Central Banks

Economists Say Politicians Can't Resist Inflation

Investor's Business Daily
Date: 11/17/98
Author: Michael Chapman

Central banks are supposed to be independent - immune from political pressures.

But bankers in Asia and Russia aren't acting that way. Recent economic slowdowns have led to one response: inflation.

German politicians are leaning on the ultracautious Bundesbank. In the U.S., the Clinton administration wants a new ''global financial architecture,'' an international New Deal that could possibly include a global central bank.

There are 61 central banks around the world, including the U.S. Federal Reserve. Most haven't been around too long: the Bank of Japan started in 1882; the Fed in 1914; the Bank of South Korea in 1950.

As the Fed's Open Market Committee meets Tuesday, many free-market economists say central banks are getting too political.

The pressure on central banks comes from those who think that inflation can ''stimulate'' an economy and create jobs. They act as if a country can spend its way out of recession by printing more money. But as central banks lose their independence, economists say, they make recessions more likely.

''Central banks and fractional-reserve banking systems have flooded their countries with money and credit,'' said Jeffrey Herbener, an economist at Grove City College in Grove City, Pa. ''The result is a worldwide financial crisis and bust.''

If bankers stopped trying to control the economy, they ''would have prevented the boom and, thus, the crisis and bust,'' he said.

Are central bankers kowtowing to politicians? Consider the following:

Germany's new Social Democratic chancellor, Gerhard Schroeder, wants the Bundesbank to cut interest rates and live up to ''its responsibility for economic growth in Germany.'' Finance Minister Oskar Lafontaine said that the bank's ''monetary policy also has a role to play with growth and employment.''

But since the late '40s, the Bundesbank has always considered price stability its main role.

Lafontaine actually attends Bundesbank policy meetings. This would be the same as letting U.S. Treasury Secretary Robert Rubin sit in on Tuesday's Open Market Committee meeting.

And Lafontaine may replace Bundesbank chief Hans Tietmeyer with Ernst Weltke, a Social Democrat, in '99. This may further compromise the bank's independence.

Italy's prime minister, Massimo D'Alema, insisted in October that the Bundesbank cut rates so that other European central banks could follow suit. The Bundesbank did not, but Italy cut its discount rate to 4% from 5%.

Russia's central bank is printing rubles. Somewhere between 55 billion and 130 billion new rubles will flood that country by year's end. Inflation may hit 200%.

The Bank of Japan has been spreading yen since '92. To prevent a liquidity crunch, the discount rate was cut to 0.25%.

Japan plans to pump about $500 billion of yen into its banks through loans and deposit insurance. Meanwhile, the government ignores broader economic reforms.

Thailand's central bank inflated the baht faster than the Fed inflated the dollar leading up to July '97, when the baht was devalued. Thai banks then gave loans to riskier projects and created a real-estate bubble that burst. As a result, the International Monetary Fund has lent Thailand $18 billion.

The IMF says 11 countries are now in recession and nine others are close. The IMF has taken nearly $160 billion from taxpayers, mostly in developed countries, to artificially boost slumping economies in East Asia, Russia and South America.

Treasury Secretary Rubin is working with the IMF on a $30 billion deal for Brazil.

And the Fed forced a $3.6 billion rescue of the hedge fund Long-Term Capital Management. Fed central bankers essentially decided that the private fund was too big to fail.

Mutual fund tycoon George Soros took a $2 billion bath in the Russian market.

He says capitalism is ''inherently'' unstable and wants politicians to build a global central bank and an international FDIC to control the world economy.

President Clinton and Secretary Rubin apparently agree.

Still, inflation has fans.

Hans Sennholz, professor emeritus of economics at Grove City College, said, ''Wall Street loves it - the boom'' that initially happens when goods get cheaper because of easy money. But a bust eventually occurs.

The only way a country can end a recession is by cutting taxes and spending, Sennholz says. But politicians don't want to surrender control.

''Governments will do everything in their power to make things worse,'' he said.

Even free-market economists split over central banks.

Some argue they're no more than tools of politicians and can't be reformed. Others say the banks can work well and are needed to give investors confidence.

Central banks often promote reckless lending, says Jim Walker, chief economist for global emerging markets at Credit Lyonnais Securities Asia.

Political failure rather than market failure is ''at the root of today's financial market turmoil,'' he said. ''The decade-long growth boom that preceded the '97 crisis was the result of easy money and bad policies.''

Herbener agrees. He says government must stop controlling the money supply and let the market set the price of credit - just as it sets the price of most products and services.

But Carnegie Mellon University economics Professor Allan Meltzer says central banks can work - as long as they stay out of politics.

He says Asia's central banks got in trouble when they tied their exchange rates to the dollar. As long as the dollar depreciated against the yen, Meltzer says, this policy worked well.

''This kept prices low in Japan,'' he said.

But from '95 on, the dollar strengthened. The central banks should have changed their policies but didn't, Meltzer says.

''So they had to run bigger surpluses to keep their prices in line, and this was a big failure,'' he said.

''In Indonesia, it's a real catastrophe,'' said monetary analyst Kurt Schuler. ''The central banks turned an economic slowdown into a depression. Their policies caused reckless lending. Russia is the same way.''

The fault of the central banks in Asia is ''huge,'' said Larry Kudlow, chief economist at American Skandia.

''They're the greatest villains,'' he said. ''They've increased their money supply in the aggregate by 20% to 25% in '96 and '97. That's too high.''

Thanks to central bankers, the currencies of Thailand, Malaysia, Indonesia, South Korea and Russia depreciated the most, Kudlow says. Singapore and Taiwan showed some self-restraint.

Kudlow praises the Fed, however, noting that the central banks in the U.S. and Europe work better than those in Asia.

Judy Shelton, a professor of international finance at the DUXX Graduate School of Business Leadership in Monterrey, Mexico, blames the world monetary system, not central banks.

The system is ''completely broken down,'' Shelton said. Experiments with fixed, pegged, floating or mixed exchange rates haven't worked.

In Asia, central banks show more integrity than the governments and finance ministers, she says. Russia is the exception. It's pumping out ''paper trash.''

Monetary stability ended in '71, when the U.S. went off the mixed gold standard, Shelton says.

She supports a neo- gold standard. In September, Fed Chairman Alan Greenspan suggested such a system might work again.

''Keynesianism on a global scale,'' as pushed by Clinton and Rubin, proves ''they're drawing the wrong lesson,'' Shelton said. ''They think government is smarter than the market. They're wrong. Look around.''

A global central bank would be a big mistake, University of Georgia economist and banking expert George Selgin said.

''It assumes (central banks) can solve the world's problems - a faulty assumption,'' he said. ''Thomas Jefferson opposed a national bank, which is a monopoly.''

Sennholz considers a global New Deal ''baloney.'' It's ''political insanity - the idea that the U.S. can police the world,'' he said.

''Central banking is central planning,'' said Burt Ely, president of the financial consulting firm Ely & Co. ''It's a tool of the government. Central bank independence is a farce in developing countries,'' he said.

Meltzer agrees. In developing countries, most central banks ''aren't really independent of government,'' and ''in many of these countries, they do more harm than good,'' he said.

Russia's central bank is indistinguishable from the government, he says.

But central banks are needed in advanced countries to control the bulk of prices, Meltzer says.

''The Fed is fairly independent, but less so than the German Bundesbank,'' he said.

That may change in the new Germany.