Lawrence White is one of the leading monetary economists in the world, having made notable contributions to the theory and practice of free banking, central bank policy and economic history. In an article written a few years ago, White complains about the United States Federal Reserve System, arguing that the Fed is violating the law and exceeding its statutory authority under the Federal Reserve Act. "Central bankers today are discretionary rulers over the economy’s monetary and financial institutions", writes White. "Defenders of the rule of law, who in general decry the arbitrary rule of men, should specifically decry the rule of central bankers".
For White, the American central bank’s unprecedented bailouts during the Global Financial Crisis should elicit outrage from across the political spectrum. The Fed has more than doubled its balance sheet, invested in assets that could expose taxpayers to large losses and has precipitated a significant increase in the monetary base that may lead to troublesome inflation.
Australians, meanwhile, have looked to their own Reserve Bank with admiration rather than scepticism, and some have even credited it with keeping Australia out of the economic panic that began in 2007. There is a strange indifference surrounding the question of whether the RBA adheres to the rule of law when it does things like fiddle with the cash rate or intervene in asset markets.
Perhaps it is time, however, to ask whether the Reserve Bank – like the Fed – could do better when it comes to acting consistently with the rule of law. Answering this question helps establish a red line in public policy debate; it says to anyone proposing a new idea using fancy economic reasoning that the idea must first pass the basic test of being compatible with the rule of law before being thrust upon Australians.
Discretion in Monetary Policy
In 1873, Walter Bagehot wrote an intriguing book titled Lombard Street that explored the world of finance and banking and provided an eye-opening analysis of how financial crises should be managed. An important part of Bagehot’s contribution is the often quoted ‘Bagehot dictum’, which states that in difficult economic times central banks should come to the rescue of firms facing a liquidity – as opposed to insolvency – crisis; that is, central banks should save those firms that are otherwise solvent but due to short-term factors have been placed in a tenuous position. And it should lend to them at a penalty rate.
Bagehot’s dictum is a rule of thumb that has been ignored by central banks in the modern era. Central banks nowadays make politicised interventions in the marketplace, picking and choosing winners and losers without reference to a preannounced lender-of-last resort policy. It is this unchecked discretion in monetary policy that makes a mockery of the rule of law.
The Reserve Bank began its central banking operations in 1960. Central banking is primarily about influencing the money supply, and consequently influencing the level of inflation and unemployment in the economy. To carry out its objectives, the Bank has a board that exercises discretionary control over short-term interest rates in the overnight money market, i.e. the market for loans between financial intermediaries. This short-term interest rate then affects other interest rates throughout the economy.
Is the RBA acting consistently with the rule of law in targeting the overnight cash rate? If we interpret the rule of law as meaning adherence to a fixed Bagehot-style rule, then most certainly not, since there are few real checks on its meddling. Whereas once central banks operated with reference to a gold standard that constrained their monetary interventions, the age of fiat paper money has significantly enhanced the RBA’s discretionary power to decide how much money to pump into the economy (Bank officials retort that their inflation target of 2-3% limits their discretion, but holding it to account is not as simple as it might initially seem given varying measures of underlying inflation).
A consequence of the absence of a monetary rule has been the creation of uncertainty among private actors. Market participants trying to factor RBA policy into their business plans are faced with a daunting task in the absence of an easily ascertainable method of predicting which way the winds will shift the cash rate any given month. This state of affairs is the essence of the ‘rule of men’, where observers hang on to the words of a group of bureaucrats, and is the antithesis of the ‘rule of law’, where stable guidelines of general application are promulgated.
Yet another unsavoury aspect of the monetary policy business is the opaqueness of the RBA’s discretion. This lack of transparency can be seen in the way that the Bank shies away from the media spotlight, preferring instead to manage the appearances of its officials in carefully scripted testimonies before parliamentary committees. In addition, the agency enjoys significant exemptions from freedom of information legislation, and furthermore, doesn’t actually provide reasons for its decisions in a way that allows the public hold individual board members accountable for their views.
Added to the potent mix of secrecy is the Reserve Bank’s budgetary processes, which are ‘off-the-books’ in the sense that the Bank just prints the money it needs to carry out its functions without needing to seek parliamentary authorisation for its spending. Although legislation does specify that the RBA is to return profits to the Treasury, the process is far removed from other departments or agencies of the state. In these ways, the Bank fails to respect the spirit, if not the letter, of the rule of law.
Independence versus Accountability
Compounding the problem has been the doctrine of ‘central bank independence’ which rose to popularity in the 1990s. The doctrine was, as with many bad ideas, motivated by a seemingly plausible rationale – to remove political considerations from central banking by insulating the technocrats at the RBA so they could carry out their work in the best interests of the community.
But a degree of latitude from intervention by politicians, while a noble objective, has become a code-word for secrecy. The need for free and frank discussion outside of the democratic realm is cited by central bankers as a reason for not releasing transcripts of the open market committee or for keeping hidden agreements with foreign central banks and governments.
In any case, the much vaunted ‘independence’ of the RBA is greatly exaggerated. Appointments to the board, which are made by the Treasurer, have been politicised, undermining the so-called independence of the RBA. It makes sense that Treasurers would take into account more than just merit when making appointments: they are likely to select someone that already agrees with Cabinet’s own policy preferences. A blatant example of this was the appointment of Robert Gerard – a donor to the Liberal Party who had contributed $1 million to its coffers and was a supporter of low interest rates – by Peter Costello.
The board itself is a coalition of vested interests populated with representatives from lobby groups and commercial entities who are heroically asked to set aside their sectional interests and prioritise the ‘public good’. The current board comprises powerbrokers with links to Walmart, Origin Energy and other major firms. Even the only academic member of the board, Professor John Edwards, was formerly employed by HSBC Bank and was an advisor to Prime Minister Paul Keating – a detail that would’ve been looked upon favourably by the Labor government that appointed him.
Politicians don’t like high interest rates before elections, and it seems the RBA has been happy to accommodate their political masters. Ian McFarlane himself admitted that "[the 2001 election] did have some small weight in our decision. If there was a really strong case to do something, we would always do it regardless of the election campaign. But it would have to be a pretty strong case". Since it gained ‘independence’, the Bank has only raised rates once before an election, and that was during the 2007 campaign.
It’s little wonder, then, that between 1991 and 2007 Australia was a high inflation country. Investor Chris Leithner points out that monetary aggregates rose at a rapid rate: M1 increased 404%, at an annualised compound rate of 10.2%. Naturally, this has significantly devalued the purchasing power of the currency in Australians’ pockets and reduced standards of living – and all the while the Bank has continued to keep a lid on information that could be crucial in evaluating its performance.
A way forward
Contrary to the arguments of central bankers all over the world, when markets get more information, this can be expected to reduce uncertainty, bolster confidence and improve economic outcomes. Economic historian Robert Higgs, for instance, has shown how lack of investor knowledge about the government’s expected policy actions delayed recovery during the Great Depression. Similarly, studies have shown that greater transparency is often associated with less inflation variability.
A long-term plan is likely to entail eliminating the RBA altogether and shifting towards a less discretionary system, such as that under free banking, where both parliamentary and central bankers’ discretion is taken out of the equation. Only then can a monetary system truly consistent with the rule of law – one which is the product of voluntary interactions rather than central planning by authorities – come into being.