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Interview with Thammarak Moenjak author of Central Banking: Theory and Practice in Sustaining Monetary and Financial Stability

Mon, 02 Mar 2015 13:17:00 GMT

cover image Moenjak

To get 30% off your copy of Central Banking: Theory and Practice in Sustaining Monetary and Financial Stability, order now direct at wiley.com and enter our promo code MON30 at the checkout.

Jacob Bettany: Can you tell us a little bit about your background and how you came to write this book?

Thammarak Moenjak: My life has evolved around central banking since I was 18 years of age, when I received a scholarship from the Bank of Thailand (BOT) to study B.Sc. Economics at the London School of Economics, and PhD in Economics at the University of Melbourne. 

At the time that I was a student in the 1990s, central banking was still shrouded in relative mystery. Inflation targeting, the monetary policy regime that put much emphasis on transparency, only started to become widespread in advanced economies during the late 1990s and emerging market economies in the early and mid 2000s. 

As a student, I had to try to piece together materials from different sources of what monetary policy was actually about. While I had a good exposure to monetary theory from the various excellent university courses that I took, at the time there were only limited sources of references that I could refer to with regards to the actual practice of monetary policy by central banks. Similarly, as for other aspects of central banking, whether its history and evolution, its role in money issuance, in the payments system, in banking supervision, the materials were scattered all over and, as a student, I had to piece them together on my own. 

You could thus say that my inspiration for writing this book was to put everything together in a coherent and easy-to-understand manner, so the reader would see the whole picture of central banking, and have insights into how central banks think and act.

One reason I was able to write this book was that, once started working at the BOT, I had a good opportunity to rotate and get deeply involved with various key aspects of central banking, including modeling and forecasting, monetary policy strategy, reserves management, financial stability assessment, and corporate strategy. I took careful observations of how theories were actually applied and adapted in practice.

But I also learned that central banking could be very different across countries. I was fortunate enough to be sent to trainings and seminars conducted by various other central banks and multilateral institutions, including the Federal Reserve Bank of New York, the Bank of England, the Bank of Japan, the Reserve Bank of New Zealand, the Bank of Korea, Monetary Authority of Singapore, the Bank for International Settlements (Hong Kong Office) and the IMF Institute in Singapore. These experiences allowed me to observe the common themes, and specific differences in central banking as practiced by global central banks.

author photoBut knowing central banking from the central banker’s perspective alone was also probably not enough. In the years 2008-2009, I was also fortunate enough to be sent to work as Assistant Chief Representative at the BOT New York Office, where I had the chance to closely observe policy responses to the global financial crisis, and to also participate in various meetings, conferences, and seminars organized by global investment houses in New York where I learned how the big private players in financial markets operated. I also took careful notes of what I learned during this period.  

After 13 years at the BOT, I took a study leave to attend a Master in Public Management at the Lee Kuan Yew School of Public Policy, National University of Singapore, during which I also was a Lee Kuan Yew Fellow at the John F. Kennedy School of Government, Harvard University. I decided that it was the time I converted my notes and my observations into a book. I approached Wiley at their Singapore office, and the publisher and staff were very helpful. They suggested I write and submit a book proposal, which I did.

Once the manuscript was finished, it was very fortunate that some of the people who I most respected in the central banking and academic circles across continents were kind enough to agree to give their invaluable time and effort to review the manuscript, and ultimately give kind endorsements for the book. These kind individuals included Mr. Paul Volcker, the former Chairman of the Federal Reserve; Professor Charles Goodhart of the London School of Economics and former Bank of England’s MPC member; Dean Kishore Mahbubani and Professor Charles Adams of the Lee Kuan Yew School of Public Policy; Professor Robert Dixon of the University of Melbourne; and Professor Christopher Worswick of Carleton University. I must admit that it was very heartening for me as a first-time author to have received such an honor from these great thinkers and practitioners indeed.

JB: Why is this book necessary at this time? How does it distinguish itself from other books on the topic?

TM: Central banking affects all of us, although not many people might have noticed the effects. For most countries, banknotes in circulation are issued by the central banks. Whether money in our pockets can retain its purchasing power well or not depends chiefly on the central bank’s conduct of monetary policy. When central banks raise interest rates, commercial banks are likely to follow suit, and we might be charged higher rates on our loans or receive higher rates on our deposits. If central banks are not careful enough in their actions, bank failures might arise, bringing in financial instability that affects all of us.

