The Evolving Role of Central Banks

INTERNATIONAL MONETARY FUND

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1991
• ISBN:
  9781557751850

NONE

Part I Role and Functions of Central Banks

1 Government Financing, Domestic Debt Management, and Monetary Policy: Some Lessons from the Italian Experience

CESARE CARANZA*

The relationships and potential conflicts between monetary and fiscal policies have been widely debated in the economic literature. A number of important contributions to this debate appeared during the 1970s and the 1980s in the wake of the tidal wave of fiscal deficits in some major industrial countries and the successive efforts for fiscal consolidation. As always, the facts of life set the tune for economic research.

The economic consequences of high and persisting public deficits have been extensively analyzed. It is well known that monetary accommodation of fiscal deficits may fuel inflation, maintain excessively low real interest rates, and, in the end, distort the allocation of resources. On the other side, the attrition between a lax fiscal policy and a restrictive monetary policy may crowd out private investment and, in the extreme case of noncooperative solutions à la Sargent-Wallace, to an unsustainable situation of ballooning public debt fueled by the growth of interest payments.

But I do not want to lecture about the economic theory of government deficits. As a former central banker, I rather want to analyze the impact of government deficits on monetary policy learning, from the practical experience of my own country. Italy makes an interesting case for study because of the potential for conflict between fiscal and monetary policy. With a public debt that roughly equals gross domestic product (GDP) and a fiscal deficit of about 11 percent of GDP, the conflict is a fact of life.

I shall begin with some basic facts and figures that are essential for understanding the Italian experience. Then I shall describe the policy response of the monetary authorities, the strategy they followed to finance these growing fiscal deficits while maintaining a reasonably sound monetary policy. Third, I shall review the results of these policies and the problems still unsolved. Finally, I shall sketch the prospects for the future.

Public Debt in the 1970s and 1980s

We begin, then, with the facts and some figures. During the last two decades, Italy has experienced high and continuous public sector deficits and a ballooning public debt. At the same time, it has had a restrictive monetary policy aimed at maintaining the exchange rate of the lira within the European Monetary System (EMS) band. Although the lira has been devalued from time to time with respect to the deutsche mark, those changes did not compensate for the inflation differential with our major trading partners in Europe. In effect, Italy maintained a relatively strong exchange rate policy to reduce inflation to the level prevailing in our major European trading partners.

This objective of reducing inflation has been largely achieved. Consumer inflation peaked in 1980 at 21 percent. From that extremely high level at the beginning of the decade, it has declined over the last three years to an average of between 5 percent and 6 percent. At the same time, real growth improved. In the first half of the 1980s, GDP grew at an annual average of slightly less than 2 percent; in the second half of the decade, it grew at slightly more than 3 percent. More important, the productive sector of the economy recovered during the 1980s from the dark years of the 1970s. Private enterprises regained productive efficiency, competitiveness, and financial strength.

Meanwhile, the status of public finances deteriorated sharply. A few numbers will convey the basic scenario. The public sector borrowing requirement averaged 13 percent during the 1980s. From 14 percent in 1983, it decreased to the present level of about 11 percent. For 1991, the Government is aiming to reduce the deficit to about 9 percent, but that goal may prove elusive. As a consequence of these continuing high fiscal deficits, the stock of public debt grew rapidly. In 1990, it will roughly equal GDP, compared with about 50 percent at the beginning of 1980. Interest payments on public debt grew from 5 percent of GDP in 1980 to 9.5 percent in 1990. Primary deficits (that is, net of interest payments) climbed to 6.5 percent of GDP in 1983, then decreased gradually to 1 percent in 1990. Actually, the primary deficit, which is a key element in the story, has been cut. Yet, this improvement has been too slow and half-hearted to break the vicious circle of high deficits, higher debt, higher interest rates, and still higher deficits. That, in brief, is the scenario of the 1980s: a dramatically improving private sector; satisfactory real growth; a sharp reduction of inflation; but a heavier burden of public debt, with only partial improvement in the reduction of primary deficit.

The Two-Sided Coin of Monetary Policy

By what strategy have the monetary authorities tried to reconcile the financing of high deficits with an acceptable monetary discipline? The monetary authorities, and the central bank in particular, did not implement just a quantitative monetary policy, aimed at control of the monetary base, they tried to implement a structural or “qualitative” monetary policy, one that would develop the financial structure of the country in order to cope with the huge demand for funds from the public sector, while also modernizing the instruments of monetary control. They sought, of course, to keep the creation of the money base under control. At the same time, they sought to change the rules of the game for the financial sector. They tried to deepen and broaden the financial markets, to channel savings, and household savings in particular, into public securities.

