Should central banks be governed?
Speech by Deputy Governor Jon Nicolaisen at the Norwegian Academy of Science and Letters, 12 April 2018.
Please note that the text below may differ slightly from the actual presentation.
1 Delegation of instruments
How should central banks be governed? The usual answer is through delegated authority, combined with subsequent democratically based supervision and evaluation. This requires striking a balance between central bank independence on the one hand, and the need for political authorities to follow up the central bank’s operations on the other hand.
The work of the Central Bank Law Commission, headed by Svein Gjedrem, former Ministry of Finance Secretary General and Governor of Norges Bank, places this question in a present-day context. The Commission’s proposal to separate the management of the Government Pension Fund Global from Norges Bank is probably the proposal that has received the most public attention. I will not go into this issue this evening.
The Commission also presents a number of proposals related to the central bank’s governance structure. Some of the proposals touch upon the essence of the relationship between the political authorities and the Bank. This should arouse interest far beyond Norges Bank, at least for those who have an interest in state governance systems and structures.
First, I would like to go back to the mid-1980s when the current central bank act (Norges Bank Act) was passed by the Storting.
These were challenging years for the Norwegian economy. The liberalisation of credit markets led to a surge in household borrowing. In the course of 1985, private consumption rose by 10 percent and house prices soared. The 1986 wage settlement culminated in a lock-out and oil production in the North Sea was shut down in April. At the same time, the price of oil fell sharply, to USD 10 per barrel.
The fall in oil prices and high consumption growth resulted in large trade deficits. In spring 1986, the Norwegian krone, which was then pegged to a basket of currencies, came under heavy pressure. During the Storting’s deliberations on the so-called “Easter Package”, which contained proposed austerity measures, the Willoch Government sought a vote of confidence, but was defeated and resigned.
On 11 May 1986, immediately after the new Brundtland Government assumed office, the Norwegian krone was devalued by 10 percent. The Government was of the opinion that it had no choice. The pressure on the krone was too strong.
A decade of high cost growth and frequent devaluations had weakened confidence in the krone and the credibility of the fixed exchange rate regime. Inflation was high and variable. How could economic policy have failed so fundamentally?
At that time, most of the policy instruments were the responsibility of the Government and particularly the Ministry of Finance. The Government set the krone exchange rate and decided the interest rate. Norges Bank implemented the Government’s policy by intervening in exchange markets.
During the 1960s and 1970s, regulatory optimism was a prominent feature of economic policy. Considerable emphasis was placed on maintaining economic activity and employment levels in the short-term. Episodes of soaring inflation were met with compensation in the wage settlements. Each time domestic cost growth threatened Norway’s competitiveness, the exchange rate was adjusted. The result was wage-price spirals and repeated devaluations.
After the devaluation in May 1986, the Government decided that the value of the Norwegian krone should continue to be stabilised against a composite basket of currencies. At the same time, the politicians of the time understood that they had to take action to restore confidence in the krone. The history of repeated devaluations and high inflation could not continue.
To ensure monetary policy credibility, the authorities had to commit themselves. The krone was to be defended, and this meant a more active use of the interest rate.
Responsibility for interest rate setting was delegated to Norges Bank. This increased the credibility of the new monetary policy. Inflation was reduced and balance in the economy was gradually restored, but not without considerable costs. The Norwegian economy had to go through a tough course of treatment and entered a deep recession. It would take several years for the economy to recover and to restore confidence in the nominal anchor.
The crisis in the Norwegian economy showed how costly it can be to lose confidence in monetary stability. Confidence and credibility can be rapidly eroded, but can take a long time and require great sacrifice to restore.
Already before the crisis, in 1985, the Storting had passed a new central bank act, after many years of preparatory work. One important change was that the Act raised the threshold for overruling Norges Bank in its interest rate setting.
The new Act gave Norges Bank considerable formal authority to set the interest rate. But the Bank’s real room for manoeuvre was nevertheless not apparent when the Act came into force.
During the work to prepare the Act, the position of the central bank in government had been the subject of broad debate, and the debate continued in the years after the Act entered into force. Then Norges Bank Governor Hermod Skånland was of the opinion that the Bank’s legal position was unclear. He pointed out in particular that although the Bank had been assigned responsibility for interest rate setting, it was at the same time required under the Act to “… conduct its operations in accordance with the economic policy guidelines drawn up by the government authorities…”. He described it in the following way: “… while the wording of the Act designated Norges Bank as the competent authority in the use of an instrument, the Bank’s freedom of manoeuvre was tied up through guidelines for that same instrument”.
