What Does Central Bank Independence Mean and Why Is It Important?

5 Mayıs 2024

Although attempts by states to assert authority over currency can be traced back to the 3rd millennium BCE in ancient civilizations like Egypt and Sumer, the history of modern central banking dates back to the late 17th century. The oldest central bank is considered to be the Swedish Riksbank, established in 1668, followed by the Bank of England, established in 1694. The existence of central banks serves two functions. Firstly, it is to issue the national currency, which is recognized as the legal tender within the country’s borders and is considered a symbol of sovereignty.

Secondly, due to the nature of payment systems where the default of one institution in fractional reserve banking could affect the entire system and since the functioning of the credit mechanism provides societal benefits, central banks undertake the role of lender of last resort.

With the realization that governments could abuse their power to create money for short-term gains, thereby disrupting economic balances and harming societal welfare, efforts were made to regulate control by tying the quantity of money to valuable metal reserves, such as gold. This ensured that monetary policy became rule-based, preventing the exploitation of political power over currency. However, as the global economy developed rapidly, and the amount of gold became insufficient to accommodate the increasing money supply, deflation risks emerged.

The economic crisis that triggered events leading to the First World War and the Great Depression experienced during 1929-33 also highlighted the impact of incorrect decisions related to the extremely rigid monetary policy known as the gold standard. Consequently, the system was revised after 1944. Under the Bretton Woods system, alongside gold, the US dollar served as a reserve currency. The world’s largest economy, the United States, was entrusted with the task of exporting capital to the global economy and maintaining the value of currencies. However, when it became apparent in 1971 that this system could not meet the needs of the growing world economy and rapidly increasing international trade, and the parity of 1 ounce of gold to $35 could not be maintained, the responsibility of preserving the value of national currencies fell to national central banks.

The crises of the 1960s and 1970s led to a major revolution in economic thought. Economists such as Friedman, Phelps, Lucas, and Prescott demonstrated that there could be no trade-off between inflation and growth and that economic policies needed to be rule-based. Policies not bound by rules led to uncertainty and time inconsistency issues, undermining investment, production, growth, employment, and overall societal welfare. It became a fundamental truth in economics that employment cannot be permanently increased or sustainable growth cannot be maintained through monetary expansion, such as lowering interest rates below market equilibrium or increasing the money supply.

Inflation is an illegally taken tax. Financing public expenditures or reducing the real value of debt by diminishing the value of money, even if only temporarily deceiving or attempting to deceive the public, is tantamount to stealing money from people’s pockets. It is unethical to attempt to decrease the quantity of goods and services purchasable with the same amount of money without people’s realization. Moreover, it cannot have a lasting positive effect on the economy.

The greatest power of political authority over the economy lies in fiscal policy. With the approval of representatives of the people, governments can collect as much tax as they wish and spend the revenue wherever they please. Although wrong fiscal policies also disrupt economic balances and negatively affect societal welfare, they are legitimate because they are transparent and impose accountability on the government. The decision is subject to evaluation by the public. If successful, support continues; if unsuccessful, people can demand accountability or change their preferences. Both outcomes are legitimate and morally consistent. However, this is not the case with monetary policy. Using monetary policy to finance public spending for short-term political gains or attempting to increase employment and growth by stimulating domestic demand is not only futile and lacking transparency but also morally problematic.

The primary task of a central bank is to maintain price stability. The sole contribution of monetary policy to growth and employment is to ensure price stability permanently, thus creating a predictable environment for business and investment. This, in turn, enhances productivity, competitiveness, and societal welfare. The independence of a central bank is a public good. Although it serves societal benefits, the independent exercise of power by an institution whose governance is determined through appointment raises the issue known as the “democratic deficit.” Therefore, in democratic countries, central banks are periodically required to be accountable to both governments and the representatives of the people. Indeed, in our country, the Central Bank informs the Turkish Parliament’s Planning and Budget Commission twice a year.