A positive peculiarity of the Italian situation is the high saving propensity of the household. It is important to assess those high fiscal deficits of 11 percent or 12 percent of GDP against the high saving in the household sector, saving of between 20 percent and 21 percent of GDP. If a channel can be activated to transfer a major part of this saving into funding of the public debt, money creation can be reduced and kept under control.

In pursuit of more depth and breadth in the markets, the authorities introduced an enormous amount of financial innovation. They floated new kinds of securities: financially indexed securities and, short-term and medium-term securities. Many new instruments appeared in the financial markets, as well as new intermediaries. Some years ago, I wrote an article reviewing this process of financial innovation in Italy, which I called a lopsided process. It was lopsided because the public sector was the major, and almost the only, innovator. The reason was simply because its appetite for funds was so huge that it had to find new sources of funds.

So, this broadening of the markets, to channel more private saving into public debt, was the first major element of the monetary strategy. The central bank, in particular, also tried to improve instruments of monetary control, to regain some maneuvering room for interest rate policy. One of the more significant developments in this direction was the so-called divorce in 1981 between the treasury and the Bank of Italy, whereby the central bank discontinued the commitment to act as the residual buyer of treasury bills at auctions of public securities. This divorce, which strengthened the role of the central bank in setting short-term interest rates, wrought a crucial change in the conduct of monetary policy in Italy.

These were the broad directions of policy; now we come to the results. The effort to channel private saving into public debt was a major success. The distribution of public securities in the economy changed dramatically. In the late 1970s, only about 20 percent of public securities in circulation was held in private sector portfolios; by the late 1980s, it had increased to more than 70 percent.

Of course, concomitant with the increase in private sector holdings was an equally dramatic decrease in the share of public securities held by commercial banks and the central bank. This redistribution meant less creation of base money and broad money. And in fact, money creation decelerated throughout the decade. In 1984, the Bank of Italy began to announce money targets, such as growth targets for M2 and for credit to the private sector. Although the credit target usually overshot, the M2 money target was almost always hit. The predominant tool for controlling money growth was interest rate policy, as permanent credit ceilings on bank loans were removed in 1983.

Real interest rates had, for the most part, been negative in the late 1970s. After the credit and monetary crunch at the beginning of the 1980s, real interest rates jumped to relatively high positive levels. Over the remainder of the decade, real rates remained high, although they showed a slight declining trend from the early highs. This was the precondition for marketing such a huge amount of public debt to the private sector. Even today, real interest rates in Italy remain a bit higher than in other major industrial countries. The differential, by the way, explains the huge inflows of capital into Italy during the more recent years. These relatively high real interest rates notwithstanding, Italy continued to enjoy a good performance of private investment.

Last, but not least, among the major results of the strategy has been the gradual liberalization of foreign exchange controls. We took the final step just this year, 1990. Since last May, capital controls have been completely removed, even on short-term capital movements. This liberalization is a crucial element of the story; from now on, our financial markets will not be protected from external competition by artificial barriers.

The increasing financial openness of the Italian economy has thus far brought huge capital inflows. The reason, simply enough, is the higher real interest rate, relative to other countries, combined with the prevailing expectation of exchange rate stability. For foreign investors, Italian financial markets provide good buys. Bonds, treasury bills, and treasury certificates, all with relatively high yields, are plentiful.

The results summarized above represent the positive aspects of the Italian situation. But the coin has a tarnished side. Of the two problems I want to discuss, one is more technical, the other is more general. The technical point concerns the implications of the shortened average maturity of Italy’s public debt. To market that enormous amount of debt to the private sector during a period of high and variable inflation rates, the treasury had to accept a major shortening of maturities. This occurred not only as a direct shortening, by which I mean an increasing amount of treasury bills, for instance, but also as an indirect shortening. The treasury issued large quantities of socalled treasury certificates with maturities of between 4 and 7 years. Their yield is linked, however, to short-term rates, to the treasury bill rate; so the interest payments on them reflect the movement of short-term rates.

