Why should the central bank be separated (independent) from the government as the authority of fiscal policy? Generally, there are at least two answers.
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By Akhmad Rizal Shidiq
·8 minutes read
DIDIE SRI WIDIYANTO
At the end of August, the House of Representatives (DPR) discussed plans to amend the Bank Indonesia (BI) Law. In it there is a plan to form a kind of board tasked with determining monetary policy and led by the finance minister. The BI governor is one of its members.
This idea is practically 180 degrees opposite to Article 9 of Law No. 23/1999 on BI, which is currently in effect. This article forbids any form of interference by any party, including the government, in the duties of BI in setting and implementing monetary policy. The plan to abolish Article 9 and to form a monetary board can be read as an effort to uproot BI\'s independence as the monetary authority. Revoking BI\'s independence, regardless of who proposed the plan, is not the right step. It could even be said to be a step back in the governance of our macroeconomic policies.
Why should the central bank be separated (independent) from the government as the authority of fiscal policy? Generally, there are at least two answers. First, the independence of the central bank is important, so that monetary policy is credible, in the sense that it can be trusted by economic actors (companies and households, owners of production factors) as the basis for their economic decision-making.
On the other hand, within the framework of Keynesian macroeconomic standards, monetary policy can affect two things: inflation and short-term economic growth.
Monetary policy will only have a positive impact if economic actors react as expected by the central bank -- and this depends on how confident economic actors are that central bank will carry out these policies consistently in the future. On the other hand, within the framework of Keynesian macroeconomic standards, monetary policy can affect two things: inflation and short-term economic growth.
The problem is that they both go in opposite directions -- an economic expansion leads to an increase in the price level, aka inflation. This dilemma raises the problem of time inconsistency (Kydland and Prescott, 1977, and Barro and Gordon, 1983), which erodes the credibility of the monetary policy in the eyes of rational economic actors.
As an illustration, let\'s say that the central bank issued a tight monetary policy in order to cut inflation to stay at 3 percent per year. However, once the economic actors base their production activities on this relatively low 3 percent inflation rate estimate, the central bank has more incentive and room to loosen monetary policy in order to achieve the second objective, stimulating aggregate demand. Realizing this incentive, the economic actors estimate inflation would be above the 3-percent target.
As a result, aggregate demand did not move as much as the central bank had hoped, defeating the original aim of a tight monetary policy to push inflation down to 3 percent. To be credible, the monetary policy incentives to stimulate aggregate demand need to be removed. This is done by making the central bank independent, relieving it from the obligation to affect short-term economic growth and assigning it to focus on monetary policy based on certain long-term macroeconomic benchmarks, such as natural economic growth rates or exchange rate stability on the basis of the real productivity of domestic assets.
Second, BI independence is needed in order to balance the effects of monetary and fiscal policies in the management of macroeconomic stabilization. In conditions where fiscal policy is too dominant, the central bank must always close the output gap that cannot be met through government budget policy by increasing the money supply, which means additional inflationary pressure (Sargent and Wallace, 1981). This theoretical framework of the economy touches on political aspects. Governments, anywhere, tend to favor dominant fiscal policy. Apart from being able to activate the economy in the short term through the multiplier effect of government spending, fiscal expansion policies -- for example additional subsidies, development spending, or tax cuts -- are also very attractive to the government and politicians, because they are popular among the Indonesian public.
That is why, in the political cycle leading up to elections, the pressure to widen the government\'s budget deficit usually increases. However, this populist policy also has the potential to cause inflation. The central bank can adopt a tight money policy to counteract it. However, the tight money policy, apart from cutting off the real effect of the government\'s expansionary fiscal policy, is also unpopular among the common people. Without independence, governments and politicians have enormous incentives and power to pressure the central banks to ignore this important but unpopular inflation control brake. This is why the tenure of governors and board of governors of an independent central bank usually does not follow a political cycle in order to be free from political interference.
BANK INDONESIA UNTUK KOMPAS
Governor of Bank Indonesia Perry Warjiyo in a presentation on the latest economic developments in Jakarta, on Thursday (2/4/2020).
From these two arguments, it is clear that the idea of central bank independence is not just a political agreement, but is based on an economic theory built within a solid and elegant framework of dynamic time consistency; with the aim of macroeconomic stability that is essential for long-term economic growth. The effect of central bank independence is a very active topic of empirical research. In various studies between countries, central bank independence appears to be associated with low inflation rates, financial system stability and relatively little impact on economic output (see, for example, Klomp and de Haan, 2010; Cukierman, 2008; and Alesina and Summer, 1992).
How about Indonesia? The last episode of uncontrolled inflation as a result of sloppy fiscal policy occurred in the 1960s. After that, the Indonesian inflation rate was relatively stable -- except for the brief episode of high inflation in the 1998 crisis as a result of efforts to save the banking system. This is the fruit of the orthodox but pragmatic tradition of fiscal and monetary technocracy (Hill, 2013), in the form of consistency of conservative budget deficit and inflation control policies, even in the period before BI independence was enacted in 1999. The tradition of macroeconomic management which was institutionalized until recently played a major role in driving our long-term economic growth (Temple, 2003; Perkins, 2013).
Crisis mitigation
If so, why did the discourse on revising the law and revoking BI\'s independence suddenly come up? I don\'t know exactly, but I suspect that it came from the intention of the central bank to play a more active role in overcoming the economic crisis caused by the recent pandemic.
This intention is actually natural. Now that the era of high and uncontrolled inflation in the 1970s and 1980s in many countries has ended, the central bank has begun to widen its policy focus beyond controlling inflation and has begun to streamline policies that stimulate aggregate demand and maintain financial system stability, especially when economic growth is low and stagnant or crises hit.
The amount is quite large, Rp 398 trillion or around 44 percent of the total financing for 2020.
For example, the US central bank launched a quantitative easing policy by actively buying financial assets, including government debt securities, as part of the efforts to recover from the 2008 crisis. Indonesia has done the same in the economic crisis caused by Covid-19 this time. It\'s just that, in the so-called "burden-sharing" financing scheme agreed upon by BI and the government, in addition to purchases on the secondary market that are commonly used by central banks to support economic recovery, BI also buys government debt securities directly from the government on the primary market. The amount is quite large, Rp 398 trillion or around 44 percent of the total financing for 2020.
Given the depth of the crisis caused by Covid-19, while the threat of inflation in a crisis situation like now is relatively low; this “burden-sharing” emergency scheme can be accepted, with a number of notes.
However, the content of the BI bill that would uproot BI\'s independence is actually counterproductive to the objectives of this scheme.
First, with this radical form of emergency scheme, the commitment that such policy would only be executed one time (one-off) must be upheld and the timespan must be clear. Economic actors need to be convinced that BI will not continue to distort the financial market to cover the budget deficit. This commitment is only credible if BI is independent. Otherwise, the time inconsistency problem mentioned above will occur, threatening the success of the intended economic recovery program.
Second, the revision of the BI Law based on short-term interests of economic recovery ignores the possibility of a bluntness in monetary policy in the future. The permanent loss of credibility in monetary policy as a result of political interference through amendments to the BI Law for temporary purposes will make it difficult to control inflation policies, which are important in a normal economic cycle. As a result, the idea of uprooting the independence of the central bank (in the midst of a crisis!) is like shooting oneself in the foot of a broken leg. I, frankly, really do not understand what is on the minds of the "panel of experts" that proposed this draft law to abolish BI\'s independence.
ARSIP UNIVERSITAS LEIDEN
Akhmad Rizal Shidiq
Akhmad Rizal Shidiq, Lecturer in Economics at the Leiden Institute for Area Studies, Leiden University
