The issue of an independent Central Bank: Should it be or should it not be?

CBSL and the Government are two arms of the State created for the common benefit of citizens. Hence, neither one should override the other

Public debates on public policy should create informed citizens

With the news release that the Government is going to introduce a new Monetary Law Act, commonly known as MLA – the law under which the present Central Bank (CBSL) has been established – to make the Bank more independent, many concerned citizens have begun to express their views on the subject. 

This is a salutary development since in a democracy, it is essential that the public speak up in public supporting or opposing any public policy being formulated by public authorities. It generates a free and healthy discussion of these vital public choices giving the concerned citizens an opportunity to test their views against counter views that may be presented by others. Subjecting one’s views to searing exploration by others will help not only the view-presenter but also society at large. Thus, after this process is over, people would be able to either support or oppose, or even propose amendments to, any legislative measure, not as an ignorant lot but as informed citizens.

This is an essential requirement of economic democracy to which all political parties, specifically the present Government, have committed themselves. But as Emperor Asoka had pronounced in one of his rock inscriptions, in a public debate ‘one should treat his adversary with honour and respect in every way on all occasions’. Thus, the debate should be at an intellectual level and not guided by personal emotional feelings.

People trust central banks if money value is preserved

CBSL is an important subject in which citizens should get themselves engaged in a public debate if there is any move to change its governing law. This is because every citizen has a stake in CBSL: the paper money issued by it is being held by all as a way to keep a part of their wealth or to make payments. 

If the value of the paper money so held falls against the prices of goods and services – a development known as inflation in common parlance – they stand to lose. The loss comes from the fact that they become poorer since the paper money they hold now can command a smaller basket of goods and services than before. In such a situation, it is inevitable that citizens will lose faith in CBSL as well as the paper money issued by it. 

If, on the other hand, the value of this paper money is kept stable over time, it will cause the citizens to have faith in both CBSL and its money. Such a faith in money is essential for an economy to conduct its transactions and ensure the continuous production of goods and services that would bring prosperity to all. 

CBSL and the Government are two arms of the State 

The current debate whether CBSL should be independent or not is irrelevant since the legislators who approved of MLA in 1949 had decided to set up the Bank as a semi-autonomous institution within the sovereign state of Sri Lanka. In this case, it is important to remember that both CBSL and the Government are two arms of the State created for the common benefit of citizens. Hence, neither one should override the other.

Two types of Central Bank independence

In terms of the law, the Bank enjoys two types of independence which other government bodies do not have. 

One is related to the policy measures which the Bank has to adopt for maintaining the stability of the general prices in the economy. This is known as ‘policy independence’. The other is the independence it enjoys to handle its budget without going through the normal budgetary process which other public institutions have to compulsorily comply with. This is known as the ‘budget independence’. 

Both these versions of independence together help the Bank to do its job properly without the interference of the political masters who may have personal interest in driving the Bank’s policy toward their own political goals.

Finance Minister cannot issue directives to the Central Bank  

Though the Bank is listed under the Ministry of Finance for administrative purposes, the Minister cannot issue any policy direction to the Bank as in the case of other public institutions which come under his purview.

Hence, the Central Bank’s monetary policy – the policy to change interest rates and the quantity of money and credit in the economy – is a preserve of the Monetary Board which is specifically entrusted by Law to do the job. This vital power is given to the Board in order to protect the value of the money being held by the public. The value of money falls when the prices of goods and services go up and the main cause of such price increases in the long run is the over-production of money by a central bank. As such, it is the responsibility of the Monetary Board to keep such price increases within permissible limits by keeping money supply increases in check.

Conflict between the goal of monetary policy and that of politicians 

The permissible limit of price increases is simply the rate of increase in prices that would not discourage money holders to make long term choices concerning consumption, investment, saving or working. It is generally accepted that this limit pertaining to Sri Lanka is about 4% per annum. Any price increase above that limit is therefore considered injurious to the economy. 

To keep the price increases within this limit, the Monetary Board has independence to change the interest rates and credit levels as it considers desirable. For instance, if prices are rising above the permissible limit, the Monetary Board will increase interest rates and cut down the credit levels to make the use of money more expensive. 

This is where the policy action of the Monetary Board and the interest of political masters would directly be in conflict. Political masters may desire to have low interest rates and higher levels of credit to appease their voters and thereby win elections. When inflation has set in the economy, lowering interest rates and increasing credit levels are like giving sugar to a diabetic. Hence, the Monetary Board has been given policy independence by legislators to conduct monetary policy without the interference of the political masters.

