17 December, 2017

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Discretion That Leads To Policy Inconsistency Is The Biggest Enemy Of A Central Banker

By W.A Wijewardena –

Dr. W.A. Wijewardena

Principles of Central Banking 3

Difference between a programmed computer and a central banker

If one asks the question “who is the biggest enemy of a central banker?”, the answer plainly hits on the discretionary powers given to central bankers by the statutes under which central banks have been established. It is not because discretionary powers are unnecessary or harmful, but because those powers have been mishandled by those within as well as outside central banks.

There is a fundamental difference between a programmed computer and a central banker. A programmed computer will work according to a set of established rules and will not deviate from them until its final target is achieved. In other words, there is no possibility for a programmed computer to abandon its mission midway through if the ground conditions become unfavourable to its work. Thus, the client of the programmed computer can depend on it for delivering the desired result, come rain or shine.

Changing environment permits central bankers to change too

A central banker too starts his work with a set of rules to guide him. For instance, if he is to bring inflation down to a certain value, he starts with a money supply target based on his best projection of the growth in the economy, how will the external sector look like and how the government will behave in the forthcoming period. However, whilst on this mission, he is given powers to deviate from the rules and pursue a mission completely different from his original mission. These powers known as the discretion of a central banker have made central bankers in the eyes of their clients totally unreliable and undependable. If there is anything that has caused central bankers to lose their face, credibility and reputation it is nothing but the use of these discretionary powers for serving the interests of powerful groups.

The good-intentioned discretionary powers

Central bankers have been given these discretionary powers for a good reason. They operate in social environments and societies change dramatically over time. Hence, a central banker cannot go by rigid rules when the ground conditions have changed and they need to be flexible in their approach. To give this flexibility of operation to them, they have been given discretionary powers to change the course according to what they perceive as the best for the new conditions that have emerged.

If they go by the same old rules when new conditions have emerged, it is like treating a patient with the same old drugs when he has developed new complications. So, like good physicians who can change the medication in the midcourse of a treatment program, central bankers too have been permitted to change the medication if new problems have arisen after they have set themselves on a given mission.

To use discretion needs qualifications

But to exercise discretion requires a lot of qualifications on the part of the person doing so. First, the person using the discretionary powers should have a sound knowledge of the economy, its interconnection to various sub components and the impact which a slight change to the policy would have on the rest of the economy.

It is like a physician taking a holistic view of the human body when he treats a patient since one medication for ailment in one part of the body may have adverse consequences or contraindications on other parts of the body. The physician’s task is to minimise or eliminate those contraindications altogether.

Second, the discretionary power user should be guided by only a single objective. That objective is to attain the best results for his original mission by changing the course in the light of the newly emerging conditions in the economy. It is not the total abandonment of the original mission but introducing changes to the rules so as to get the best results.

Third, the discretionary powers should never be used to satisfy various power groups in the economy which may seek to ‘capture the regulatory powers’ for their benefits. A good physician will not succumb to the pressures coming from outsiders for changing the treatment procedure unless such changes are in the best interest of the patient being treated by him.

Fourth, the discretionary power user should be ready to change even the changes that he has effected if such changes do not yield good results. In other words, while the discretionary powers have given him flexibility, he himself should be flexible enough to accommodate new ideas and views in order to accomplish his task successfully.

Governments highjack central banking policy

Central banks have been mandated to implement a particular monetary policy package in order to bring down inflation and stabilise the value of money they have produced. But the governments which have taken control of central banks on behalf of societies have a different objective. That objective is to allow people to lead an easy life by producing more money and win elections by using that strategy.

Since more money today will lead to inflation tomorrow, it is simply exchanging tomorrow’s inflation for today’s votes. Hence, from the government’s point of view, it is perfectly logical and rational for it to expect the central bank to follow an easy monetary policy. That easy monetary policy has, as its components, low interest rates, expanded credit volumes and increased money supplies.

If a central bank continues to implement its monetary policy to bring down inflation and stabilise the currency disregarding this wish of the government, then, there is a consistency in its policy over the time. But, this can happen only if it works under a given set of rules which cannot be changed midway through after it has started its monetary policy action. But discretion allows it to change its policy action midway through. If it changes its rules by using its discretionary powers simply to accommodate the wishes of the government, then there is inconsistency in its policy over the time.
Central banks and governments will resort to this policy change thinking that the people have a short memory and they could therefore be fooled all the time. Hence, the success of the central bank’s midway policy change will depend on its ability to ‘fool people’ consistently and continuously.

