4 October, 2023


Four Popular Fallacies Relating To Central Banking

By W A Wijewardena –

Dr. W.A Wijewardena

The presentation of the new Central Bank Bill for public debate by the Government had offered opportunities for citizens to express their views on the central bank and central banking. Some of these views are valid but many others are fallacious. Even the Supreme Court which looked at only the bill’s constitutionality had been bombarded by these fallacious views. It is demonstrative of the public’s low literacy of central banking. It is therefore opportune and timely to examine the nature of these fallacies and their validity.

Fallacy #One: The central bank is a creation of the government and therefore it cannot be independent of the government

There are some leading central bankers and academics who have subscribed to this view. For instance, the former Governor of the Reserve Bank of India, Dr. Y.V. Reddy, maintained that the central bank is a creation of the government and therefore it cannot be independent of its creator. A similar view was expressed by the former Central Bank Governor W.D. Lakshman when he proclaimed, while delivering the 70th anniversary oration of the bank in 2020, that the bank ‘stands ready and willing to join hands with fiscal and policy planning authorities to help open the vistas of prosperity for the benefit of the people’ in the new Sri Lankan developmental state. His argument was that modern governments follow a special developmental strategy to push their faltering economies forward and it is the duty of the central bank to be an active partner of that strategic mission. An example he quoted was post-war Japan. Immediately after the war, Japan had followed a loose monetary policy to provide direct subsidies to people and create economic recovery financing funds. The result was the acceleration of inflation to three-digit levels at 295% in 1946. Hence, contrary to what Lakshman has portrayed, the Bank of Japan got itself involved in inflation fighting moves – called disinflation – as the top priority of the economic strategy. Hence, even for a developmental state, it is highly risky for a central bank to become a partner by adopting an accommodative monetary policy stance.

Central banks have been created not by the government but by the nation who is organised as a state. In the case of Sri Lanka, this is the democratic socialist republic which is made up of all the citizens living within that territory. It is the state which is sovereign and not the government which is simply an arm of the State. To serve the people, the state has created two different organs, one called the government, and the other called the central bank. Each one of these organs have specific duties toward the people. The government, delivering prosperity to people by adopting appropriate economic strategies, should make that prosperity a quality one by maintaining law and order, observing the rule of law, and administering justice. In the case of the central bank, the duty is to preserve the value of money which it has issued and owned by people by making real sacrifices. If money is issued irresponsibly in excessive amounts as was the case in post-war Japan, the real value of the money held by people will start falling. To prevent it, the sovereign state has created a special organ called the central bank.

This is obvious in the case of the first central bank in the world, the Central Bank in Sweden or the Sveriges Riksbank, which was set up in 1668. The bank was set up by people to protect their money from the king, the government, who used the bank’s power to issue money and engage in wasteful wars with neighbours. That bank has been functioning as an independent arm of the state since then except in some intervening years during the reign of Gustav, III, in the early 19th century. When the Riksbank refused to issue coins to enable the king to invade Russia, he tried to punish it by getting his debt office to issue parallel coins for circulation. For a temporary period, the Riksbank was driven to backwaters but after the king was defeated in war, the bank got back its independent status.

Hence, it is fallacious to argue that the central bank has been created by the government. Rather, it has been created by the people who are organised as a state to serve them. It is just like the creation of the government by the state. Hence, while a central bank cannot be independent of the state, it is certainly independent of the government, which should also serve people together with the central bank. The two organs of the state have too different roles to play in a nation state. To serve the people properly, neither organ should dominate the other organ. Instead, they should work together collaboratively. It is only through such collaborative work that a central bank could preserve the value of money which people have acquired by spending their labour or engaging in business.

Fallacy #Two: All moneys issued by a central bank are inflationary

This is also a fallacious statement because there is a portion of money which a central bank can issue without causing inflation. Money here is not just the notes and coins issued by a central bank but the total money supply in the system. That consists of all the monetary assets, that is, assets which can be used to make payments. In Sri Lanka’s case, they are made up of all coins and notes held by people, all the demand deposits which they hold in commercial banks, all time and savings deposits which they have with commercial banks, and 50% of the deposits in foreign currency held in personal foreign currency accounts, the successor to the earlier non-resident foreign currency accounts. It is this stock that helps people to buy goods and services in the market.

However, money is needed by a nation to conduct its transaction of goods and services smoothly. Imagine that a country produces only one commodity, coconuts. If there are 10 units of coconuts and 100 units of money, each coconut is exchanged for 10 units of money. But when the coconut production goes up from 10 to 20, a 100% increase, money stock should also increase from 100 units to 200 units. If this does not happen, the price of a coconut falls due to the inadequate availability of money. But if the money stock increases by more than the increase in the coconut production, it will lead to an increase in the price of coconuts which causes inflation to set in if allowed to happen continuously.

