By W.A Wijewardena –

Dr W.A. Wijewardena

Fischer’s last lesson to central banks: never say never

The reputed economist and Central Bank’s Deputy Governor Dr Nandalal Weerasinghe, in a public lecture delivered last week at the Central Bank under the theme “The Role of Central Banks in Macroeconomic and Financial System Stability” is reported to have concluded his presentation quoting Stanley Fischer, presently Governor of the Bank of Israel and formerly the Deputy Managing Director of IMF and Professor of Economics at the Massachusetts Institute of Technology. Weerasinghe has quoted the ten lessons which Fischer had drawn for central banks from the ongoing global economic crisis dubbed by some as the ‘great economic recession’ in a Dinner Lecture titled “Central Bank Lessons from the Global Crisis” delivered at the Bank of Israel in 2011 (available at: http://www.bis.org/review/r110414f.pdf ). While all the ten lessons of this veteran economist and respected central banker are inspiring, the conclusion of his tenth lesson is the most important: In that, Fischer had advised his fellow central bankers that they should never say ‘never’.
Though this slogan appears to be puzzling, Weerasinghe could not have chosen a better phrase to summarise his lecture in just three words.

Central banks should not be guided by fixed dogmas

What Fischer meant by this slogan is that in a crisis situation, one may be forced to adopt measures that are totally unconventional and out of the box. Hence, if one sticks oneself to fixed dogmas and goes by the stand that he will never deviate from those cherished dogmas, he is at a difficulty in finding a fast and appropriate solution to the crisis. Hence, ‘never’ is a dangerous word for a central banker. Instead, a central banker should be open minded, ready to try out new solutions and flexible enough to change his path if it becomes unsuitable. In other words, it is not appropriate for a central banker, and for that matter for any other policy maker, to frame laws for the future when sometimes they may have to violate them. This is because the future is uncertain and fraught with new problems for which old solutions may not work. As a result, crises may require them to adopt policy measures which they would not have even thought of adopting under normal circumstances. This piece of advice from Fischer which Weerasinghe left with his audience, mostly of fellow central bankers, is sensible enough.

Price stability and financial system stability are in conflict with each other

Weerasinghe in his lecture has spoken of the conflict between the two objectives of a central bank, namely, the macroeconomic stability and the financial system stability. When relating to the Central Bank of Sri Lanka, they refer to the two co-objectives of the Bank, namely, the economic and price stability on one side and the financial system stability on the other. The Central Bank was mandated with these two objectives by an amendment to the Monetary Law Act or MLA effected in 2002 as a consequence of the modernisation project which the Bank had been implementing at that time.

The era of the confusion of the objectives of the Central Bank of Sri Lanka

Before 2002, under MLA which was enacted in 1949, the Central Bank’s objectives were all over. It had to pursue policies to stabilise the domestic value of the rupee meaning that it has to maintain stability in the general price level or an inflation free world. It also had to stabilise the external value of the rupee or maintain a fixed exchange rate regime with no volatility in the exchange rate. These two objectives were referred to as the stabilisation objective of the Central Bank. In addition, the Central Bank had to pursue two objectives which were called its development objective. One such development objective was to promote and maintain a high level of production, employment and real income in the country. This required the Bank to take effective action to prevent periodical fluctuations in the level of production or employment in the economy. The other development objective was to encourage and promote the full development of its productive resources or simply attai

n long term economic growth.

The central bank cannot fix prices and exchange rate together

It would appear that these objectives were in conflict with each other. John Exter, the architect of both MLA and the blueprint of the establishment of the Central Bank, admitted that the stabilisation of the external value of the rupee was in conflict with the stabilisation of its domestic value. For instance, if there is a massive inflow of foreign exchange to the country, either due to a favourable external trade position or an inflow of foreign loans or foreign investments, to prevent the rupee from appreciating and thereby stabilising its value, the Central Bank has to buy such foreign exchange by issuing rupees to the sellers. But it would increase the domestic money supply and lead to inflation. Similarly, when there is a shortage of foreign exchange, the Central Bank will have to sell foreign exchange from its reserves to prevent the rupee from depreciating in the market. But that would lead to a decline in the money supply since the private parties who buy such foreign exchange have to part with their rupee balances. When money supply falls in that manner, it would lead to the opposite of inflation, namely, decline in prices or deflation. Whatever it may be, the domestic price stability is threatened.

Not to try growth and inflation control together too

Similarly, the Central Bank’s development objective and its stabilisation objective were in conflict with each other. To have a stable exchange rate and an inflation free country, the Bank has to pursue tight monetary policies in the form of increasing interest rates and curtailing credit levels. But that would reduce economic growth and prevent the Bank from facilitating economic development of the country. If on the other hand, the Bank tries to attain its development objective by reducing interest rates and expanding credit, it will lead to an increase in money supply and unless that increase in money supply is checked at appropriate times, it will generate inflation in the economy. Inflation will increase the domestic cost of production and reduce the competitiveness of its exports leading to balance of payments problems. That will then put pressure on the rupee to depreciate. Having recognised these obvious conflicts and inconsistencies in the Bank’s objectives, John Exter expected the Bank’s management to strike appropriate compromises among the objectives. Accordingly, if inflation is rampant and it reduces the real wealth and the real prosperity of people, the Bank should give priority to its stabilisation objective. If on the other hand, it is the unemployment and lack of economic growth which are the problems, then, the compromise will be to give priority to economic growth.
This however requires the central bank officers to be super fine-tuners of the economy.

