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The challenge of central bank independence: Boldness required

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Central Bank independence is one of those topics that is currently on the front burner. Around the world the number of cases where governments have become publicly at odds with the choices of their central banks have increased significantly, which has a lot to do with the tilt towards more populist politics in many countries. Here in Nigeria we have had, and still have, questions about the independence of our central bank. Before we delve into that it is useful to understand the logic of central bank independence.

Central banks are in theory supposed to think about the big picture. Not that they should not care about day-to-day issues, but their broad mandate typically focus on stability, and indirectly, preventing cases of instability. This broad focus however means that in many instances they have to take decisions which in the short term may not look so good. Take for example, decisions to raise interest rates which theoretically help keep future inflation in check but also tend to dampen economic activity. In the short term it always sounds like a bad decision to dampen economic growth, but the central bank knows that if they don’t act now then the consequences ofhigher inflation down the line would be much worse than whatever short term negative effects you have today. In summary, the central bank is supposed to be the adult in the policy making room. Or as the popular example goes, the person at the party who decides to stop serving alcohol when people are about to get too drunk.

As you can imagine, being the adult in the room does not always go down well, especially when the people in the room are indirectly your bosses. Central banks frequently come under pressure from governments to take action that may be in the short term interest to politicians but are detrimental to the economy. The conflict between governments and central banks mean that central banks frequently have to choose between being tough enough to say no to governments, or saying yes and having the economy suffer the consequences.

The most popular example of this conflict is the case between former US president Lyndon B. Johnson and his then federal reserve (the US central bank) chairman William McChesney. The Fed wanted to raise rates because they thought the economy was too hot which could lead to a severe recession in the future. President Johnson wanted to not raise rates because he had an election coming in a few months and didn’t want the economy to cool. After a series of discussions, which included a plea by the president to wait until his surgery before continuing discussions on the matter, the Fed went ahead and raised rates anyway. As the story goes the president summoned the chairman to his office and physically assaulted him. The chairman stuck to his guns and insisted that they had no choice but to act according to their mandate and they had done so.

Cases of this conflict between governments and central banks continue until today. Just last year the governor of the Central Bank of India opted to resign instead of ceding to calls to indirectly finance the agenda of the Indian government. Also, President Trump has been at war with his current Fed chairman, Powell, over the decision to raise US interest rates.

Of course, central banks don’t always fight for their independence. Sometimes they cave to government demands. If you ever wonder how economic basket cases like Zimbabwe or Venezuela end up with such high inflation and worthless currencies, it typically starts with their governments asking their central banks to finance their deficits and their central banks not being tough enough to say no. When the Zimbabwean government ran into funding problems in the late 90s it simply got the central bank to print money to finance its ever increasing deficits, cue the chaos that followed. The story is the same with Venezuela.

And so, we get to Nigeria. Back in the 80s and 90s we had many cases where the relationship between the CBN and the FG was a bit too romantic. We didn’t keep records back then, but we all heard stories of the president ordering the CBN to bring bullion vans filled with cash and the central bank obliging. Coincidentally the 80s and 90s were the periods with the highest inflation we have ever seen, and not coincidentally very sluggish economic growth. Since the return to democracy in 1999 both parties have however mostly been responsible. We started reporting how much credit the central bank gives to the federal government. We even set legal limits for how much credit the CBN could extend to the FG. The result of responsible behavior is that in real terms credit to the FG has fallen almost consistently up until 2014.

Since 2014 though, the reverse has been the case. Between 2014 and September 2019 the credit extended to the FG has risen from N530bn to over N7tn. That is trillion with a T. The relationship between the two is so romantic that in the FG’s Q3 2018 budget implementation report there is N1.6tn deficit that was officially financed by no one even though the money was spent. Essentially, the CBN is not saying no the federal government, a behavior which if not corrected could spell doom for all of us down the line.

Of course, it is easy for me to write this from the comfort of my couch. It is definitely a lot more difficult if you have to sit in a room with the president, cabinet, and governors and say “sorry, we can’t do this” to their faces. But the central bank as an institution is going to need to find a way. If they don’t then its only a matter of time before all the emperors find themselves with no clothes.

 

Nonso Obikili

Dr. Obikili is chief economist at BusinessDay

 

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