This book aims to provide readers with an understanding of and insights into the roles and functions of central banks, the theories behind their thinking, and actual operational practices. In the wake of the global financial crisis of 2007-2010 there has been a renewed interest in central banking on the part of academics, practitioners, and the general public.

"The power of central banks is enormous, but is also very fragile."

At this juncture, I have not seen many comprehensive books on the central banker aimed at students or a general audience. The few current books on topics relating to central banking are mainly for expert audiences. They often delve deeply into a particular subtopic such as money market operations, central bank independence,

monetary policy transparency, or the Basel rules. This approach makes it difficult for nonexperts and novices to follow the material and put it in a proper context. Textbooks on monetary economics, on the other hand, can offer a very rigorous theoretical background on monetary policy, but they often do not provide detailed descriptions of actual operational practices, and might not cover other important topics relating to central banking. In contrast, popular books about central banking intended for a general audience often focus on personalities and events, and do not offer enough theoretical background in a systematic manner for the interested reader to conceptualize why central banks might choose to adopt or abandon a particular practice. This book aims to bridge the gaps by providing an introductory overview of central banking in a manner that is systematic, up-to-date, and accessible to a general audience and students who have minimal background in macroeconomics. Theoretical reviews and examples of how theories are applied in practice are written in an easy-to-understand manner.

JB: Who is this book for, and what kind of background do you need to understand it?

TM: The book is aimed at all those who might be interested in central banking, whether they are students, new central bank recruits, central bank staff, financial market and policy analysts, or the interested public. 

With complicated theories being explained in an easy-to-understand manner, and key concepts relating to central banking linked together in a coherent context, readers with only a minimal background in macroeconomics should be able to follow and gain insights into the thinking behind central bank actions.

With the background provided by the book, readers should be able to conceptualize, link together the different facets of central banking, make informed judgments about a central bank’s actions, and have the ability to even anticipate central bank actions in advance. Interested readers will also be able to investigate further the topics that interest them.

JB: What challenges did you face writing the book?

TM: Once I started writing the manuscript, I realized that the challenges were manifold, from practical issues such as meeting the deadlines, to conceptual issues like how to structure the book and link theoretical concepts with operational practice. Here I would like to highlight three key conceptual challenges I faced. 

First was how to convey to the global readers the underlying nature of central banking, recognizing that central banking could be very different in different countries. On this matter, I decided to start with the evolution of central banking and the evolution of the international monetary system, so that the reader would understand that the nature of central banking has always been evolving in response to the prevailing economic, social, and political context, as well as the body of theoretical knowledge at a particular point in time. Then I tease out the common themes, and point out specific differences that might exist among modern central banks. I also decided to use the US central bank, the Federal Reserve, as a reference point, since its actions were most widely known and followed by the global audience.

Second was how to present the multifaceted nature of central banking in a coherent and easy-to-understand manner. The topic of monetary policy itself, for example, has many sub-topics from broader ones such as central banking independence and monetary policy regimes, to narrower ones such as money market operations and monetary policy tools. Each of the sub-topics is often filled with jargon and could be a book on its own. The challenge was how to link all the key topics and sub-topics together in a coherent and insightful way, using minimal jargon, and given the limited space. And mind you, monetary policy is only one of many central banking functions.  

Third was on presenting the relatively new topic of financial stability. At this moment, even the definition of financial stability has not been widely agreed upon. This is in contrast to monetary stability where “low and stable inflation” is almost universally accepted to be the practical definition. As such, the challenge was how to convey the different dimensions of financial stability to the reader in a most tractable way. Here I decided to put financial stability as having three over-lapping dimensions, i.e. stability of the macro economy, stability of financial markets, and stability of financial institutions, and then describe how central banks could use policy tools to ensure financial stability both ex ante and ex post.

JB: How is the book structured?

TM: There are four main parts to the book. The first part gives an overview of central banking, from the history of central banking and the international monetary system, to the roles and objectives of modern central banks. Modern mandates of central banks such as monetary stability, financial stability, and full employment are also reviewed and discussed. 

The second part of the book deals with monetary stability, the dominant mandate of modern central banks. In this part, theories that are the basis of the practice of monetary policy are reviewed and discussed along with actual practice of policy implementation in financial markets, and monetary policy transmission mechanisms. The role of exchange rate in central banking is also discussed. 

