ABSTRACT
The issue of central bank (CB) capital and of rules for the distribution of CB profits to owners would appear, at first glance, to bear strong similarities to such questions for private corporations. After all, central banks and private firms are incorporated within a similar legal structure and utilize similar accounting principles. However, this resemblance in formal procedures hides several important differences. Unlike private corporations, CBs are set up to achieve aggregate policy objective(s) rather than to maximize profits. Unlike a private corporation, a negative net worth (or capital) at the CB does not imply that the bank will go bankrupt and cease to operate. Finally, the main owner of the CB is the government rather than private individuals, implying that any distribution of profits increases the spending power of government and that CB losses ultimately translate into revenue losses or extra expenditures for the central government. Until the mid-1980s, most CBs were dominated by governments and functioned to a large extent as divisions of treasuries or ministries of finance. As such they were utilized for a variety of (often conflicting) purposes such as helping finance government expenditures, trying to stimulate economic activity and exports, and maintaining price stability and financial stability. As a consequence, the precise magnitude and sign of CB capital was a relatively mute issue. The last two decades have seen the emergence of a new consensus according to which: (1) the CB should focus mainly on assuring price stability even at the cost of substantial neglect of other objectives; (2) the bank should be free to set monetary policy instruments independently of other branches of government; (3) as in earlier times, the CB is still expected to use its policy instruments to safeguard the stability of the financial system, particularly during times of foreign exchange and other financial crises. This chapter accepts those three principles as desirable features of modern monetary policy-making institutions and focuses on two issues, the first of which is positive and the second normative. The positive issue concerns the implications of alternative levels of CB capital and of rules for the distribution of profits to governments for the extent to which the CB is able to set its monetary policy instruments without interference from the political establishment. When central
banks functioned mainly as arms of the treasury, this question was irrelevant: CB independence (CBI) in the modern sense was mostly non-existent and central banks were not expected to be independent. The normative issue is the potential trade-off between democratic accountability (DA) and CB independence. This trade-off comes into play when the occurrence of sufficiently large economic or political shocks forces the CB to engage in policies that have substantial fiscal implications, such as the bailout of a large segment of the financial system. Since it involves a redistribution of resources, such an action allows a non-elected institution (the CB) to make fiscal policy decisions. This is questionable on the grounds of DA and raises important questions of institutional design and, given this design, the precise choice of a point along the trade-off between DA and CBI. The remainder of the chapter has nine sections. The first three focus on positive issues. The opening section briefly discusses the conditions under which the level of CB capital is likely to affect its independence and argues that independence is affected only when this capital crosses a certain, probably negative, threshold. The next reviews sets of circumstances that lead to negative levels of CB capital. The channels through which low, or negative, levels of CB capital might affect the conduct of monetary policy are discussed in the last of these sections on positive issues. The focus of the next four sections is mostly normative. The first of these examines ways to improve the thorny trade-off between democratic accountability and CBI. The following considers factors that should affect the desirable level of CB capital. The extent to which concerns about CB capital should be relaxed (and if so, how) during extended depressions is discussed in the next section. The eighth section discusses principles for the allocation of profits between government and the CB with particular emphasis on methods for rebuilding negative or insufficient levels of capital. The final section considers the impact the 2008-2009 crisis is likely to have on central banks.