Professor, and later Chief Justice of the Supreme Court, Carsten Smith was a member of the committee responsible for drafting the Norges Bank Act. His view differed from that of Skånland. By assigning responsibility for interest rate setting to Norges Bank, the Act gave the Bank independent responsibility in the conduct of monetary policy. At the same time, Smith noted that monetary policy was part of the overall economic policy, which was the responsibility of the Government and the Storting. It had to be possible to govern the Bank, but the threshold for overruling the Bank’s decisions should be high.
Under the Act, only the Government, not the Ministry of Finance alone, can instruct the Bank, and this must follow a certain procedure: the Bank must be consulted before a resolution on instructing the Bank is passed and the matter must be presented to the Storting in a white paper forthwith. Thus, instructions to the Bank can only be given with full disclosure.
Perhaps Skånland and Smith were both right. The wording used in the Act “… in accordance with the economic policy guidelines drawn up …” is undeniably imprecise. Different authorities, such as the Government, the Ministry of Finance and Norges Bank may have had different perceptions of what this really implied. With hindsight, we know that the provision was significant, at least when the Act was new. Governor Skånland held the opinion, rightly or wrongly, that the Bank’s freedom of manoeuvre was limited. He claimed that if the Bank had had monetary policy autonomy, the interest rate would have been raised earlier and the crisis might have been less severe. Thus, the ambiguity of the Act had significant consequences for the conduct of monetary policy.
Today, there is no doubt about the point made by Carsten Smith: the Norges Bank Act assigns the authority, and the responsibility, to conduct monetary policy to Norges Bank. According to the Act, any conflict with the political authorities must be dealt with according to the instruction procedures.
It is time to pause for a moment here.
What was really the point of delegating policy rate setting to the central bank? If the authorities had already decided, why could they not implement the necessary policy themselves?
There are several reasons why the authorities delegate tasks. If the required exercise of judgement is primarily technical and should not reflect politically motivated choices, it is appropriate that authority is delegated to a technical authority. Furthermore, delegation can mean that important long-term considerations are given priority. It may be necessary, although demanding, to accept short-term sacrifices to achieve a better balance in the economy over time.
A delegated mandate with a clear objective can both clarify the division of responsibilities in the conduct of economic policy and establish the importance of giving priority to long-term stability. It can in turn strengthen the policy’s credibility and hence promote the success of the policy.
Internationally, it gradually became common practice to give central banks the responsibility for bringing down inflation. Central banks were considered well-suited to exercising the necessary professional judgement. In order to have the room to exercise professional judgement and to give credibility to the exercise of judgement, the authorities recognised at the same time that central banks themselves had to be responsible for the use of the instruments. The independence of the Federal Reserve and the Bundesbank was cited as an example. In 1990, New Zealand was the first country to introduce an explicit inflation target for its central bank and it was soon followed by others. Inflation was gradually brought down in most western countries and has since remained fairly low and stable.
Central banks are not alone in pursuing long-term objectives on behalf of society and with legal authority. In Norway, a superior authority can in principle instruct subordinate agencies. The degree of autonomy varies. The strict instruction procedures put Norges Bank’s autonomy in a unique position.
2 How should a central bank be governed?
Autonomy brings with it a new problem: How can the authorities ensure the democratic control of an independent institution? The words “control” and “independence” sound indisputably like two mutually exclusive terms.
How the political authorities govern Norges Bank affects the Bank’s real independence, its exercise of authority, and accountability.
Norges Bank must be governed within the framework set out in the Norges Bank Act. The Act is adopted by the Storting, which thereby defines the general principles for the central bank’s functions. Through regulations pursuant to the Act, the Government specifies the division of responsibilities for the overall economic policy, including the central bank’s operational authority and the specific objectives it is required to pursue.
There are two important points in the Act. First, the Act gives the Bank authority over some instruments, such as the key policy rate. Second, the Government, as I have already mentioned, can only instruct Norges Bank based on defined procedures and with full transparency. The threshold for instruction is thereby high.
The Central Bank Law Commission proposes that Norges Bank’s formal independence should be strengthened by further restricting the Government’s power of instruction: the Government may still set the objectives for the Bank’s operations, but the Bank may only be subject to instruction in specific cases under extraordinary circumstances.
Other provisions in the Act also underpin Norges Bank’s independence. The Bank cannot extend credit to the government, and the Bank’s budget is determined independently of the Ministry and the Government. In addition, the Bank has both the right and the obligation to give advice to the Ministry when it concludes that measures should be implemented by bodies other than the Bank.
