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Analysis of the economic arguments of an independent central bank - Essay Example

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This paper tries to find the optimal level of independence of a central bank of a country to implement the most effective monetary policy. The autonomy of the central bank and monetary policy is considered in the essay as an issue of degrees, as central bank cannot be fully independent on practice…
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Analysis of the economic arguments of an independent central bank
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___________ ____________ ____April 2006 Analysis of the economic arguments of an independent central bank Introduction Central banksthe world over have quiet but strong presences. With low public visibility they perform the most vital of functions viz. that of creating and putting into circulation legal tender money. As is known legal tender money serves as a means of payment, a unit of account and a store of value. The most important matter that arises in reference to letting the Central Bank have this legal right to create and circulate legal tender money is, if it should be under the control of State executive. If yes, then to what degrees and if no, then again to what degrees. It must be remembered that while affecting this right to any amount of degree the State is also assuming responsibility for the value of legal tender to an equivalent extent. Maintaining internal and external value of legal tender money is a function of inflation targeting and appreciation/depreciation of currency. Whether such critical monetary policy outcomes be left independent in the hands of Central Bank professionals or be merrily dictated by elected politicians who are often not trained in such trade. We discuss this and concomitant issues in paragraphs below. Analysis The most preferred and often cited argument favoring an independent central bank is that the power to expend money should be separated or delinked substantially from the power to create money. In case these two capabilities converge we have spendthrift governments indulging in fiscal profligacy while the Central Bank simply acts as a 24/7 mint or currency printing house. State control over the ability to create money has resulted in several episodes of economic mess. Even in the days of the ancient Roman Empire the tax collection by state officers in the form of silver coins ended up being melted and corrupted with inferior metals. This gave Caesar substantial money to divert to his luxuries and such spending was a multiple time of what came in as collected tax. The result was a spiraling inflation as now more coins vied for smaller stock of market wares. In today's monetary systems running on paper, plastic and electronic money the Roman story has been repeated quite often. The Latin American inflations are fable material with inflation rates sky rocketing often to 200% or more. In some extreme cases what was affordable at twilight became unaffordable by daylight. With complex and fine lending and borrowing of money as investible funds, interest rates have turned indicators that are pliable in the hands policy makers or dictators as the case may be.Government, myopic with political avarice, and desirous of sweeping hustings have dictated lower interest rates, keeping economic realities on window sills. This tended to raise up spending and then employment though only in the short term, but finally and in the medium to long term it caused severe inflationary pressures. Inflations were crippling when such spending was directed less towards real sector and more towards wasteful expenditure resulting in the physical output not meeting the heightened stock of money in circulation. It is at once natural for a political system to dictate manipulation of monetary policy and maintain only a short run vision of popularity in or around the election period even risking higher inflation just because this option always was available to detractors or competitors for votes. The Keynesian prescriptions did not build a specific treatment of inflationary situations despite the fact that such situations had arisen. It was preoccupied with determination of the output levels and relied only on a simplistic analysis of inflation via media the demand and supply theory of money. Enunciation of the Phillips curve added a logical sequence to analysis of inflation. The Phillips curve, in its native form, posited a long-run trade-off between inflation and unemployment. However this causality has been reexamined and redefined theoretically and empirically. Some analysts viewed that inflation might lead to growth however empirically it was rebutted with fine tuned derivation that inflation is, on the contrary, negatively correlated with growth particularly when the inflation is running in highs of double digits as was shown by Fischer (1993) and Bruno and Easterly (1995). While long run inflation and unemployment trade-off under Phillips curve came under attack ,the short run trade-off between inflation and unemployment remained unseated and it is this trade-off which forms the cornerstone objective of today's monetary policies the world over. Employment ,external value of currency and inflation remain the purest objectives of any monetary policy. It may be noted that employment gets affected with a lag and transmission