"Just prior to the recent global financial crisis, central banks were still at an infantile stage in the development of “macro-prudential” tools, or tools that were meant to help prevent, or deal with, systemic risk to the financial system, should one occur. The focus of bank supervisors had earlier been on the “micro-prudential” side, i.e.  preventing and dealing with risks to individual financial institutions
rather than systemic risk."

The third part of the book deals with financial stability, the increasingly important mandate of central banks, particularly with lessons from the recent global financial crisis. The multi-dimensional nature of financial stability is discussed, along with relevant theoretical developments that would help conceptualize the framework that central banks use in safeguarding financial stability. Tools that central banks use to monitor risks to financial stability as well as to mitigate those risks, ex post and ex ante are also discussed.

The last part of the book covers the future of central banking by discussing future challenges and their implications on monetary and financial stability, and how central banks might deal with them. Such challenges include the intensification of the globalization process, the continued evolution in financial services, and unfinished business from the recent global financial crisis. The book finishes by presenting how central banks might adopt a public policy framework to formulate and

implement their strategy to effectively deal with possible future challenges.

JB: The book begins with some introductory material, could you provide us with some background on Central Banking, its history and the way it has evolved in modern times?

TM: It could be said that modern central banking originated with coin sorting and storing for merchants. Bank of Amsterdam was created in 1609 to help the merchants of Amsterdam, a premier trade center, sort and store coins of different makes and of different sovereigns. Other cities soon followed suit. 

In 1656, the Bank of Stockholm was created in Sweden. When the Swedish parliament voted to reduce copper content in newly minted coins, people panicked and rushed to the Bank to withdraw the older coins which had the same face values but higher copper content, so they could melt them. This threatened the survival of the Bank of Stockholm, until it found a solution by introducing notes that were backed by the coins stored at the Bank. These notes could be said to be the first modern banknotes, i.e. notes with a fixed face value, paying no interest. 

Although the Bank of Stockholm ultimately failed (in 1668 the Swedish parliament approved a new bank to replace the Bank of Stockholm, and which later became the Sveriges Riksbank, now the world’s oldest central bank) the use of banknotes which had claims on coins stored at the Bank grew in popularity. Merchants could use banknotes to settle claims among themselves, without actually touching the stored coins. The popularity of banknotes later became prevalent among the general public and remained so until today.

Meanwhile, other banks that were later to become central banks were also created in other European countries including England, France, and Spain to partly help finance their sovereigns to conduct wars, and later to help manage general government finance. Central banks thus became bankers to the government. Their close ties to the sovereigns empowered the central banks, enhanced the credibility of their banknotes, and attracted other commercial banks to open their accounts at the central banks. Central banks thus became “central” in the sense that they also acted as bankers to other banks. At this stage, however, many central banks remained private institutions, seeking profits and competing with other commercial banks.

While their power grew, there came a call on the central banks to act as guardians to the financial system. In the early days, commercial banks often failed which led to general financial panics. With the general acceptance of their banknotes and their close ties to the government, central banks seemed to have the power and prestige to help rescue these commercial banks. 

By undertaking this role of a guardian to the financial system, central banks took more responsibility as a public institution. It was precisely this reason that the Federal Reserve, the U.S. central bank, was created in 1913 as a public institution to help safeguard the country against financial panics. To make sure that the money they put into rescue would not be wasted, many central banks became bank supervisors, also able to examine commercial banks’ books, which meant that they became institutions of an even more public character. 

By the mid-1970s, the power of central banks reached a new height with the use of active monetary policy. Prior to the 1970s monetary policy was passive, i.e. central banks passively issued money according to the amount of gold reserves or other reserve assets they had. Indeed, prior to World War I, the world was on the gold standard, money could not be printed without the full backing of the country’s gold reserves. At the end of World War II, the world transitioned to the Bretton Woods System whereby the US dollar acted as the backbone of the system. Other countries would hold US dollars as reserves to back up their own currencies while the US government promised full convertibility of US dollars to gold at 35 ounce per US dollar. By the late 1960s, however, the strains on the system were already apparent, as the US ran huge budget deficits, while at the same time, other countries started to relax control on international capitals as they finally recovered from the ruins of World War II.

With the breakdown of the Bretton Woods system, central banks realized that they could pursue monetary policy quite independently from the amounts of gold reserves or US dollar assets that they had. Ultimately, albeit with much trial and error, the conduct of monetary policy became a key modern central banking function. If they choose to do so, modern central banks can actively use monetary policy to ensure price stability, to influence employment and long-term economic growth, as well as to safeguard and sustain financial stability.

