The current economic crisis has created a debate about the core role of a central bank, a senior Sri Lankan monetary official said, while the practice of central banking itself is under heavy fire in the United States.

Some central banks in relatively stable economies now only have one core objective of generating a low level of inflation (inflation targeting), though many still regulate the banking system and also have growth objectives.

Role Model

"Until the recent crisis people were not so sure of the role of the central bank in supervision and regulation," H N Thenuwara, assistant governor of Sri Lanka’s central bank said at a regional banking regulation seminar in Colombo.

"In some countries they established new institutions and took this function away from the central bank, so that the central bank could devote itself to its main objective, price stability.

"Now both academic, theoreticians, practitioners; all discuss what should the central bank’s major objective be, should it be price stability or maintaining financial system stability."

In Britain the regulatory function was taken away from the Bank of England, which led to a debate about the speed of rescue and the ability of the central bank to spot risky lending practices of banks early during the current crisis.

Thenuwara says countries like New Zealand established ‘inflation targeting’ laws committing the central bank to a low level of inflation of about 2.5 percent a year.

"There is no conclusion so far," says Thenuwara. "But I have seen many research papers that have taken this subject very seriously and debating on prioritization of the two objectives."

But critics say that even inflation targeting is not enough and the problem goes deeper into the central banking itself. Even low levels of inflation are cumulative and bubbles will build up slowly over time, unless deflation is allowed to happen.

In the US, the Federal Reserve and paper fiat money is coming under fire especially in congress, with particular blame being put on a Fed decision in 2002 to cut rates despite falling prices, which fired an unsustainable asset-price bubble.

Greatest Crisis

On July 21, Fed chairman Ben Bernanke came under heavy fire from members of the House Financial Services Committee, at his semi-annual testimony to the US congress.

"The Federal Reserve in collaboration with the giant banks has created the greatest financial crisis the world has ever seen," Texas congressman Ron Paul greeted Bernanke in an opening statement.

"The foolish notion that unlimited amounts of money and credit created out of thing air can provide sustained economic growth has delivered this crisis to us.

"Instead of economic growth and stable prices it has given us a system of government and finances that now threaten the world’s financial and political institutions."

A central bank lowers interest rates in an economy by artificially creating non-existed ‘savings’ by inserting reserves into the banking system, though administrative decision-making.

The resulting imbalance between savings and credit demand pushes inflation up, gives incentives for mal-investment leading to commodity bubbles and asset-price, especially housing.

When brakes are applied (by raising rates) the bubble eventually collapses leaving the financial sector and the economy badly damaged. If monetary brakes are not applied, an economy under a paper money central bank monopoly dissolves in to hyper inflation.

Sri Lanka’s central bank tightened monetary policy relatively early before a recent asset price bubble spread to commercial bank, though it was too late to entirely prevent it from getting into the sub-prime finance company sector.

Regulating Whom

The US Fed is seeking increasing powers to become a systemic regulator.

But some representatives are opposing the move, saying it would distract the Fed when renewed inflation from recently printed money required it to focus on an exit strategy.

"The proper conduct of monetary policy is the best way the Fed can serve the American people," representative Spencer Bachus told Bernanke.

"Asking the Fed to serve as a systemic regulator gives a false sense of security that will inevitably be shattered at the expense of the taxpayer."

"A distracted and over-extended central bank subjected to potential political interference is a luxury that we cannot afford."

Bachus said the Fed should be relieved of existing regulatory responsibilities.

The US government has spent hundreds of billions of dollars bailing out banks, which collapsed after too-loose monetary policy was tightened, while the Fed itself doubled its balance sheet buying up dud assets that markets would no longer touch.

Congressman Paul meanwhile is bringing a proposal to audit the Fed’s paper fiat monetary activities though the general accounting office (GAO), a non-partisan watchdog.

Audit Avoidance

Bernanke devoted the last part of his prepared testimony to fight the proposal saying it could compromise monetary policy independence.

"A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability," he said.

"We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence."

But Paul said the political interference in the Fed, especially by past chairmen who were near re-appointment had been well documented.

"Just the fact that they can issue a lot of loans and special privileges to banks and corporations - that’s political," he pointed out.

"This idea that it would be political because we know what happened afterwards just doesn’t seem to add up."

Drawing attention to a statement in the Wall Street Journal which quoted Bernanke as saying that "We absolutely will not monetize the debt", Paul made fun of Bernanke.

"Well, that’s one of the major reforms some time in the distant future that would be beautiful," he said.