channel is the economic activity and economic growth is the more sought after objective then the employment generation as such. While political masters may be tempted to manipulate monetary policy to suit their short term political objectives the Central banking professionals, having no such ulterior targets, nurture and design monetary policy generally on a much longer horizon. This is assuming the fact that Central Bankers are true professionals and not just putty material bureaucratically churning out staid and stolid monetary policies which are far removed from market realities. By conscious and effective delegation of decisions in respect of interest rates, money supply, employment rates, economic growth and development rates and other concomitant monetary matters to a professionally run Central Bank, an economy can target a more comfortable level of inflation over longer run than would be the case when such independence is lost to non monetary short run political objectives. Several research efforts have tested the argument of the link between better inflation management and Central Bank autonomy. We have already posited a direct link that a more autonomous Central Bank implies a better managed inflation. However the above research efforts seem to arrive at three major conclusions. Firstly, a negative correlation between central bank independence and long-term inflation is widely seen. It essentially holds our contention that a low inflation rate is more likely when autonomy of central banks is higher. A higher state control or low Central Bank autonomy generally leads to bouts of higher inflation. Secondly, these research efforts exhibited the translation mechanism of above negative relationship by arriving at another negative correlation between central bank autonomy and the long-term budget deficit stated as a percentage of the gross national product. Countries with more autonomous central banks tended to have smaller fiscal deficits than those where State dictated the terms. Profligate budget deficits translated state control in higher inflation. Recent efforts at limiting the sizes of budget deficits and giving them an orderly structure of cost carrying lending to the State, evolved in many countries since 1980s,are an example of delinking fiscal and monetary policies on the one hand and lending substantial autonomy to the concerned Central Banks on the other. Most importantly the research efforts found that autonomy of the Central Bank was quite unrelated to the expansion of output and economic growth. More important variables seemed to have a larger say, particularly when discovered in a favorable tandem, in ensuring expansion of outputs and bringing about economic growth. Medium to long term implication are fairly evident and it can be surmised comfortably that production and employment will not possibly suffer if more autonomy is attached to the Central Bank. On the contrary a professional Central Bank can consciously work to gather up the above stated favorable tandem of variables and target GDP and GNP growth rates proactively. Thus protecting monetary policy decisions from State dictates can better assist the cause of lower inflation while a decent economic growth rate can be targeted concurrently. Short run considerations of political nature force the economy in bouts of uncontrolled accelerations which often turn uncontrollable and unsustainable. This might ultimately have deleterious consequences of even causing industrial closures, bankruptcies, run on banking institutions and result in depressed economic output and increased unemployment. "In nearly every major financial crisis of the past decade. from East Asia to Russia, Turkey, and Latin America. political interference in financial sector regulation helped make a bad situation worse. Political pressures not only weakened financial regulation generally, they also hindered regulators and the supervisors who enforce the regulations from taking action against banks that ran into trouble. In so doing, they crippled the financial sector in the run-up to the crisis, delayed recognition of the severity of the crisis, slowed needed intervention, and raised the cost of the crisis to taxpayers"(Jones, Jamaica). Global polity has awaken to these realities in the light of Latin American,Asian,Russian and several other economic crises and there has been a global move to leave monetary policy and attendant policies in the hand of the Central Bank as increased and clear legal mandates. It may be ironic to note that such legal mandates have mostly come about out of the volition of reforming polity and Central Bankers all over the globe were simply passive takers. They were, in fact, all along unconcerned if their articulated intellectual demand for autonomy are heard or not. Economic conditions have secular direction in the long run whereas in the short run they wobble around secularity dynamically. There are numerous economic ups and downs as reflected in, say, demand shocks- in such events monetary policies has to be changed in order to send signals of alignment to the real sector. On many occasions monetary policy has the goal of maintaining low inflation and attempt a signaled stabilization of output. In the event when the economy has overheated restrictive monetary policies will develop goals of restraining inflation and preventing the output to assume dumping dimensions. On the converse when recession is feared or has arrived