This he did at the age of 39 years which, by any standard, is too young an age to hold that prestigious and demanding post. The wisdom he enunciated in bringing the theory of central banking into practice in an emerging nation was quite admirable, if not enviable.
He made himself a one man committee, having been released from the Federal Reserve Bank of New York at the request of the Government of Ceylon, on the establishment of a reserve bank for Ceylon supported by a few local experts.
While the contributions made by the local experts would have been helpful, the Report he submitted to the Government was, by and large, the product of John Exter’s wisdom. Hence, the report is popularly known to date as the Exter Report. The report consists of two parts: the first on the rationale of establishing a central bank in Ceylon and the second on the complete legislation relating to the bank with fine commentaries on each section of the law.
Hence, Exter Report has served as the bible for many generations of central bankers to understand the unambiguous meaning of each section of the legislation titled Monetary Law Act.
He could not return to USA after submitting his report, because the Government of Ceylon had other plans for him. The Government, having considered the need for a competent professional to oversee the formation of the fledgling Central Bank, invited him to serve as its founding Governor. It is reported that he accepted this invitation on condition that he be relieved of duty after three years. True to his words, he resigned from the post in 1953 to pave way for a Sri Lankan to assume that top position in the Central Bank.
He returned to USA in 1953, but did not join the Federal Reserve System again. Instead, he joined the World Bank and was placed as its Division Chief for the Middle East. He was a risk taker and did not remain in one place for long. Accordingly, he served the World Bank only for one year. In 1954, he rejoined the Federal Reserve Bank of New York as its Vice President in charge of International Operations. Thereat too, his career ended abruptly in 1959 when he left the Federal Reserve Bank to join First National City Bank which later became Citibank.
He became the Senior Vice President of the Citibank and looked after its relations with foreign central banks and governments. This job gave him a wonderful opportunity to witness how various governments and central banks conducted themselves irresponsibly threatening the stability of the respective macroeconomies and their currencies. His remark about US Fed to his one time Harvard Colleague Paul Samuelson in early 1960s testifies to this: “The Fed is printing too many dollars and they flow out of the country into foreign central banks who demand gold”.
When Samuelson tried to attribute Dollar’s woes to productivity differences between USA and Japan, Exter had a similar short reply: “The Bank of Japan was running its printing press even faster than the rest of the world”. So, he predicted that dollar would fall pretty soon (and Japanese yen as well) and US would not be able to maintain the official price of gold against the increase in gold prices in the open market. He then transferred all his assets to gold and waited patiently. His strategy paid him a handsome bonus in 1971 when the US Government decided to sever the official Dollar-Gold link and allow gold prices to be determined in the market. Having made a huge fortune on the gold market in this manner, he retired prematurely from formal employment in 1972 and went into private consulting. This was his occupation until he died in 2006 at the age of 95.
John Exter was a free thinker. He never hesitated to raise his voice against what he believed to be imprudent. He was a severe critic of irresponsible central banking, albeit he was one time a central bank governor. In a speech he made in 1987 , he criticised the Fed printing hundreds of billions of dollars and stimulating the banking system it oversees to create many hundreds of billions of dollars more. In a paper he presented in November, 1988 , he compared the Fed’s running its printing presses at higher and higher speeds to a far worse economic disaster than that was experienced in the thirties. “Since money runs like water” he announced. “…market forces every minute of everyday try to restore equilibrium, while central banks worldwide, especially our own Fed, intervene every minute of everyday to prevent it. So, uncertainty abounds.
Markets do not like uncertainty”. He then said that eventually markets would win, but by that time, confidence would have eroded. He also advised that anyone who bets on the side of the market and not on the side of authorities would also win. His prescription was simple: “The safest and most liquid asset will be gold. It will be by far the biggest run out of paper money into gold in history”. His pre-occupation with gold was in fact to a fault. His famous inverted pyramid with gold as the base was a sure way to prevent the financial systems based on paper certificates from collapsing on themselves and becoming a burden to authorities who would be called upon to rescue them at the expense of monetary and price stability.
The Central Bank of Sri Lanka is eternally grateful to John Exter for the firm foundation he laid for the Central Bank, enunciating its philosophical rationale succinctly and clearly and converting the Bank from a mere piece of legislation to a ground reality. This gratitude was demonstrated by the Bank by naming its International Conference Hall after John Exter in 2007 and redesignating its Anniversary Public Lecture as John Exter Memorial Oration. I am deeply honoured by being invited by the Bank to deliver the first John Exter Memorial Oration.
