Bank Indonesia: absolute independence for the future of Indonesia

Anthony Budiawan Managing Director of Political Economy and Policy Studies (PEPS)

 IO – on April 30, 2020, wrote: BI Has Not Printed Additional Money for Liquidity Injections, This Is the Reason. “Bank Indonesia (BI) indicates that it will not print additional money to increase funds or bank liquidity or to patch up the government budget deficit”. Thus opens the news article above. 

BI monetary policy indeed must be praised. BI is determined to maintain the independence of our central bank, in accord with Article 23D of the 1945 Constitution. 

This does not signify that BI will take a “hands-off” attitude during the COVID-19 pandemic. On the contrary, BI has responded to a drop in liquidity and the economy by disbursing nearly IDR 300 trillion in funds from the end of February to March 19, 2020.

This liquidity injection was mostly used to buy Government Securities (SUN) on the secondary market, amounting to IDR 163 trillion. 

Besides, there are many more that have been done by BI. In essence, carrying out a credible and responsible monetary policy, carrying out the functions of the central bank in a professional manner following the constitution’s orders: becoming an independent central bank. 

Central bank independence is achieved through the separation of monetary policy and fiscal policy. This separation is to keep the monetary policy from being used for political purposes (fiscal policy). Among other things, flooding the money supply by printing money, to finance the swelling budget deficit, in a way that is often irresponsible. 

The independence of the Central Bank is very important to maintain economic stability and long-term inflation rates. Especially in the era of fiat currencies whose value is not protected with, for example, commodities. Which, it is very easy to increase the money supply (print money). The impact on the long-term economy is very detrimental. High inflation. 

Whereas in the commodity-based currency regime (for example the gold standard) the money supply depends on the number of gold reserves. This ratio is always fixed. Because the gold standard uses a fixed exchange rate against gold: 1 ounce = 35 US dollars (1934-1971). Thus, the government cannot increase the money supply at will, because it is bound to the amount of gold reserves. And inflation is maintained. 

If the amount of gold reserves increases, for example, there are new gold mines (like in California in 1848), then the money supply will automatically increase. At the beginning (short term), people felt their purchasing power went up, they felt more prosperous. However, the price of long-term products turns out to be rising: inflation is increasing. 

The average inflation of the gold standard (US) regime in the 1880- 1914 period was only 0.1 percent per year. While the average inflation of the fiat money regime (US) in the 1970-2000 period reached 5.2 percent. 

Inflation makes domestic products relatively more expensive. And foreign products are relatively cheaper. As a result, the trade balance becomes deficit and makes gold flow abroad, gold reserves fall, money supply falls, and prices will fall.

Conversely, in trading partner countries that have trade surpluses, gold reserves rise, money supply rises, and prices rise. 

This mechanism makes the domestic and foreign prices balanced again. That is, monetary mechanisms occur automatically, without being able to be manipulated. Underlying independent monetary policy. 

But history shows there are only government regimes that want to try manipulation. They deliberately increase the money supply, by changing the exchange rate to be lower (debasement). As a result, inflation rises. 

In the era of the gold standard, the role of the “central bank” was enough to follow simple but effective rules of the game. In terms of inflation, the central bank increases the benchmark interest rate (discount rate) to absorb excess liquidity (reducing the amount of gold in circulation) to cause prices to fall. And conversely, in the case of deflation (or inflation is too low), the central bank lowers the benchmark interest rate to increase liquidity (increase the amount of gold in circulation) to make prices rise. 

In other words, the central function of the central bank is to control inflation, which results in an improvement in the trade balance. In the gold standard regime, this function occurs automatically, without being able to be influenced by the government. That is, independent. 

Proposals to increase the money supply by printing money will make inflation rise, as explained above. The trade deficit will widen. This situation endangers the Indonesian economy in the medium and long term. 

The constitutional order for an independent BI is correct. And BI must always maintain that, for the long-term interests of Indonesia, not the interests of the regime for a moment. 

BI can improve the economy during the COVID-19 pandemic by implementing a monetary policy mix. One of them is through the purchase of state debt securities in the secondary market, such as the one in Jakarta so far. 

Hopefully BI will be more credible in maintaining Indonesia’s monetary.