Why I Like Independent Central Banks

It is often argued that next to the Chief of State, the head of the Central Bank is the most powerful individual in a nation.

Monetary policy plays a tremendous role, at least in the short run, in dictating economic health. With monetary union in the Gulf becoming, at least in part, a reality in the near future, Central Bank governance deserves our attention. At present, it is my understanding that the new Gulf currency will be pegged to the United States dollar, and even if that position changes it would most likely be managed against a basket of highly traded currencies.

Under these circumstances the independence of the Central Bank from the executive and legislative branches of government is not as crucial as if the Gulf currency was to float in global markets.

The problem with pegged currencies is that Central Bank control over macroeconomic policy is greatly reduced by the need to keep the currency properly aligned with the currency to which the local currency is pegged. In some real sense both good and bad policies are exported by the underlying country to the Country pegging their currency.

It should be the goal to ultimately float the Gulf currency in financial markets. Such floating requires that market practitioners are interested in buying and selling the currency. That in turn requires that the currency moves in reflection of a set of economic not administered realities.

Understanding the importance of monetary policy, the executive and legislative branches of government are often keen to maintain power and representation over the Central Bank governance process. In some sense, of course, no Central Bank is independent. Central Banks are formed by government laws and the government is always in a position to change the laws and restructure the Central Bank.

What we mean by independence is not that the executive and legislative branches cannot question Central Bank management, but rather that they defer to the management decisions. We also believe that Central Bank managers should be accountable for their policy decisions. Consistently poor policy actions will harm the nation, and the Central Bank management team must be held accountable.

However, there is a difference between the short-run and the long-run. Tenuring the Central Bank Board affords Board members the protection they need to make unpopular decisions. We do not, however, see lifetime tenure as an appropriate policy.

In their calculus of providing for the greatest common good, the Central Bank often has to make decisions that are likely to help some and harm others. They are also likely to need to make unpopular short-run decisions to provide for the long-term economic health of the nation. Often these decisions are counter to the short-run political benefits desired by the executive and legislative branches. In order to avoid pressure, while we believe it is essential that the Treasury and Central Bank should work together, the Treasury should not be represented on the Board.

In the end, I would hope that the new Gulf currency would become a global currency. The key benefits of an independent Central Bank are greater monetary control over the Gulf’s macroeconomic policy and hopefully better macroeconomic outcomes.

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