Merits of an Independent Central Bank
Independence of central banks has been a major topic of discussion for many years. In 1823, Ricardo, a member of the British parliament and an economist stated that all central banks that are responsible for the issuance of paper money should be independent and should at no time “lend money to the government” and should never be under its control or influence (Ricardo 1824). These sentiments were radical at the time as they were the complete opposite of what the Bank of England advocated. In 1998, the Bank of England gained independence ultimately confirming that Ricardo was right with his assertions (Bordo 2007). The subsequent discussion details some of the merits of having an independent central bank.
There is need for more central bank independence. This is informed by a number of factors. First, there are frictions that occur in the traditional roles versus functional roles that central banks play. Central banks were charged with financing public sector deficits which meant that they were susceptible to control by central governments. This role conflicted with that of ensuring price and exchange rate stability. Central banks across the world are charged with issuing paper money and it is only prudent that they have the independence to control price stability over a period of time to ensure that inflation does not occur (Forder 1998). The short nature of government terms mean that some of the economic policies adopted may be geared towards the achievement of goals through means like issuing more paper money which may eventually create runaway inflation or debase a currency (Mishkin 2000).
In order for the central banks to actively control inflation and ensure stability of price and the exchange rates, they must exercise restraint in spending patterns. Tight monetary control is one of the ways that is employed to ensure that there are no discrepancies in spending versus controlling. This role is however compromised when central banks act as lenders of last resort. The bank of England spent £1.3billion in order to bail out 26 small banks. In 2007, it was forced to tighten its monetary control but still had to bail out Northern Rock. The financial crisis that occurred from 2008 that entailed the nationalization of Bradford and Bingley and forced a broad bailout and re-capitalisation of banks put a strain on the Bank of England since it was forced to spend money in order to control negative effects of bank collapse to the economy (Acocella et al 2012). Another function of an independent central bank is prudential supervision which entails ensuring that the monetary policy is sound and is adhered to by other banks (Syrichas 2008). This supervisory role is compromised when central banks act as lenders of last resort.
The second reason for having a more independent central bank stems from the dilemma of following well defined rules or using judgment in crafting economic policy. During the Keynesian era (1950s-70s), there was a policy of exercising macro-economic discretion that meant there were few rules as central banks were not independent from the national government. After the Keynesian era, there came the period where monetarist experiments were conducted as a means of attempting to reduce discretion that was enjoyed by central banks in terms of their policy formulation. Presently, there are macro-economic rules that have to be adhered to in order to guarantee the success of an economy which can only be achieved by having a more independent central bank.
The third reason to have more independent central banks is the lack of credibility that national governments have especially on monetary matters. Orphanides (2009) argues that the greatest driver that has led to many politicians in democratically elected governments to relinquish the responsibility of monetary policy to independent institutions is temptation. While some of these politicians may feel that they are capable of rightly controlling monetary policy, future leaders make them skeptical as they may not be as capable. Citizens have a right to know what their entrusted decision makers are doing at what time and why. The responsibility given to independent institutions goes hand-in-hand with accountability. An independent central bank is the best bet for informing the public on the decisions that have been made and their impact on the economy and livelihoods (Sullivan & Sheffrin 2003). Moreover, these institutions are the best poised to explain deviations from preset objectives in case they are not met satisfactorily. Here the political ruling class is absolved of nay wrongdoing in case of a failure in monetary policy.
It is prudent to note that the independence of central banks does not necessarily mean that there should be no contact or dialogue with political powers of the day. On the contrary constant and ongoing contact with government officials and other authorities enhances the competence of central banks and ensures that there are numerous benefits to all stakeholders including fiscal authorities. In the long run, fiscal policies should be in tandem with all policies of the Monetary Union and central banks should always be agents of the public.
References
Acocella, N. et al, 2012. Central banks and economic policy after the crisis: what have we learned?, ch. 5. In: Baker, H.K. and Riddick, L.A., eds. Survey of International Finance. Oxford: Oxford University Press.
Bordo, M., 2007. A Brief History of Central Banks. Federal Reserve Bank of Cleveland.
Forder, J., 1998. Central bank independence – conceptual clarifications and interim assessment. Oxford Economic Papers, 50, pp.307-334.
Mishkin, F.S., 2000. What should central banks do? Review – Federal Reserve Bank of St Louis, 82(6), pp.1-13.
Orphanides, A., 2009. Comment on ‘What have economists learned about monetary policy over the past 50 years?’ by Lars Svensson. In: Deutsche Bundesbank, ed. Monetary Policy Over Fifty Years–Experiences and Lessons. Routledge, forthcoming.
Ricardo, D., 1824. Plan for the Establishment of a National Bank, reprinted in J.R.McCulloch, ed, 1888. The Works of David Ricardo. London: John Murray
Sullivan, A. & Sheffrin, S.M., 2003. Economics: Principles in action. Upper Saddle River, NJ: Pearson Prentice Hall
Syrichas, G., 2008. Monetary policy strategy and the euro: lessons from Cyprus. Central Bank of Cyprus Working Paper 2008-6.
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