In a speech entitled “The changing role of central banks“, given by François Groepe, Deputy Governor of the South African Reserve Bank, at the University of the Free State, Bloemfontein, he highlights there are limits to what these institutions can achieve, and there are challenging times ahead.
The past few years have been extremely challenging, both domestically and internationally. The aftershocks of the global financial crisis of 2008-09 have persisted. The advanced economies are still struggling to recover on a sustained basis, while the emerging markets, initially the main engine for the recovery, have fallen out of favour in the past four years, as the Chinese economy has slowed and brought commodity prices down with it.
Low growth is not the only issue. We are seeing increasingly widespread discontent about rising income and wealth disparities in many countries, where the fruits of growth have not been equitably shared and have been aggravated by persistently low growth.
The initial responses to the financial crisis involved both monetary and fiscal policy loosening. But fiscal space was eroded very soon as debt ratios rose to unsustainable levels. This placed a near impossible burden on monetary policy, which persists to this day.
Referring to the post-crisis focus on central banks, Mohamed El-Erian appropriately titled his most recent book The only game in town. Today, I would like to highlight the role that central banks can play in the economy and, perhaps more importantly, point out the limits to what central banks can do. It is important to understand these limits because, I would argue, the biggest risk to central bank independence is the possible backlash from being unable to deliver on unreasonable expectations. Central bank mandates have expanded – perhaps appropriately so – but there are limits to what monetary policy was designed to achieve. Central banks cannot be, and should not be regarded as, “the only game in town”.
Later he makes the point that centrals banks are less insulated from the political arena.
The main argument for independence is that it minimises the politicisation of monetary policy decision-making and avoids what is known as the “political interest rate cycle”. This refers to the incentive of politicians to lower interest rates in advance of elections. The argument is that an operationally independent central bank does not have to bow to such pressures.
The global crisis has created challenges for central banks that could undermine this seemingly comfortable insulation from the political arena. The expanded mandate of financial stability in itself may have implications for their independence, while the other possible objectives – such as financial inclusion and direct finance – imply political decisions being made by unelected officials.
Compared to financial stability decisions, decisions on monetary policy, while not easy, are more straightforward and better understood by the public. They usually involve the use of one tool, namely the interest rate, and there is a clear objective. The financial stability mandate is more complicated, as it is a shared responsibility. It generally involves government in crisis resolution, particularly when public funds are involved, and the policy tools are more directed at particular sectors; it may therefore be more politically sensitive as the distributional impacts are more apparent than in the case of monetary policy. Furthermore, as has been argued in a paper published by the International Monetary Fund, financial stability is difficult to measure but financial stability crises are evident, so policy failures are observable, unlike successes. As has been noted in the IMF paper, “central banks would find it difficult (even ex post facto) to defend potentially unpopular measures, precisely because they succeeded in maintaining financial stability”. Whichever failures may be perceived on the financial stability front have the potential to undermine monetary policy independence through a general loss of credibility of the central bank.
In conclusion, we are living in challenging times. Central banks are called on to do more and more, and are still called on to provide solutions to the low-growth environment we find ourselves in. But, as I have argued, although central banks play an important role in the economy and society at large, there are limits to what they can do – and these limits are not always well understood. Mohamed El-Erian argues that while we should give central banks due credit, their effectiveness is waning given the limited number of tools available to them. He argues that the world has come to a critical junction, and faces a choice of two roads. One road “involves a restoration of high-inclusive growth that creates jobs, reduces the risk of financial instability, and counters excessive inequality. It is a path that also lowers political tensions, eases corporate governance dysfunction, and holds the hope of defusing some of the world’s geopolitical threats. The other road is one of even lower growth, persistently high unemployment, and still worsening inequality. It is a road that involves renewed global financial instability, fuels political extremism, and erodes social cohesion as well as integrity”.
This is a sombre warning – and relevant both domestically and at the global level. It is clear what the preferred road is. Taking it requires political leadership and political will. This is not a responsibility that can be abdicated to central banks.
