Alfred M. Mthimkhulu
For months, I have considered sharing thoughts on the independence of central banks. There is so much live discussion on this subject globally and I am very cautious on the merits of new outpourings, mine included. That a central bank must be independent is the orthodoxy of our time as was the gold standard once upon a time. A sure way of denting one’s reputations is to argue against central banks’ independence. We won’t take you seriously. But, it is not an unreasonable argument.
Way back in 1694, some wealthy Protestants fleeing Louis XIV’s reign in France settled in England. England’s finances were in tatters thanks to perpetual wars. The newcomers offered government a loan of £1,2 million. Government accepted. The loan had no maturity date meaning that it would not be repaid. Importantly, the loan was seed capital for the Bank of England (BoE). Like other banks of the time, the new bank issued own notes backed by gold. Over time and because of its size, other banks entrusted it with their reserves and its influence grew cementing its centrality in the entire financial system.
When the First World War begun in 1914, UK Treasury was once again in dire need of funds for war but the Governor of the BoE would have none of that. He even instructed the Bank’s office in Canada not to take instructions from UK Treasury insisting that the only public officer worth his audience was the Prime Minister. This created serious problems. It could have even led to UK defaulting. To avert that, Prime Minister summoned him and made it clear to the Governor that the Bank would be taken over if he persisted in his unfortunate stance. The Governor backed down and wrote the Chancellor of the Exchequer “to accept my unreserved apology for anything I have done to offend you”.
In the words of historian Liaquat Ahamed on whose book “Lords of Finance” this narrative draws, “the Bank kept expanding its role as chief underwriter and promoter of government debt” during the war.
Interestingly, a century earlier France had been England’s foe. At that time, Napoleon Bonaparte formed the Banque de France to introduce a new currency. The new currency was backed by gold after the torrid decade since the 1789 revolution had decimated whatever currency was in place.
Like the BoE, the Banque was privately held. Napoleon himself and some in his family were shareholders along with a few banking dynasties. Private ownership was important to present the Bank as independent. But after his defeat at Trafalgar in 1805, Napoleon revamped his financing arsenal so that he could control it.
“The Banque does not belong only to shareholders, but also to the state,” he declared.
“I want the Banque to be sufficiently in government hands without being too much so” and so began increases in money supply to fund the war.
Some hundred years later (1913) and across the Atlantic, President Woodrow Wilson was signing the Federal Reserve Act to birth the United States’ central bank. He wrestled with board composition: should it be made-up of mostly bankers or politicians? Today, a century later, not much has changed on this.
There is for instance concern on President Trump’s real or perceived encroachment on the Fed’s decision-making processes hence comments by a member of the Budget Committee that “(President) Trump repeatedly tries to intimidate the Federal Reserve in a way Presidents have never done and risks collapsing our entire economic system”.
An informative article in the Economist magazine (April) titled “The independence of central banks is under threat from politics” discusses more such seeming infringements on central banks’ independence in India, Turkey and the EU.
But we need not over-entangle ourselves in these debates and forget our goal. We seek to develop our economies. For that we need a responsive financial market. All we need to draw from the debates are possible paths to our envisioned futures.
Unfortunately, instead of inferring such paths we try as much as possible to replicate advanced financial markets ignoring how they were nurtured by their distinct circumstances and preferences. For instance, their goal was never inclusive growth or poverty alleviation yet that is our overarching goal. We also overlook that the developed financial systems are what they are now because of a myriad other supporting institutions and laws we do not have and that such took centuries to evolve.
In the 2000s, Indian-born and bred Tarun Khanna, a professor of entrepreneurship at Harvard University, talked of “Institutional Voids” in developing countries. Institutional voids are gaps in an economy’s institutional architecture. In Zimbabwe’s financial system for instance, institutional voids are evident in the absence of a fully-functional credit rating system which would reduce transactions costs in the financial market. The absence of a vibrant bond market which would inform the pricing of debt instruments and thus all other financial securities in the market is another missing institution.
The bond market itself would be dependent on analyses by the credit rating system, analyses that would enable investors to appropriately price risk thus boost efficiencies across the entire financial system. Such missing institutions force existing ones to multi-task. For example, a central bank can then be seen launching a credit rating system. It can be seen funding high-risk strategic projects directly or indirectly because commercial capital cannot price the risk and domestic Development Finance Institutions are mere shells with patchy capital. At low levels of development, the central bank will always have its hands full.
We have debated the independence of central banks from the time we formed them centuries ago. Maybe our answer is in that realisation.
Alfred M. Mthimkhulu, Senior Lecturer, Graduate School of Business, NUST Email: [email protected] Twitter: @mthimz