By Hema Senanayake –
An important argument takes place between Nicolases (Bram & Howard) and a presidential team of advisors, namely Indrajit Coomaraswamy, Sharmini Cooray & Shanta Devarajan in the pages of Daily FT. Nicholases’s original proposition was that the new CBA Should be amended by a future government to allow the central bank to focus on macroeconomic stability and allow to purchase treasury bonds directly from the Treasury Department when it is necessary but the presidential team of experts argue that the new CBA should not be amended to facilitate that. This is an interesting policy argument.
Before I present my views, I would like to quote what cognitive neuroscientist Dr. Caroline Leaf said about good arguments. She said that it is important to recognize that arguments are not about you against the other person, but rather about you and the other person against the issue at hand. Keeping this in mind I submit my views henceforth.
No “strong” central bank can be independent operationally (administratively, yes) without the full backing of a common taxation authority which is the treasury department or the government. The European Central Bank (ECB) is not backed by a common taxation authority and therefore ECB is the weakest central bank among developed economies like the U.S. and Japan. During the great depression of 2008 to 2009 in the U.S. the monetary policy with having zero bound interest rate and inflation the economy could not be stimulated, then the government launched a very aggressive fiscal policy program. This crisis has shown the interdependency of monetary policy and fiscal policy.
Nicolases initial proposition is true. The origin of the concept of independent central bank is linked with the Quantity Theory of Money (QTM) of Irving Fisher in 1930s and Milton Friedman’s in 1960s. They submitted that “MV = PQ” which is known as the equation of exchange. In this equation M= money supply, P = the price of goods and services, and V = velocity of money that change hands, Q = quantity of goods and services produced. If both variables V and Q are constant any increase of money supply (M) must increase Prices (P), that is inflation. So, the supporters of independent central bank argue thinking that central bank’s increase of base money cause inflation and therefore the primary focus of central bank should be to maintain price stability.
Accordingly, Coomaraswamy and his team argue that “the primary function of a central bank is to serve the public by safeguarding the value of their currency—that is, the amount of goods and services people can buy with a given amount of currency—which is another way of saying that the primary objective of a central bank should be price stability, as the CBA provides.” (Daily FT, Dec. 05, 2023).
However, recent evidence and theory suggest that increasing base money would not necessarily contribute to inflating the system if other economic forces including market forces contribute to prolong deflation. This was what happened in the lost decade of Japan and subsequent years. From 1991, Japan fought a battle of around 25 years of deflation and stagnation with many rounds Quantitative Easing, increasing base money, sometimes by foretimes within a period of 6 years, finally to reach its inflection point somewhere in August this year.
Contrary to the argument of Coomaraswamy and his team, Nocolases argue that the CBSL should not be permitted to focus on the control of inflation without paying heed to the negative impact of its policies on phenomena such as growth and employment and, more fundamentally, the priorities accorded by the GOSL to various macroeconomic phenomena. When CBSL officials are asked to justify their policies and their consequences to Parliament they should not be allowed to absolve themselves of responsibility for the negative impact their policies have on phenomena such as growth and employment using the argument that these policies only have a bearing on monetary phenomena. They further argue that fiscal policy also has a bearing on aggregate demand, and via this both monetary and real phenomena, it cannot be argued that monetary policy can be implemented by the central bank without reference to fiscal policy and, perhaps more fundamentally, without reference to the priorities accorded by the Government to targeting these phenomena. I like this argument and find it appropriate.
Specifically, Nicolases argue to amend two things in CBA. First, the CBA should be modified to require the CBSL to take into account the impact of its interest rates policies on a broader range of macroeconomic objectives than simply inflation, with these objectives and the priorities attached to them determined by the GOSL and, by extension, the democratic process. I agree, but not entirely.