The way central banks conduct their affairs has changed significantly since the time of John Exter. Yet, the basic core principles governing central banks have remained unchanged over those 60 years . His principles of central banking are equally valid and relevant to current day central banking as well. His knowledge on central banking, global economy and domestic economic conditions was so profound that he could talk on any subject on central banking. Hence, if Exter had been alive today, he would have definitely talked with authority on the current issues faced by central bankers. In order to honour him, I have selected an appropriate topic for my oration. That is how central bankers should face challenges in an era of economic and financial turbulence.
I may have to confess at this stage that the life of a central banker is never a cosy one. To an outsider, it may look like prestigious, highly remunerative and enviable. However, inside central banks, the story is different. The truth is that central banks always have to go through turbulent periods of one type or another. Depending on the degree of turbulence faced by a central bank, the life of a central banker too become miserable to a greater or a lesser degree. The turbulence may come from external sources completely outside the bank’s control. It may come from within the domestic economy, sometimes due to factors for which the bank is not responsible.
It may also happen due to follies which a central bank may have committed in the past . Whatever the source and the degree, the central bankers have to find solutions to take the economy away from turbulence and it should also be done quickly. In this context, the prescriptions made by central bankers are not easily palatable to the community. A central banker, as a prescription, may say something which the people would not like to hear or do something which people do not want it to do . They may present a gloomy and pessimistic picture of an emerging situation. They may warn of greater dangers lying ahead for the society. The end result of all these unsavoury pronouncements is that the central bankers becoming the most hated species in the universe.
What this means is that a good central banker can never be a popular central banker. By the same token, the reverse is also true. That is, a popular central banker can never be a good central banker. Hence, central bankers should pursue their policies firmly and consistently without fear or favour. If a central banker is attacked more and more by people rationally or irrationally, it is a sure sign of his having performed his duty without fear or favour. But, these attacks on central bankers could sometimes get into personal levels and would be embarrassing.
Such attacks would also affect the reputation and the credibility of central banks. Hence, while recognising the right of individuals to criticise the central bank action and tolerating such criticisms as a necessary part of a growing free society, central bankers should endeavour to clarify the rationale of their action to the members of the community. Such clarifications will help people to understand and appreciate why a central bank has taken or not taken a particular policy action. It will also give an opportunity for a central bank to weed out misunderstandings which people may have been harbouring in them about its policies.
Let me now turn to some leading episodes of turbulence that central bankers in emerging economies are experiencing in the current period.
• Inflationary pressures arising from global commodity price increases, namely, the price of crude oil and prices of major food items.
• Counter-terrorism related financing that threatens domestic price stability.
• Growth spurring central bank-financed development funding that aggravates the demand pressures and negates inflation fighting policy measures.
Let’s analyse each one of these cases and appraise how central bankers should take the challenge to overcome them.
How to tame inflation
The world, with the exception of a few developing countries, had experienced relative price stability and hence, low inflation in 1990s. This period spurred faster growth in developed countries leading to a trickling down of the benefit of higher growth to the developing world by way of higher exports and resultant economic expansion. The relative price stability prompted many countries, as feared by John Exter, to loosen their grip on inflation and relax monetary policy as a way to promote growth further and seek full employment. This led to overheat the domestic economies causing inflation to raise its ugly head.
Inflation Caused by Negative External Shocks
While the domestic economies had been plagued by inflation that had originated from domestic sources, two external shocks were delivered to the entire world in the form of rising fuel and food prices. This in fact exacerbated the already overheated domestic economies requiring quick adjustment measures. The initial reaction of many governments to the two shocks was to temporarily absorb the cost by not adjusting the local prices in terms of increased foreign prices.
The rationale of this non-action was the widespread belief that price increases were temporary and government’s action would harm the private sector initiatives. Hence, many countries in the world resorted to non-action as a policy for the sudden upsurge of the fuel and food prices.
However, the reality was somewhat different. The increases in fuel prices continued to loom over the globe making it a permanent feature of the global economy. Hence, the non-action was a bad decision on two counts. First, it prevented the consumers from economising on the use of fossil fuel, because they did not have to pay the higher price as required by the rising world market prices. Hence, it delayed the much needed adjustment in the demand for fossil fuel worsening the market shortage, given the constrained supply conditions.
The result was the continued increase in the energy prices in the world markets, making the subsidisation no longer affordable. Second, when the governments were driven to the wall because they could no longer bear the cost of the subsidy, the adjustment needed became somewhat large. If the subsidy had been met by curtailing the expenditure elsewhere in the budget, most notably by curtailing the capital expenditure programmes, it would have adversely affected the long term growth prospects. If, on the other hand, the subsidy had been met by borrowing from the banking system, the resultant monetary expansion would have threatened the future price stability. This in fact drove all governments to a dilemma.
