Every nation has what I like to call the “guardians of the flame”. These are the institutions that give backbone to statehood because they are the instruments through which a nation-state assures its sovereignty, security, governance, and basic economic life. The president or Head of Government, the parliament that makes the laws, the judiciary, the armed forces, the intelligence and security services, the police, and the central or reserve bank which issues and manages the legal tender currency, otherwise referred to as “fiat money” in economic jargon.
Although all institutions matter, the list of “the guardians”, the indispensable and irreplaceable ones, is essentially a very short one. Since the global financial crisis of 2007/2008 and its aftermath, when central banks saved the global economy from complete collapse through strong, concerted though belated action, their profile as guardians in national and global economies has become even sharper.
Recent controversies surrounding central banks in India and closer home in Nigeria have brought to mind the matter of the independence of reserve banks and why it matters for effective governance and public policy. In India, the independence of the Reserve Bank of India (RBI) and its respected governor, Professor Raghuram Rajan, was recently perceived to be under threat when the Indian government proposed through its Ministry of Finance that its nominees should form the majority in a new, formal Monetary Policy Committee of the RBI. Domestic and international concern about what was seen as an attempt to subordinate the decision-making process of the Indian reserve bank to political interference quickly mounted. The matter was ultimately resolved with agreement on the establishment of a committee with equal representation from the RBI and the Indian government, but with the RBI governor to have a deciding vote in case of a deadlock.
This ensures, of course, that the ultimate judgement on Indian monetary policy still rests with the country’s reserve bank.
Prior to this controversy, monetary policy rates in a democracy as mature as India had been set essentially only by the governor of the RBI and his deputies. Unlike India, Nigeria’s central bank has for many years had a formal 12-member Monetary Policy Committee (MPC) consisting of the CBN governor, the four deputy governors of the Bank, and seven other outside members including the Permanent Secretary of the Federal Ministry of Finance. The reason for this delicate balance of “internal” (CBN governors) and “external” members is to ensure that the Bank remains independent in making monetary policy while involving other knowledgeable outside experts. As a matter of fact, all members of the MPC are independent in that role. They vote individually for decisions based on their own assessment of available economic data and the macroeconomic situation.
What exactly, then, is central bank independence, and why does it matter? Simply put, central bank independence means the ability (and desirability) of a central bank to undertake rational economic and operational activities and make decisions without external interference from outside the bank. “External interference” is usually understood to refer to the government of the day. Naturally, a government would be more concerned with responding to political pressures and imperatives, which it can then channel into the economic arena through fiscal policy and its instruments such as the ministries of finance, budget and planning. But the independence of a reserve bank must also mean independence from other forces including economic agents with vested interests such as commercial or investment banks, and even foreign portfolio investors.
The main rationale for central bank independence is that economic decisions such as monetary policy should not be affected by what economists have dubbed the “time inconsistency” problem. This is a situation in which decisions that may be politically expedient today may be economically ruinous for a country in the longer term. Central banks should think and act rationally in the longer term national economic interest, even if their decisions may be politically unpopular from a short-term horizon.
In other words, they should not be influenced by politicians who are obsessed with the next election cycle. The temptation that politicians have to subject central banks to their short-term political goals is very strong, but they often neither understand nor care about the long-term consequences of this path. This is partly because the core competences of political leaders frequently lie elsewhere. Where institutions are weak, vested political or commercial interests can easily bend such institutions to the service of sub-optimal agendas or even well-intentioned but ultimately misguided notions of “national interest”.
Historically, central banks, the first of which was the Riksbank of Sweden in 1668 followed by the Bank of England in 1694, were not independent. They were mainly financial appendages of state policy that financed wars and other strategic national ambitions. But the evolution of the global economy in the past 40 years or so, especially the global inflationary spiral that followed the oil prices hikes by oil-producing countries in the early seventies, led to the independence of central banks becoming the global norm. Even the Bank of England became independent only in 1998. Today, central banks that are perceived as subservient quickly lose the respect of citizens, domestic economic agents, and foreign investors.