Determining the GOSL priorities and macroeconomic imperatives should not purely be allowed to democratic process, instead much deliberated CBSL policy prescriptions accorded for GOSL must be taken into account and should be validated by the democratic process, like what we do with IMF’s staff agreements. For example, GOSL likes borrowing from commercial banks, but in this budget bank borrowing approved by the parliament is zero and therefore, it forces banks to make loans to the private sector (businesses and households) and private credit growth without any significant negative impact on the current account is an important macroeconomic parameter. I do not think the idea of zero bank borrowing originated from a democratic process. There are some technicalities in setting macroeconomic objectives and thinking that it can arise purely via a democratic process is a mistake. This means that GOSL cannot set macroeconomic objectives and fiscal policy without reference to monetary policy and vice versa. Since CBSL must have responsibility in helping GOSL to determine its macroeconomic objectives, I agree with Nicolasses when they argue that “when CBSL officials are asked to justify their policies and their consequences to Parliament they should not be allowed to absolve themselves of responsibility for the negative impact their policies have on phenomena such as growth and employment using the argument that these policies only have a bearing on monetary phenomena.” (Daily FT, December 5, 2023).
However, Coomaraswamy and his team insist that even though the CBA specifically states that “the primary object of the Central Bank shall be to achieve and maintain domestic price stability” (Section 6 (1) of CBA); “the Central Bank shall take into account, inter alia, the stabilization of output towards its potential level” (Section 6 (4) of CBA), which means the economic growth and employment. So, they do not negate the first amendment proposed by Nicolases, instead point out that already CBSL is mandated to take into account the macroeconomic objectives set forth by GOSL. Let us agree on this point as long as CBSL theoretically acknowledges that its policy decisions have impact on macroeconomic phenomena in real sector.
Secondly Nicolases argue that the CBA should be modified to permit the CBSL to purchase Government debt in a manner consistent with its overall interest rate strategy, and not simply as a short-term ‘transitory provision’ at the discretion of the Governor of the CBSL. I agree with this point perhaps for two different reasons.
My first concern is this. Fire is dangerous, but useful. Some thinkers argue that fire fundamentally made us human. All governments are not bad. Government borrowing can be made limited by setting legal limits on its overall budget balance and primary balance. Thinking about bad governments and preventing CBSL purchasing government debt would have a negative impact on overall interest rate strategy. Once we had this bad experience in February 2015, when the then Prime Minister suddenly instructed CBSL to cancel “private placements” in issuing bonds and to rely only on public auctions. With the very first issue of bonds under that policy, the interest rate was pushed up by around 300 basis points (the said policy was pulled back later within months). Similar things could happen when the government has to solely rely on primary dealers in borrowing, as CBSL is helpless under new CBA being unable to purchase government debt to have a balance between overall interest rate strategy and monetary growth, as unnecessary monetary growth that affects to inflation can be contained with macroprudential policy tools in liaison with the Ministry of Finance. Ultimate result of the new CBA could be the government continuingly pay huge interest cost.
My second point is this. The current money system is called “Fractional Reserve Banking” or “debt money” system. In this system most of the money is created by designated commercial banks not by CBSL. Verifying this is rather simple. Take the total stock of money and deduct the amount of money created by CBSL. Technically, most of the money is created when commercial banks make loans. This system is highly flexible and even though it tends to create debt bubbles. And there is another system of banking called “Full Reserve Banking”. In this system, all money in circulation is created by the central bank (or the government) debt free. In this system banks function as intermediaries only without creating any money. This system is less flexible but creates no debt bubbles. Both proponents of QTM, Irving Fisher and Milton Friedman, favored converting to Full Reserve Banking from current “debt money system” with a monetary rule so that government can’t create any amount of money it wishes. A Japanese economist Professor Yamaguchi, after running a detailed simulation opined that the said conversion can be done gradually to retire public debt without any negative impact on the economy. He explored as to how Full Reserve money policies or public money administration policies (instead of current debt money system) that incorporate balancing feedback loops such as anti-recession and anti-inflation are introduced for curbing GDP gap and inflation. I add another gap here called “Systemic Gap” which is the gap to be filled by component of debt that can never be paid back when the supply and demand equilibrium is met. Findings were convincing.
But given the less flexibility of the Full Reserve System, it is important to explore as to how both money systems could be used alternatively, when necessary, in confronting major debt crises and pandemics like Covid-19. It would be a hybrid money system for open emerging markets consisting of Public Money Administration and Fractional Reserve System. The idea is to create a certain amount of money debt free while maintaining the flexibility of the economy allowing commercial banks creating a certain amount of “debt money” under the CBSL’s overall policy for total monetary growth. CBA should be amended significantly to facilitate an advanced hybrid monetary system. Young mathematical economists can run a perfect simulation. Do it, I would suggest.