Thus, Norges Bank has a substantial degree of autonomy in its use of instruments, but the Bank’s operational objectives and the instruments at its disposal are determined by the political authorities.
The formulation of the central bank’s operational objectives has a significant impact on its real degree of influence and responsibility. The greater the scope for the exercise of judgement provided by the objectives, the more leeway the political authorities give the central bank. In Norway, this can be illustrated by the difference in the monetary policy mandates under the exchange rate and inflation targeting regimes.
In the 1980s and 1990s, Norges Bank was to keep the krone exchange rate fixed. Even though Norges Bank set the key policy rate, there was little room for judgement and assessments. Flexibility was limited, and the fixed exchange rate regime had to be abandoned in autumn 1998.
In 2001, Norges Bank was given a new operational objective: an inflation target for monetary policy. Henceforth, monetary policy was to be oriented towards keeping inflation low and stable. At the same time, monetary policy was to seek to stabilise developments in output and employment. The mandate implied that Norges Bank had to exercise a considerable degree of professional judgement and manage the trade-offs between different considerations. It gave the Bank more responsibility, but also broadened the scope for pursuing a more flexible monetary policy.
On 2 March 2018, the Government adopted a new and more modern regulation on monetary policy. The new regulation clarifies the Bank’s mandate and underpins the flexible approach to inflation targeting.
An important counterbalance to the Bank’s independence is the powers of the Storting and the Government to oversee the central bank in the performance of its tasks. This ensures democratic control of the Bank. Oversight takes the form of evaluations of the Bank’s conduct of monetary policy, through supervision of the Bank’s operation and by monitoring compliance with the rules for the Bank’s activities.
Transparency is important in order to monitor the Bank’s exercise of authority. The Bank shall therefore inform the public of its assessments on which monetary decisions are based.
Norges Bank’s Executive Board reports on its activities in the Bank’s Annual Report, which is submitted to the Storting in connection with the Financial Markets Report, and also forms the basis for the hearing of the Governor before the Storting Standing Committee on Finance and Economic Affairs. Norges Bank also publishes monetary policy reports containing documentation of analyses and professional judgements four times a year. In 2017, the Bank took another step towards greater transparency by publishing the minutes and the votes of the Executive Board’s monetary policy meetings.
3 Framework for Norges Bank’s activities
The Bank’s purpose and functions comprise more than the conduct of monetary policy. This is specified in the Central Bank Law Commission’s proposed objects clause: “The purpose of Norges Bank’s functions is to maintain monetary stability and promote the stability of the financial system and an efficient and secure payment system”. These are naturally the primary objectives of a central bank.
The Norges Bank Act also establishes important principles for the Bank’s governance structure.
The Government appoints the Executive Board of Norges Bank, including the Governor and Deputy Governors. The Executive Board is Norges Bank’s executive and advisory authority. The Board is also responsible for ensuring that the Bank’s activities are subject to adequate governance and control, and for supervising the Bank’s administration. The Board has a majority of external members, providing a corrective to the internal specialist environment, but also ensuring the legitimacy of the Board’s supervisory function. The Audit Committee, which serves the Executive Board, is selected by and among the Executive Board’s external members.
Norges Bank’s Supervisory Council supervises the Bank’s operation and ensures compliance with the rules governing the Bank's activities. The Council also adopts the Bank’s accounts and approves the Bank’s budget. The members of the Supervisory Council are appointed by the Storting, and the Council reports the results of its supervisory activities directly to the Storting. This ensures independent supervision of the central bank.
The Supervisory Council shall not supervise the Executive Board’s exercise of discretionary authority under the Act. The latter is followed up by the Government and submitted in a report to the Storting.
The Central Bank Law Commission has proposed substantial changes which deserve attention.
The Commission’s proposals can be considered a modernisation of the Norges Bank Act and a desire to clarify the lines of responsibility between the authorities and Norges Bank. At the same time, the proposals are far-reaching and will, if they are implemented, change the balance between the Bank’s management and governing bodies, and between the Bank, the Ministry, the Government and the Storting. This could affect the Bank’s position in more general terms and raise fundamental questions related to the Bank’s autonomy.
The Commission proposes that the Supervisory Council should be discontinued. The Commission also proposes that a committee for monetary policy and financial stability should be established, with responsibility for the use of policy instruments in those areas and chaired by the Governor of Norges Bank. Furthermore, the Commission proposes the establishment of a board for Norges Bank composed exclusively of external members. The board should be appointed by the Government and be responsible for central banking matters not assigned to the committee and for the Bank’s operation, budget and administration. The Governor will not be a member of this board.
