Why the Central Bank should not be “independent”

Central Bank

By Kasun Thilina Kariyawasam

The Sri Lankan Government has announced plans to make the Central Bank of Sri Lanka (CBSL) “independent”. So far, the framework or methodology that will be applied to a new and “reformed” the CBSL have not been made clear. Therefore, this article is a critique to the general concept of an Independent Central Bank (ICB) that has been promoted across the world by neo-classical economists and institutions such as the IMF.

Firstly, the term “independent” is intended to disguise the true function and ideology behind the proposed reforms. In most cases, such institutional changes are carried out in extremely opaque methods without seeking the informed consent of the public. Customarily, such reforms are undertaken in the trappings of liberal representative democracy, where economic issues are under-discussed in favour of other social and cultural discourses.

The concept of an ICB appropriates the rhetoric of existing liberal institutions such as the “independent legal system,” where sovereign law stems from a mutually agreed moral code of conduct. However, unlike the legal system, economic activities are dynamic and sequential. Therefore, institutional responses that are archetypal and ideologically embedded can have adverse effects on stakeholders – in this case, the citizens of Sri Lanka. 

Viewed in such a way, ICBs are fundamentally antithetical to democracy. This antidemocratic orthodoxy often disguises itself with nomenclature that indicates goodwill. For example, we often hear of ‘free’ markets, ‘liberalisation’ and ‘independent’ central banks. Therefore, so called neutrality is merely a process of maintaining an ideological hegemony of a particular class interest.

Traditionally, monetary policy (credit creation) and fiscal policy (spending) are both handled by the same entity, as one tis gives government’s ore space to implement policies. However orthodox economists seek to strip Central banks of their fiscal powers by making them ‘independent’. This however is an inherently undemocratic act as choosing what money should be spent on has long term implications for the welfare of citizens and the long term productivity of an economy.

The idea of an ICB, in abstract, is to dislocate the Central Bank from the control of elected representatives and attach it to financial institutions and their class interests. In highly financialised economies such as USA and UK, speculative behaviour, monetisation and extraction caused by financial interests directly inhibit the growth and productivity of the economy. In such economies, the rigid and automated mechanisms of ICBs help carry out financialisation, austerity and privatisation. ICB policies therefore create the conditions for a self-fulfilling prophecy by extracting wealth rather than creating it.

A brief history of central banks

Before moving explaining methodological inaccuracies of ICBs, it’s important to understand the historical development of central banks. Money is a medium of exchange, therefore it has the ability to proportionate produced values. However, as Stuart Mill argues, money is a mere veil. Providing finance can determine the directionality of an economy, and therefore that functions needs to be vested in a democratically accountable institution. 

In earlier economic models, there were national banks, which were sovereign institutions which provide credit for the interests of the nation. Arguably, the first central bank was the Swedish Central Bank established in 1668 (Sveriges Riksbank) and managed under the guidance of the monarch of Sweden. The modern day national bank model originated in the United States, though it later went through heavy reforms to accommodate financial markets. 

The most well-known example of an efficient national bank is the Bank of Japan, established in 1882, which was used to finance the country’s war economy as well as its post-war miracle’ growth – which at one point was 17%. Behind this miracle is a little known macroeconomic infrastructural method called ‘window guidance’ (also known as economic suasion). Motivated by state policy, the Bank of Japan gave credit to commercial banks to invest in industries. Many modern Japanese household brands were the result of this monetary planning system. Similar systems were in place across the Asian tigers – so why were they dismantled? 

The Asian Tiger economies developed economic bubbles and were bailed out by IMF packages in late ’90s. One of the policy adjustments recommended by the IMF was to make Central Banks independent, which devastated those Tiger economies further. Some such as Malaysia, Indonesia and Thailand are still struggling to recover. Today, China is the only country in the region that uses window guidance, which partially explains its uninterrupted growth. China has a specific banking system for the purpose of lending – it is estimated that 70% of bank borrowing is spent locally based on industrial feasibility.

This system is not very different from what exists in contemporary Germany, which is an industrial powerhouse. Germany has more than 3,000 small community banks (Sparkassen) which lend to small and medium size companies (mittelstand). When we think of the German economy, we tend to assume that it’s the likes of Siemens, Daimler AG, Volkswagen, and BMW that run the show. 

However, 50% of German exports come from SMEs which are champions of niche market segments and often more industrially sustainable and agile. These SMEs do not borrow from the major banks but from community banks. This has a democratising effect as the banks are community oriented and therefore accountable to the locality.