This provides a safe formula for a central bank to allow money supply to increase without causing inflation. That is, if the increase in money supply is set at the same rate as the real economic growth, it does not cause inflation. For instance, if the real economic growth is 5%, and if money supply is increased only by 5%, then, there is no inflation in the economy. But if money supply is increased by more than the real economic growth, the excess money will cause the total demand in the economy to rise faster than the supply and elevate the prices.

Accordingly, to say that all money supply increases are inflationary is fallacious. This should be corrected to say that only the money supply increases in excess of the real economic growth are inflationary. If a central bank plays the game according to this rule, then, there is no harm in increasing the money supply of the country.

Fallacy #Three: The Central Bank should not be accountable for its action

As presented above, the Central Bank is an organ of the state created for the specific purpose of issuing money and preserving its value by conducting appropriate policies. But if it is totally independent, it may amount to the creation of a monster who cannot be controlled by anyone. This is not suitable for the operation of a democratic system of government.

The central banks throughout the globe are required to account for their actions. This is specifically important because to serve the people better, they enjoy independence with respect to determining its budget and conducting monetary policy actions.

The central bank is the only creature in society which can acquire assets just by issuing new currency. For instance, suppose the political authorities require the central bank to build a house in a remote area for use by its partymen. Technically, what the central bank should do here is to open its vaults, take money out and spend for the construction of the house. There is no necessity for it to go through the normal procedures relating to the handling of public finances of the country. The same argument is true for buying a building in a foreign country, say, in Brazil. It can do so at its own discretion. A central bank, unlike any other unit in the economic system, can spend money without a limit. This is highly dangerous.

One way to make the central bank accountable is to force the bank to be transparent in its expenditures. Since the senior managers of a central bank like the Governor, Board members, and Deputy Governors could spend money at their own discretion, such expenditures should be controlled by forcing the banks to be transparent. To satisfy this, the Bank of Canada requires all these senior officers to disclose in the bank’s website all monies they have spent on foreign travel and in entertaining visitors. Once they are disclosed, the members of the public or the Parliamentarians could exercise vigilance over it and keep an effective check on them. If there is an unduly high expenditure incurred by the senior managers, they are required to provide an explanation for the same.

The central bank is given the budget independence to perform its duty by the nation more efficiently and more effectively. Hence, any expenditure incurred by the bank under this privilege should necessarily contribute to its main mission in society. In this context, any expenditure incurred by a bank to construct a building in a remote area for use by partymen of a political party or buying a building in a foreign country does not serve that main mission. The board and the senior officers who approve of such expenditure programs should satisfy themselves that it is directly related to the main function of the bank. There must be a procedure to collect it back from those who have approved of such expenditures without references to their connection to a bank’s main functions.

With respect to policy, what is going inside a central bank is like the operation of a Blackbox. The public knows that there is an issue in the system, something is happening in the central bank, and there is a press notice announcing the policy action taken by the bank. All these are very secretive. Modern central banks seek to overcome this opacity in policy action of a central bank by getting it to disclose the policy action taken by the Board to the members of the public. In the case of the Bank of England, the monetary policy committee discussions and conclusions are released to the public forthwith. It enables the public to learn of which members have spoken at the meetings, and what they have contributed to the deliberations. This is a far advanced method of assigning accountability to a central bank.

Hence, the central banks should be made accountable for their actions, both with regard to the budgetary expenditures and policy framing.

Fallacy #Four: Central banks can create real wealth and prosperity for people by issuing money

Central banks have only one weapon and that weapon is the power to issue money. But money does not have a real existence and it is only a notion in the mind of people. If anybody wants to use money issued by a central bank for his real consumption, he should first convert that money into a real good or a service. If this link is severed, there is no meaning in having money.

This is the difference between the nominal or money sector in the economy and its real sector. What people seek to develop is the real sector which will provide consumable real goods and services. The development of the real sector comes from the hard work expended by people by using the physical and human capital combined with technological advancements. These are activities completely outside the purview of a central bank.

A central bank can support the real economy if the money it creates can influence people to work hard, acquire physical and human capital, and employ technology to produce a new product efficiently. Any such acquisitions are based on investments financed out of the savings of a nation. Savings should be voluntary savings made by consuming less than what one has produced. Once these savings are recycled, a nation can increase the production of real goods and services.

Savings which are involuntary and arise from the financial system through the creation of new money will not contribute to the sustained economic growth of a country. In this sense, the contributions which a central bank can make by printing new money to economic advancement is rather limited.

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com

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    “The development of the real sector comes from the hard work expended by people by using the physical and human capital combined with technological advancements. These are activities completely outside the purview of a central bank.”

    Is it not where the day time robbery of labour and hard work by the State through central bank comes from by printing the nominal value (then morphs
    it into face value and market value) in seconds with less cost for paper, metal or electronic form than peanuts?

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