Government can change monetary policy but should take responsibility

If there is any disagreement between the Monetary Board and the Minister of Finance about the appropriate interest rate policy, the present MLA has called both parties to reach agreement on the appropriate policy. However, if an agreement cannot be reached, taking into account the sovereign powers of the sovereign state, MLA has permitted the Government’s view to prevail on the Central Bank. Accordingly, the Minister of Finance has been empowered to give direction to the Monetary Board to implement the Government policy having informed the Board that the Government will take responsibility for any consequence of adopting such policy.  

Central Bank’s independence is not independence of those who work in the Bank. It is the independence of the citizens from undue interference from politicians who desire the Bank to print money and help them finance budgets that basically allocate resources for unproductive purposes in the absence of a mechanism for deciding on priorities in the economy. In the long run, the country is engulfed with inflation where all citizens have to bear the cost.

This is a very special case and a Minister of Finance would use this provision very sparingly. Furthermore, the Government’s taking responsibility for misfired monetary policy action is a non-enforceable commitment since its adverse repercussions would not be known immediately. By the time its adverse consequences in the form of accelerated inflation are known, the Government that caused such mayhem may not be in power to answer questions. 

In fact, in the whole history of CBSL, this provision had been used only once by a Minister of Finance. That was in 1959 when the Government wanted CBSL to cut interest rates in order to win the elections scheduled for the following year. Since then, no government has invoked this provision. Hence, this provision could be deleted from the law book without any impact on the working relationship between the Government and CBSL.

Job security of Governor, Board members and senior officers

The Central Bank has been given budget independence to attain two objectives. One is that its employees can work independently without the fear of losing their salaries if they do not yield to the pressure of the Government. The other is that the Bank can incur interest expenditure without Finance Ministry approval to take out excess liquidity from the market by issuing its own interest bearing securities. This flexibility in needed for the Monetary Board to make quick and fast decisions regarding its policies. 

To strengthen these goals, there are several other provisions that have been introduced to the current MLA. One is the tenure and the removal processes relating to the CEO of the Bank, the Governor, and the policy deciders of the Bank, Monetary Board members. The Governor is to be appointed not by the Minister of Finance but by the Head of the State, namely, the President. Once appointed, he holds office for six years. 

Similarly, the Monetary Board members, other than the Secretary to the Ministry of Finance, are to be appointed by the President for a period of six years on the recommendation of the Minister of Finance and with the concurrence of the Constitutional Council set up under the Constitution. The removal of both the Governor and the Monetary Board members, except again the Secretary to Ministry of Finance, cannot be done arbitrarily and there is a set procedure that has to be followed in that connection. Similar provisions have been made in MLA with respect to the removal of Deputy Governors, the next level senior officers in CBSL. The career security of the Governor, Monetary Board members other than the Secretary to Ministry of Finance and Deputy Governors have made CBSL more autonomous than ordinary government institutions.

Instances of past Governors thwarting political interferences

Despite these provisions in MLA, the autonomy of CBSL can be compromised by political masters if the stature of the persons holding these high positions is weak. However, in the past, there are many instances where Governors had, as professional central bankers, stood up to politicians or other outsiders to protect and preserve the autonomy of the Bank. 

In 1973 in which year I joined CBSL as a probationary staff officer, the private secretary to the Minister of Finance – Dr. N.M. Perera – had written to Governor Herbert Tennekoon that the minister wished to have the list of names of officers to be recruited to the Bank for his approval. Governor Tennekoon in a polite letter reminded the Minister that in terms of Section 10(a) of MLA, the responsibility for recruiting such officers vested with the Monetary Board and therefore he did not see any reason why the list should be submitted to the Minister for approval. 

Similarly, in 1994, a letter from the office of Prime Minister Ranil Wickremesinghe had requested Governor H.B. Dissanayake to release a non-staff officer working in CBSL to Ministry of Industries with full pay from the Bank for its service. Governor Dissanayake informed Wickremesinghe that provisions in MLA did not provide for such release. In both cases, to their credit, Dr. Perera as well as Wickremesinghe accepted the position of CBSL upholding the autonomy of the Bank. 

Governor A.S. Jayawardena in 2003 defied even a Cabinet decision to have the services of the Bank’s Director of Economic Research released to the Ministry of Finance when the Bank was short of skilled officers. 

