A transition from authoritarianism to democracy is a time of great uncertainty. The keepers of the status quo may feel threatened by what would happen to the central bank after a pending regime change. While still in power they can be tempted to shore up temporary popular support through manipulating the country’s monetary policy. Fear of losing power, however, is likely to tempt incumbents to tighten their grip on the central bank and its monetary policy. Unfettered central bank autonomy is an important way to ensure the certainty of democracy, writes Yonnas Kefle.
All central banks are not created equal. Just like countries, they are many and diverse. According to my recent casual inquiry, there are 158 central banks in the world: The oldest is the Swedish Sveriges Riksbank established in 1668, the most influential is probably the US Federal Reserve, and the smallest is the central bank of the Republic of Nauru. As an Ethiopian who lives abroad, I was curious how Ethiopia’s central bank stacks up among global banks and what it needs to do to raise its standards. Unlike central banks of many countries, information on what Ethiopia’ central bank does is not widely available in the public domain. Digging deeper, however, I was astonished to learn of Ethiopia’s law, which stipulates that the central bank is only “accountable to the Prime Minister of the Federal Democratic Republic of Ethiopia.” I am hopeful that this will change because the functions of central banks are too complex to be monitored by any individual and too consequential to be shrouded in secrecy. In the interest of public knowledge, I will share some information about the roles of some central banks, primarily the central bank of the United States, known as the Federal Reserve Board (the Fed), and discuss the importance of safeguarding the autonomy of central banks from partisan politics especially in emerging countries.
Modern countries issue official legal tenders called Money. We the people use money as a store of value, a unit of account, and a medium of exchange. Countries create central banks, institutions that manage the production and distribution of their money. These central banks are delegated to manage money through the conduct of monetary policy and through supervising and regulating other banks and financial institutions in their countries. For example, the United States established the Fed by the 1913 Federal Reserve Act to essentially do just that. The American House of Representatives further mandated the central bank to maximize the nation’s employment, stabilize its prices, and moderate its long-term interest rates. The Fed accomplishes these tasks using monetary policy tools. Monetary policy is the responsibility of the Board of Governors of the Federal Reserve System. To be clear, monetary policy is the expansion or contraction of a nation’s money supply to meet mandated economic goals. If the economic goal is to reduce unemployment, the Fed increases the money supply using expansionary monetary policy causing a surge in aggregate demand, the total amount of goods and services consumers normally purchase during any given period. By contrast, if the desired outcome is to curb inflation, the Fed shrinks the money supply using a contractionary monetary policy in order to raise interest rates and restrict the availability of bank credit. A contraction of the money supply thus increases the interest rate and decreases consumption, investment, government spending, as well as net exports. The purpose of a restrictive monetary policy is to raise interest rates and restrict the availability of bank credit. In this way central banks conduct monetary policy by controlling their nations’ money supply, the amount of money circulating in the economy at any given time.
Just what do we mean by the nation’s money supply? In the context of the United States, the money supply is comprised of coins, paper currency, and checkable deposits which together are designated as M1. The paper money (currency) is issued by the Federal Reserve Banks. Only about 51 percent of the American money supply, involves paper money and coins. The next level of the money supply known as M2, includes individual shares in money market mutual funds in addition to the entire stock of currency and asset bundled in M1. Therefore, expanding the money supply is not a matter of simply printing dollars. The amount of money in the economy can be manipulated by managing the level interest rates and influencing the availability and cost of credit in the economy. Monetary policy directly affects interest rates and, indirectly, moves stock prices, wealth, and currency exchange rates. Through these channels, monetary policy influences spending, investment, production, employment, and inflation. Combined with other factors, effective monetary policy spurs economic growth while a misguided one can ruin an economy. The basic macroeconomic equation of monetary policy is MV = PQ [(where M=Money supply, V=Velocity (number of times average currency is spent per year), P=Price (price of goods and services), and Q=Quantity (quantity of goods and services)]. V is assumed to be stable and thus constant. Therefore, when central banks increase M, either P, Q or both P and Q rise. If the economy is closer to maximum employment, the general price levels tend to rise more than the production of goods and services. Further increase in the money supply in this case will cause inflation. When an economy is in recession, however, monetary policy will cause Q to increase at a faster rate than P. In all cases, government officials must keep out of this process allowing central banks to accomplish their tasks of maintaining stable prices, promoting optimum employment and achieving sound economic growth.
