How do central banks get their power?

In many countries, the appointment of a chairperson of a central bank is one of the most exciting occasions. In the United States (US), some people claim that the chairperson of the Federal Reserve is the second most important citizen after the president. This is because of the enormous influence he or she has over the economy, and therefore, the welfare of the people.

Ours is the age of knowledge. While for maximum competence, most people specialise in a certain field and achieve excellence in little, in the world of today, it requires everyone to know something about institutions that affect our lives. One of such institutions is the central bank. How does a central bank get its power? Power over what? Over anyone who has a role in the economy.

A central bank is often established by a statute which defines its role, what it may do and what it may not. For example, European law forbids the European Central Bank from funding a government.

At any time, people in an economy face some of the following macroeconomics: growth or lack of growth, employment or lack of employment, inflation or deflation. In all these phenomena, a central bank has a role, which is positive or negative.

There is lack of unanimity among economists as to how effective a central bank’s power is over these macroeconomics. It may reduce its lending or discount rate to encourage lending and borrowing in the commercial sector. It is generally agreed that short-term interest rates may either stimulate or deter economic activities. Some economists contend that in the long run what a central bank does to the rate of interest does not affect the progress of the economy.

The other tools a central bank uses to influence the state of the economy are open market operations, which is selling or buying bonds or stocks. It may also give directives to influence financial institutions on what type of loans to grant.

One of the memorable phrases which the Nyasaland African Congress (NAC) regularly used in opposing proposals to federate the Rhodesians and Nyasaland still lingers in my memory. It was “poles apart”. The NAC would say the interest of Africans and those of white settlers are poles apart.

In the global economy at present, it seems the problems and interests of developing countries and developed countries are poles apart. In Malawi, inflation and interest rates of over 20 percent have been around for years and they contribute to indifferent economic growth rates. In development countries, policymakers get puzzled on how to stimulate their economies with inflation and interest rates hovering around one percent. Japan, which has been in this fix for more than a decade, has been joined by other developed countries.

In The Economist of April 23-29 2016, the heading Free Exchange is completed with the words money from heaven. The article talks about helicopter money. Central banks are being urged to print money and give it to the people or institutions by way of stimulating the stagnant or slow moving economies. Yet with us, the printing of extra bank notes is the bogey we fear most.

The advantages of helicopter money are clear. Unlike changes in interest rates, stimulus paid for by the central bank does not rely on increases in borrowing to work. This reduces the risk that central banks help inflate new bubbles.

There are some economists who advocate complete laissez faire in the financial system. They say there should be no State central banks and let the financial system evolve naturally through competitiveness. But others say abolition of State banks would result in private monopoly institutions performing central bank’s functions. They say this is one of the cases where a regulated State monopoly serves the interests of the public better than a private monopoly.

What is an interest rate? It is defined as the price you pay for borrowing capital. Economists, at least some of them, say there are two types of interest rates, the nominal and the real one. The nominal one is initiated by the central bank through tools we have mentioned above. The natural interest is the one reflecting the demand and supply of goods which can be bartered.

Obtaining a loan in Malawi today with lending rates of up to 40 percent does not make business sense. How many businesses can yield more than 40 percent profit to meet the cost of repaying the loan?

It is suggested that direct dealings between manufacturers of equipment, for example, and those who want to use them can overcome the prohibitive rates. No need to use borrowed money. The creditor and borrower will agree what extra to pay. n