ABSTRACT
This chapter argues that the financial strength of a central bank is an important factor in determining policy outcomes. Although small changes in central bank finances are not material to macroeconomic policy performance in wellcapitalized central banks, it can be demonstrated that poorly capitalized central banks are often constrained in their policy choices or, even when not so constrained, sometimes loosen policy to avoid large losses for reputational or political economy reasons. Roughly speaking, the importance of central bank financial strength for policy outcomes increases exponentially as central bank finances become weaker or policy commitments become more ambitious. More generally, the financial strength of an independent and credible central bank must be commensurate with its policy tasks and the risks it faces. The chapter is organized as follows. In Section 2, the concepts of central bank financial strength and policy performance are discussed and contrasted with the analogous concepts for private commercial enterprises. An important distinction is drawn between microeconomic efficiency – which is important in all enterprises at all times – and financial strength, which is essentially a measure of how likely it is that a central bank will be financially unconstrained when choosing the setting of its policy instruments. Financial strength is thus a function not only of the accounting valuation of the central bank’s balance sheet but also the nature of the policy regime, the predicted volatility of the economic environment and the degree of desired financial independence granted the central bank by the political system. Section 3 provides the reader with an overview of central bank financial strength in a variety of countries. It is clear that different countries have different views and points of emphasis on the issue. Central bank microeconomic efficiency is a universal concern, but losses become a macroeconomic concern only when their nature and extent limit operational capacity and/or damage credibility. The chapter then discusses in Section 4, why cross-country comparisons of central banks are difficult, primarily because of idiosyncratic and opaque accounting practices. Notwithstanding these problems, evidence that central
bank accounting is becoming more transparent over time is presented. Given these caveats, the section provides quantitative evidence that policy performance, as measured by the rate of inflation, is significantly worse in countries with financially weak central banks. Section 5 considers the variety of ways in which central banks have been recapitalized or strengthened in practice. It argues that the method and/or instruments used can have a critical bearing on whether an improvement in policy performance is subsequently attained. Section 6 concludes.
