Economic Confidential, September 2008

ESSAY

Nigeria's Monetary Policies and Sustainable Macroeconomic Performance

By *Oluba Martin. Ph.D

Conceptual Clarifications

Along with fiscal policy which is concerned with revenue and spending activities of the government, monetary policy is widely used to ensure that predetermined macroeconomic goals are achieved. Monetary policy refers to the ways of managing money in an economy and consists in the modification of the quantity of money by the central bank in order to achieve certain set macroeconomic targets such as price stability, economic growth, full employment etc. Consequently by keeping inflation low and reasonably stable, entrepreneurial activities that will crystallize in improved macroeconomic performance will be enhanced. Monetary policy can also exert short-term influences on real activity such as orchestrating a temporary boom. The central bank's ability to modify the supply of money derives from its statutory monopoly over the supply of monetary base which equally enables it to determine the conditions at which the banks borrow from it. Being able to determine bank's borrowing conditions the central bank central is able to influence the conditions at which banks lend and borrow from each other and through these mechanisms can change the interest rate which consequently has implications for many other economic indices. Many economy managers have used expansionary fiscal and monetary policies to combat unemployment while restrictive monetary policy through its upward pressure on interest rates is used to fight inflation. But interest rates can either be manipulated directly by fiat or by either increasing or reducing the monetary base or reserve requirements. As in many other countries the central bank of Nigeria also play such other roles as lender of last resort, regulator of the banking subsector in order to effectively and easily affect the quantity of money. It is equally entrusted with leading roles in achieving financial sector stability. In regulating the banking subsector, the central bank empowers the banks to create money titles that are instantly redeemable as money very much differently from credits whose redemption is possible at future dates. Thus the banking policy reinforces the monetary policy of the central bank. Since monetary policy is primarily concerned with influencing the quantity of money, it can either be expansionary where the stock of money in the economy expands or it can be contractionary with decreasing stock of money availability.

Developmental Role: Obvious Truths

Some of the major concerns is whether the conduct of monetary policy partly deducible from the above description truly creates lasting developmental impacts or whether it causes short-term prosperity with longer lasting damaging consequences. Firstly, when monetary policy is ill-designed and implemented, the destructive consequences at the macroeconomic level far outweigh the supposed immediate salutary gains. Bernanke (2003) noted that "the upshot is that the deep 1973-75 recession was caused only in part by increases in oil prices per se. An equally important source of the recession was several years of over expansionary monetary policy that squandered the Fed's credibility regarding inflation, with the ultimate result that the economic impact of the oil producers' actions was significantly larger than it had to be. Instability in both prices and the real economy continued for the rest of the decade" . The recent United States credit crisis was a clear manifestation of the capacity of monetary policy to create counterproductive effects if not well designed and implemented. One of the reasons why this is possible is because of the bank's monopoly status over the production of money and near-monies as well as the abuse of the lender of last resort role which invariably orchestrates attendant moral hazard. The resultant effect being that banks become reckless in their dealings believing that in case of any eventuality, they will be bailed out. It was precisely this type of thinking that heightened the subprime lending crises. That way, certain monetary policy frameworks become sources of moral hazards as the monetary authorities have become underwriters of risky investments. These effects cumulatively undermine the case for free markets. As Greenspan (1997) succinctly admitted, "the fiat money systems that emerged have given considerable power and responsibility to central banks to manage the sovereign credit of nations. Under a gold standard, money creation was at the limit tied to changes in gold reserves. The discretionary range of monetary policy was relatively narrow. Today's central banks have the capability of creating or destroying unlimited supplies of money and credit" . On the whole, poorly articulated monetary policy will inevitably result in costly crises such as the ones described already. Recall the Asian financial crisis in 1997. "Thailand's economy developed into a bubble fueled by "hot money". More and more was required as the size of the bubble grew. The same type of situation happened in Malaysia, although Malaysia had better political leadership, and Indonesia, which had the added complication of what was called "crony capitalism". The short-term capital flow was expensive and often highly conditioned for quick profit. Development money went in a largely uncontrolled manner to certain people only, not particularly the best suited or most efficient, but those closest to the centers of power" .

