Development Central Banking, Part 2

Answering the Questions about Development Central Banking

Gerald Epstein

This is part 2 of a two-part series by regular contributor and Political Economy Research Institute (PERI) co-director Gerald Epstein, adapted from his recent International Labour Office (ILO) working paper “Development Central Banking: A Review of Issues and Experiences.” Part 1 is available here. The full paper is available here.

In both the developed and developing world, countries face significant transformational challenges. According to the International Labour Organization (ILO), global unemployment is over 200 million, with vulnerable employment being almost 50% of the total; among youth the unemployment rate stands at 13.1% but, in some places, such as the southern European countries, it is significantly higher. If current trends continue, these levels of unemployment and unemployment rates are unlikely to decline appreciably (ILO, 2014). In fact, in some respects, current trends are virtually guaranteed to get worse. Specifically, climate change, which is already creating considerable economic dislocations in many parts of the world, is predicted to accelerate over the next decades. It will especially harm poor and economically vulnerable communities (IPCC, 2014).

Historically, central banks have often been part of the policy apparatus that has helped to guide and provide financing for important development and transformational projects. (Bloomfield, 1957; Brimmer, 1971; Chandavarkar, 1987; Epstein, 2007). However, with the rise of the “Washington Consensus”, the global drive toward financial liberalization and the elimination of so-called “financial repression”, central banks were instructed or chose to follow the increasingly prevalent norm of the “inflation targeting” approach to central banking. This approach eschews virtually all goals other than keeping inflation in the low single digits. Its tool-kit was limited to just a few and ideally only one instrument – a short term interest rate (Bernanke et al., 1999; Anwar and Islam, 2011).

This approach to goals and instruments was accompanied by a drive to change the governance structure of central banks. Hitherto, they had tended to be integrated into the government’s policy apparatus but were also potentially subject to inappropriate influence by government officials. Now, they were able to “independently” implement inflation targeting policy structures and, especially, resist excessive financing of government expenditures.

If inflation targeting is not the best monetary policy framework for achieving broad economic and social goals, then what kind of central bank frameworks—goals, governance and instruments—are likely to best help developing countries address the key problems they face? Important lessons can be learned from history with respect to the kinds of central bank frameworks that have been tried and those that have been successful in achieving macroeconomic stability and economic development (Epstein, 2007, 2013).

Historically, central banks in both developed and developing countries have done as Olivier Blanchard suggested: they have focused on multiple targets and, following the rules of Tinbergen, utilized multiple instruments to achieve these targets (Tinbergen, 1952). Following the Second World War, central banks in Europe and Japan utilized interest rate ceilings, subsidized credits and other credit allocation policies to facilitate economic reconstruction and industrial upgrading (Hodgman, 1973; U.S. Congress, 1972, 1981; Zysman, 1983).

Also after the Second World War, there was a major transformation of central banking in the developing world. In many respects, these changes paralleled those in the developed world just described. But in developing countries, central banks were much more emphatically agents of economic development than in many richer countries.

The Great Financial Crisis has generated some cracks in the “new monetary consensus” of one target (inflation) and one instrument (the policy interest rate) with a recognition that it is not sufficient to meet the macroeconomic and development challenges that many countries face. These cracks are broad ranging and include: discussions at the centers of macro-policy orthodoxy, such as the IMF; debates over central bank mandates that highlight the dual-mandate of the Federal Reserve (high employment and price stability); the emphasis from the Bank for International Settlement (BIS) and elsewhere on the need for central banks to take into account financial as well as price stability; the monetary experimentation in core central banks; creation of development central bank mandates in several countries including Bangladesh, Argentina and others; and finally, the flagrant violation of inflation target strictures by many central banks that claim to engage in “inflation targeting lite”.

Nevertheless, central banks and policy makers more generally have been reluctant, to put it mildly, to embrace a new consensus that central banks should become integral partners in a macroeconomic initiative to confront key challenges. The consensus, at best, is that there can be some tinkering around the edges of inflation targeting. This is indicative of a reluctance to recognize the broad changes that are actually taking place in monetary policy management in response to the crisis.

Possible objections that have been raised to a more development approach to central banking and some responses to these objections include the following.

Why not just assign the central bank to macroeconomic stability and the fiscal authority to development? There are many problems with this solution. Even achieving macroeconomic stability itself requires more than simply targeting inflation. In addition, there is too much uncertainty in macroeconomic policy making so that there needs to be genuine coordination and learning by doing. Finally, as Tinbergen noted, policy instruments are not independent of each other. Thus changes in one instrument, say the interest rate, will not only affect inflation, but will also affect employment and the real exchange rate, which have a big impact on development. It has been known for decades that these instrument interdependencies can render a decentralized “assignment problem” costly and even unworkable.

Is there is a trade-off between development central banking and macroeconomic stability? It is true that, in the past, some developing countries that had central banks with broad powers and little distance from government, were part and parcel of macroeconomic regimes that were associated with failed macroeconomic policies. At the same time, there are many examples, as described above, where central banks that were partners in development-oriented macroeconomic policies led to more rather than less economic growth and macroeconomic stability. In these cases, such as the industrializing Asian countries and Europe and Japan after the Second World War, directing credit to rising industries rather than commodity or real estate speculation actually contributed both to macroeconomic stability and to economic development. Here macroeconomic stability and development were complementary results of development central banking, not substitutes. The lesson then is simple: the need is for good policies and appropriate policy coordination, together with appropriate checks and balances, so that central banks can play a positive role in fostering both macroeconomic stability and development. Pretending that a singular focus on inflation control will lead to either macroeconomic stability or economic development is not, as has been observed, a winning policy.