As the Commission proposes discontinuing the Supervisory Council, the board and the Ministry of Finance will conduct direct supervision of the Bank. The Storting will largely have to rely on information from the Ministry and hearings in the Storting.
The supervision of the Bank’s operation and the evaluation of policy implementation are currently divided between the Supervisory Council and the Ministry. This organisation helps to safeguard the Bank’s professional independence, and simultaneously ensures democratic transparency and control.
Norges Bank’s Executive Board states in its consultation response that: “The Commission’s proposed organisational solution could present challenges for this independence because the Ministry is given direct responsibility for supervising the central bank’s board and is also to evaluate the Bank’s exercise of judgement. […] Without the Supervisory Council, the Ministry’s oversight and supervision of the Bank’s board will be far more extensive and more direct than is currently the case.”
The distinction between the evaluation of the Bank’s exercise of judgement and the supervision of the Bank’s operation may be demanding to maintain when the Ministry is responsible for both functions. Today, this distinction ensures that the Bank’s exercise of authority cannot be overruled through supervision.
In a separate consultation response, Norges Bank’s Supervisory Council has gone further, referring to Article 75 c of the Norwegian Constitution, which states that the Storting is to “supervise the monetary affairs of the Realm”. Interpretations of this provision may differ. The Commission has clearly assumed that it is unnecessary to have a separate body in the Bank appointed by the Storting. Nevertheless, the Supervisory Council’s statement illustrates that the Commission’s proposal encroaches upon the relationship between our government authorities.
Nor is the current arrangement, with a separate supervisory body in the Bank without challenges. The current Act specifies that the Supervisory Council’s supervision does not comprise “the Executive Board’s exercise of judgement pursuant to the Act”. At the same time, the Executive Board has “the executive and advisory authority”. It is essential to draw a line between active supervision and the Executive Board’s responsibility for the Bank’s exercise of authority, including the objectives and principles of the activities the Executive Board has been assigned to approve.
If the Supervisory Council is to continue to supervise the Bank, it may therefore be necessary to clarify its responsibilities, role and powers as a supervisory body. I would like to refer here to the Central Bank Law Commission’s clarifications in the Report:
“The Supervisory Council’s supervision should, as today, be retrospective supervision based on the minutes of board meetings. The Supervisory Council must not be some kind of ‘super-board’ for Norges Bank. The right to directly or indirectly override board decisions would create an ambiguous division of responsibilities. (…)
(…) Especially in the Bank’s core areas, such as the conduct of monetary policy, the verification of legality will be restricted to matters that do not require technical evaluation. But the Executive Board must also have significant freedom to use judgement, for example when choosing solutions for operations within the bounds of the legislation.”
As mentioned, the Commission also proposes to create a board for the bank with only external members – ie without the Governor of Norges Bank. The proposal appears to be inspired by company law. The considerations and principles that were to ensure sound corporate governance, management and oversight were further developed in the 1990s. This has led to changes in company law and has had a significant impact on how undertakings are governed. This also applies to the day-to-day operation of Norges Bank.
Nevertheless, we must note here that central banks, by virtue of their social mission and their unique position, differ from commercial enterprises. This is also recognised by the Commission. Among other things, the Governor will still be appointed by the Government, and not by the board. Thus, this is not a pure company model where the board appoints a general manager. Consequently, the Governor is not ultimately responsible to the board. In addition, it is proposed that the conduct of monetary policy and the use of instruments related to financial stability be the responsibility of an expert committee chaired by the Governor.
According to the proposal, important functions, such as the management of the foreign exchange reserves and interbank payment settlement, will fall under the board’s area of responsibility. Thus, the Governor will no longer have the ultimate responsibility for these functions.
The Bank’s functions are closely intertwined and need to be viewed as a whole, as demonstrated during the financial crisis. A division of responsibility for central banking matters with a dual structure, as proposed by the Central Bank Law Commission, will be demanding, particularly when the Governor is not a member of the board. Grey areas in the division of responsibility and work could engender a lack of clarity and competence conflicts.
Central bank decisions are normally made by a board or a committee, but it is customary that the Governor chairs the body that makes these decisions. Norges Bank has good experience with one and the same governing body – the Executive Board – being responsible for both central banking matters and for managing the Bank. With the Governor chairing the board, it would be natural to have independent supervision of the board’s activities, along the lines of that currently conducted by the Supervisory Council.