What would be the challenges faced by a central bank in such a situation? The money supply increases arising from the monetisation of the subsidy would definitely threaten the future price stability. If it does not further tighten the monetary policy, the ensuing inflation would become uncontrollable. But tightening monetary policy would mean lower credit growth and high interest rates. As a result, tighter monetary policy would mean lower economic growth and higher unemployment, a necessary sacrifice which a country has to make to enjoy long-term price stability.
However, lower growth would further erode the living conditions of people who had already been hit by higher market prices. Since governments are bent on continuing with providing relief to masses, a central bank could not expect to seek support from the government either. The chances are that central bank’s proposals for appropriate price adjustments could be vetoed by the governments .
The challenge faced by central bankers amidst hostile self-interest promoting groups and individuals is very clear. That is to take monetary policy action to fight long term inflation, while properly managing counter groups. In order to check the monetary growth arising from the monetisation of subsidies, it is necessary that the governments adjust the domestic prices to reflect international prices. It should be done as and when the requirement arises covering the full amount.
If the adjustment of prices is either too late or too short, then, the partial policy action would dilute the central banks’ policy measures to restore both price stability and monetary stability. Hence, it is of utmost importance to persuade the governments to go for full adjustment of prices. This requires excellent communication and negotiation skills on the part of central bankers.
Since inflation is costly for governments at elections, they too have a beneficial interest in taming inflation. Hence, one may tend to believe that persuading a government to make the full adjustment of prices to check long term inflation is an easy task. But, this does not happen so easily. The full adjustment of fuel prices, as required by high international prices, is beyond the control of central banks. It should be done by governments and, for governments to do so, they should be convinced of its long term benefits.
It may require senior central bankers to appear before cabinets of ministers or sub-committees of cabinets several times and argue their case for a full price adjustment cogently and convincingly. At the beginning when there is no positive response from authorities, the experience may be frustrating and discouraging. However, it is not proper for central bankers to give up hope so easily. For the sake of future price stability, the attempt made by central bankers should be persistently pursued until the desired final results are attained.
Once the domestic consumer prices are fully adjusted, the domestic prices would automatically elevate to higher levels in several rounds such as the upward adjustment of transport costs and the consequential secondary price adjustment of goods that require transportation. A central bank may be criticised at this stage for inflating the economy and raising the cost of living of people. Central banks’ communication policies come in handy at this stage.
Many central banks fail to inform the public that the price increases that were effected were for the purpose of killing future inflation, though there would be short term price increases raising the cost of living of people temporarily. For the benefit of long term price stability, it is necessary to undergo short term hardships. How far the public would accept central banks’ version would depend on the effectiveness of their communication policies.
In addition to the market adjustment of fuel prices, should a central bank continue with tight monetary policy when a country has been hit by a severe external shock? Or in the alternative, should a central bank not relax monetary policy to permit the economy to get into a higher growth path? The answer to these two questions is that the central banks cannot and should not play with monetary policy, though there could be compelling demands to act to the contrary. The external shock in the form of higher fuel prices raise the overall costs in the economy. Higher costs make production uncompetitive and cause the economy to move to a lower output level.
The resultant economic recession and high unemployment would increase the welfare costs to a significant level. But, the way out for an economy in such a situation is not through monetary policy, but through real adjustments such as improvement in productivity and moving into less energy intensive production methods. This real adjustment, though somewhat painful and difficult, has to be made by an economy in its own long term interest. The developed countries which were very badly hit by the first oil price shock in early 1970s got out of the problem without causing long term inflation through improved productivity and alternative use of energy.
What would happen if central banks relax monetary policy when a country is hit by a negative output shock arising from an increase in fuel prices? First of all, it causes the economy to postpone the required real adjustment, because the monetary policy incentive acts as a temporary veil placing businesses in a false sense of complacency. The more disastrous outcomes yet to happen in the future as a result of low productivity and high costs would be temporarily hidden from the vision of all. As a result, the long term sustainability of economies concerned would be at stake.
Second, the relaxed monetary policy would cause to build inflationary pressures by increasing the nominal aggregate demand over and above the already constrained aggregate output. Consequently, the long term inflation that is set in the economy would worsen the position of businesses by raising the other costs as well. Hence, monetary incentives are not the solution to negative real shocks in an economy. As already mentioned, businesses should absorb higher costs through improved productivity, adopt energy saving production techniques and concentrate more on research and development to gain capacity to face such future external shocks.
