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The rule of law – or the rule of central bankers?

By Sukrit Sabhlok - posted Monday, 13 May 2013

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 disgust, and 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 foisted upon Australians.

In 1873, Walter Bagehot wrote an intriguing book titled Lombard Streetthat 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.

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About the Author

Sukrit Sabhlok is a PhD Candidate at Macquarie University Law School.

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