The purpose and functions of a Central Bank
The powers of central banks have steadily increased over the couple of decades partly due to abandonment of the Gold Standard in the 1930s and partly due to the surge of global inflation in the 1970s and 1980s after collapse of the Bretton Woods Agreement and abnormal rise in oil prices. Until the late 1980s, only the Federal Reserve, the German Bundesbank and the Swiss National Bank enjoyed legal independence while most others were kept under the thumbs of finance ministries. The Reserve Bank of New Zealand became the first central bank to be given independence with a clear mandate to fight inflation.
Today many of the central banks enjoy increased respect for defeating inflation, but more particularly in the United States, for keeping the economy on an even keel by ensuring more than eight years of uninterrupted low inflation growth — the longest peacetime experience in American history.
Over the years central bankers have been popularly referred to as captains, admirals, pilots and life boat men. These nautical titles have been conferred on them because it was assumed that central bankers know exactly where they were heading, how their craft regarding the economy worked and how their actions will affect its course. But the fact is otherwise. Because of lags in publication of data they do not know precisely where their economies are going and some of the policy dilemmas they face are the equivalents of not knowing whether the earth is round or flat. So far with all that increased power and dependence central bankers still find that their ability to steer countries with precision is limited.
The role of the central bank has been defined in terms of banks, money and inflation. But unfortunately at the pinnacle of their power they still have to ask three questions. What is a bank? What is money? And
What is inflation? These three broad questions give rise to a number of trn questions which are:
(a) What is a bank? The old time tested saying is that a bank borrows ed If we stick to this definition should we not treat all the so callednon-bank financial institutions such as merchant bank leasing companies and venture capital organizations as banks? Then again what would be the status of NGOs engaged in borrowing and lending? As the boundaries between different sorts of financial institutions have become blurred, central banks have found it difficult to define, let alone monitor banks.
(b) What should be the measure of money? The broad measure of money being accepted now is M3. Is it adequate or all embracing? Does it include all monetary transactions in the economy?
© Then again, can the central bank fight inflation because of the time Lag of monetary policy, paucity of data, built-in deficiencies of CPI and the evolving nature of the economy? Even if it can do so, should the central bank in its quest for price stability, control inflation in prices of consumer and producer goods or control price inflation in assets and commodities? Focusing on CPI inflation alone is too narrow. Besides, achieving low inflation does not guarantee economic and financial stability. History has shown that inflation in prices of assets such as shares and properties can sometimes be even more dangerous than consumer price inflation.
(d) As a part of monetary policy the central bank determines the price of money through interest rates. At a time when governments are privatizing many businesses and liberalizing prices does it still make sense for central banks to act like planners and fix the price of money i.e. interest rates underestimating their ability to use monetary policy to encourage growth when there is either ample spare capacity or more new capacity has to be created? Will there be no point of trade-off between price stability and growth?
(e) Even if a central bank is granted autonomy to maintain price stability can it actually and always ensure this? It is true that in recent years the degree of inflation, in various countries, was in an inverse ratio to the autonomy enjoyed by the central bank. But this correlation does not prove causation. On the contrary, there are instances that demonstrate that this is not so. Germany’s Reichbank was statutorily independent when the country suffered hyper-inflation in 1923. Bundesbank also failed, despite all its independence, to avoid inflation when the German government chose to ignore its advice on the appropriate exchange rate for unification, it is a sobering fact that the increased prominence of central banks during this century has coincided with more inflation and not less. For example, Britain’s consumer price index shot up from 100 in 1974 to about 700 in 1999. The Federal Reserve could not prevent or cure the Great Depression in the United States in the 1930s. Nor could central banks cure stagflation in the 1970s. In the recent past Bank of Japan could not activate the economy even with almost zero interest rate.
(f) Can a central bank by following zero inflation policy avoid booms and busts in the economy and induce so called NAIRU? History shows it cannot. If so, should it follow a policy of moderate inflation to boost employment and growth? Who will set such target inflation rates, the government or the central bank and what would be the criteria?
(g) How the central bank should function to avoid conflict between exchange stability and price stability and blend monetary policy with fiscal policy in an open economy today?
(h) Finally, is a central bank necessary under all circumstances? If not, under what circumstances can a country go without a central bank? After all, the first recorded reference in England to a “central bank” was only in 1873 by Walter Bagehot and the world’s oldest central bank, the Bank of Sweden, was established in 1668 largely as a vehicle to finance military spending. The Bank of England was created in 1694 largely to finance war with France. Furthermore, why so much power should be vested in the central bank which is not an elected body contrary to the spirit of democracy? After turning a full circle there is now growing demand for abolition of central banks. Argentina sometime back pegged its currency to a fixed rate with the US Dollar and set up a currency board to ensure that the level of domestic money is fully covered with supply of US Dollars at the fixed exchange rate; Panama has gone a step forward and adopted the US Dollar as its legal tender. Indonesia in its recent economic turmoil toyed with the idea of currency board; Mexico is currently considering such a move. With the introduction of the Euro and establishment of the European Central Bank, central banks of 11 member countries will go out of the business of creating and controlling money very soon. Furthermore, the question remains how the central banks will meet the new challenge of electronic money? In a few decades final settlement may conceivably be made electronically by the private sector without the need for clearing through the central bank. If so, central banks could lose their ability to set interest rates.
Apart from these general questions there are certain particular questions in the context of Bangladesh. They are:
a) If at a point of time the Bangladesh Government is not prepared to lay down proper conditions for the central bank to pursue price stability policies why should autonomy be claimed for administrative reasons alone? After all, this reason is common with other autonomous undertakings. Why there should be special dispensation for Bangladesh Bank particularly when its administrative competence is not significantly better than others and when its profits are generated by its monopoly over money creation and subsidies provided by the government by placing all foreign exchange reserve at its disposal and when the net worth of Bangladesh Bank is big negative? In short, why Bangladesh Bank should refuse to muddle through its way like others?
(b) Then again, if Bangladesh Bank is given full operational freedom to pursue price stability how it proposes to attain this goal?
(c) Are the purposes of Bangladesh Bank spelled out in the preamble to the Bangladesh Bank Order consistent with this goal?
(d) Are the purposes stated in this preamble mutually consistent? If not, what amendments are called for?
(e) Are the functions of Bangladesh Bank, as organized now, consistent with the goal of price stability or the goals as propounded now? If not, what amendments are called for?
(f) Are the powers of Bangladesh Bank to supervise the banking system necessary to frame and enforce monetary policy or are more powers necessary to bring other institutions under its control?
(g) Is Bangladesh Bank prepared, at the cost of penalty, to pursue a policy of price stability with target inflation rates as in New Zealand, U.K. and a few other countries? After all, autonomy should be accompanied with accountability for performance.
(h) Finally, if the Bangladesh Government decides tomorrow to replace Bangladesh Bank with a currency board to follow a fixed exchange rate regime, how Bangladesh Bank will make a case for its survival instead of depending on “what has been will be”? *
* Based on talk given to senior officials of Bangladesh Bank
On Central Banking Central and Central Banker …rumination of a Banker-By: A.K.N.Ahmed