Economic Overheating Due to Terrorism Fighting Expenditure
There are many emerging economies that have been faced with protracted terrorism problems . The costs to be incurred by these countries in terms of human lives, destruction of property and setback to economic activities have been enormous and totally wasteful. In certain countries, total anarchy and warlordism have completely displaced law and order and the writ of the democratically elected governments. In consequence, governments have to fight terrorism and fighting terrorism requires the use of real resources.
For governments which are already constrained by shortage of resources, allocating resources for fighting terrorism means foregoing some other useful activity for which such resources could have been utilised. In order to raise the required resources, many governments have resorted to taxation, borrowing or simply inflating the economy by issuing currency.
When a country’s sovereignty has been compromised, the government of that country has no choice but to use all its resources to eliminate terrorism and re-establish its writ. The failure to restore law and order as quickly as possible would result in causing severe economic, social and human costs which could not be continued to be borne by any society. Longer the time taken to bring about a peaceful environment in which every citizen could pursue his career, profession or business without the fear of losing his property or life, greater the human misery that reduces the overall welfare level of the society.
Since the ultimate objective of any society is to raise the happiness of its citizens, terrorist activities are the destroyers of human happiness and contentedness. Hence, from the point of view of the society, the real resources utilised for fighting such terrorist activities are fully justified.
Economists have no dispute over this thesis. The purpose of economics is to find ways and means of raising welfare of people in a society. Therefore, any element that causes a reduction in welfare is considered by economists as a bad . To eliminate bads, such as environmental pollution, societies have to use real resources. Economists use the marginal rule to determine the optimal use of resources for eliminating bads from the society.
According to this rule, the society’s welfare level becomes optimal, when the social benefit of eliminating the bad is greater or equal to the social cost of eliminating the bad. In other words, the real resources used for fighting terrorism would bring maximum welfare to a society, if the additional real resource cost would bring at least an equivalent social benefit. Terrorism is also a bad, since the exposure to one more incident of terrorism reduces the total utility of citizens. Hence, the most preferred level of exposure to terrorism by any citizen is the zero level. Consequently, the optimal use of real resources to fight terrorism too is subject to this celebrated marginal rule.
The question before us is how a central banker should respond to this general desire of the society. The only weapon which a central banker has is the ability to create credit and, through such credit, acquire real resources from the society. Terrorism is fought by using real resources. Hence, can’t a central bank marshal real resources for a government to fight terrorism? Technically, a central bank could do so. Economists call this imposing an inflation tax on the economy, because it involves inflating the economy by printing money and forcing the private individuals and businesses to part with their real resources for use by the government.
As long as individuals and businesses are willing to accept the money printed by a central bank in exchange of the real resources held by them, the power of a central bank could be used for this purpose. But, like any other natural phenomenon, inflation tax too has its own limit of channelling resources from the private sector. That limit is the level of inflation at which private individuals and businesses are willing to accept the money printed by a central bank for exchanging their real resources. Normally, at high inflation levels, public refuses to accept central bank’s money and at that level, inflation tax becomes impotent .
Financing government expenditure by using inflation tax is what Exter disliked most. He was a scathing critic of Fed running its printing press and debasing the value of dollar. Having warned the others of the impending danger lying ahead, Exter used his expert knowledge to convert all his dollar assets to gold. He also advised others that “the best asset of all, whether in inflation or deflation, will be gold at the base of the pyramid. Accumulate what you can of it, either above ground, like coins or bullion, or in the ground, like unhedged mining shares”
Even in the Exter Report, he argued that deficit financing or a cheap money policy would simply lead to higher consumption through increased imports leading to balance of payments problems. He said that such policies would not be efficacious in developing countries which are heavily dependent on foreign trade. He had a final warning for those who advocated deficit financing uncritically for developing countries .
Though societies should fight terrorism with real resources mobilised from the society, it is not advisable to use central bank’s nominal resources to fight such wars. This is because when inflation raises its ugly head, it is also like a terrorist who has no mercy on anyone who fails to index his income with inflation. Irrespective of the age, sex, wealth, creed or race, inflation impoverishes everyone.
A terrorist exerts fear in the minds of people. In the same manner, inflation too exerts fear, helplessness, destitution and hopelessness in people. That is why during normal times, inflation is regarded as the public enemy number one .