In America, the Fed uses monetary policy primarily to stabilize inflation at a minimum level without any government interference. Since it must be held at a minimum, inflation must be a bad thing. What is inflation and why is it bad? To beginners, inflation means that prices of goods and services on average rise, although some particular prices may fall. There are two types of inflation: demand-pull inflation and cost-push inflation. The first type occurs when total spending exceeds the economy’s ability to provide output at the existing price level. Economists describe this phenomenon as a condition where “too much money is chasing too few goods.” It is most likely to occur during the expansionary phase of a business cycle. The second type of inflation, Cost-push inflation, is generally initiated by increases in wages or other resource prices. Unlike demand-pull inflation, cost-push inflation is self-limiting and shrinks the economy lower than its potential production possibilities. By imposing a “hidden tax” on those who hold money, inflation has a forceful impact on both the level and the distribution of income. It can erode the asset values of households if it is allowed to grow uncontrollably. When the average price of goods and services is expected to remain stable, people will be confident in the purchasing power of their money. So when inflation is minimized, saving and capital formation increase because consumers become more motivated to save and businesses feel more confident to invest.
A nation’s inflation rate over the longer run can be primarily managed by central banks’ monetary policy. In America, the Fed’s primary task is to ensure that the economy benefits from low and stable inflation to keep operating efficiently. When inflation is low and stable, individuals can hold money without having to worry the loss of their financial asset’s purchasing power. Moreover, households and businesses can make more accurate financial decisions about borrowing and lending as well as about saving and investing. Longer-term interest rates are also more likely to be moderate when inflation is low and stable. Some central banks, Bank of Canada and the Reserve Bank of Australia for example, have clear and well-defined objectives and explicit targets for the yearly rate of inflation, and share their targets with the public. The banks typically use price indices such as the Consumer Price Index, the weighted average of prices of a basket of consumer goods and services for targeting purposes. In the case of the United States, monetary policy aims to keep inflation around 2 percent over the long run to maintain a reasonably healthy and productive economy. Globally, the core functions of central banks rotate around stabilizing the monetary and financial systems of their respective nations.
Central bank transparency of monetary policy has increased in recent decades and rightly so. Presently, most central banks consider transparency is important to accomplish their missions. As a result, they provide the general public and the markets with accurate and timely information on their analysis of economic conditions, their monetary policy objectives, strategies, assessments, decisions and even the reasons for their policy decisions. They inform consumers and investors alike about their mandate and how they perform their tasks, and tell them exactly what their monetary policy can do and cannot do. Central bank transparency is important because it enables the public to understand and trust their monetary institution, enhancing the banks’ credibility and effectiveness. More importantly, predictable central bank policies help consumers form realistic market expectations and enable investors to make more efficient business decisions. In recent decades more central banks promote increased transparency and richer communication. A casual observation reveals that the majority of central banks both in industrialized as well as in emerging market countries publish minutes of their policy meetings. In the U.S, the Fed periodically shares its monetary policy goals and strategy with legislators and the public. Openness is replacing mystique in the financial sector.
Now, a few words about central banks’ independence is in order. A central bank’s autonomy is the extent to which it conducts its monetary policy functions free from any interference from ruling political parties, or executive and legislative branches of government. A research for industrially advanced countries indicates that the more independent the central banks, the lower the average annual rates of inflation. The less independent the central banks, the higher the average annual rate of inflation. In the United States, the Fed is basically an independent agency. The Federal Reserve Banks are privately owned and publicly entrusted to promote the general economic welfare of the people. They are quasi-public banks, which means that, though they are privately owned, they are managed in the public interest. Neither the President, nor the Congress has to approve or reject the Fed’s monetary policy decisions. To be sure, the seven members of the Board of Governors of the Federal Reserve System are appointed by the President with the confirmation of the Senate. However, their appointments last 14-year terms and are scheduled not to coincide with presidential terms, solidifying their independence. No one can fire Fed Board members, and the Fed receives no funding from the President or the House of Representatives. Similarly, the central banks of most other developed countries enjoy high degree of autonomy, and their members are assured of uninfringeable job security. Given the havoc wreaked on American consumers and investors by his disastrous trade war with trading partners, one can only imagine if the Federal Reserve Board was accountable to President Trump. The independence of central banks from government officials is even more crucial in developing countries.
