Central bank

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?

To begin with, central bank independence is a theory that it is optimal for the government to delegate control of monetary policy to a credible, conservative central banker to eliminate inflationary bias as described by Rogoff (1985). Central bank independence has become a phenomenon around the world mainly because it has been linked with the financial stability (low inflation) in many countries where it has been adopted. However, there are criticisms of complete independence of central banks hence why accountability arrangements are crucial. The global financial crisis of 2007 has made the issue of central bank independence even more pertinent, which I will discuss in this essay.

Up until recently, only the United States (Federal Reserve), Germany (Bundesbank) and Switzerland (Swiss National bank) were seen as independent central banks. The striking trend of many countries towards central bank independence since the 1990s followed growing evidence in theory and experience (shown in empirical studies) that more independent central banks resulted in better realisation of monetary policy. This coincided with a trend in explicit inflation rate targeting in monetary policy. This was based on growing consensus among economists such as Kydland-Prescott (1977) and Barro-Gordon (1983) that monetary policy does affect inflation; in that there is an inflation bias when agents, who are rational, expect monetary authorities to increase output (to reduce unemployment) in excess of the natural rate thus they adjust their prices up accordingly.

Firstly, in theories which support the establishment of independent central banks, it is shown that governments or central banks dependent on the government are shown to be ‘inflationary biased' when conducting monetary policy due to dynamic time inconsistency and a lack of credibility of authorities under discretion, rather than sticking to a ‘rule'[Barro-Gordon (1983)]. This can be related to the idea that the government could try to influence voting behaviour by pursuing expansion policies to reduce unemployment and lower interest rates to induce a ‘feel-good factor', thereby increasing the chances of winning an election as shown in the model by Rogoff-Sibert (1988). This suggests that the government is myopic because they have an incentive to increase output in the short term which has profound effects, such as higher inflation, in the long run [Alesina (1988)]. Whereas, an independent central bank should not be influenced by elections in the short term so would be able to focus on monetary policy in the long run, therefore, it could prevent these ‘political business cycles' and bring about price stability.

A central bank that is politically insulated is therefore more likely to be able to resist pressure from the government; such as to facilitate financing large government budget deficits, which usually leads to inflationary pressures, by its purchases of government securities (on the open market). It is also argued that central bankers have the technical skills or expertise to conduct monetary policy effectively whereas politicians do not. For example, central bankers are able to make inflation rate forecasts in order to adjust interest rates as necessary to meet their inflation rate target. Moreover, an independent central bank is more credible and therefore more likely to be effective at monetary policy because the public tend to distrust politicians in general. King (1997) by using the Rogoff model, showed that expected loss under pure discretion is greater than loss under a conservative central banker (LC < LD) which implies that it is optimal to delegate control of a central bank to a ‘conservative' central bank governor. This implies that central bank independence overcomes the principal-agent problem in that a central bank would have more incentives than politicians to act in the interest of the public, especially if the central bank is held accountable to government.

An independent central bank can therefore pursue policies that are in the interest of the public yet they may be politically unpopular. Besides, an independent central bank could be used almost like a ‘scapegoat' by the government if monetary policy breaks down which implies that this is favourable for politicians because it diverts public pressure from them. In contrast, a principal-agent problem would arise if the central bank was completely independent from government which means that accountability arrangements are crucial. An autonomous central bank would also be undesirable because it would be seen as undemocratic to allow monetary policy, which affects society to be controlled by unelected group of people. Therefore the argument against the independence of central banks with respect to it being ‘undemocratic' depends specifically on the structure of accountability of the central bank; it is ‘model specific' as argued by Goodhart (1996). As Milton Freidman argued, ‘money is too important to be left to central bankers and unelected officials.' There appears to be, however, a contradiction here because if the central bank is accountable to government this means that government could put pressure on the central bank to act in a certain way or risk being replaced by the government but in practice, the Governor and the Board of an independent central bank have a tenure of usually 5 years or more so do not have to act in fear of being sacked.

Accountability in this context means in the form of transparency so that the government and the public can ensure that the independent central banks are credible and are able to achieve the inflation targets set. In the UK for example, if the Bank of England misses the inflation target of two per cent by more than 1 per cent point above or below, the Governor of the Bank of England has to write an open letter to the Chancellor of the government explaining why, which is part of the accountability arrangements. The minutes of the Monetary Policy Committee meetings are also published as a check on the independence of the Bank of England. There is a growing prominence for newer independent central banks to be pre-committed to targets publicly set by the government so that they are accountable. Countries such as New Zealand, Canada and the UK have adopted a framework of inflation rate targeting for monetary policy so that targets, set by the government or agreed between the central bank and the government, act as a constraint on the central banks' ability to behave in a discretionary manner as well as enhancing the transparency and the accountability of the central banks. This is supported by Svensson (1996): ‘By increasing accountability, inflation targeting may serve as a potential commitment mechanism, reduce or eliminate any inflation bias…and increase the likelihood of achieving and maintaining low and stable inflation, as well as anchoring and stabilising inflation expectations.' This suggests that central banks should have instrument independence but not goal independence because the goal (inflation rate target) is decided primarily by the government which overcomes the problem of the central bank not being democratically elected, consistent with the views of Debelle-Fischer (1994). It also illustrates why accountability arrangements are so significant for the effectiveness of central bank independence.