Kydland and Prescott: Rules better than discretions    

Two economists, one a Norwegian Finn E. Kydland and the other an American Edward C. Prescott in a paper published in the Journal of Political Economy in 1977 under the title ‘Rules Rather than Discretion: The Inconsistency of Optimal Plans’ came up with a plausible explanation which later came to be known as Time Inconsistency of Monetary Policy. The duo got the Nobel Prize in economics in 2004 for this contribution made to the science of economics.

In the Nobel Prize accepting oration, Prescott reiterated the good results delivered by the theory they had developed together saying that “People now recognise much better the importance of having good macroeconomic institutions such as an independent central bank”. The message is that an independent central bank, with appropriate checks and balances, cannot be captured by politicians or power groups.

The core of human beings is rational

According to Kydland and Prescott, monetary policy is a kind of an economic planning conducted by a central bank. In their view, economic planning is not a game played by policy makers against nature (because nature’s way is to apply its natural laws to make good performers winners and ill-performers losers without taking a side, and so planning is introduced to moderate the winners and support the losers) but against what is known as the rational man.

A rational man is a person who, before he makes a move, will consider all the costs involved and all the benefits that it would bring to him and decides to make that move only if benefits are greater than the costs. Hence, a rational man does not want to suffer from losses knowingly and if he has made losses once he very quickly learns from his past mistakes and he cannot be fooled again and again.

This behaviour of rational man is demonstrated by the folk saying among the Sri Lankans that “one who has fallen into a pit in the night will not fall into the same pit during the broad daylight”.

But contrary to what Kydland and Prescott have concluded, this rational man is a part of nature and hence any economic planning aiming at the rational man is an economic planning aiming at nature as well. While all those in a society are not rational at all times, the core feature of human beings, and also of animals, reflect rationality in behaviour unless the person in issue is mentally deranged. However, even after ignoring this subtle difference, one can agree with Kydland and Prescott that fooling rational men continuously and consistently is not a game which a central bank could play on them without losing its credibility.

Policy inconsistency generates sub-optimal results

What is policy consistency? Suppose one has the objective of completing a degree in four years which requires his whole attention to the task before him. While doing this, suppose that he is lured to take part in university politics which aims at establishing a fair society for him as well as for many others. If he rejects this sub-objective and concentrates on his main objective of completing a degree, he is consistent throughout and his choice brings him an optimal choice. But if he uses part of his time for the degree and a part of his time for university politics, he is inconsistent because he has declared one thing at the beginning and done something else later.

Though he may attain both objectives partially through this new approach, his accomplishment is not optimal. Hence, for him to attain an optimal choice, he should be consistent throughout, that is, after choosing a university degree as his objective, he should not deviate from that objective for whatever the reason. So time consistency arises when a person promises to do something in the future and continues to deliver it as time goes on. By the same token, time inconsistency arises when a person promises to do something in the future but deviates from it as time passes thereby failing to deliver his promise.

Rational people take action to protect themselves

A rational person who observes the person making the promise in the first instance will form the judgment that he will not deliver his promise in the future. Accordingly, the rational person takes action to protect himself from the adverse consequences of the deviation of the person making the promise or gain benefits from such deviations. This happens in the case of the agricultural credit schemes implemented by governments in South Asia.

At the time of introducing the schemes, the governments concerned and the policy makers make the bold announcement that the loans are repayable and action will be taken to collect the loan money from the defaulters by resorting to legal channels. But the rational borrowers immediately make the judgment that the governments will not live up to their word and when the elections arrive, choose to write-off those loans. Hence, right from the beginning, the rational borrowers work on the expectation that the government one day will offer a loan forgiveness scheme and continue to default the loans even when they are in a position to repay those loans.

Rational people predict that central banks will not keep to their words

Kydland and Prescott applied this general observation on the inconsistent behaviour of governments, policy authorities and rational people to monetary policy. According to them, there is a game between private people and central banks about the future inflation. Private people set their expectations about future inflation and central banks set their optimal monetary policy in accordance with such expectations.

If people make their expectations taking a part of the past behaviour of the central banks into account – known as adaptive expectations – then, there is no problem since expectations do not fully deviate from the actions taken by central banks subsequently. But if expectations are made rationally – which is the case in most instances since a person knowingly does not make the same mistake again – then, the central bank’s action program is predicted accurately by people that the bank will not keep to its word.

