Over time central banks have acquired an aura of inscrutable impartiality and infallibility. For instance, the US Federal Reserve, the Bank of England and the German Bundesbank are viewed as apolitical authorities meant to ensure financial and economic stability. Central bankers with fixed-term tenures are viewed as effective bulwarks against partisan decision-making by short-sighted or venal political executives. Does empirical evidence justify such confidence in central banks? Have central banks ensured that inflation targets and financial stability objectives are reasonably well met? This article ruminates on basic and even primal issues related to central-bank performance and their seeming lack of accountability.
In the last two decades, Western central banks have been more fixated on the stability of financial institutions and inflation targeting than on asset-price bubbles and overall issues of productivity, competitiveness and unemployment. Central banks posit that they cannot be certain if a sustained rise in asset prices indicates an asset-price bubble or not. By similar logic it should be difficult for central banks to know if inflation is structural or cyclical. Central banks make considered judgements on inflation, and hence why not about asset-price bubbles? Central banks raise or cut interest rates even when such action should preferably be taken only when accompanied by, for example, supply-side or labour market measures. Of course, the latter take much longer to work their way through a national economy. If the argument nevertheless is that the supply side and other matters should be dealt exclusively by governments, it is time to consider how to formally promote closer and regular coordination between central banks and finance ministries.
The flip side of statutory autonomy for central banks has to be accountability. It is surprising that political executives or academics have not sought greater accountability from central banks. To be provocative, it could be argued that the US Federal Reserve’s move to reduce interest rates after the internet bubble burst in 2001-02 was designed primarily to revive stock markets and “animal spirits”. Several prominent US economists are convinced that the Federal Reserve’s low interest-rate policies were misconceived, and were partially responsible for the real estate bubble of 2007-08. Now, we are back to disproportionate reliance, in the UK and the US, on low interest rates and quantitative easing to promote growth.
Central banks should be held accountable for the fact that the banking sector’s risk capital buffers continue to be inadequate more than three years after the meltdown of 2007-08. For example, on December 8, 2011, based on its latest stress tests, the European Banking Authority again raised its estimate of the capital requirements of the continent’s banks by ^115 billion. Commerzbank, which is Germany’s second-largest lender after Deutsche Bank, will reportedly need additional government support. Commerzbank is already 25 per cent government-owned, and its share price has fallen 68 per cent in 2011. This comes on top of reports that several German Landesbanks will need funding assistance from regional state governments. Separately, on December 12, 2011, the UK’s Financial Services Authority released a lengthy report detailing the failures of bank management, regulators and government that led to the collapse of the Royal Bank of Scotland.
In the course of 2011, central governments have changed in five euro-zone countries — Ireland, Portugal, Greece, Italy and Spain. Ireland’s relatively high fiscal deficit has been caused by the government assuming private bank debt. However, despite the banks’ excesses, which are partly responsible for the high unemployment and social turmoil that led to the unseating of the five governments, there has been little discussion about the performance of central banks in these countries.
In the euro zone, Greece and Italy now have technocratic governments and Ireland, Portugal and Spain have a freshly-elected leadership. This gets close to a controlled laboratory experiment in comparing the performances of governments run by economists and professionals and by elected representatives. Although the nature and extent of the economic challenges – in terms of fiscal deficits, current account balances and public debt to GDP ratios – are different across these five countries, it will be instructive to contrast their economic indicators over the next few years.
Clearly, central banks cannot insulate national economies from the irresponsible decisions of their elected governments. However, to ask an over-simplistic question, do finance ministries inevitably succumb to vested interests or short-term considerations driven by political requirements while central banks remain impervious to pressures from political or business interests? If the answer is yes, by simple-minded extension, finance ministries should also be staffed by economists and professionals and granted statutory autonomy. Yet fiscal policy and the work of finance ministries is justifiably considered too integral to the functioning of governments to be outsourced even to a statute-based body. However, monetary policy, too, has economy-wide impacts with associated political consequences for governments. Hence the question remains: Why have political executives delegated monetary policy-making to central banks? To an extent, central bank autonomy is considered necessary to ensure the financial-sector disasters of the past do not recur. Further, perhaps cynically, it is useful to have an entity separate from government to blame for inflation or bank breakdowns.
My sense is that to reduce the risk of recurring financial-sector crises, banks and other financial sector intermediaries should be compelled to become more like utility companies with similar levels of profitability. Further, bank management should not be allowed to allocate most of the benefits to themselves, as the risks are borne entirely by shareholders and taxpayers. Are central banks, including the Reserve Bank of India (RBI), promoting such a transition? At times, central banks are mistakenly impressed with bankers extolling the precision with which they can construct perfect hedges against market and credit risk with tools borrowed from thermodynamics and stochastic calculus.
To sum up, how do we improve transparency and accountability in central-bank decision-making and regulatory policing? Central bankers would be more accountable if there were adverse consequences for their senior management, at least in terms of reputational damage, for non-performance. In India, there should be statute-based performance audits of the RBI on a periodic ex-post basis. Independent auditors should have full access to all decision memos, and their reports should be submitted to the government and tabled in Parliament for discussion.
The author is India’s ambassador to Brussels. These views are personal.