Another argument against central bank independence is that it makes it more difficult to coordinate monetary policy and fiscal policy than under one institution (the government). However, this argument is weak as historically, it has been shown that there was inflation volatility even though monetary policy and fiscal policy were coordinated together by the government. On the other hand, it can be argued conversely that an independent central bank is desirable to limit the financial powers of the central government because it separates the right to spend money (nested in the government) from the right to create money (which lies with the central bank).

Secondly, empirical studies such as the ones conducted by Bade-Parkin (1982), Grill-Masciandro-Tabellini (1991) and Alesina-Summers (1993)[1] have shown that there is a negatively correlation between central bank independence and inflation, which also explains the increasing prominence of central bank independence in recent years. In fact, the study by Grill-Masciandro-Tabellini (1991) appears to show a ‘free lunch' in so far that, countries with higher central bank independence on average have relatively low inflation rates without real economic costs in terms of lower output growth or higher output volatility in contrast to the theory of Barro-Gordon (1983). However, as economists we are sceptical of ‘free lunches' and it is well known that correlation does not imply causation so we should be wary of taking this prima facie, because there could be other macroeconomic variables which have not been taken into consideration. The findings of Alesina and Summers (1993) suggest that, “it is possible for nations to achieve these benefits without setting a monetary policy rule by insulating the central bank from political control.” This implies there could be other factors which result in low inflation rates in different countries. For example, the Bank of Japan which was a dependent central bank until 1999, i.e. heavily involved with government coordinated economic policy-making, also had low average consumer price inflation (according to the IMF) compared to countries with independent central banks, such as the US and Germany. Nevertheless, there is not enough evidence to fully support the relationship between central bank independence and inflation because studies have only been based on a relatively small sample of banks over a small period of time. Moreover, as Alesina and Summers (1993) noted, “The degree of central bank independence varies considerably across countries.” The implication is that the difficulty is in how to measure central bank independence as different indexes use different criteria to ‘quantify' independence so they are subjective.

In addition to empirical studies, the experience of Germany where it's Bundesbank, a particularly independent central bank, seemingly had a good track record at keeping low inflation so other central banks started to follow its example. The ‘SIB' index used in Loungani-Sheets (1997) is a measure of the similarities between the characteristics of a given bank and the characteristics of the Bundesbank which implies that the Bundesbank was seen as benchmark for central bank independence. Furthermore, the European Central Bank (ECB) was based on the model of the Bundesbank and other countries in the European Monetary Union had to make their central banks independent in order to join the European System of Central Banks. The ECB is arguably the most independent central bank in the world because it has both instrumental and objective independence from any political influences of countries in the EU. The ECB also has limited accountability and can conduct meetings of its governing council in confidence; it is independent in the literal sense in that it can conduct policy free of any constitutional safeguards and political restraints. Furthermore the ECB had to be at least as independent as the Bundesbank if Germany was to join, giving up the Deutschmark. However, the apparent success of the Bundesbank could have been a fallacy as Leaman (2001) argues, as the independent central bank (then known as the Reichsbank) did not prevent the hyperinflation in Germany during the 1920s and also broke down during the Great Depression. He adds, “The sanctification of institutions like the Bundesbank (‘not all Germans believe in God but all Germans believe in the Bundesbank') in turn creates a mythology of power and effectiveness which is internalised by its exponents.” This implies that it is perilous for countries to follow the same model as the Bundesbank of an autonomous central bank. This is supported by Goodhart (1996) who suggests that the success of the German model (Bundesbank), ‘depends on circumstances and conditions particular to Germany.' A possible explanation is that central bank independence may be an endogenous variable when the public could be particularly inflation adverse, such as Germany as a result of an experience of hyperinflation, which increased the propensity for the Bundesbank to be committed to price stability [Alesina and Summers (1993)].

A possible reason why central bank independence appears to be related to low inflation in empirical studies and in Germany is because it coincided with a period of what is described as the ‘Great Moderation' where there were relatively few shocks to economic activity up until the financial crisis in 2007, regardless of monetary policy or whether or not the central bank was independent. Despite inflation rate targeting by independent central banks being attributed to bringing about a long period of price stability and output growth since its implementation, the recent financial crisis has shown that inflation rate targeting alone is not enough; it should not be the sole macroeconomic goal. Indeed, the current global financial crisis has shown that monetary policy may have detrimental effects on other real economic variables. Central banks abandoning inflation rate targets would damage the credibility that they have established over recent years so it is highly unlikely that they would lose independence over monetary policy instruments.