Today the average maturity on public debt is about 2.5 years. That is not drastically short, although it is much shorter than the average maturity some years ago. Still, a shorter average maturity of the public debt creates special pressures on monetary policy. At the same level of debt and of annual deficit, a shorter average maturity means that the debt stock must be recycled more frequently. The yearly gross issues of public securities in Italy reach 50 percent of GDP, against 10 percent in France, 5 percent in the United Kingdom, and 3 percent in Germany. Each month, Italy’s public issues equal 4–5 percent of GDP—ten times the average stock of bank reserves. This high rate of turnover is a major threat to monetary policy. If a treasury bill auction is not completed satisfactorily, a serious problem of monetary control ensues. If not enough bills or bonds are sold in a month, bank reserves may get out of control. So refinancing of the debt becomes a continual and delicate game.

For the economy as a whole, the situation represents a high degree of financial fragility. The system is acutely exposed to external shocks from abroad and from changing expectations in domestic markets. This is one cost Italy has paid and will continue to pay for such a delicate equilibrium, which so far has been maintained but remains a cost and a threat for the future.

Now, to the second and more general point. Italy has had a primary deficit since 1965. In fact, for the last twenty-five years interest payments on the public debt have been covered not by taxes but by the issue of new securities. In this situation, public debt is no longer “irrelevant” in the Ricardo-Barro sense. Private agents in the economy consider their holdings of public debt as net wealth and its stream of interest payments as part of their disposable income, with expansionary effects on their spending decisions.

In addition, neither does the Keynesian description of interest payments measuring the conflict between producers and rentiers hold true. The absence of a conflict of interest between taxpayers and recipients of interest payments weakens the pressure of public opinion on government and parliament to cut the deficit and act to consolidate public finance.

Solutions

What solutions to these problems are possible? For a number of years now, the central bank has been insisting that the primary deficit must be cut and indeed, reversed into a primary surplus. If this first step is achieved, one can expect a reinforcing circle of improvements. Less demand pressure on the financial markets, because of the reduced deficit, would lessen pressure on interest rates. Since interest payments at short-term rates are a major component of the deficits, lower interest rates would further lower the overall deficit, and so on. It is easy to say that the starting point for readjustment should be cutting or even reversing the primary deficit, but it is difficult to do. In the end, the issues are sociopolitical and require a sociopolitical decision. If the country really wants to do this, it must choose to pay more in taxes or to cut public expenditure.

Italy has lately made some progress in the right direction. The Government plans to reverse the primary deficit into a (small) primary surplus the next fiscal year. The complete liberalization of capital movements, the decision to keep the lira within the narrow band of the EMS, and the expected further steps ahead in monetary policy coordination among European countries made it necessary to accelerate the process of fiscal consolidation. By the end of the so-called stage one of the European economic and monetary union, the monetary financing of fiscal deficits will not be allowed and deficits themselves will be limited to the financing of public investments.

Will this be the end of the story? The end of the conflict between fiscal and monetary policies? I do not think it will be an easy task to achieve this result, but certainly the proposed new rules of the game will make an appropriate policy mix easier to implement. If interest rates are given over to stabilizing the exchange rate within the EMS band, another instrument is needed to affect demand: fiscal policy. But the reabsorption of the structural deficit is the precondition for giving back to the fiscal instrument the degree of flexibility necessary for controlling the economy over the short term. With sound public finances and a monetary policy explicitly geared to maintaining price stability, we might see also in this area the end of the cold war, the long cold war, between the public sector and monetary discipline.

2 The Central Bank’s Role in Financial Sector Development

DEENA KHATKHATE*

Ideas about the central bank and its role in the economy have gone through various phases during the last four decades. In the 1950s when economic development of the developing countries came to the forefront, the role envisaged for the central bank in the old vintage models of central banking in highly industrial countries was questioned on the ground that it would be too negative to deal with the problems of development. In regulating monetary expansion, earlier central banking principles and praxis used the interest rate as a price of saving and treated all borrowers uniformly, regardless of their ability to bear the burden of loans. ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Content Page
• Foreword
• Preface
• Introduction
• Part I Role and Functions of Central Banks
• Part II Central Bank Independence
• Part III Role of the Central Bank in Financial Crises
• Part IV Role of the Central Bank in Economic Transition and Reform
• Background Papers
• Selected Bibliography
• List of Participants
• Footnotes