Should central banks be governed? Yes, of course they should! The question is how central banks should be governed. Choosing between different governance models, functions and objectives is crucial, both for the Bank’s real independence and for the division of responsibilities between the Bank and the political authorities.
In an open democracy like Norway, such choices must be ultimately made by the Storting. This evening, I hope that I have shed light on some of the issues the Storting will have to address going forward.
Thank you for your attention.
- See Official Norwegian Reports NOU 2017: 13 New central bank act. The Act relating to Norges Bank and the Monetary System and the organisation of Norges Bank and the management of the Government Pension Fund Global (Summary in English).
- The central value of the Norwegian krone was raised from 100 to 112. The decision was made on Sunday 10 May, applicable from 11 May.
- Section 2, first paragraph, of the Act No 28 of 24 May 1985 relating to Norges Bank and the Monetary System etc. (Norges Bank Act)
- Skånland, H. (1991). Sentralbankens oppgaver i dag og i fremtiden i Norges Bank 175 år: Tre foredrag om sentralbankens plass og oppgaver [Central bank responsibilities present and future in Norges Bank’s 175 years. Three speeches on the position and functions of the central bank], Norges Bank’s Occasional Papers No. 19, p 9 (in Norwegian only).
- Smith, C. (1994), Norges Banks rettslige selvstendighet [Legal Autonomy of Norges Bank] in Stability og langsiktighet [Stability and a long-term perspective]: festschrift for Hermod Skånland, p 87 et seq. See also Smith, C. (1985), Sentralbank og pengevesen [Central Bank and the Monetary System]Nordisk Administrativt Tidsskrift, p 325 et seq (also printed in Smith, C. (1992), Rettstenkning i samtiden [Contemporary legal thinking] p 42 et seq).
- Also certain preparatory statements contributed to raising doubts. In Proposition No 25 (1984-85) to the Odelsting on page 101, the remarks on section 19 stated: “It is assumed that Norges Bank cannot formulate rules that are not fully in accordance with the view of the Government and the Ministry on this point at any given time.” See also Syrstad, H. (2003), Sentralbankens uavhengighet [Central Bank Independence] Fagbokforlaget, in particular chapters 11, 12 and 17.
- Skånland, H. (1991). Sentralbankens oppgaver i dag og i fremtiden i Norges Bank 175 år: Tre foredrag om sentralbankens plass og oppgaver [Central bank responsibilities present and future in Norges Bank’s 175 years. Three speeches on the position and functions of the central bank], Norges Bank’s Occasional Papers No 19, p 10.
- See Alesina, A. and G. Tabellini (2007), “Bureaucrats or Politicians? Part I: A Single Policy Task.” American Economic Review (97): pp 169-179.
- In the literature, this is referred to as the time inconsistency problem, see Kydland, F. E. and E. C. Prescott (1977) “Rules Rather than Discretion: The Inconsistency of Optimal Plans”. Journal of Political Economy 85 (3): pp 473–91.
- The relationship between the political authorities and the central bank is an example of what is referred to in literature as the principal-agent problem. The political authorities (the principal) are responsible for economic policy and delegate authority to the central bank, which in this case is the agent. When the authorities assign a task to the central bank, it must, on the one hand, give the central bank sufficient authority to carry out the task as intended and, on the other hand, it must ensure that the task is carried out in line with the intention.
- Section 1 of Regulation No 278 of 29 March 2001 on Monetary Policy.
- Section 3 of Regulation No 305 of 2 March 2018 on Monetary Policy. The Government specified in the Regulation that “inflation targeting shall be forward-looking and flexible so that it can contribute to high and stable output and employment and to counteracting the build-up of financial imbalances”.
- Norges Bank’s letter of 28 February 2018 to the Ministry of Finance.
- Section 3 of the Norges Bank Act.
- The full wording of Section 1-2 of the bill reads as follows: “(1) The purpose of Norges Bank’s functions is to maintain monetary stability and promote the stability of the financial system and an efficient and secure payment system. (2) Norges Bank shall otherwise contribute to high and stable output and employment.”
- This is laid down in the Regulation of 17 December 2009 on Risk Management and Internal Control in Norges Bank. The Regulation is based on the rules governing financial undertakings, see item 5.4.3 of the Proposition No 58 (2008-09) to the Odelsting.
- Norges Bank’s letter of 26 October 2017 to the Ministry of Finance, p 6.
- NOU 2017: 13 New central bank act. The Act relating to Norges Bank and the Monetary System and the organisation of Norges Bank and the management of the Government Pension Fund Global, p 438.