Central Bank Independence

As the Maldivian new constitution is being drafted in the parliament, numerous economic and business issues have been raised in the parliament. One of these issues is the rejection of an independent central bank in the Maldives.

Central bank independence is a widely approved issue among many economists. The central bank is given legal independence to peruse some specified goals drawn by the parliament through an act. Some independent central banks perform multiple roles such as keeping a stable currency, maintaining (or working towards) full employment and achieving economic prosperity and welfare. Independent central banks do not have independence in setting their own goals but they have independence in using various measures to achieve those goals. In other words, an independent central bank would have “instrument independence”1/.

Why should a country have an independent central bank?

Firstly, to escape from short-termism of politicians. Politicians usually seek public support in any way they can, sometimes using economic measures. Higher growth rates are attractive but might be harmful in the long run. Excessive growth rates would expand the economy beyond its long run economic potential and this eventually would lead to higher inflation. This might not be the case for the Maldives as no one would be able to determine the definite long run potential of the economy. But deficit budgets and high growth rates witnessed in recent years could be depicting a picture similar to this scenario. We need to learn that what is attractive for short term might not be the best for long term.

Secondly, central banks which are departments of governments use power of the central bank to finance budget deficits. In simple terms, a government might print money and increase money supply to finance budget deficits. This kind of act would have adverse effects on the economy by increasing inflation as a result of higher money supply. More than 40% of the revenue to the Maldivian budget of 2007 comes from foreign donors and loans. I am not sure how these become revenue but my question is what if the government is not able to get all these aid and loans fully. It is difficult to get even already pledged funds and hence it is unlikely for the government to meet the expenditure using mentioned loans and aid mentioned in the budget. So how is the Maldivian government going to meet its expenditure? An independent central bank compels a government to meet its expenditure by more legitimate means such as taxing or borrowing from banks etc.

There is also empirical evidence that an independent central bank would lead to more stable prices as policy economic decisions could be made independent of political motivations.

An economy would be best managed by an independent central bank. An independent central bank would also increase the accountability of the bank. When a central bank is regulated by an act, it has to answer for actions. For example, in UK if the inflation creeps outside the inflation target, the exchequer has to explain the reasons to the parliament. An independent central bank provides the opportunity to find the best policy actions for various problems.

There are also arguments against central bank independence such as an independent central bank does not bring out same outcomes for developed and developing countries. It is more applicable to developed countries rather than developing countries.

But it will be a shame if the purpose behind the move by the parliament is based on political motivations. I believe that the Maldives should have an independent central bank to increase accountability and keep the Maldivian central bank ahead, ready for future changes. In a foreseeable future the Maldives would witness the need for a wider usage of monetary policy and other instruments to manage the economy as the business and financial sector is growing rapidly in the country.

References
1/ Fraser, B.W. (1994), Reserve Bank Bulletin December 1994, Australia