Money is the same thing as any other commodity save that it is not demanded for its own sake but rather primarily for the purposes of exchange. Tracing the origin of money back to the era of barter and use of metallic coins, particularly gold, pretty much confirms this position. Commodities or things of value exchanged for things of value. Therefore monetary manipulations such as in excessive monetary expansions without underlying value only create paper income. Here lies the problem. Since money is like any other commodity, the forces of demand and supply determine the worth or price of money as is the case in all other commodities. Thus without expansions in the demand for money, its supply can only decrease the 'price' or worth of money. The demand for money on the contrary is dependent on productivity because as economic agents produce and offer their output in exchange, they earn (or invariably demand for) money. Monetary policy therefore does not have the kind of capability which is often arrogated to it as being best in spurring economic growth over a medium term period. Over time since the evolution of money, it has not been able to buy outstanding economic performance while increasing employment with low inflation. Monetary expansion beyond the output levels which it should support in exchange and for exchange purposes only creates a false perception of wealth in the short run because of the increase in paper income backed by law which consequently misguides investors and distorts economy-wide resource allocation. In the short run, expansions in money stock as described, reduces the purchasing power of money which is inversely related to inflation. Thus the more the expansion without corresponding expanded demand which arises from increased productivity the higher the loss in value of money to inflation. This can consequently be worsened through heightened expectations of future inflation depending on how the economic agents on the basis of past experience perceive the length of possible inflation to be. Thus distortion of relative prices, misguidance of resource allocation process with consequent inefficiencies as well as frustration of perspective planning which is in the heart of entrepreneurial productivity are some of the fruits that the inflationary outcomes may yield over a longer period depending on how long the transmission will last. Aside the immediate value loss, expansionary monetary policy for example will naturally depress the interest rates below the supposed market level. The market rate may approximate a natural rate here in which economic agents voluntarily lend and borrow without any artificial injection of money. New money notes which are not backed by value but are rather empowered by the statutory backing given to the central bank to print money will give the impression that economic agents are now voluntarily supplying more money to the loan market out of their savings. It therefore depresses the interest rate below what it should be, thus consequently triggering increased borrowing of these hot money for investment purposes. This boom can be sustained for as long as there is continued outpouring of more paper money. This is typical of Nigeria, which economy has been propelled by inflation. But any slight contraction or correction of this process will invariably have a reverse effect and as such longterm investments which are caught up in the process will become bad.

Let us assume that the central bank has very good intentions of popping up the macroeconomic performance of the country. The important question is whether central banks are truly independent to bring to life these good intentions. How much choice does a central bank have in rejecting to finance budget deficits proposed by the executive and legislative arms of government? The answer is not far fetched. Central banks are created and empowered specifically for paper money creation and its management. Historically speaking particularly based on experience from this part of the world, the central bank has little choice when it is faced with the financing of public sector fiscal deficits. Unfortunately, our macroeconomic environments are historically replete with fiscal dominance such that more and more paper monies are printed in order to finance those deficits. Even when paper monies are not used to finance them, all other alternative financing options will have virtually same deleterious effects on the economy. Since 1965 Nigeria's fiscal disposition has been in favour of deficits which were 99.9% financed through ways and means - the central bank's term for printing new currency. The fact that the central bank does not have full autonomy in a practical sense when required to play a role in financing deficits means that there is very little it can do with its monetary policy to enhance economic performance as its policy plans can be exogenously frustrated through government's fiscal activities. "The long history of fiscal mismanagement of oil booms in Nigeria severely proscribed the Central Bank of Nigeria's ability to pursue a coherent monetary policy. Without the support of a disciplined and broadly predictable fiscal stance, the central bank was unable to make credible commitments to an inflation target or, indeed, to any other intermediate target such as the monetary supply or the exchange rate. Monetary policy could not reliably anchor inflation expectations" .

Consequently, the central bank's role in modernizing payments, enhancing interbank operations and other ancillary activities essential to the effective workings of monetary policy do not automatically result in development. The reason being that this activity which enhances fractional reserve operations only enables monetary expansions which as earlier pointed out in absence of increased marching levels of productivity can only worsen the conditions of the country. A central bank's role in providing money market infrastructure as described should be matched with a policy which expands productivity at the same speed or else there will be consistent short-term bouts of boom which consequently penalizes more and more productive engagements over a medium to long-term.

Nigeria's Monetary Policy Landscape

As pointed out already, aside the inherent problems of fractional reserve banking, the efficacy of monetary policy in Nigeria has been historically undermined by fiscal dominance as well as persistent liquidity overhang which in part derives from the former. In spite of the various stages of transformation which the framework for monetary policy management has been subjected to over the years these albatross have not abated. Periodization of monetary policy episodes is summed up in the table below:

Monetary Policy Episodes in Nigeria :

No. Policy Period Key Elements of Policy Management

1. Period of Direct Control (Pre-SAP) " Direct monetary control prevailed throughout the period prior to the adoption of the structural adjustment programme;

* Key ingredients of the policy framework include: sectoral credit allocation, credit ceilings and cash reserve requirements, administrative fixing of interest and exchange rates and imposition of special deposits;

* Monetary targets were hardly ever realized;

* Strategy created distortions in resource allocation

2. Period of Indirect Monetary Framework - Short-term (1986 - 2001) " Use of market instruments in monetary management;

* Adoption of monetary targets and instruments over a one-year period for the 1986 - 2001 period;

* Nigerian treasury bills (NTBs) was the main instrument Open market operations during the period;

* Complementary instruments included the adoption liquidity ratio, cash reserve requirements, discount window operations, mandatory sales of NTBs, 200% cover of forex demand at the AFEM with NTBs etc.