"...the biggest challenges for central banks at present are threefold. First is the intensification of the globalization process. Second is the continued evolution of financial services. Third is the unfinished business."

JB: How much power do Central Banks really have?

TM: The power of central banks is enormous, but is also very fragile. Modern central banks owe their power to their monopoly in money issuance. Relating to that monopoly, modern central banks also have the power to regulate money conditions, i.e. to conduct monetary policy, which could influence the business cycle, employment, economic growth, and inflation to a certain extent.

 

The monopoly over money issuance and the ability to conduct monetary policy to influence the business cycle already give central banks an immense power, even if they are not bank regulators. If they are bank supervisors (many but not all modern central banks are bank supervisors), then they also have the power to directly influence commercial banks, whether through regulation or moral suasion.  

And now we might want to talk about the fragility of the power of central banks. The power of a central bank essentially rests on the trust placed on the central bank by the public. At the most fundamental level, the trust in the central bank arises from the belief of the public that the central bank would not abuse its monopoly power on money issuance, or conduct monetary policy in such a way that the value of money diminishes very fast. 

If the central bank is trusted by the public, then money issued by that central bank would be widely accepted, and would maintain value well. With money being able to retain value well, the central bank can marginally adjust money conditions (or conduct monetary policy) to help influence the business cycle if it chooses to.  

Without the trust in the central bank, the money could soon diminish in value, or worse, becomes worth less than the paper that it is printed on. The central bank would also lose its ability to use monetary policy to influence the business cycle. Once that trust is lost, the central bank would find it hard to regain its power. Power of central banks, as mentioned earlier, is thus enormous but is also very fragile.

JB: Increasing complexity in the global economy makes for an increasingly volatile environment. In your view how well are Central Banks prepared for Systemic Shocks?

TM: Just prior to the recent global financial crisis, central banks were still at an infantile stage in the development of “macro-prudential” tools, or tools that were meant to help prevent, or deal with, systemic risk to the financial system, should one occur. The focus of bank supervisors had earlier been on the “micro-prudential” side, i.e. preventing and dealing with risks to individual financial institutions rather than systemic risk.

The recent global financial crisis, however, revealed how inter-linkages among different types of players of the financial system meant that a seemingly small risk in one part of the system could propagate and compound such that the once seemingly healthy financial institutions in another part of the financial system could also run into troubles through both direct and indirect exposures. 

In late 2008, at the height of the global financial crisis, the whole global financial system was at the brink of a collapse due to the failure of Lehman Brothers. Although Lehman was not among the very largest financial institutions (and was not under direct supervision of the Federal Reserve), it was an institution that was in the middle of the global financial inter-linkages. Once Lehman failed, there was a threat of bank runs across the globe, even for banks that were not direct counterparties to Lehman but nonetheless had exposures in markets that Lehman had been present in.

In the wake of the recent crisis the authorities, including central banks, have made great strides in two key areas. First is the introduction of new regulatory tools, particularly macro-prudential tools that should help deal with systemic risk. Second is the recognition of the need of coordination among relevant regulatory agencies. 

First, after the crisis, policy tools have been designed, redesigned, and refined at central banks and multilateral organizations around the world which should help central banks deal with systemic shocks by:

(1) Help monitoring and identifying risk while they are still forming (e.g. the identification of both domestic and global systemically important financial institutions (SIFIs) as well as various financial indicators to help assess risk buildups in the macroeconomy, financial markets, and financial institutions);

(2) Help intervening against risk buildups, (e.g. time-varying capital requirements, dynamic provisioning, extra capital buffers for SIFIs, liquidity coverage ratio, net stable funding ratio, as well as other refinements made in Basel III);

(3) Help restoring financial stability, once a crisis should already occur (e.g. emergency liquidity windows for banks and non-banks, purchase of financial assets, and non-orthodox monetary policy such as quantitative easing).

Second, apart from new policy tools, central banks now realize that coordination among different agencies is very important in dealing with systemic shocks. In the UK, the spread of the crisis was partly blamed on coordination failures among the central bank, the Financial Services Authority (FSA), and the Treasury. After the crisis, the UK government split the FSA into two separate parts and put the part that deals with regulations of various types of financial institutions into the Bank of England. The US, meanwhile, created Financial Stability Oversight Council (FSOC) to help identify risks that might be a threat to financial stability across the financial system.

"As the world gets more interconnected and financial systems get more complex, central banks will find that to sustain monetary and financial stability, they will have to more effectively coordinate with other players, domestic and overseas."

