The relationship between central banks and governments: what are central banks for?

Abstract

In order to consider the problem of the relationship between central banks and governments, it is necessary to go back to first principles and consider what society needs from central banks. The role of the central bank is explored as being to provide a stable financial environment as a basis for real economic activity. This involves the provision of a safe money asset; an appropriate level and composition of lending to the corporate sector to finance capital investment; and lending to government as required, subject to maintaining the value of the currency. The evolution of this traditional role in relation to banks and government is analysed in terms of collateral, emphasising their interdependencies. The argument developed here is that the problem of insufficient collateral for the financial system is a product of weak economic conditions and financial instability which has eroded confidence in the valuation of assets, and that this has been compounded by central bank independence. As a result, it is argued that central banks should not be independent of government, but rather that the traditional constructive mutual relationships between central banks and government (and retail banks) be restored.