Central bank independence

Why has the idea of enhancing the independence of a central bank gained such popularity in recent years around the globe? Do accompanying accountability arrangements matter?

The desirability of Central Bank Independence (CBI) has snowballed since (Alesina, A 1988) stated that his paper “argues tentatively” that independent Central Banks have been associated with a lower average inflation rate and “may have been responsible” for reducing politically induced volatility of monetary policy and inflation. As a result, we may be lured into the assumption that CBI was the brainchild of Alesina or Rogoff (who produced literature with similar results around the same time) and that it is a brand-new, groundbreaking concept. However, the issue of CBI is as old as central banking itself with David Ricardo arguing its benefits (or certainly the drawbacks of non-independence) in a paper written in 1824. Keynes articulated his thoughts on central bank independence while testifying to the 1913 Royal Commission into an Indian central bank. He stressed that the ideal central bank ‘would combine ultimate government responsibility with a high degree of day to-day independence for the authorities of the bank’. Clearly, as it is government legislation that created and gave powers to the central banks, there has always been a relationship between the two and they cannot be entirely distinct. Debate surrounding CBI considers the appropriate level of distinction (if any) and the potential benefits to the economy at large that such a separation would provoke. So if the theory behind the benefits of independence is almost two centuries old, then why has its popularity only soared in the last few decades?

(Goodhart, C.A.E 1994) utilises Friedman’s analysis of the Phillips Curve (1950s) to suggest that “stagflation” in the 1970s is a primary factor behind the surge towards CBI. The Phillips Curve displays the apparent inverse relationship (when the pressure of demand in an economy is low) between inflation and unemployment. Thus, Phillips suggested that the authorities were able to choose an optimal combination, or find a sufficient trade-off between the two, which is exactly what Governments attempted to do in the 50s and 60s. However, this theory was shot to pieces in the 1970s when the rate of inflation consistent with a given level of unemployment kept rising: “stagflation”. Friedman explained this by stating that the inverse relationship only ran true in the short-run. In the medium and long-run, he argued that the Phillips Curve would in fact be vertical and that there was no trade-off between inflation and unemployment. The implication of this was that those in charge could now use monetary policy as an instrument to control inflation in the medium and long term without compromising growth or employment within the same time horizon; thus enabling fiscal policy and supply side measures to be utilised in stabilising shocks in the short term. Governments soon adopted medium-term financial strategies for bringing down inflation and began to use supply-side measures for promoting growth. Herein lay the problem, in that now a conflict of interest arose for those in charge. In the short-run, with expectations given, expansionary monetary and fiscal policies would raise employment and allow excess growth above the long-term level. However, Ministers were aware that although it may take some time to show up, higher inflation will be the inevitable result in the long-run. (Goodhart, C.A.E 1994) holds a very cynical view of politicians and suggests that they may forgo their medium-term economic responsibilities and lower taxes or raise expenditures before elections to induce a “feel-good factor” that would get them re-elected. The resulting inflation would only rear its ugly head after the election when they could tackle it by raising interest rates and thus maintain the boom/bust cycle. If they did not get re-elected it would be the next Government’s problem and hence political short-mindedness and lack of credibility is laid bare for all to see. (Fraser, B.W 1994) is a lot less sceptical of politicians and argues that it is uncertainty rather than exploitation of the short-term inflation/unemployment trade-off that can inject inflationary bias into the policy making process. He argues that because no-one knows with any confidence what the long-term growth capacity limits are or what the ‘natural’ rate of unemployment is, it is very difficult for politicians to heed warnings about operating above these limits whilst under pressure from the electorate to maintain or stimulate growth. Similarly, they do not know the length of the lags between policy changes and their impact on growth and inflation, thus Fraser implies that it is only natural for politicians to believe that they can push the economy a little bit further. Or, as William McChesney-Martin, the Governor of the US Fed from 1951 to 1970, said “They may be reluctant to take away the punchbowl just when the party gets going.”

Irrelevant of your personal degree of cynicism towards politicians, it is clear that an independent authority with a long-term vision of price stability and no inclination towards inflation is the only remedy to rescue the electorate from a spiral of inflationary doom inflicted by governments. Pre 1971 a large degree of price stability was autonomous in the developed world with first the Gold Standard, then the Bretton-Woods system anchoring prices to a fixed level. (Fraser, B.W 1994) proposed that the earlier arrangements had imposed an international discipline on countries but when those arrangements passed into history, the responsibility for maintaining price stability reverted to national authorities. This perhaps adds more credibility to Fraser’s lack of scepticism as for example, (excluding war times) the UK government had not had this burden since 1717, a completely incomparable financial era. Coupling this 250 year knowledge gap, with the temptation of short-term benefits at long-term costs, it is of no surprise that Government-managed monetary policy was doomed to collapse. After this was realised, the move towards an Independent Central Bank evolved naturally as it solved both the politicians’ and public’s concerns. Following over a decade of failure, politicians wanted rid of the price stability burden and someone else to blame for its failure (Kane, E 1980) and the public wanted monetary policy to be controlled by an institution with credibility (Rogoff, K 1985) so that their expectations were met.

