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Jaimini Bhagwati: Defying dogmas on central banks

Last Updated: Thu, Jan 17, 2013 20:10 hrs

The American Economic Association (AEA) held its annual conference in San Diego on January 4-6, 2013. Among other topics, the conference focused on the role of central banking and that of the US Federal Reserve on the 100th anniversary of the central bank’s creation. A number of papers were presented at the conference: “Measuring Central Bank Independence, Policy Implications and Federal Reserve Independence” by T F Cargill and G P O’Driscoll; “The Effectiveness of Central Bank Independence Versus Policy Rules” by John B Taylor; “What’s Wrong with the Fed: What Would Restore Independence?” by A H Meltzer; “Shifting Mandates — The Federal Reserve’s First Centennial” by C M Reinhart and Kenneth Rogoff.

The justified scepticism about the effectiveness of central bank independence in ensuring price and output stability comes through starkly in these papers. It is factually correct that, irrespective of central bank independence, they have a better record in lowering the variability of inflation compared to variability of output. Mr Cargill and Mr O’Driscoll correctly maintain that “central bank policy is better understood from a political economy perspective ... than [from] a modern view which focuses on de-jure independence and the technical aspects of monetary policy”. John Taylor makes a pertinent reference to Milton Friedman’s comment that “legislating rules for the instruments of policy was the better alternative”.

In the conference at a session on the impact of fiscal policy during recessions, Olivier Blanchard and Daniel Leigh of the International Monetary Fund presented a paper titled “Growth Forecast Errors and Fiscal Multipliers”. This paper suggests that fiscal multipliers may have been well above one during 2008-10 in the first two years of the crisis (a multiplier number above one means that a one per cent reduction in expenditure should reduce output by more than one per cent). The implication is that the 0.5 multiplier number used to justify sharp cuts in government spending underestimated the contraction impact on GDP. However, the authors downplay any suggestion that fiscal consolidation has been overdone in the Europe. In fact, the paper emphasises that fiscal multipliers vary across countries and time.

Proponents of austerity argue that in open economies that need labour market and other reforms, fiscal stimulus leaks to foreign suppliers. Further, for economies with convertible currencies the ability of fiscally stressed governments to continue to borrow at low interest rates depends on the government’s credibility with creditors around the world. Fiscal conservatives insist that even for US government securities, which are traded in deep and liquid markets, it is risky to be casual about fiscal consolidation. 

On December 12, 2012, Ben Bernanke announced that the Fed would keep buying Treasuries and mortgage-backed securities at the rate of $87 billion a month as long as US unemployment remained above 6.5 per cent and inflation did not rise above 2.5 per cent. It is remarkable that the central bank of the world’s largest economy is explicitly targeting an unemployment number in addition to its objectives of limiting inflation and maintaining financial stability. Earlier, on December 10, Mark Carney, the Governor-designate of the Bank of England, made an equally arresting statement when he said that central banking objectives could include targeting of nominal GDP.

The new Japanese government wants the Bank of Japan (BoJ) to raise its inflation target from one per cent to two per cent. The Japanese government has also suggested that, given Japan’s aging population and overvalued yen, it intends to pick up the slack in private demand. The government has demonstrated its resolve by committing to spend an additional 10.3 trillion yen ($116 billion). If the Japanese government continues on this path, the extent to which growth recovers in Japan would give an indication of the size of the fiscal multipliers at work in a large, open and deflationary economy.

In de facto terms, central bank autonomy in the US and the UK seems to be driven by the circumstances the economy is facing. Namely, if it is a deflationary, low-growth situation, the central bank works in tandem with the government and, among other measures, monetises government debt through quantitative easing. In contrast, under inflationary circumstances central banks are independent of governments and raise interest rates even if it stops the economy in its tracks.

More seriously, several central banks in the US and Europe have become quasi-market participants by sharply expanding their balance sheets. For example, the Fed’s balance sheet has grown from about $800 billion in mid-2008 to over $3 trillion now. Nominal interest rates have been pushed down so far that real interest rates are negative, which impacts savers adversely and helps banks revert to profitability. Clearly, the overall impact has political overtones.

It follows that central bankers in developed countries are under closer scrutiny since their spheres of influence have widened even as their regulatory oversight shortcomings have been overlooked. They acquiesced in becoming the sole masters of the universe after errant yet too-big-to-fail financial firms fell into disrepute. Now they are being held accountable for unemployment levels and economic growth in addition to financial stability and inflation.

On balance, in fairness to central banks they have to make complex choices depending on whether the capital account is relatively open or closed and whether it is a large or small economy, part of a currency union and whether the country is more of a price taker or price maker.

On the issue of central bank autonomy little can be added to what Allan Sproul, president of the Federal Reserve Bank of New York, wrote way back in 1948: “I don’t suppose anyone would argue that the central banking system should be independent of the government. The control which such a system exercises, over the volume and value of money is a right of government and is exercised ... with powers delegated by the government. But there is a distinction between independence from government and independence from influence in a narrower sense. The powers of the central banking system should not be a pawn of any group or faction or party or even of any particular administration, subject to political pressures and its own passing fiscal necessities.” The evidence, particularly from the last 10 years, indicates that most countries have found it difficult to meaningfully implement these impeccable principles by converting them into practical and transparent central banking rules. Hopefully, we can do better in India.

The writer is India’s High Commissioner to the United Kingdom. These views are his own

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