* Proactive adjustment of MRR in trying to manage liquidity conditions helped in the deregulation of interest rate policy

3 Period of Indirect Monetary Framework - Medium-term (2002 - 2006) " Rather than one year, a two year period was now in place for monetary targets and instruments;

* The adoption of the time fame is predicated on some guess of a transmission time lag of about 24 months within which monetary policy is expected to affect its ultimate objective;

* Policy was subject to bi-annual reviews;

* The main instruments of monetary policy management include open market operations, reserve requirements, discount window operations, foreign exchange market intervention as well as the movement of public sector deposits in and out of commercial banks;

* Consolidation and recapitalization of banks was introduced to strengthen the financial sector and consolidate the gains of policy;

* In 2004/5 new measures were introduced. These include: tight exchange rate band of plus/minus 3 per cent, two week maintenance period of cash reserve in addition to movement of public sector funds

4. Post-Banking Consolidation (2006 - 2007) " Following persistence of excess liquidity in spite of all the above a review became necessary and include: zero tolerance on ways and means advances, gradual run-down of CBN holding of TBs, aggressive liquidity mop-up operations-frequent OMO sales supported by discount window operations, unremunerated reserve requirements, increased coordination between the Bank an the fiscal authorities, restructuring of debt instruments into longer tenor debts, increased deregulation of forex market etc.

From the explanations in the schedule above, the dissatisfaction with the ability of monetary policy strategy at each stage to achieve its target objectives of price stability and minimal inflation has led to the adoption of other tactics which eventually yielded equally futile outcomes. The reason for this is primarily ascribable to the fact that the root causes of instability in prices are not addressed by these policies but are rather aggravated by them. Based on historical experience the fiscal dominance that has resulted in excessive money creation is a consequence of the pervasive corruption in the system which unfortunately is exogenously determined and controlled. It is primarily the cause of excess liquidity in the system as illegally and corruptly leaked government funds are best laundered in cash. No doubt however that the poor banking habits is a factor yet in a highly inflationary environment it pays to some extent to hold money in very liquid forms preferably in cash. CBN's regular interventions on the other hand only create hiccups within the larger system which rather than orchestrate stability in prices only does the contrary. Perhaps it needs be explained again that the value of money is dependent on the demand and supply of money. There may be an expectation element which is a secondary factor that may affect the value of money but it is never a strong factor in the absence of the primary causative element: money. Resort to inflation targeting is equally a no solution. (see my essay titled 'Inflation targeting or mis-targeting in Nigeria') Let us look at the implications of these years of monetary management when output expansions are not appropriately taken into consideration.

Nigeria: A Victim of Unproductive Debt Expansion

United States of America is usually a ready example used by many Nigerian economists when justifying their penchant for short-term monetary stimulation. The argument is usually based on the premise that the American financial system expands money massively and yet over many years the economy did not go under. But those who argue this way forget that the naira fiduciary media created by the central bank is demanded neither in America nor in any other country. But even in recent times that there are news of holdings of naira outside Nigeria, the quantity has been very inconsequential. On the contrary, the excess money created by the American financial system is bought and held as foreign exchange reserves by most of the countries of the world. Nigeria for example is holding almost US$64 billion. China is holding US$1.8trillion in its reserves as at June 2008. Collectively therefore the countries of the world such as Nigeria in pursuing their unjustified huge accumulation of external reserves purchase the inflationary consequences of the United states loose monetary policy by narrowing the difference between the supply and demand for money. Table 2 below presents the 10 most prominent clients for the purchase of American inflation. Secondly, the level of productivity in the United States is so high that it drives an equally high demand for the money. America's GDP in 2007 was the highest in the world US$13.8 trillion and its per capita GDP is US$46,000. Nigeria ranks a distant 41st position with a GDP size of US$166 billion and 137th in percapita GDP which is US$ 2,000. So where is the productivity that underscores Nigeria's persistent loose monetary policy? And which countries and in what proportion hold the Nigerian naira?

