Beware the dangers of mixing politics with central banking

Samantha Robb
Currency Value Reflects Highest Inflation Rate In The World
Stimulation of the economy for political ends precipitates inflation (Source: Getty)

With inflation rising to 3.1 per cent and hitting the headlines this week, the Bank of England governor has written to the chancellor to explain the increase, facilitating renewed pressure for an interest rate hike.

As the spotlight focuses on the Bank of England’s monetary policy committee, it’s a good time to consider the dangers of mixing central banking with politics.

Central banks are the gatekeepers of a country’s fiscal health, and their role of setting monetary policy is crucial for the stability of their economy.

Read more: Carney backs inflation to peak before the end of the year

Achieving this mandate is a balancing act that needs careful consideration and a solid grasp of the fundamentals that make up a successful economy.

Sometimes, however, fiscal prudence does not suit the agenda of the party in power, and if the monetary policy is set by branches of the government, the stability of the economy could be at risk.

Politicians like the money supply to increase before elections, because a reduction in interest rates stimulates economic activity. Consumers increase borrowing and consumption, and businesses borrow more to invest in production, making employment figures look more attractive.

However, this stimulation of the economy precipitates inflation. As inflation increases, the economy goes into reverse. Eventually there is a reduction in the money supply, and interest rates increase.

There are no shortage of examples of politics mixing with central banking – to the detriment of both individuals and the economy.

Raghuram Rajan, the former governor of the Reserve Bank of India, was recently squeezed out of his job by politicians belonging to the ruling Bharatiya Janata Party. And in July this year, South Africa’s ruling ANC party proposed that the country’s central bank be nationalised. It is no surprise that the rand fell by about 1.5 per cent, to R13.45 against the dollar, following the news.

But perhaps the most spectacular example of economic mismanagement for political reasons is Venezuela’s central bank, which can only be described as a catastrophe. The weakening economy of Venezuela under the regime of President Nicolas Maduro is forecast by the International Monetary Fund to reach a consumer-price inflation rate of a massive 1,640 per cent by the end of 2017.

This has been in part precipitated by the disastrous management of the central bank by Nelson Merentes, who was recently asked to step down as governor. The impact on the economy includes shortages of food staples such as milk and flour, while leading to medicine shortages, electricity cuts, rising unemployment, and a significant increase in crime.

To prevent inflation spiralling out of control in this way, there has been an increasing global trend in recent years to give monetary policy decisions to independent central banks.

Research shows that countries that do this tend to fare better. In addition to making more measured economic decisions, a country with an independent monetary policy garners more credibility, which in turn earns more confidence from the international community.

This in and of itself helps to maintain the favour of the ratings agencies, investors, and citizens.

If you look at countries where there is governmental meddling in the banking system you will see a high incidence of crippling interest rates: Malawi, Angola, Argentina and Nigeria are good examples.

These serve as cautionary tales to nations tempted to corrupt central banking with politics.

However independent they are, though, central banks will always be accountable to their masters and walk the fine line of holding onto independence, while trying not to invoke the wrath of the institution that can pull the rug – the government.

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