Despite conveniently tying together, these two arguments are not exhaustive in explaining the rise in popularity of CBI in recent times. Under the Maastricht Treaty, all states wishing to enter the European Union must have an independent national central bank so as to complement the ECB and the European System of Central Banks, whose job it is to ensure that the Euro area benefits from price stability. The EU has adopted such a hard-line stance on the basis that the success of the German economy of maintaining low inflation has arisen from the independent nature of the Bundesbank. Therefore, the installation of an independent central bank (the scope of independence is not legislated) has been ‘forced’ upon all twenty-seven member states regardless of whether they had previously suffered inflationary problems. However, it must be noted that by applying to join the EU, each member state is already willing to concede its control over monetary policy in the long-term to the ECB, so an intermediate step to a national independent central bank would not present a significant hurdle.

Many commentators have looked at who in the economy benefits most from CBI and have drawn conclusions on the reason for the growth of central bank independence from there. Those emphasising the interests of the financial sector as key are perhaps the most logical. (Posen, A 1993) and (Bowles, P & White, G 1994) suggested that independence has been encouraged by financial interests and global institutions taking advantage of a “crisis of governance” in the 1980s and 1990s. The benefits for such institutions are obvious; a credible monetary policy allows for accurate expectations within a business plan and low inflation maintains real wages and ensures low interest rates for accessing credit. Therefore we can accredit some popularity of central bank independence to the shift in political power towards large corporations, with the most notable example being the USA. Linked to this, (Maxfield, S 1997) proposed that Governments in some fast-growing economies hold the perception that foreign investment from such large corporations will therefore be more forthcoming if they have an independent central bank. Other commentators have looked elsewhere in society with (Piga, G 2000), suggesting that the aging of some populations has promoted creditor interests. However, this is not supported by the speed of reform as although populations are aging, they do not do so suddenly whereas the popularity of central bank independence took off very rapidly.

So it can be seen that there may be many different reasons behind the surge in popularity of CBI and as a result it seems natural to conclude that different levels or types of independence would be more suitable for these different variations. Similarly, the different nature of governance and democracy in countries dictates the need for a reasonable amount of flexibility and varying accountability within central bank independence.

The norm within the literature is to follow Fischer’s (1994) dichotomy between ‘goal’ and ‘instrument’ independence, although many different measures of independence have been investigated and published; most notably (Cukierman, Webb, and Neyapti, 1992) and (Grilli, Masciandaro, and Tabellini, 1991). Goal independence refers to the central bank’s capacity to choose policy goals without being under the direct influence of the fiscal authority (usually the Government). The Bank of England lacks goal independence because the inflation target, which is very specific measure, is set by the government. In the USA, the Humphrey-Hawkins Act requires the Federal Reserve to conduct monetary policy to promote the goals of ‘maximum employment, stable prices, and moderate long-term interest rates’. These goals are described in vague terms providing the Fed some leverage to translate these into operational goals and thus allowing it a high level of goal independence.

Instrument independence alludes to the central bank’s ability to freely adjust its policy tools in pursuit of the goals of monetary policy (Walsh, C 2005). Despite lacking goal independence, the Bank of England has instrument independence: it is provided its inflation mandate by the government and then it is able to choose its instruments without any further direction. However, the Federal Reserve has complete instrument independence in addition to having a large degree of goal independence. How can a nation that prides itself for being democratic justify handing over complete control of monetary policy to a group of un-elected officials? In addition, such a system would surely not resolve the issue of uncertainty regarding inflation policy as the public, who clearly distrusted them before, now have to rely on politicians to choose suitable people to control monetary policy. The simple solution is accountability; if central banks make their decisions transparently and/or are held accountable for their actions, the public can feel a lot more confident in making expectations. The reputation of a central bank plays a key role in how much accountability is required; the longer the CB has delivered its promises/targets, the more trustworthy it is deemed to be and the less accountability is required.

The empirical evidence seems to support this assertion. The German Bundesbank, often compared to Rogoff’s “Conservative Cental Banker” (Rogoff, K 1985), has a very high level of independence but almost no accountability and this is sustainable only because of its reputation. Since the hyperinflation of the 1920’s the Bundesbank has been careful to reflect, or even cultivate a public acceptance of the need for price stability (Bank of England 1996). This means that the inflation-averse German people are happy to trust the Bundesbank to deliver low inflation because of its impeccable track record over the last 50 years. This suggestion is strengthened by the following graph, where low inflation is related positively to low accountability:

At the other end of the spectrum, the Bank of England and even more so the Reserve Bank of New Zealand are held accountable for their results, despite their comparative lack of independence. This may be explained by their relative infancy within the realms of CBI (The BoE became independent in 1997 and the RBNZ in 1989) and so in either case there has not been enough time to build a reputation. With regards to the UK, the terrible collapse of the Medium-Term Financial Planning system under Thatcher may remain a coal stoking the fire of the public’s political cynicism, adding further need for a high level of accountability.