It was necessary to start from this premise in order to clear doubt concerning predication of our pro-inflationary monetary policy argument on the United States system. The demand for the United States dollars for use in exchange and as an asset will not likely abate. Nigeria is not America and we must begin to design programmes that proffer well tailored solutions based on our peculiar problem contexts and appropriate economic theory and policy. Let us now examine the sincerity and effectiveness of our monetary policy. We use the growth rates of broad money supply as a proxy for monetary policy based on our earlier definition of monetary policy as concerned with the change in the quantity of money. We equally use the growth rate of output as a proxy for growth rate of demand for money. Recall that by exchanging the goods and services produced, one is in effect asking for money. Thus based on the classical barter relations, things of value exchange and money is no different. The GDP represents the monetary value of all goods and services produced within the economy and thus are a good measure of the true demand for money for real economic activities. Relating the growth in money supply (M2) to the growth in GDP gives us a picture of unproductive debt expansion i.e. money that is not backed by any real productive activity.

It is evident that we have been living on an inflationary boom. Money has grown at a rate that is by far in excess of the growth of output and has left in its trail substantial heights of inflation. Inflationary booms overtime equally exerted destructive pressures over enterprises. Inflation misleads businessmen in their investment decisions, which causes much waste and many bankruptcies. In fact, it is the root cause of the boom-and-bust cycle which wreaks havoc on economic activity. Indeed, inflation breeds many evils of which most people are unaware (Sennholz: 2005) . Monetary inflation via loans to business causes over-investment in capital goods, especially in such areas as construction, long-term investments, machine tools, and industrial commodities. On the other hand, there is a relative underinvestment in consumer goods industries. And since stock prices and real-estate prices are titles to capital goods, there tends as well to be an excessive boom in the stock and real-estate markets (Rothbard: 1995) . Hayek (1970) noted that an unforeseen depreciation of the value of money which is a consequence of inflation harms creditors and benefits debtors. This is however important but by no means the most important effect of inflation. And since it is the creditors who are harmed and the debtors who benefit, most people do not particularly mind, at least until they realize that in modern society the most important and numerous class of creditors are the wage and salary earners and the small savers, and the representative groups of debtors who profit in the first instance are the enterprises and credit institutions.

Generally, high rates and volatility of inflation not only make forecasting future inflation rates more difficult, but uncertainty regarding future inflation increases the risks associated with investment planning and thereby reduce the level of investment spending. High rates of inflation can produce a high degree of uncertainty about future inflation, which might indirectly affect investment spending adversely. Increased inflation uncertainty lowers investment by obscuring price signals (Milton Friedman 1977) . Inflation uncertainty negatively affects FDI. Increased uncertainty about future inflation-which generally exists when the rate of inflation is high-adversely affects investment spending. Similarly, uncertainty about future price levels could force investors to delay investment decisions, since investment is a sunk cost and largely irreversible. Without this uncertainty, consumers and producers could better plan for the future.

Most generally, inflation is a consequence of government spending policy and its financing. Government intervention brings about banks' credit expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play. The banks, for one thing, would never be able to expand credit in concert were it not for the intervention and encouragement of government (Rothbard: 1969) .

Positive economic growth is primarily a consequence of falling rates of time-preference, which invariably results in the increase of share of saving and investment to consumption, as well as declining rate of interest. When the rate of interest drops because of the interference of government and the central bank which promote the inflationary expansion of bank credit and not necessarily because of lower time-preferences and higher savings, businessmen, react as they always would when the rate of interest falls. They invest more in capital and producers' goods. Previously seeming unprofitable businesses now seem profitable thus encouraging investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable. The investors behave as they would when voluntary savings actually expanded prompting them to increase their investment in capital goods, industrial raw material, construction etc relative to the production of consumer goods. Entrepreneurs are glad to take advantage of the expanded credit and borrow - as the money is obtained at cheaper rates - to invest in capital goods. However, this borrowed credit is eventually expended on higher rents and wages. Naturally, the expanded business demand results in increased labour demands and labour costs. Eventually, these higher costs cannot be sustainably paid by the business men when the inflationary boom ends: they have made a false investment.

One important thing that emerges from our analysis is that the bulk of aggregate output growth from 1965 has been driven by monetary inflation with consequent impacts on investment through the medium of artificially lowered interest rates. These rates may not easily be widely and directly observed as such as a result of myriads of such effects across transaction types, sectors and across time. This accounts for the many occasions of depressions which have been observed. In the case of inflation, the impact is general although it does not affect all sectors, segments or sections of the economy at the same time, but the effect appears more general and will be difficult to be isolated. We carried correlation analysis between inflation and the growth rates of investment given three scenarios namely (a) same year that inflation occurs (b) a year after inflationary episodes and (c) two years after the recorded inflation. The reason for these amendments is based on the understanding that inflationary effects occur in a step-wise fashion and is not restricted to one-year but may actually extend to several years after the recorded inflation. This analysis is only an approximation as it is extremely difficult to meaningfully track the full effects of inflation particularly on investment behaviour. But using a simple assumption we examine at least partially how estimates of the changes in price levels are related with investments over the periods.