Policy fine-tuning is not easy 

The difficulty with this type of super fine-tuning was that nobody knew at what stage they have to shift the policy from stabilisation to development or vice versa and at what stage they have to exit the policy if they were following a policy supporting either stabilisation or development. As a result, the policy may be continued to an extent where it would really be hazardous to the long term health of the economy. On top of that, a central bank which operates in a given political set-up has to yield to the pressures of political authorities to have low interest rate regimes supported by loose credit policies to promote economic growth as a top priority. The Central Bank of Sri Lanka is also not free from such political pressures and cannot operate independently of their influences. Hence, what was done in the past was the periodical tightening of the monetary policy coupled with one-off episodes of depreciation of the rupee when these growth promoting policies led to inflation and through inflation the pressure for the exchange rate to depreciate. But then, even before sufficient results relating to inflation and exchange rate stability had been attained, they were very quickly forgotten and policy regimes were changed to support the development efforts through low interest rates and expanded credit levels. It in fact has led to compounding of Sri Lanka’s macroeconomic problems.
During this period, financial system stability had not been recognised as an important objective of the Central Bank at least in law. Hence, it was necessary to make that too an objective of the Bank.

The great debate over priority of objectives

But, when it was decided to amend MLA to make both the price stability and the financial system stability the objectives of the Central Bank, a debate took place in the Bank as to whether they should be made co-objectives of the Bank or the price stability objective should have overriding superiority over the financial system objective. The argument put forward by the latter group was that a central bank has the prime responsibility toward the community for preserving the value of the currency. But when the Bank seeks to maintain the financial system stability, it has to provide liquidity to the banking system and that liquidity will create new money leading to an increase in the money supply and through it, to inflation in the economy. Hence, when the financial system stability conflicts with its price stability objective, the Bank should give priority to the latter at the expense of the system stability which is not important, according t them, as far as the Central Bank is concerned.

The wisdom of A.S Jayawardena 

But this writer recalls that the then Governor A.S Jayawardena took a different view. He maintained that both the financial system stability and the price stability are interrelated and the failure to attain one objective will necessarily lead to the failure to attain the other objective too. This is because the Bank seeks to realise its price stability objective by changing the interest rates and credit levels. These two policy instruments are to be operated through the banking system and if the banking system is not stable, then, the Central Bank will fail to operate its price stability instruments successfully. Hence, he opined that both the price stability and the financial system stability should be co-objectives of the Central Bank. This was how MLA was amended in 2002 making these two objectives the co-objectives of the Bank giving equal weight to both.

Weerasinghe vindicates A.S Jayawardena

Weerasinghe in his lecture has argued supporting the view taken by A.S Jayawardena. He has taken his audience through the current debate specifically what was learned after the onset of the so called ‘the great economic recession’ in early part of 2000s. Prior to that, according to Weerasinghe, the consensus was that a central bank should concentrate on its price stability objective and in extreme cases where the inflation is rampant, it should give the highest priority to the inflation control measures relegating the financial system stability to a secondary place. Accordingly, Weerasinghe says that there was a major push to take the financial supervision away from central banks to facilitate them to focus solely on controlling inflation.

Why bank supervision was kept in the Central Bank 

This writer recalls that Sri Lanka too came very close to that level when the amendments to MLA were proposed in 2000, but Governor Jayawardena prevailed upon the advocates and managed to keep the bank supervision function within the Central Bank. He had two valid reasons, this writer recalls, to support his view. One was that the Central Bank could act swiftly to arrest any impending financial system instability unlike an outside authority with its ability to supply liquidity and marshal the resources of commercial banks.

This was proved when the Seylan Bank fiasco hit Sri Lanka in 2008 and at that time, the Central Bank managed not only to solve the Seylan Bank issue but also to prevent it from becoming a major systemic issue endangering the entire financial system stability of the country. The other was that the Central Bank has already developed its skills in supervising the financial institutions and it is unlikely that a new authority would gain that capability immediately. Even if it gains that capability within a reasonable period of time, Jayawardena argued that there will be a hiatus in the supervisory responsibilities of the country and the country cannot run that risk since financial crises come almost without warning. His foresight that these two objectives are interlinked and cannot be separated from each other has now been vindicated by Weerasinghe who has quoted Ben Bernanke, Chairman of the Federal Reserve System in USA. In an address delivered at the Federal Reserve Bank of Boston 56th Economic Conference in 2011, Bernanke has said that monetary policy and financial stability are now co-equal responsibilities of a central bank (available at: http://www.federalreserve.gov/newsevents/speech/bernanke20111018a.htm ).

Tinbergen Principle

However, Weerasinghe points out the limitations of a central bank in trying to attain these two co-equal objectives with only one instrument available for that purpose. He says that since the two objectives are in conflict with each other they should strengthen each other and not function as opponents. In this respect, Weerasinghe has drawn the attention of his audience to the limitation of policy objectives and instruments to achieve them as proposed by the Dutch Economist Jan Tinbergen who got the first Nobel Prize for Economics in 1969 known as the Tinbergen Principle. According to this principle, one policy objective needs at least one policy instrument and therefore, when interest rate is used by a central bank to control inflation, it cannot be used to gain financial system stability as well. Hence, Weerasinghe recommends that a central bank should use interest rate to control inflation and use system-wide prudential measures, also known as macroprudential measures, to attain financial system stability. The veteran economist Charles Goodhart of the London School of Economics too confirms this in an article he wrote in 2008 under the title “Central Banks’ Function to Maintain Financial Stability: An Uncompleted Task” (available at: http://www.voxeu.org/article/two-goals-one-instrument-how-can-central-banks-tackle-financial-crises )

Overall, Nandalal Weerasinghe’s public lecture is a valuable addition to the knowledge on the subject and useful for designing the future policy strategies of the Central Bank.

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