There are three main channels by which the BoE demonstrates its transparency and accountability to both the Government and the public at large. Primarily, the inflation target itself is the cornerstone of the authorities’ medium-term price stability objectives and provides an indisputable measure of failure or success that is simple to understand. This is in stark contrast to the MTFS where numerous measures (e.g. £M3, M1, PSL2), which were not immediately recognisable to the man on the street, were used and muddied the water if targets were missed. In addition the minutes of the meetings between the Chancellor and Governor, where monetary policy decisions are made and discussed, are published each month along with the Inflation Report, detailing the Bank’s own scrutiny of inflationary patterns. In comparison to The New Zealand Approach, where the Governor can be sacked for missing an inflation target, having the Governor of the BoE write a letter for the same crime seems particularly soft. However, if we compare the relative successes of the two banks since they adopted independence, we see that until 2007 the BoE never missed a target and that in 1990 New Zealand had 8% (RBNZ Website) inflation when its target was 0-2%. This evidence seems to add credence to the suggestion that more accountability is required with a lesser reputation.

The 1990s saw both developed and developing countries move in their droves towards increased central bank independence. This trend was sturdily influenced by empirical analysis of the relationship between macroeconomic performance and independence [see Alesina and Summers (1993), Jonsson (1995), andEijffingeret al. (1998)], which among the developed countries suggested a negative relationship between independence and inflation. For this reason alone it is of no surprise that CBI popularity grew, but coupled with the earlier stated reasons it seems to have become a necessity to successfully run a modern Government and economy.

By adopting independence, a restriction on government interference in monetary policy is imposed; while making the central bank transparent and accountable imposes a restraint on how it utilises this independence. Both of these constraints are desirable as they allow those more knowledgeable to influence policy and provide those responsible for making policy someone else to blame if it fails. However, transparency by itself is not necessarily adequate for a monetary institution; after all, what good is the CB missing its objectives but just being very honest about it after? Instead, transparency can help the institution combat inflation bias and promote confidence in expectations, either by itself or in conjunction with central bank independence or even a formal central bank contract (Bank of England 1996), as in New Zealand.

Finally, the empirical evidence linking independence, accountability and low inflation is conclusive. From the graphs above we note the inverse relationship between accountability and independence, which suggests that they are substitutes rather than compliments (Bank of England 1996). Hence, we can conclude that in terms of inflation targeting, accountability is equally as important as central bank independence, as one or the other (not necessarily both) is required for success. In addition the positive relationship between accountability and inflation history suggests that, at least for a short time period, accountability can be used as a substitute for a reputation of low inflation. Thus providing an instantaneous removal of the problems associated with the rational expectations model and allowing low inflation to be enjoyed by all.

References:

• Alesina, Alberto. “Macroeconomics and Politics.” In NBER Macroeconomics Annual,
  pp. 17-52. Cambridge, 1988.
• Alesina A, Summers L.”Centralbankindependenceand macroeconomic performance: some comparativeevidence.” In Journal of Money, Credit and Banking 25: pp 151-62(1993)
• Bank of England. “Central Bank Independence & Accountability: Theory and Evidence.”
  In Bank of England Quarterly Bulletin, February 1996, pp-63-68
• Bowles, P and White, G. “Central bank independence: A political economy approach.”In The Journal of Development Studies31(2) (1994), pp. 235-264
• Cukierman, A., S. B. Webb, and B. Neyapti. “Measuring the Independence of Central Banks and its Effects on Policy Outcomes.” In The World Bank Economic Review, 6, pp. 353-398. 1992
• Fischer, S. “Modern central banking.” In The future of Central Banking (1994),
• Eijffinger SCW, Schaling E, Hoeberichts M.”Centralbankindependence: a sensitivity analysis.” In European Journal of Political Economy 14: pp.73-88 (1998)
• Fraser, B.W. “Central Bank Independence: What does it mean?” In Reserve Bank of Australia Bulletin, 1994.
• Grilli, V, D. Masciandaro, and G. Tabellini. “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries.” In Economic Policy 6, pp 341-392. 1991
• Goodhart, C.A.E. “Central Bank Independence.” In Journal of International and Comaparative Economics, 3. 1994.
• Jonsson G. “Institutions and macroeconomic outcomes – theempiricalevidence.” In Swedish Economic Policy Review 2: pp.181-212. (1995)
• Kane, E. “Politics and Fed Policymaking: The More ThingsChange, the More They Remain the Same,”In Journal of Monetary Economics,6,2(April 1980), pp. 199-211
• Maxfield, S. “Gatekeepers of Growth: The International Political Economy of Central Banking in Developing Countries” 1997
• Piga, G. “Dependent and Accountable: Evidence from the Modern Theory of Central Banking,”In Journal of Economic Surveys vol. 14(5), December 2000, pp 563-95
• Posen, A. “Why Central Bank Independence Does Not Cause Low Inflation: There is No Institutional Fix for Politics.” In R. O’Brien (ed.), Finance and the International Economy. 1993, pp 40-65.
• Rogoff, K. “The optimal degree of commitment to an intermediate monetary target.”In Quarterly Journal of Economics100(1985), pp. 1169-1189
• Walsh, C. “Central Bank Independence” Prepared for The New Palgrave Dictionary December 2005
  RBNZ Website: http://www.rbnz.govt.nz/keygraphs/Fig1.html