politicians also lack expertise for taking hard decisions in issues of great economic importance.

The strongest argument for an independent central bank rests on the view that subjecting the central bank to more political pressure would impart an inflationary bias to monetary policy. Politicians in a democratic society are short-sighted because they are driven by the need to ‘win’ their next election. Accordingly, they are unlikely to focus on long-run objectives of promoting growth with stable price level.

Politicians will seek short-term solutions to problems, such as high unemployment and high interest rates, even if these solutions have undesirable long-run consequences. For example, to ‘create’ jobs, politicians will not hesitate to pump money in the economy, even if they have to print them in the billions. At the same time, they would not hesitate to lower interest rates to please business leaders even in the midst of inflationary pressure in the economy. A politically insulated central bank is more likely to be concerned with long-run objectives and thus be a defender of exchange rate stability and a stable price level.

More often it has been observed in developing countries that politicians generate a political business cycle. That is, just before the elections, they pursue expansionary policies (increasing money supply and reducing interest rates) to lower unemployment, or pursue populist policies of subsidising utilities, providing cheap loans etc. After the election, the bad effects of these policies – high inflation, high interest rates, a weak currency – come home to roost, requiring contractionary policies that politicians hope the public will forget before the next election.

Putting the central bank under the control of politicians is also considered dangerous because the central bank can be used to finance large fiscal deficit, even by printing money with adverse consequences for inflation. An independent central bank is better able to resist this pressure from the MoF. Some politicians may prefer an independent central bank which can be used as a public ‘whipping boy’ to take some of the heat off their backs. An independent central bank can pursue policies that can be politically unpopular but are in the public interest.

The bottom line is that public support for an independent central bank has grown rapidly in most parts of the world. Given the nature of our political culture and experience of recent years, an autonomous central bank with a competent governor is in the best interest of the country. Even if our central bank is autonomous or independent, a professionally weak governor would not be able to exercise its independence and would succumb to the pressure of political leadership.

The IMF’s structural benchmark notwithstanding, it is in our interest to have an autonomous central bank with a professionally competent governor. The government should be careful in appointing a commercial banker as governor. Pakistan’s central bank needs a central banker and not a commercial banker as governor. As a first step towards autonomy, the government may like to remove the finance secretary from the board of directors. Section 13(b) of the State Bank Act says that “no person shall be or shall continue to be a director or member who is (a) salaried government official”. The finance secretary is a salaried government official.

Finally, it is in the interest of the country as well as for the autonomy of the SBP to have a high powered monetary policy committee consisting of professional economists with macro-money-international economics specialisation.

The author is principal and dean at NUST School of Social Sciences & Humanities, Islamabad Email: ahkhan@nbs.edu.pk

From: TheNews