monetary policy can turn expansionary while it carefully targets inflation from, say, reaching double digit figures. The quicker the monetary policies react to economic realities the more is their effect on the real sector. Similarly a supple shock coming about, say as a result of major disruption in industrial activities or through a natural caused decline in food production, can be tackled by making investible resources available more to real sector through cheap money policy or grant money policy. It must be remembered all real sector demand and supply shifts have to be considered in all permutations and combinations and requisite variations in monetary policies are dynamic tasks needing attention of full time professionals who have the economy under constant watch through mammoth data sources. However the Central Bank autonomy needs to be given out under careful considerations. Globally three preconditions are specified for central bank autonomy. Primarily the legal and operational schemata in which monetary policy is conducted should be clearly stated. In these schemata clear definition of Central Bank autonomy must be made to avoid any futuristic confusion on what was expected of the Central Bank. Similarly the Central Bank must be clear as to what it is trying to achieve in its monetary policy statements, stating operative variables and exact monetary instruments used in getting to these objectives. For establishing its credibility the Central Bank must be clear about these issues in short as well as long run perspectives. Secondly the Central Bank must keep its stance, objectives and programmes in front of major economy participants and the State quite transparently. This helps crystallize accountability of Central Bank to its owners also. Lastly the Central Bank should ensure that it has resource based wherewithal to go about its mission. The above three preconditions will become clear if we set out to examine the autonomy of the European Central Bank (ECB).Article 7 of the ECB Statute states that while exercising the powers and carrying out the tasks and duties conferred on them by this Treaty and this Statute, neither the ECB, nor a national bank, nor any member of their decision-making bodies shall seek or take instructions from community institutions or bodies, from any government of a member state or from any other body. The 17 members Governing Council of the ECB is not allowed to take or seek instructions from anybody, politicians included. Politicians are not allowed to give such instructions. The ECB is financially independent and has a clear mandate, laid down in the Maastricht Treaty. Its primary objective is to maintain price stability and should support the general economic policies in the Community, with objectives such as economic growth and high employment. "Under the arrangements for the Euro, monetary policy will be controlled by the European Central Bank (ECB)....... However, one of the strongest arguments in favour of doing things this way is only rarely debated, and is almost never countered directly. This is the argument that the Euro is good because it means there will be a central bank which is totally outside political control, indeed so far outside political control that for all but one country it is not even located on national territory"(Jones, Jamaica). Conclusion In conclusion we can state that autonomy of the Central Bank and monetary policy is an issue of degrees. Complete independence from State is neither feasible nor desirable as Central Bank derives existence and functionality mandate through State passed statutes. Since State can change these statutes it retains statutory control over the Central Bank. However, at the same time is it is also true that owner of money creation should not have a major role in borrowing it from the Central Bank on profligate proportions. A short sighted political intrusion in Central bank operationality would spell disasters in terms of application of monetary variables and instruments leading to severe symptoms of short to long term economic distress. Operational freedom should be left with those who really do know operations and not assumed even by State on their behalf without diluting State's rights to give a directional nudge." Administering and monitoring monetary policy is costly, politically and economically, because banks enjoy expertise and/or informational advantages over governments and because time and other resources are required for governments to monitor banks. Thus, governments cannot costlessly ensure that central banks conduct policy precisely according to their current will. Accordingly, central bank independence must refer to how far the bank could stray from the current government's desires before the latter would prefer to pay the costs of altering the bank law or of seizing the monetary reins itself"(Lohmann,1992). References Bruno, Michael and Easterly, William.1995." Inflation, Crisis and Long-run Growth". National Bureau of Economic Research Working Paper Series. No. 5209.August. Fischer, Stanley.1993. "The Role of Macroeconomic Factors in Growth," Journal of Monetary Economics. Vol. 32.December. Jones ,Peter W. "Jamaica: is an independent central Bank feasibile" Global Thinking Research & Development. Lohmann, S. 1992. "Optimal Commitment in Monetary Policy: Credibility Versus Flexibility." American Economic Review. 82.273-86. Read More
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