If central bank policy becomes too highly coordinated with government policy, will governments exert inappropriate pressure on the central bank to fund fiscal deficits, or even to support cronyism or corruption? In some countries, or even in all countries at some time, these worries may be legitimate. It may be wise, then, for there to be checks and balances, including a certain degree of operational independence, to give the central bank some insulation from direct control by the government. At the same time, it is often important for the central bank’s policies to be coordinated with the government’s development plan. For example, even corrupt governments usually have development plans. The central bank could usefully orient its policies around promoting the key macroeconomic goals of the development plan, even when a corrupt government is failing to achieve the plan. In this case, of course, this might entail the central bank leaning against the wind with respect to the government’s actual policies, though not the government’s publicly announced development plan. In the more common, and general, case the central bank’s policies would be coordinated with those of the government.

Do central banks lack the knowledge to generate employment, support investment in key industries or target the real exchange rate? While there might be some truth to this, rather than supporting the continuation of a focus on inflation targeting, it points to a key reason why a broader mandate is useful and even necessary in many countries. Central banks in developing countries often have one of the largest pools of highly trained and skilled economists and technicians. In an inflation targeting regime, this collection of highly scarce human resources is being utilized to learn everything that can be possibly learned about movements in commodity prices and their connection to monetary policy. They spend almost no time or energy learning how monetary and credit policy affects employment, skills upgrading, technological development and sectoral growth. If central banks were given a broader mandate, then their staff would have to learn more about the economies in which they operate. They might have to talk to labor ministries, agricultural ministries, and women’s associations about how their policies affect women and children and the environmental ministries about the impact of policies on the environment. In this case, some of the skilled labor in central banks can be deployed to understand how monetary policy can affect these broader issues and this would be likely to generate a considerable increase in their social and economic productivity.

Is it a mistake to ask central banks to “do too much”? Central banks cannot do everything; they are not a panacea. This point is well taken. Central banks should be seen as one key macroeconomic and financial institution that must work in concert with other key financial and macroeconomic institutions. As discussed earlier, latterly Asian country developers have utilized development banks to help finance and coordinate their industrial policies. Today, development banks can once again play key roles in helping to mobilize long-term or patient capital for development purposes. Central banks can play a supporting role in providing lines of credit, credit guarantees, and the like for high quality projects. They can further help out by maintaining a stable, competitive exchange rate. Lastly, they can help by playing a coordinating role among various macroeconomic and sectoral agencies and private finance.

So it is true that central banks cannot provide all of the solutions to the development challenge. However, if they abandon or at least strongly modify their current inflation targeting structure to become more development-oriented, they can become a much bigger part of the solution than they have been in recent years.


Anwar, S. and Islam, I. 2011. “Should developing countries target low, single digit inflation to promote growth and employment?” Employment Sector Employment Working Paper No. 87, ILO, Geneva.

Bernanke, B.S.; Laubach, T., Posen, A.S. and Mishkin, F.S.1999. Inflation targeting: Lessons from the international experience. Princeton University Press, Princeton, NJ, USA.

Bloomfield, A. I. 1957. “Some problems of central banking in underdeveloped countries”, in The Journal of Finance, Vol. 12, No. 2. May, pp 190-204.

Brimmer, A. F. 1971. “Central banking and economic development: The record of innovation”, in Journal of Money, Credit and Banking, Vol. 3, No. 4, November, pp 780-792.

Chandavarkar, A. G. 1987. “Promotional role of central banks in developing countries”. IMF, Treasurer’s Department, Working Paper, wp/87/20.

Epstein, G. 2007. “Central Banks as Agents of Economic Development”, in Ha-Joon Chang, ed. Institutional Change and Economic Development, United Nations University and Anthem Press pp 95 – 113.

__________ 2013. “Development central banking: Winning the future by updating a page from the past”, in Review of Keynesian Economics, Vol. 1 No. 3, Autumn, pp 273-287.

Hodgman, D. R. 1973. “Credit controls in Western Europe: An evaluative review”, in The Federal Reserve Bank of Boston: Credit allocation techniques and monetary policy. Federal Reserve Bank, Boston, pp 137-161.

International Labour Office (ILO). 2014. Global Employment Trends, 2014, ILO, Geneva.

Tinbergen, J. 1952. On the theory of economic policy, North Holland Publishing Company, Amsterdam.

U.S. Congress, House of Representatives, 92nd Congress, 2nd Session. 1972. Foreign experiences with monetary policies to promote economic and social priority programs.

U.S. Congress, Joint Economic Committee, 1981. Monetary policy, selective credit policy and industrial policy in France, Britain, West Germany and Sweden. Government Printing Office, Washington D.C.

Zysman, J., 1983. Governments, markets and growth, Cornell University Press, Ithaca.

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