Abandoning a program midway through  

What actually happens is that when central banks start controlling inflation by adopting a tight monetary policy – that is, by increasing interest rates and curtailing both the credit and money levels – it causes economic growth to slow down. The slowdown is reflected in a reduction in the growth rate and an increase in unemployment. Since there is a belief that economic growth is an attainment of the policies of the government, any slowdown in the growth is considered as a failure of the policy of the government. Hence, the government prevails upon the central bank to deviate from its tight monetary policy stance and liberalise the release of credit, increase money supply and cut down interest rates in a bid to rescue the slowing down economic growth.

Since the central bank deviates from its previously announced policy action, it generates a time inconsistency in its monetary policy. This time inconsistency becomes successful if the central bank and the government are in a position to fool the people. But the rational people, who know that central banks will yield to the pressure of the government midway through their monetary policy, make the judgment that the central bank will abandon its targeted inflation policy by exchanging long-term inflation for the short term economic growth.

Rational people know this reality and therefore all their actions are based on a high inflation rate scenario in the future: When negotiating for wage contracts, they ask for higher wages than justified by the existing inflation rates; when they go for long term contracts, they set prices in such a way to reflect their high inflation expectations. The result is to build-up high inflation expectations slowing down economic growth further. Thus, both the central bank and the government are defeated by this rational action of people who do not trust the actions of the central bank however much its action is presented to people as a credible policy program.

It is hard work that brings prosperity and not cheap money

The monetary history of the world has in fact proved this behaviour. Whenever the governments have tried to use monetary policy to generate economic growth, the results have been completely different. As Ludwig von Mises correctly identified in 1912 and as reiterated by John Exter, the founder Governor of the Central Bank of Ceylon in 1949, the use of the monetary policy to generate economic growth has resulted in further inflation, brought balance of payments difficulties to countries and put pressure on the exchange rate to depreciate.

The only country which has been able to break away from this vicious outcome has been Singapore, whose old guard leaders did not believe that money can bring in prosperity. They believed that it is the hard work, knowledge and technology that will bring in prosperity and by working on that model have been able to maintain stable prices, stability in exchange rate and high economic growth.

Say ‘no’ to monetary politics

Since governments have high-jacked monetary policy actions of central banks, these policies are known today as ‘monetary politics,’ which has been made possible by allowing politicians to use central banks’ discretionary powers to their advantage. Hence, the biggest enemy of a central banker today is the discretionary powers given to him when there are opportunities for others to highjack those policies for their private gains.

*W.A Wijewardena can be reached at waw1949@gmail.com

Related posts;

Principles of Central Banking 1

Principles of Central Banking 2

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Latest comments

  • 0
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    The prime objective of a Govt is to provide a satisfactory income and standard of living for its people. The CB coming under the Govt has the role of ensuring the economic and financial stability of the country by regulating the currency.

    At times these two objectives may be at a variance. For instance when the Govt does not have funds to fulfill its obligations and meet targets, the CB and Treasury are called upon to provide the funds. CB does this either by borrowing through bonds and the treasury by increasing taxes. CB also acts in accordance with advice from the IMF which is its principle lender. It is expected to meet certain targets.

    So all this is a balancing act where descretion has to be used and the result will be proportionate to the ability, knowledge and experience of the key players. It is not an easy task. But at the same time the weaknesses of the people involved and the system are well known. The glaring mistakes made by the Govt and CBSL are evident to all and the lack of responsibility and accountability is apalling.

    The American economy is emerging from the recession. Even Greece is said to be on the road to recovery. But our pundits say that everything is very rosy and we are the hub of the world. Our policies keep changing day by day as do the suits of the Governor CBSL. We are facing problems on the foreign, social and political fronts which also affect the economy. What does not change is the bleak outlook of the man on the street.

    The sooner we admit our mistakes and ensure we dont repeat the same over and over again, the better. There is no alternative for long term economic planning and policies. Mahinda Chintana is a broad outline but no one really knows how it is to be achieved financialy and where the money is to come from. There seems to be a mismatch between policy and financial management.

  • 0
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    Dr. Wijewardena you understand and are qualified for the job and should be the head of the Central Bank of Lanka – Not that uneducated, third class, nincompoop and corrupt sycophant – Nivard Cabraal who thinks he is so HOT and SEXY!!

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