Despite the sophisticated tools and the awareness of the importance of coordination among different agencies in dealing with systemic shocks, however, it is still only fair to say that the authorities are at a disadvantaged position in this game of cat-and-mouse against systemic shocks. Nature of shocks to the economy often changes as the economy evolves. As the world has become increasingly more interconnected, a shock that occurs far outside one’s jurisdiction could also threaten the domestic financial system through ripple effects.

Furthermore, the fast changing environment means that tools designed in response to an earlier crisis might not necessarily help

prevent the next one. Despite the disadvantaged position, however, we can say with a great degree of confidence that central banks are now more much aware of, and much better prepared for, systemic shocks compared to the pre-crisis period.

JB: What are the biggest challenges for Central Banks at present, and how confident are you that they can meet these challenges?

TM: I have argued in the book that the biggest challenges for central banks at present are threefold. First is the intensification of the globalization process. Second is the continued evolution of financial services. Third is the unfinished business. Each of these challenges would already certainly complicate the work of central banks to a great degree, and the interactions among these challenges could bring about greater complexities that central banks will need to learn to cope with. 

The intensification of globalization suggests that external forces are likely to exert greater influences on domestic inflation and domestic financial system, whether through greater trade and service linkages, international capital flows, or the greater importance of cross-border financial services and international financial institutions. 

The continued evolution of financial services suggests that non-bank financial firms that might not necessarily be supervised by central banks (e.g. mutual funds, pension funds, hedge funds) are likely to play a greater role in the financial system and complicate central banks’ work, while new payment technologies (e.g. digital money and mobile banking) could also lead to unforeseen changes in the financial landscape that central banks work in. 

Furthermore, unfinished business from the recent global financial crisis remains and is still being played out. High levels of public debts in advanced economies that were partly a result of financial rescues during the crisis, for example, put headwinds onto the global growth prospects. While regulatory reforms being made (e.g. the Dodd-Frank rules, as well as Basel III), should help mitigate risks known to contribute to the last crisis, could also alter behaviors of players in financial markets and the global financial landscape. Central banks would need to learn and understand changes that will come with these changes.

JB: To what extent will the role of the Central Bank change over the next 5-10 years?

TM: Over the next 5-10 years, it is quite safe to say that most central banks will continue with their current mandates of monetary stability and financial stability, although specific practices to achieve these mandates might be further refined and tailored to meet their specific circumstances. What will noticeably change is likely to be the higher degree of coordination with other domestic and overseas regulatory agencies, as well as with other central banks and multilateral institutions.

The mandate of monetary stability is likely to remain important since it is now known and accepted that if the central bank wishes for sustained long-term growth of the economy, it is best that the central bank uses monetary policy to maintain price (and monetary) stability so that individuals and firms in the economy can optimally make their consumption and investment decisions.  Optimal consumption and investment decisions would ensure better allocation of resources within the economy, and thus better long-run growth.

While there have been questions with regards to how new payments technology such as e-money or digital money might affect monetary stability, it is arguable that as long as the central bank retains the monopoly of traditional money issuance and/or regulates the issuance of these new forms of money, then the central bank will still be able to effectively fulfill its mandate of monetary stability. The money issued by the central bank is implicitly guaranteed by the power of the sovereign. So even with the introduction of alternative forms of money, it would be the money introduced by the central bank that receives the most trust, if the central bank does not abuse its power, that is. 

The mandate of financial stability is also likely to remain very important for central banks, and in fact is likely to be emphasized even further, as the recent global financial crisis has shown that the costs of financial instability to society could be enormous. It is arguable that prior to the recent global financial crisis, financial stability mandate took a backseat to monetary stability mandate. Since then, it has been recognized that financial stability is also a prerequisite for monetary stability as a financial crisis could bring about a deflationary spiral.  Going forward, central banks are likely to keep on refining the framework and tools to ensure that they could pre-empt a crisis from occurring, or, if one should inevitably

To get 30% off your copy of Central Banking: Theory and Practice in Sustaining Monetary and Financial Stability, order now direct at wiley.com and enter our promo code MON30 at the checkout.

occur, that they could pre-empt it from spreading and worsening uncontrollably.

Apart from the emphasis on sustaining monetary and financial stability, coordination across regulatory agencies is likely to also become more important. As the world gets more interconnected and financial systems get more complex, central banks will find that to sustain monetary and financial stability, they will have to more effectively coordinate with other players, domestic and overseas.