So, a central bank’s best support for fighting terrorism by a government is to maintain price stability and help the society to create more wealth. When one type of a terrorist is eliminated, central banks should not bring in another type of a terrorist who is in fact fiercer than the eliminated terrorist in peaceful times. The elimination of terrorism creates a peaceful environment for people to pursue their life objectives, participate in democratic processes, enrich cultural activities and enjoy a higher well-being.
Similarly, the elimination of inflation creates an environment conducive for people to take a medium to long term view and create more wealth which is a sine qua non for attaining the former list of goals. Hence, the elimination of both terrorists, actual terrorism and inflation, should be done by any society. Central banks could help the society to attain these twin goals by keeping monetary policy tight and creating an inflation-free-world. This is one of the most formidable challenges presently being faced by central bankers throughout the globe.
Economic Growth and Inflation
Many central banks have, in the laws establishing them, employment as one of the important goals. The entry of employment objective into the law books of central banks is due to the belief that unanticipated inflation can influence output and employment. Since unanticipated monetary growth brings about unanticipated inflation, the argument boils down to the belief that unanticipated monetary growth generates output and employment. In other words, if central banks could surprise people by raising money supply when they had not anticipated it at all, there could be real gains that would cause the economy to expand .
The employment objective that has been assigned to many central banks is, in fact, in conflict with their price stability objective. When a central bank expands money supply in order to spur economic growth, it causes the aggregate demand to expand but due to rigidities in aggregate supply, it creates only an excess demand for goods and services.
The excess demand so created would push the price levels up. Hence, in the long run, there is no any change in output or employment, but only the price level. This is why Milton Friedman repeatedly announced that “inflation is always and everywhere a monetary phenomenon”. He maintained this position in all his writings .
John Exter too maintained a similar position. In all his writings and public interviews, he warned of the faster running printing presses at the Fed. He in fact went one step further and argued that paper money without the backing of a commodity like gold would mean nothing because of the excess production of money by the Fed.
His prognosis was that people who have lost confidence in paper money would convert all their assets into gold. “It would be by far the biggest run out of paper money into gold money in history. I cannot say when, but it is now months, not years away” . Though the time frame he has given has not materialised, the excess production of dollars by the US Federal Reserve System in the last half a century has led to the fall of the dollar in the international markets against other currencies prompting foreign central bankers and investors to convert dollar assets into assets denominated in other currencies.
Central bankers should not be tempted to using monetary policy for creating employment and output, because such nominal weapons like monetary policy cannot bring about real outcomes. This wisdom has been displayed by the old guards in Singapore who refused to believe that money can create wealth. As Goh Keng Swee, the economist behind Singapore’s economic miracle, put it later, “the way to a better life was through had work, first in schools, then in universities or polytechnics and then on the job in the work place. Diligence, education and skills will create wealth, not Central Bank credit” .
So, the biggest challenge faced by central bankers is to first convince themselves that it is hard work that creates wealth, output and employment and not money. And then, convincing all others who have illogically kept high hopes about central banks that they should use monetary policy to spur economic growth. John Exter, in the first interview he gave as the Governor of the newly established Central Bank of Ceylon, warned “…There is no financial wizardry by which the Bank can suddenly pull out of a hat a higher standard of living for everybody.
The Bank’s contribution must necessarily be a long-run contribution. The Bank does not itself produce goods and services, but it should, by creating the right monetary conditions, enable the country…” to do so . Understanding and acting upon this piece of advice is in fact a challenging task for central bankers today.
CONCLUSIONS
The lives of central bankers are not very cosy as many would have liked to believe. They have an obligation by the society to maintain price stability and create an environment conducive for people to work hard, invest more and produce more.
In the accomplishment of this duty by the society, they will have to function consistently and firmly, without fear or favour. They very often become unpopular, because they speak what members of public least expect them to speak. This becomes much more important when economies go through episodes of turbulence.
When an economy is hit by a negative external shock, the real requirement is an adjustment to the new situation through improvement in productivity and the adoption of new techniques to economise on the use of resources. These real problems should not be tried to be resolved by using nominal weapons like central banks’ cheap money.
The effect of such a strategy would be to generate permanent inflation in the economy leading to an increase in all the costs faced by businesses. Such a situation would force businesses to adopt strategies to fight inflation rather than raise productivity. If, on the other hand, an inflation free world is created, the environment would be conducive for fostering innovations and growth. Hence, real problems have to be resolved by using real weapons and not through nominal weapons which cannot influence real matters on a permanent basis.
W A Wijewardene is deputy governor of the Central Bank of Sri Lanka in charge of monetary policy with 36 years of central banking experience. This is the prepared text of the John Exter Memorial Oration 2008.
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