In 2007, when there was undue interference from the Ministry of Finance in CBSL’s monetary policy, Governor Ajith Nivard Cabraal took the matter with the President who was the Minister of Finance as well. It led to the issue of a special circular by the Secretary to the President that CBSL should be permitted to conduct its monetary policy without interference. The result was dramatic and the inflation rate that was running at two digit levels consecutively for three years and had peaked to 23% in 2008 was brought down to single digit at 3.4% in 2009. Since then, inflation has remained at single digit level and averaged at 5%.

Central Bank independence is for citizens

So, Central Bank’s independence is not independence of those who work in the Bank. It is the independence of the citizens from undue interference from politicians who desire the Bank to print money and help them finance budgets that basically allocate resources for unproductive purposes in the absence of a mechanism for deciding on priorities in the economy. In the long run, the country is engulfed with inflation where all citizens have to bear the cost. 

Critics of Central Bank independence

Those who argue against Central Bank independence normally present two views to support their arguments. One is that both monetary policy and fiscal policy should work together to create wealth in a country. The other is that for a developing economy like Sri Lanka, a little bit of inflation is always desirable in the initial stage of economic development.

Money is not a real product but a mental thought 

Both these arguments are based on a misidentification of money’s role in an economy. Money as against a real good, say like rice, is only a mental notion without any real existence. It, therefore, assumes only a nominal role. That is the reason for calling everything measured in terms of money ‘nominal’, like nominal prices, nominal income or nominal interest rate and so on. It can facilitate the acquisition of a real good like rice or a house, if people are willing to use it to make payments for same. 

Hence, in ushering economic prosperity, money is only a facilitator and not a real contributor. Real contribution, as the first Singaporean Finance Minister Dr. Goh Keng Swee said in 1991, comes from hard work done by people of all walks of life – students at schools, undergraduates at universities and workers at work places – and not from the money printed by the Central Bank. 

In today’s context where the world is moving toward the Fourth Industrial Revolution or 4IR, it is not just hard work but ‘smart work’ that would bring prosperity to a country. Central banks can only facilitate this process by keeping price changes in check or keeping inflation within limits. The real contribution should come from the Government which is in a position to influence the real production of goods and services.

Government and Central Bank should appreciate and respect each other

 Central banks have always been at the receiving end when it comes to conducting monetary policy. Both the public and the politicians have been critical of Central Bank’s actions. The challenge faced by them was covered by me in my Central Bank’s 68th Anniversary Oration delivered in August 2018 under the title ‘A Revisit to Central Bank Independence: How to Resolve the Emerging Issues’ (available at: https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/speech_20180828_68th_Anniversary_Oration_e.pdf). 

I have argued here that since central banks have to operate within a sovereign state, their action should be subject to public oversight. Both the Government and the Central Bank are arms of the State and they should collaborate with each other for the common benefits of the people who make up of the State. In this context, each party should recognise and appreciate the respective roles played by the other: the Government should respect and uphold the independence of the central bank, while the bank should facilitate the Government in its efforts to create prosperity for people. Neither party should make undue demands from the other.

Woes of ex-Central Bank Governors

In this background, it is encouraging that four ex-Chairs of USA’s Federal Reserve System – Paul Volcker. Allen Greenspan, Ben Bernanke and Janet Yellen – have called for making the Federal Reserve System independent of the government (available at: https://www.cnbc.com/2019/08/05/former-fed-chairs-volcker-greenspan-bernanke-and-yellen-call-for-independent-fed-in-wsj-op-ed.html). 

Several former Governors of the Reserve Bank of India have done better by calling for greater autonomy for the Bank throughout the period. Highlighting the danger of RBI functioning as an arm of the Ministry of Finance, its ex-Governor C. Rangarajan in a public lecture in 1993 called for greater autonomy for RBI. 

Ex-Governor Y.V. Reddy sarcastically told journalists who asked his whether RBI Governor was independent that ‘RBI Governor was independent and he got permission from his Finance Minister to say so’. In the recent past, all past Governors of RBI have asked for an independent RBI. The staff unions of RBI have asked the government to appoint a Collegium of Experts to select governors and deputy governors, instead of allowing a few bureaucrats at the Finance Ministry to do so. 

A critic might say that these ex-central bankers had been responsible for compromising the independence of the respective institutions while they held office. But, their value judgment based on experience should not be discounted by those who aspire to have a stable money system.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)