These coefficients demonstrate clearly the inverse relationship between investment growth and inflation. Going by this analysis, two years after officially reporting inflation, it is expected that between 2000 and 2003 investment would decline almost by 100% of the increase in prices. For the same period, the effects on average may not have been fully felt in the first and second years. Basing our analysis mainly on IG2, we can observe that investment is quite sensitive to changes in prices. All coefficients save that of the period of the crash show very good inverse correlation of between 30% and 100%. In IG0, we see many positive correlation points which confirm the short-term inflationary booms. Thus within the first year of monetary expansion, investment appears to have grown. But same inflation which caused this seeming growth will account for the destruction of these investments few years down the line.

Very close relationship can be deciphered from the graph in figure 2. Whereas inflation occurs first and investment growth reacts, investment has reacted oftentimes more than proportionately to the rate of change in inflation after some period of time (which from the graph is clearly not corresponding to the period of official inflation report). This more than proportionate response is an indication of the extent to which the investor is misled in the occurrence of monetary inflation. The investor/entrepreneur, wrongly feels that the inflationary situation is a profit situation and consequently waits for some period before eventually changing his business orientation in more than proportionate times than the increase in prices. The level of this misguided perception is also what determines the level of collapse in investment and output. Since investments are sunk in periods of boom, the height of the loss will be positively correlated with the level of sunk costs/investment.

For instance, prior to 1974, broad money supply grew by 13.8% (1973). However, in 1974, through 1977, money supply grew by 89% (1974); 55.7% (1975); 41.5% (1976); and 34.5% (1997). The forced savings of this period and the consequent mal-investments that followed resulted in the depression of the 1978 with real output declining by about 6%. These periods also witnessed massive investment booms with investment/GDP ratio increasing from 26.8% (1974); 42.6% (1975); 52.4% (1976) and 55.2% (1977). Investment also grew in percentage terms rapidly from 2.6% (1974) to 50.3% (1975) and 33.8% (1976). However, the continued expansion of money supply which was sustained even after the depression of 1978 could not support continued investment growth afterwards. By 1978 investment fell by 27.5% and could not recover from this persistent collapse for close to a decade. Even as a share of income, investment continued to crumble. This situation was also worsened by the fall in oil prices in the international market which consequently severely affected the earning prospects of the country. So the buffer that protected the economy from the earlier depression was withdrawn with a resultant effect of sliding investment growth. In addition to poor earnings, and depleting reserves, government sustained its fiscal deficit posture thereby aggravating the conditions of credit creation out of thin air.

He Who Cares to Hear…

Contrary to several unfounded impressions that the Nigerian macroeconomic environment is stable the truth is that unfortunately it is not in spite of all the numbers that are presented by concerned authorities to prove their case. Theory as already explained, as well as abundant evidence show how unfounded these positions are. Macroeconomic growth so far as you can see, has been precariously inflation driven as figure 1 above clearly shows. Unfortunately too, no country is prepared to buy off the excess fiduciary media that is created rapidly by the Nigerian central bank and the commercial banks. As a show of the impotency of these actions, real economic activities die on a daily basis. There is no level of intervention by the central bank in the absence of the conditions for the growth of entrepreneurial productivity that can alter the economically swaggering status of this country unless a honest reversal of the process of excessive money creation. There is no evidence that this has abated as the recent margin facility extravaganza have shown irrespective of policy pronouncements on recent monetary policy framework. The only saving grace so far for this country is the occurrence of good oil prices in the international market. Should oil prices drop slightly to the budget benchmark levels the crash that will follow will be unimaginable. Our monetary and fiscal policy must be appropriately harmonized such that at the fiscal end, there is a balanced budget and at the monetary policy end, growth of money supply should not exceed the growth of output by more than two percentage points if it should at all. This rule-based policy making must be complemented by a truly effective justice system and zero tolerance on official corruption which of course can only be driven by the president himself for maximum efficacious outcomes.

* Martin Oluba, PhD, DBA is an Executive Director in Forte FinancialLimited, Lagos Nigeria; an adjunct Professor of economics at the Swiss Management Center, Switzerland and Vienna as well as adjunct faculty (mentor) at the North central University, Arizona. He is also a Guest Columnist with the Economic Confidential.