Central Bank independence and inflation
One of the main economic challenges that Pakistan has faced in the recent decades is controlling inflation in order to mitigate the effects of increasing in prices of goods and services. Time and time again, the general public has seen the value of the ruppee depreciate and suffered under the barrage of increasing prices that have not met with an increase in wages. This article will discuss and explain first why inflation occurs, with particular attention to Pakistan’s case, and then suggest how a reformed institutional setup of the State Bank of Pakistan can help assuage inflation to a considerable extent.
So, why does inflation occur? In macroeconomics, this is a topic that has been studied in great detail and with a lot of success. The widely accepted theory of why inflation occurs was first postulated by the great economist Milton Friedman who famously said, “Inflation is always and everywhere a monetary phenomenon”. The idea is simple: There is a direct positive relationship between inflation and the money supply, or the amount of currency issued or in circulation in the economy. Hence, as you increase money supply, you cause inflation. To illustrate the robustness of this theory, I graphed above the percentage increase in money supply and of inflation. Notice how, in the graph, money supply and inflation grow at almost the same rate, a testament to the power of the theory.
Now we have an understanding of the strong positive relationship between money supply growth and inflation, we ask how is it that money supply is set so high? In all modern societies, the decision on setting money supply, and hence inflation, rests in the hands of the Central Bank, or in Pakistan’s case, the State Bank of Pakistan. Historically, the money supply was pegged to an intrinsic commodity, like gold or silver, i.e. a Central Bank could only print more money if it obtained or acquired more gold or silver. This was because all currency had an inherent promise to be converted to the pegged commodity at demand by the citizenry, something you can read off old American, Pakistani and other country’s notes. This served as a commitment device that put a limit on how much money could be printed. But in the current system, Central Banks issue ‘fiat’ currency, or currency that is not backed by any intrinsically valuable commodity. What all this amounts to is that Central Banks can, now, literally ‘run the printing presses’ or set money supply arbitrarily.
Hence, any rational individual will ask: if the main cause of inflation is so simple, why doesn’t the State Bank of Pakistan just print less money to control inflation? I mean, it doesn’t take a genius to figure this out, right? The simple answer is the problem lies in the lack of independence of the State Bank. Take a look at the structure of the Central Board of Directors, the monetary policy committee that sets money supply (details here), you can see that the Secretary of the Finance Division, a member of the Pakistani Government, is a permanent voting member on the monetary committee. This is highly unusual. In the developed world, Central Banks are independent authorities with no members of the elected Government on the monetary policy committee. Our system is one in which the State Bank of Pakistan is controlled by the ruling politicians, who can and do use the State Bank’s special ability to print limitlessly as their own personal piggy bank. They print money to rationalize to the citizenry that they are taking on projects for economic development and job creation. But in paying for these projects through the limitless printing of money, what the Government fails to mention is that the limitless printing results in high inflation, a potentially bigger evil than lower economic development.
To illustrate this idea more concretely, consider the following example: the Government decides to undertake a public project but faces a paucity of funds to pay for such. In Pakistan’s case, instead of making tough and unpopular choices on where to obtain the funding, it decides to pay for this project by using the State Bank of Pakistan to print new money. But in doing so, it erodes its own currency and hence causes inflation. In most countries, Governments can not pay for the project by printing money since do not have influence on the decisions of the Central Bank. They either raise taxes or they do not undertake the project. Hence, the lack of independence of the State Bank of Pakistan fails to discipline the Government from spending and this causes inflation.
So, what have we learned? Well, we have established what inflation is, why it occurs and how its causes, in Pakistan’s specific case, are intricately related to the actions of Pakistani Government and the institutional setup of the State Bank of Pakistan.
How can this problem be tackled? The answer, as already hinted, lies in the correction of the institutional setup of the State Bank of Pakistan to provide operational independence. A helpful road map of how this setup can be corrected already exists in the form of the Bank of England Act of 1998, an Act passed by the British Government to give operational independence to the Bank of England. Obviously, I do not recommend following the British example blindly, but, in my opinion, this is a nice concrete starting point given our constitution’s historic link to the Britons’. Some transferable provisions that would apply and greatly help Pakistan are:
● Removing any, and every, elected official from the Central Board of Directors (currently the Finance Minister is a permanent member)
● Not requiring a provincial quota for members; requiring an industrial quota
● Allowing for an increase in the tenure of the Governor of the State Bank of Pakistan to allow the office to be immune from pressure of the Government; more job stability would increase reputation of the Governor’s office in the financial markets (currently the tenure is of 3 years). A nice principle might be to set tenure length that is longer than of two elected governments, so 10+ years
● legislating a ‘target inflation’ rate, that is explicitly stated in the State Bank’s charter and requiring the Governor to be answerable to Parliament when this rate is exceeded
The problem of inflation, unlike some other problems facing our country, is one that doesn’t need a huge effort to curtail. As I have argued, inflation can be greatly mitigated in Pakistan, not by doing anything magical, but by undertaking intelligent institutional and legislative changes. The new operational setup would refrain the Pakistani Government from carelessly printing money and enable the State Bank of Pakistan to undertake more prudent policies to achieve its primary goal, of the controlling inflation.
The writer is a graduate student in Economics at the University of Minnesota and a research analyst at the Federal Reserve Bank of Minneapolis. He can be reached at email@example.com.
The views expressed herein are those of the author and not necessarily those of the University of Minnesota, Federal Reserve Bank of Minneapolis or the Federal Reserve Board.
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