The recent financial crisis of 2007 however has threatened the independence of central banks around the world. The unprecedented measures taken by central bankers to tackle the crisis have raised concern that they are going beyond their powers as ‘technocrats' therefore should not be so independent. For example, independence of the Bank of England from political influence is being compromised because money being loaned to the banks (‘quantitative easing') is coming from the government (in essence, from taxpayers) and so the Treasury must have a say in the policies being taken. Fiscal and monetary policy co-ordination in order to tackle the crisis has shown that the two institutions are interdependent. As Axel Leijonhufvud asserts, “no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to hold.” Even the ECB has recognised as a result of the financial crisis that it will have to sacrifice what is left of its operational independence to resume its role in financial stability. Thus, this suggests that most central banks will be reformed after the crisis is over. For example, there are calls for central banks to have a greater role in ‘macro-prudential' supervision as a result of the crisis. In particular, the removal of supervisory and regulatory powers from central banks, such as the Bank of England was heavily criticised, although this does not apply to all countries; it could perhaps serve as a lesson of the problems it can lead to if the central bank becomes too independent or detached. This contradicts the theory that supervision was a distraction from the pursuit of price stability and creates possible political conflicts. In particular, supervision of banks was separated from the powers of some central banks because it was felt that it was necessary to prevent the undemocratic body from becoming too powerful. This view was supported by Goodhart (1996): “A central bank which is both independent in its conduct of monetary policy and responsible for banking supervision may be perceived as too powerful and separate an entity in the otherwise democratic body politic.” Nevertheless, the boundaries of central bank independence are being blurred which implies that the dominant trend towards central bank independence could be reversed as a result of the financial crisis, as already seen. As Richard Baldwin (2008) aptly summarises, “Central bank independence is the world's new gold standard. But like the real gold standard before it the system will eventually come to an end.” (from The Economist)

In conclusion, because central bank independence of central banks is a relatively recent phenomenon, it is still not yet clear which the best model is as there is not enough reliable evidence to strongly support a model from a particular country. Even Germany's Bundesbank which the ECB model is based on has not escaped criticism. It seems, however, that the middle ground for central bank independence (from complete autonomy) is for central banks to have instrument independence whilst the government retain the right to set politically agreeable economic objectives which the central bank should achieve. In this way, the government can monitor the efficiency of the central bank in achieving the agreed policy objectives; thereby making central banks accountable. Accountability arrangements which are crucial include the transparency of the independent central bank. However, the global financial crisis in 2007 has very much brought central bank independence into question which has the implication that its prominence previously could be reversed as a result.

References

Alesina, A., Summers, L.H. (1993). Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence. Journal of Money, Credit and Banking, Vol. 25, No. 2, pp. 151-162. Stable URL: http://www.jstor.org/stable/2077833

Bain, H., Howells, P. (2003). Monetary Economics - Policy and its Theoretical Basis. New York: Palgrave Macmillan, pp. 231-239.

Baldwin, R. (2008). Central bank independence under threat. [Internet] The Economist. <http://www.economist.com/node/20018263/print> [Accessed 29/11/2009]

Barro, R.J. and Gordon, D.B. (1983). Rules, discretion, and reputation in a monetary model. Journal of Monetary Economics 12, pp. 101-121.

Brealey, R.A. et al. (2001). Financial Stability and Central Banks - A global perspective. London: Routledge, pp. 67-73.

Buiter, W. (2009). What's left of central bank independence? [Internet] FT.com <http://blogs.ft.com/maverecon/2009/05/whats-left-of-central-bank-independence/> [Accessed 29/11/2009]

Fry, M., Julius, D., Mahadeva, L., Roger, S. and Sterne, G. (2000). Key issues in the choice of monetary policy framework, in (L. Mahadeva and G. Sterne, eds), 'Monetary Policy Frameworks in a Global Context', London: Routledge, pp. 1-216.

Goodhart, C.A.E. (1995). The Central Bank and the Financial System. MIT Press, pp. 60-71.

Healey, N.M., Wisniewski, Z. (Ed) (1999). Central Banking in Transition Economies. Poland: Torunska Szkola Zrazadzania Sp., pp. 284-319.

King, M. (1997). Changes in UK monetary policy: Rules and discretion in practice. Journal of Monetary Economics 39, pp. 81-97.

Leaman, J. (2001). The Bundesbank myth: towards a critique of central bank independence. London: Macmillan, pp. 246-260.

Lewis, M.K., Mizen, P.D. (2000). Monetary Economics. New York: Oxford University Press Inc., pp.423-429.

Mishkin, F.S. (2009). The Economics of Money, Banking and Financial Markets. Boston: Pearson Education Inc., pp.315-340.

Svensson, Lars E.O. (1997). Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets. European Economic Review 41, pp. 1111-1146.

[1] There are more empirical studies on central bank independence but these are the main ones which are usually quoted.

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