The myth of price stabilisation

Over time, after heavy lobbying by institutions such as the IMF or the European Central Bank, global central banks shifted to becoming mere price stabilising entities. This is ill-advised as price stabilisation is irrelevant for increasing productivity and overall economic growth. The ‘ideal economies’ which followed this path often saw their currencies devalued (the British pound is a well known example) and became volatile as a result of ideological coercion to accommodate a specific interest in the economy over all else.

Price stabilisation was propagated as a method to accommodate speculative behaviour. Price stabilisation acts as a hedging mechanism in financial speculation. Once prices are stabilised, it creates favourable outcomes for speculative financial instruments – hence the paranoia over inflation. The short term paranoia over inflation is irrational because inflation is one external indicator of an ongoing internal economic flow. Therefore, inflation needs to be understood contextually. 

For example, the highest growth era of the Asian tiger economies was accompanied by high short-term inflation. The point here is that short term inflation and economic performance has no relation unless it indicates a certain systemic micro-level failing due to short-sighted market practises. Often, state fiscal spending on developing capital stock can be inflationary in the short term – certain economies face this issue cyclically in order to advance their industrial capabilities. Therefore, price stabilisation acts as a self-imposed law to block any state spending – institutionally blueprinting austerity and necessary spending on public needs and long term business requirements.

The typical ICB strategy is to pull a couple of economic levers – in most cases ‘interest rates’ and ‘money supply’. The most misguided idea that was hard-coded by monetary theology is that it is the Central Bank that determines interest rates. However, manually set interest rates are set based on the economic performance of the particular economy. Countries that have raised interest rates recently, such as Sweden and the US, have said that they did so due to economic recovery. In fact, both countries raised the interest rates in the same month (December 2018). In a practical sense, their interest rates are actually determined by exogenous factors.

Banks on FIRE

Moreover, economic conditions are quite dynamic and cannot be accommodated by automated systems where institutional guidelines restrict capabilities and determine outcomes that are favourable to specific segment of the economy at the expense of others. This is what was observable in 2008, where the US federal reserve was fiscally blind and therefore failed to foresee the property bubble.

Another one of the main features of ICBs is that they tend to disconnect themselves from credit creation policies in order to provide banks unregulated lending. Therefore, banks habitually use this space to lend credit for speculative activities in the FIRE (Finance, Insurance, Real Estate) sector. Such economic activity is a process of asset transfer and not productive. The result of speculation in FIRE is quite evident in both mature capitalist countries as well as underdeveloped countries - increase in land prices, lack of credit for SMEs industries etc. Productive investments in SMEs are often understood as high risk, with a long wait on returns and compared to speculation in FIRE. 

FIRE also increases the overhead of businesses, making it harder for SMEs to initiate and sustain businesses due to the cost of economic rents. This is one of the current realities of the Swedish startup ecosystem (which is the second biggest startup ecosystem in the world). Stockholm is going through a property bubble and so startups are suffering from a lack of affordable urban business space to operate in. The biggest startup hub is in the UK, and faces a much worse situation due to an unregulated land/asset speculation bubble. Therefore, we need to understand that the asymmetrical lending of banks can not only have direct consequences but also long term implications.

Conclusion

Current economic orthodoxy suggests that an ICB can maintain a level of “neutrality” in financial flows. However, this so-called neutrality is in fact a self-imposed rigidity to block any economically progressive policies. From an empirical perspective, this theology is inherently non-responsive to democratic demands. 

A tricky situation that can arise with ICBs is that if and when an ICB oversteps its regulations, the elected representatives may not be empowered enough to hold them accountable. Consider the case of Latvia, where the Central Bank Governor was accused of bribery and money laundering. The Latvian Parliament (Saema) voted 55 to 0 against him, and his staff signed a petition against him. However, when he was barred, the European Union stated that it was against the EU law. Why? Because the Latvian central bank is an ‘independent’ institution.

Undemocratic and publicly unaccountable institutions cater to elitist interests. Employment is often understood as a phenomenon that is external to monetary policy. However, David A. Levy argues that some Central Banks deliberately maintain a level of unemployment as a strategy to stabilise prices despite it being against the public interest. There are several infamous incidents where Central Banks even deliberately keep such information undisclosed. In the US, the Federal Open Market Committee deliberately concealed transcripts to mislead the congress (so much for ‘open’). It should be obvious by now that attempts to make the central bank ‘independent’ are attempts to make it serve specific class interests.

The top priority of monetary policy should be economic welfare and wealth redistribution (technically, this is the priority of any democratic institution). Economic welfare provides economic sustainability. In the long run, it can also help accumulate surpluses, as better labour conditions provide better labour outcomes while allowing for easier labour mobilisation.