Independent Central Bank: The Modern Gold Standard 132.0

The Central Bank of the Philippines struggles for independence

An independent central bank is the direct descendant of the gold standard. In fact, it is a very innovative replacement that is fit for our time.

The key word here is “independent.” Independence allows central banks to exercise standard monetary policy focused on the value of the currency.The central bank is thus able to keep the typical politicians’ tendency to overspend through profligate fiscal policy from tanking the economy.

A stable currency minimizes speculation and focuses entrepreneurs’ efforts to be profitable from its real source, business process management and productivity improvement.

Note: This is a rewrite of Post 61, a Significant Post published in May 24, in the newest and latest SYNTHESiST style.

The independent central bank, like the gold standard, is expected to provide an anchor to its currency’s value. A stable currency favors savers, innovators and long-term investors and, thus, is good for the society in the long run.

A Brief History. Before 1935, when the gold standard was in place, a country fixed the value of its paper money against its physical gold reserve. If the politicians overspent, say for unnecessary wars, on inefficiency from corruption, from buying votes in elections or from deficit spending, there will be ultimately more paper money printed per unit of gold. This is a de facto debasement of the currency. Eventually, the ruling politicians will have to re-align the paper money to the physical gold. That devalues the currency.

Currency devaluation contracts the economy and often causes a depression. Extreme devaluation often causes high inflation such that those who suffer most – the poor and the fixed income earning middle class, and often led by the status-rich and educated among them – revolt bloodily or with people power.

Note: People Power events in the Philippines also happened during periods of inflation that hurt the middle class following periods of politicians’ profligacy. This is why many governments resort to populist measures like price controls in vain hope of preventing inflation, and revolt, when their overspending as evidenced by budget deficits catches up with them. All price control does is distort the market or create black markets as shortages start to occur.

In 1935, under Bretton Woods Agreement, the world shifted to the dollar standard with the US$ pegged to its gold reserve. During the ongoing Great Depression after World War I, adjusting their economies and keeping to the gold standard was too hard for the politicians.

On becoming the reserve currency, the Americans had a great deal from seigniorage — like being able to borrow money in US$. With foreign debts in US$, the Americans do not suffer currency risk or higher costs if the US$ devalue. They do have the responsibility to keep the value of the US$ stable for other countries holding US$ assets to lock-in value. In this, they were greatly aided by the size and depth of its financial markets. If foreign countries are able to find alternative investment areas, the USA could lose it seignorage benefits with bad consequences for the country.

Note: In the current, America can lose this benefit of seignorage if other countries lose trust in their ability to keep the value of the US$ stable. A stable currency locks in the value of assets over time.

The stimulus package to revive the economy ravaged by the greed of Wall Street and the weak enforcement of regulation under Republican governments has created huge deficits. If the American loses seignorage, creditors will start to demand that their lending be in currencies other than the US$. In that situation, America becomes like the Philippines and the U.S. Federal Reserve, like the old Central Bank, has the real possibility of becoming bankrupt as it struggles to service debts denominated in currencies other than the US$.

But in just another 30 years, the world’s politicians again managed a great separation between US$ as standard and the underlying gold.

In 1972, President Nixon, still fighting the Vietnam war, finally refused to let the Americans pay for the extravagance of the world’s politicians and delinked the US$ from gold. The rest of the world shifted to floating exchange rates with lots of suffering. Floating rates made countries vulnerable to international forces that led to inflation. The OPEC oil embargo in 1973 created the first oil crisis. The resulting inflation all over the world caused a lot of suffering.

Finally, in the late 1980s, the world devised the innovative concept of an independent central bank. It was supposed to be free from fiscal responsibilities that were the full responsibility of the government. The Reserve Bank of New Zealand was the first bank to formally adopt an inflation target in 1988 (See Post #35), thereby cementing a monetary anchor – the original role of gold.

The Philippines. In spirit, the Philippines is aligned to the rest of the world. In 1992, we created an apparently independent Bangko Sentral ng Pilipinas (BSP) out of the ashes of the old Central Bank. But looking closer on the enabling law, CB Act 7653, BSP’s independence is not real as it is still pretty much under political control.

Only this time, the BSP is clearly under the political power of the President whose inability to balance the budget results into the usual boom-and-bust in the real economy.

This brings us to the story on the Bangko Sentral ng Pilipinas in this series in Post #62.