ECONOMYNEXT – Sri Lanka’s central bank may not be accountable under a controversial new monetary law, if it continues to create instability as in the past or as Western central banks did recently, using its discretionary powers and weak rules, top economists warned.

There were no penalties for central bankers who fail to meet inflation targets set by the parliament, former Deputy Governor W A Wijewardena said.

Lawrence White, a professor at George Mason University and a visiting lecturer at the Swiss National Bank said Western supposedly ‘independent’ central banks which generate high inflation by pursuing Keynesian style macro-economic policy only suffer ’embarrassment’.

No Penalties

Under a controversial draft law backed by the 17th International Monetary Fund program, the central bank is only supposed to file a half yearly report in parliament, giving reasons for its failures.

“But still there is no penalty involved on any the members working in the governing board or the monetary policy board,” Wijewardena, a former Deputy Governor of the central bank told a forum organized by Sri Lanka’s Bastiat Society.

In the case of some other countries, the central bank Governor has to resign for not meeting targets, he said.

“The present accountability provisions presented in the new act are not strong enough and should be strengthened to make the central bank accountable for its own actions, “Wijewardena said. “Otherwise, it will be we who will suffer.”

“Because anybody can do anything, and if the governing board and the monetary policy board gets the support of the President and the Minister of Finance and the ruling party, they can escape.”

Wijewardena said in his experience while in the central bank, the parliament’s Committee on Public Enterprise did not have to skills or the legal power to question and hold the agency accountable for its failures.

Whether the central bank was independent under the new law was also questionable.

In old law central bank officials were appointed by the Monetary Board. The Treasury Secretary who was a member of the Monetary Board was a permanent secretary at the time of the central bank law was made. He later became a person who served at the pleasure of the cabinet and president.

Under the controversial draft law, where some provisions were struck down by the Supreme Court for being unconstitutional, several appointments including deputy governors could also be appointed by the political authorities unlike now.

“Though it has been proclaimed that the central bank will be independent under the new law, the independence had been diluted,” Wijewardena said.

“We had one offensive person in the past, now we have eleven offensive people deciding on the fate of our money.

Multiple Goals and Objectives

Central Bank independence itself does not constrain the central bank.

Sri Lanka has drawn up a new monetary law giving discretion for the central bank to engage in a bewildering mish-mash of goals and de facto targets (exchange rate policy – targeting an exchange rate), monetary policy (printing money to cut rates) simultaneously.

The central bank “shall” also take into account “stabilization of output towards its potential level” while pursuing exchange rate policy.

While targeting an output gap (real GDP targeting) or engaging in Keynesian stimulus, the central bank will also have an explicit inflation target as its key goal, which however requires the abandonment of exchange rate policy, not to mention output gap targeting.

The central bank is supposed to get ‘independence’ and also pursue the main and subsidiary goal and aims but is unlikely face any penalty for inflating the currency or prices, when it trips up on multiple goals as it had done in the past.

‘Independence’ only protects a central bank from politicians who try to use money supply to finance deficits or keep rates down to boost growth or for other purposes.

Independence refers to protection from political authorities. It does not protect the public from a central bank that tries to boost growth or close ‘output gaps’ by enforcing policy rates rates with open market operations as happened in Sri Lanka after the end of a civil war.

By legalizing output gap targeting or Keynesian stimulus, there are fears that Sri Lanka will give full discretion to a central bank keen on chasing Keynesian stimulus and trigger currency crises, debt spikes and growth shocks, as in the recent past,

Independence to Keynesians?

Independence does not protect the people from a central bank which has the discretion cut rates to boost growth or to delay which delays rate hikes under cover of a high positive inflation target.

In the 1970s, independent central banks created high inflation by trying

“Under discretion, you rely on the central bankers having the right ideas about how to implement that theory,” Lawrence White, a Professor at George Mason University and a visiting lecture at Swiss National Bank who is also an authority on monetary history said.

“If you have Keynesian central bankers you get a different outcome than if you have monetarist central bankers.

“But you also rely on the personalities and the political sensitivities of the central bankers, and how eager they are to address current inflation or employment vs how much emphasis they put on the long run.

“That is one of the drawbacks of discretion, that you rely so much on the personalities who in place. Whereas having a rule that is like a set of instructions for the central bank to follow such as ‘Your target for inflation is 2 percent inflation and you should respond’, with as Dr Wijewardena emphasized with accountability and penalties for failing to hit the targets.

“Then you have a more reliable system.

“The central bank becomes more predictable. Inflation targeting has been a partial success. In New Zealand where they did have strict penalties, it did enable them to bring inflation down without a major recession and the central bank was compliant with the rules.

“In other countries, as we saw last year in the US and Euro zone, inflation took off without much consequence for the central bank except a little embarrassment. But nobody lost their job.”

Some central banks like that of Canada, have solved the problem by having a selection committee and creating a succession plan before incumbents retire, Wijewardena said.

“You can give the discretionary power if that person is skilled, capable and competent in carrying out his discretion,” Wijewardena said.

“What is happening in the case of Sri Lanka in selecting members of the monetary board is that there is no such selection process.

“In the case of a currency board system the rule is there. If you have foreign reserves you can issue money, if you do dot have foreign reserves you cannot issue money.”

Rules vs Discretion

Under a currency board law, the parliament sets an exchange rate target at zero, similar to an inflation target but with a floating rate and takes away the agencies power to inject money through open market operations.

Many East Asians countries, and GCC have grown fast under such rules by eliminating the ability to manipulate policy rates.

Dollarization is also a rule which is tighter than an inflation target.

“When you have a rule, then you have the parliament dictating what the goal should be and what the penalties are for failing to meet the goal, the central bank can still have the independence in the choice of its technical means for hitting the goal,” Lawrence said.

“But it does not get independence to set its own goal. So, it is not goal independence.”

There are fears that Sri Lanka’s parliament will give goal independence to the central bank rubber stamping a 4-6 percent inflation target under which the country was driven into serial currency crises and sovereign default, instead of a tighter 2 percent target in more stable countries in the West and in East Asia.

Under a high inflation target, Keynesian central bankers are able to supress rates for a longer period, and trigger monetary instability.

Parliaments in defaulting African countries have rubber stamped inflation targets up to 7 percent giving wide discretion for central banks to cut rates for extended periods with printed money. (Colombo/July10/2023)