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Sri Lanka’s Central Bank
When the early central banks such as the Bank of England were established in Europe in the late 17th Century, they served as the “bank of the government”. Accordingly, they must lend to the governments to meet the governments’ expenditure requirements.
Some of the early central banks were private entities owned by the shareholders. They also acquired the monopoly status to issue private banknotes, which were backed by gold. Accordingly, the banknotes could be converted to gold so that these paper notes had an intrinsic value. All these activities show that the central banks have emerged in order to address the financial needs of the governments and of the merchants, while playing a role in stabilising the value of currencies.
The intrinsic value of currency notes faded away as the gap between gold supply and currency issuance continued to widen over the years. In 1944, the link was confined only to the US dollar, as decided at the Bretton Woods conference on international monetary system. Then, other countries could back their national currencies with a fixed exchange rate with the US dollar.
Money without gold
Even the Bretton Woods system did not last for more than 25 years. The world abandoned that indirect link between gold and national currencies since the early 1970s, creating the so-called “fiat money”. Since then, currency issuance did not require gold to back it, but a legal validity. The central banks issued fiat money, and the governments declared it to be the “legal tender” – legally valid as the medium of exchange and the standard for debt repayment. Today, most of the currencies in the world such as the US dollar, British pound and European Euro are all fiat currencies.
As the money which does not have gold-backing can be issued freely as much as the government or the political authority wants, its control by the central bank became a crucial issue. When too much money is issued, its legal tender is incapable of defending the value of money because the resulting demand-supply imbalance causes the loss of currency value.
In its evolution process, defending the value of money became the responsibility of the central bank which was not explicit in the early stages of central banking. Today, the primary objective of central banking is, therefore, maintaining price stability – in other words, keeping inflation under control. This means that it’s no more the “bank of the government” standing to fund government’s debt.
When the two functions occur in an un-coordinated manner or, perhaps under the influence of the political leadership, funding the government debt could undermine the central bank’s primary objective of price stability. Unlike the professionals who run the central banks, it is quite possible that the political leaders may have little understanding about monetary policy management. Even if they have that knowledge, it is possible they may act to achieve different political objectives by taking precedence over the monetary policy management. This means that, apparently the primary objective of price stability is at risk when the central banks were under the influence of the governments.
We are all Keynesians!
Until the post-World War time, there was no monetary policy in the world although money-printing and financing government debt existed; neither was there a fiscal policy, although the governments taxed people since ancient times and spent that money. Both the monetary and fiscal policies became the instruments of the government during the post-war period in order to achieve macroeconomic objectives – growth and stability. It was also theorized first by Keynes in his publication in 1936, followed by the economists of the Keynesian tradition up to-date.
Having faced two World Wars and the Great Depression in between during the post-war period, the Western countries needed construction and re-construction in order to restore their shattered economies. There was enough room for public spending for construction and reconstruction as well as for funding the scattered wars around the world. The resulting fiscal expansion was accompanied by money and credit expansion too.
And the “world became all Keynesian” during the post-war period, but not for that long. Since the late 1960s, inflation was rising in the Western countries imposing constraints on fiscal expansion financed by the central banks. Since the 1970s, world economic problems were different so that they required different policy stance for the governments as well as for the central banks.
Effective monetary policy was needed in order to achieve price stability, as stability was believed to help achieve growth. Besides, the adoption of flexible exchange rates has also strengthened the central banks to exercise their monetary policy authority more effectively than it was under the Bretton Woods fixed exchange rate system.
Central bank independence
The historical evidence related to the evolution of central banking and its changing policy stance over time is important in understanding the concept of “central bank independence”. In the good old days, it was not a debatable issue as “price stability” was not an explicit objective of the central bank which was mandated to support the governments.
It became a debatable issue when the price stability was threatened. Evidence suggests that, since the 1970s central banks all around the world have increasingly become more independent of the respective governments.
It was since the 1990s, however, that legislative reforms for central bank independence got accelerated even though not all of the political regimes were in favour of releasing them from their control. The acceleration of central bank reforms during this period were also pushed by two major events in the world economy.
The first was the creation of the European Central Bank (ECB) in 1998 with the purpose of maintaining price stability in the European Union (EU) and the issuance of a single currency – the Euro for the Euro Zone members. The second was the US financial crisis in 2008 that triggered waves of legislative reforms aimed at improving central bank independence.
The period since the US financial crisis was a turbulent time in the world economy with frequent crises up and until now. Many studies confirm that a greater independence of the central banks helped them to respond effectively to the specific issues of stability during this time. In the future too, different roles of the central banks may emerge to accommodate the changing global dynamics.
Case of Sri Lanka
Despite delays, Sri Lanka too followed suit, by adopting a new Central Bank Act No. 16 of 2023. Accordingly, the relationship between the government and the Central Bank has changed with the creation of its boards independent of the government appointments and representation. Further, the historical obligation that the Central Bank had in funding the government debt has also come to an end.
The Act guarantees the monetary policy independence of the Central Bank to focus on its primary objective – price stability – which relieves the government from economic and political pressure of inflation. Usually monetary policy management, which is in the hands of professional central bankers, is evidence-based, monitored constantly and guided by established information flows.
Nevertheless, it does not mean that the government and the Central Bank can work independently on their own. The two institutions must work together and perform collaboratively. This is because the Central Bank can manage the monetary policy effectively, only if the fiscal policy is implemented by the government within an agreed framework.
Moreover, many of the macroeconomic issues that the Central Bank must shoulder should originate outside the central banking premises. The bottom line is that the Central Bank has only a partial role to play with respect to the macroeconomic issues such as exchange rate management, public debt management and foreign reserve build-up as they all are problems originating from a different set of policy issues. This means that central bank independence makes sense, only if the two institutions work in harmony, coordinating with each other.
Finally, central bank independence also requires transparency and accountability. As a public institution, central bank should be accountable to the government and to the public. Transparency in monetary policy-making is a key element of maintaining a higher degree of central bank accountability.
(The writer is Emeritus Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).
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