Central Bank Independence in Ordinary and Extraordinary Times

Central Bank Independence in Ordinary and Extraordinary Times

Description

In the last decade (from 1989 to 1999) central banks around the world have grown more independent, i.e., less subordinate to the dictate of the political authorities. Central bank independence has become a kind of "graduation issue" for countries wishing to exhibit or consolidate their credentials in monetary stability and fiscal restraint. In Europe, the Maastricht Treaty on European Union has made legal central bank independence a conditio sine qua non to participate in European Monetary Union, in addition to the four criteria of economic convergence. In other parts of the world, particularly in emerging economies, governments have been compelled internally or externally (e.g., via a recommendation of the International Monetary Fund) to grant independence to their central banks. The movement towards enhanced independence for central banks has been supported by a nearly overwhelming consensus among scholars and policymakers that independent central banks are desirable from the standpoint of public policy. The argument for central bank independence is relatively straightforward. Inflation, in the view of most contemporary economists, has no long-range welfare benefits. But it does have significant costs. These costs include distortions in economic activity, the costs of repricing real assets according to a changing nominal price level, the costs of the effort people have to undertake to avoid losing the value of their financial claims, and, in cases of very high inflation, the subtle but pervasive effects of social demoralisation. Because inflation is unequivocally bad for a society, everyone would be better off if the political institutions maintained stable prices. However, experience has shown that political institutions often do not maintain stable prices. They have several powerful incentives to expand the money supply beyond the rate of real growth in the economy. The incumbent party may engage in inflationary policy in the period immediately before an election in order to increase economic activity, raise employment, and create a strong, if temporary, sense of euphoria among voters that translates into votes for the politicians then in office. A related motivation is that politicians may favour inflation as a means of (temporarily) increasing employment and output in an environment where wages are set above their market-clearing rate. Governments may also be tempted to inflate the currency out of a revenue motive: real wealth can be extracted from the public holding money balances if the value of those holdings can be eroded through issuance of additional money. Inflation may also be an effective means for reducing the cost to the government of paying back debt denominated in local currency. Inflation induced by devaluation can also reduce, temporarily, a nation's balance of payment deficit. While these may seem like real benefits to the government, in fact they rarely are beneficial. The reason is that if the government has not precommitted not to inflate the currency, the contracting parties will know in advance that the government is likely to do so. The parties will build into their contracts protections against future inflation, thus eroding the value of the currency. Even so, in the absence of a reliable pre-commitment not to inflate, the government will inflate the currency notwithstanding these contracts built on rational expectations. Once the contracts are in place, in fact, the government may be practically compelled to engage in inflation in order to mitigate the distortions that would otherwise be introduced by the contracts. It is against this background that the independent central bank finds its contemporary justification. By an "independent" central bank, we mean a particular kind of institution that is independent in some respects, but highly constrained in others. In particular, an independent central bank is relatively free of short-term political pressures: its officers serve for long periods and may not be removed from office for disagreements over policy with other government officials, and it does not take orders from any other institution. In this respect it enjoys a high degree of autonomy. At the same time, an independent central bank, as we use the term here, is not autonomous in its goals. Rather, a principal goal of an independent central bank is to achieve price stability, either absolute stability of prices, or prices that change within some range set in advance and publicly observable. A central bank that is politically autonomous but goal-constrained in this sense can devote itself to maintaining price stability, without being subject to the political pressures that might otherwise induce inflationary policies. The independent central bank can be seen as a form of pre-commitment by the political system to tie its hands, like Ulysses at the mast, to avoid taking destructive actions when the siren of inflationary temptation appears. If the central bank is truly independent of the political cycle, and is truly committed to the goal of maintaining price stability, it will not be subject to the pressures that tend to generate inflation when monetary policy is in the hands of political actors. There is some evidence that, in fact, this theory has practical merit: in the developed world, at least, independent central banks tend to have a somewhat better record of achieving price stability than their non-independent counterparts. The case for central bank independence is often presented as a virtual absolute. That is, the theory recognises no limits on central bank independence, so long as the bank itself is reliably precommitted to achieving price stability. Taken at face value, the theory would suggest that central banks should be completely insulated from politics. But this is not the case in the real world. Even highly independent central banks, such as the Federal Reserve Board or the European Central Bank, do not enjoy this kind of independence. Although they operate with a high degree of protection from political pressures, they are far from isolated from the political process. And while maintaining price stability is typically the primary goal of such institutions, it is rarely if ever the sole objective. The charters of these banks often also contain clauses that permit or require then to consider other objectives, such as maintaining the stability of the financial system, enhancing employment, facilitating economic growth, and so on. Moreover, even if the central bank charters purported to establish absolute independence, they are only pieces of paper. A legislative charter can always be revised by subsequent legislation: and even if the charter is embodied in a national constitution, the constitution can always be amended or ignored. It is obvious that there are limits to central bank independence in the real world, however much the economist's pure theory might question the rationale for such limits. Why do we observe, in fact, considerably less independence than would be suggested by orthodox economic theory?

Source Publication

Central Bank Independence: The Economic Foundations, the Constitutional Implications and Democratic Accountability

Source Editors/Authors

Jan Kleineman

Publication Date

2001

Central Bank Independence in Ordinary and Extraordinary Times

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