Now turning to my country, Ethiopia’s central bank is the National Bank of Ethiopia (NBE), headquartered in the capital city of Addis Ababa. Looking back at the history of commercial banking in Ethiopia, it was Emperor Menelik II who, in 1905, established the first bank known as the Bank of Abyssinia. For over two decades, this partly foreign-owned bank issued notes and conducted most kinds of commercial banking business activities. Too proud to rely on the whim of foreign shareholders, Emperor Haile-Sellassie, decided to establish an authentic Ethiopian bank. In 1931, the Bank of Ethiopia, was established after Bank of Abyssinia was amicably persuaded to close shop. The Imperial Government of Ethiopia appointed all Board members of the new bank, but retained most of the management, staff, premises and clients of the liquidated Bank of Abyssinia. The powers of the Board of Directors were entrusted with wide-ranging power from setting the borrowing and lending interest rates to managing the country’s monetary system. Bank of Ethiopia played essentially the role of a central bank. It acted as the monetary agent of the Imperial Government and provided refinancing facilities to other financial intermediaries. Some place it among the first indigenous central banks set up in the whole of Africa. After serving the country for five years, the Italian invasion brought the demise of the Bank of Ethiopia in 1936. The Post war Imperial Government of Ethiopia reconstituted the State Bank of Ethiopia as its central bank, entrusting it with the nation’s monetary policy and other functions of modern central banks. The Emperor established the National Bank of Ethiopia by Proclamation 206 of 1963 replacing the State Bank of Ethiopia. NBE opened shop in January, 1964 as the Central Bank of Ethiopia.
Central bank independence is especially important in countries transitioning to democratic rules such as Ethiopia. In emerging countries, governments essentially own and control central banks. Through them, they influence monetary policy and control the volume of currency circulating in the economy at any given time just like developed countries do. They administer payments of liquid funds, fix exchange rates and manage foreign reserves. They also supervise and regulate commercial banks and other financial institutions within their boundaries. Ethiopian law designates the NBE to conduct the country’s monetary policy centering on maintaining price and exchange rate stability to support sustainable economic growth of the country. Among other tasks, the NBE accepts deposits, and manage government funds deposited domestically or abroad. It buys and sells bills of exchange, promissory notes and securities, as well as precious metals such as gold and silver, and foreign exchange. It also lends money to the Government, and trade treasury bills as well as government bonds issued by the Government. In addition, it is authorized to supervise the myriad of commercial banks and financial institutions that flourished in the country, to produce the banking sector’s statistical data. By all accounts, these are functions of critical importance for Ethiopia’s economic well-being.
Most emerging economies lack operational credit markets and effective systems of taxation. So they tend to rely on their central banks’ ability to print money when applying expansionary monetary policy. When their central banks print more money, they extract the purchasing power of the assets their citizens hold. If checks and balances are not in place, governments can collect these windfall sources of revenue through deficit financing via the central banks behind the scenes. Deficit financing allow rulers to spend more than they earn, wasting money on unnecessary subsidies through direct budget transfer or via seigniorage (the difference between the worth of newly created money and the cost of producing it). Ethiopia’s law must bestow full authority over monetary policy to the central bank. Central bank independence benefits all citizens as opposed to favored groups. Naturally, politicians may be likely to be tempted to inflate the economy prior to impending elections. Insecure political leaders have the motives to wrestle control from central banks in order to buy political support bypassing creditworthiness objectives. Some may even wish to stay in power for many election cycles by manipulating central bank actions to tilt election outcomes in their favor.
Developing countries are often influenced by foreign creditors and investors in shaping their monetary policy. The extent of their central banks’ independence may vary with the governments’ perceptions of their need for international finance. In such cases, the government’s monetary policy signal reflect international/external factors. The existence of central bank autonomy reflects the government’s commitment to low inflation. Political debates in Ethiopia should include the central bank’s ability to monetize government debt. The line between the central bank and the other banks, should be clearly demarcated. As the central bank, the NBE should stay away from propping up companies, sectors, and industries favored by political leaders. Only their autonomy can empower them to refrain from such practices.
Another potential debate should cover the issue of financial liberalization, eliminating unnecessary restrictions on financial markets and institutions, associated with the central bank’s autonomy and the determination of winners and losers when the central bank terminates the practice of preferential credit. A transition from authoritarianism to democracy is a time of great uncertainty. The keepers of the status quo may feel threatened by what would happen to the central bank after a pending regime change. While still in power they can be tempted to shore up temporary popular support through manipulating the country’s monetary policy. Fear of losing power, however, is likely to tempt incumbents to tighten their grip on the central bank and its monetary policy. Unfettered central bank autonomy is an important way to ensure the certainty of democracy.
Ed.’s Note: Yonnas Kefle (PhD), CEO of GTDC LLC, had also served as an Economist at the Bureau of Labor Statistics, as a Labor Attaché at the US Department of State, and as an Adjunct Professor of Economics at Frederick Community College and Pennsylvania State University. the views expressed in this article do not necessarily reflect the view He can be reached at [email protected].