Central bank independence matters for several reasons. First, it makes central banks more effective at performing their functions, especially that of managing inflation and maintaining price stability in the context of monetary policy. For this reason, such independence is ultimately in the best interest of both governments and their citizens. It is empirically established that economic and monetary policy management in countries with independent central banks has improved in the past three decades. Nowhere is this more so than in Africa, where inflation rates in the 1980s averaged 25 per cent, but a trend of increasingly independent central banks over the past 15 years has helped improve macroeconomic stability. Second, central bank independence is also a significant factor in sovereign ratings and assessments of modern governance and institutions more broadly, just as is the independence of the judiciary.
In Nigeria, it was the independence of the CBN, stipulated in the CBN Act of 2007, that enabled the Bank wrestle inflation down into the single digits and undertake far-reaching banking sector reforms from late 2009 after the global financial crisis. The prior absence of this independence was one reason why the performance of the Nigerian economy in the 1990s was so lacklustre. Requiring external political authorisation to take the required steps, the Bank stepped in too little and too late. For the same reason, the Bank was unable to reign in politically connected crooks and “banksters” in the banking industry in the same epoch, resulting in failed banks that wiped out the savings of many Nigerians and sent several to their early deaths.
There have been frequent tensions around central bank independence in many developing and emerging market countries. In Argentina, Hungary, Malawi, Mauritius, Nigeria, and Zambia, such tensions have seen central bank governors either resign or fired. Why does this tension exist? It exists partly because, as a matter of fact, there is some fundamental contradiction between the notion of central bank independence and the political legitimacy of an elected government. Can, or should an official who is appointed by an elected political authority imbued with the democratic will of the citizens, be “untouchable”? Can an institution of the state, indeed one of the “guardians” be so completely decoupled from the larger apparatus and activities of the state? Add to these questions the problem that, in politically immature societies, the notion of any derogation from the far-reaching power of the president or head of government in which any official can be distanced from “the president has directed” is unthinkable for many!
The answer to these posers is not an automatic “no”, but rather something more nuanced. This tension requires two sides to manage. First, an enlightened political leadership must recognise, as all such leaderships in virtually all economically successful countries do, the uniqueness of the role of central banks. It is thus ultimately in the national interest to respect their operational and administrative independence.
The architecture of national economic management should include a reserve bank that is significantly independent of short-term political influence as a necessary check and balance. Central bank independence is thus oxygen for every modern state. Such a state confronts the choice, then, of being forward-looking and accepting, in the overall national interest, some enlightened limitation on its discretionary powers in the areas covered by central banking, or of retreating into a primeval past in which a government’s writ was untrammelled.
The independence of a central bank, on the other hand, cannot be absolute. Egregious malfeasance or spectacular incompetence can constitute grounds for exceptions. Moreover, accountability mechanisms exist. In Nigeria, as in many democracies, the central bank is also accountable in a number of ways. Under the provisions of the CBN Act, the governor reports directly to the president (essentially, the embodiment of sovereignty) in areas such as the establishment of a new legal tender and the approval of the Bank’s accounts. The Bank is also accountable to the Nigerian people through its periodic reporting channel to the National Assembly.
Beyond this, balance and a sense of responsibility, combined with sure-footedness, is required of central banks. They must defend their independence where need be. Shorn of that independence, they cannot truly serve the common good. But they also must be truly apolitical and stay above the political fray in order to maintain the legitimacy of that independence.
It is in the moral force of that earned legitimacy, perhaps even more than the provisions of laws which can always be cleverly circumvented, that the claim to central bank independence ultimately lies. This is why a central bank that becomes either a lapdog or an “errand boy” to politicians and their partisan interests, or a noisy “opposition party” to a democratically elected government, has lost its way. The balance is not an easy one but then, who said central banking in developing countries is easy?
THISDAY
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