Yesterday, one of our readers asked us this question:

Why is it important to keep central banks independent from the government? Wouldn’t it be better if the board of directors of a central bank are selected by the people, and therefore held accountable to the people for decisions, mistakes, and misjudgements?

At what point did central banks become concerned about targeting inflation? Before they existed, inflation was close to 0%, so surely they wouldn’t have been created with inflation targeting in mind?

The more I read, the more I feel that your ideal of a 100% reserve banking system with no central bank is the best way to control inflation (and to allow the people to understand the true cost of government projects [wars, etc] that is currently paid for through inflation). But why didn’t this work in the first place?

To answer these questions, we will turn back to history. As we explained before in A brief history of money and its breakdown- Part 2,

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury.

Under an international gold standard, there was an automatic market mechanism to keep government from inflating the money supply and to keep each country’s balance of payment in equilibrium. Hence, the world enjoyed the benefits of only one monetary medium, which facilitated trade, investment and travel. Prices were also kept in check (see What is inflation and deflation?). During that time, there were periods of price rises (e.g. during war) followed by periods of price falls (e.g. when war ends), with relatively stable prices in between.

Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ‘afford’ to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today. You can read the rest of the monetary breakdown story at A brief history of money and its breakdown- Part 2.

Now, you know how the US is able to ‘afford’ to fight extended wars in Iraq and Afghanistan with expensive professional armies today.  A gold standard will make this truly unaffordable.

Today, the central banks of the US and Australia follows an inflation targeting policy. That is, monetary policy is set ensure that there is a consistent price rise within a target range. How did inflation targeting develop? Well, it is another long story. You can read about it straight from the RBA at Inflation Targeting: A Decade of Australian Experience.

Next, we come to the most important part: why should central banks be independent from the government?

First, we have to understand the basics. What is the purpose of money? In essence, money functions as (1) a medium of exchange, (2) unit of account and (3) a store of value. To perform these functions, money has to fulfil certain properties as described in Properties of good money and its integrity cannot be tampered with.

Now, consider the situation that we described in Recipe for hyperinflation:

… imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn?t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Under the gold standard, gold is money that is under the control of the free market. No one or institution ‘owns’ or control the money. But today, the central bank is the only institution that has the authority to create money out of thin air. As we said in Recipe for hyperinflation,

Look at any piece of paper money today and you will find the words of a government decree (e.g. ?This Australian note is legal tender throughout Australia and its Territories?) and perhaps a signature or two.

In Australia, the signature belongs to the RBA governor.

What if we give the government (which already has executive power) the power to create money? This will give the government a deeper concentration of power! If you believe the old adage that power corrupts and absolute power absolutely corrupts, then you will not want such a deep concentration of power. As we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

That is why today, central banks are independent of the government, with complex and elaborate rules of money and credit creation (the exception will be Zimbabwe under Robert Mugabe). Our fear is that with this credit crisis worsening by the day, deflation may prove such a unthinkable threat (e.g. see How do we all pay for the bailout of Fannie Mae and Freddie Mac?) that the government will ‘roll back’ all these rules one by one in order to keep the entire financial system solvent. As the ancient Chinese saying goes, the journey of a thousand mile begins with the first step. Therefore, the journey towards a hyperinflation hell will begin with such measures (see Recipe for hyperinflation). Your belief in whether you will see hyperinflation in your lifetime will depend on your faith on the government to maintain the integrity of money.

Next, what if we let the people vote for the board of directors who control the central banks? If shareholders have trouble keeping the directors of their company honest and accountable, then it will be the same for the central bank.