The politics of central bank independence

Transcription

1 Central Banking The politics of central bank independence In this first of a series of articles, Michael King from the London School of Economics analyses the reasons why politicians decide to give the central bank independence when they do. 1 Michael King Although much has been written explaining why a central bank should be made independent, it is still difficult to predict when politicians will change the legislation governing the central bank. Do politicians give independence to the central bank in response to pressure from interest groups or financial markets, or on the basis of their own self-interested calculations? And how do economic ideas influence the outcome? A large economics literature has elaborated what politicians stand to gain from giving up control monetary policy, as well as addressing what monetary arrangement is likely to deliver the best outcome. However how to explain the timing of the change when politicians will delegate to the central bank remains elusive. This article reviews a number of plausible explanations suggested by the political economy literature on this topic. These hypotheses will then be examined in subsequent articles which look at the reforms over the past decade at the Bank of England, the Bank of Canada and the Reserve Banks of New Zealand and Australia. Operational independence is defined narrowly to refer to changes in central bank legislation which give the central bank control in setting short-term interest rates free from the intervention of politicians. This narrow definition is intended to focus on explaining the timing issue which is of interest to practitioners while moving beyond controversies concerning how to define and measure central bank independence. The first section reviews the increasing trend towards greater central bank independence over the past decade. The second section reviews the orthodoxy underpinning this trend, and summarises the empirical findings and technical difficulties encountered in studies of central bank independence. The third section summarises explanations found in the literature for explaining the timing 1 I would like to thank Charles Goodhart for helpful comments on an earlier draft. I have benefitted greatly from discussions and correspondence with William Bernhard, Richard Burdekin, Forrest Capie, Christopher Houghton Budd, John Maloney, Adam Posen and Andrew Walter. The views, as well as any errors and ommissions, remain my own. 50

2 Monetary Policy Frameworks of this legislative change, and points to a set of hypotheses that will be explored in future articles. Over the past decade, 34 industrial and developing countries legislated increases in the operational independence of their central banks, as opposed to only three such changes during the 1980s (Maxfield 1997). The breadth of this trend becomes greater when adding the almost two dozen independent central banks founded following the collapse of the Soviet Union in late 1991, which brought the number of central banks in the world to just under 200 by the close of the decade. This growth has been driven by the founding of the European Central Bank in 1999, the desire by emerging market countries to secure the gains from stabilisation programs, and the move by former communist countries to build market economies (Cukierman 1994). In preparation for the introduction of the euro, all eleven member states were required by Article 108 of the Maastricht treaty to bring their national legislation in line with the legislation for the ECB. Countries on the periphery of the Eurozone were also active in introducing reforms, such as Greece which failed to qualify in the first round; Sweden and the UK who opted out; Hungary and Poland who are poised to join an expanded EU; and Turkey which has requested to join. Recent OECD members Mexico and Korea increased their central banks independence as part of IMF conditionality following financial crises in 1994 and 1997, respectively. The most recent reform in Japan in 1998 followed a political scandal in that country. Table 1. Changes in existing central bank legislation Trends in independence OECD & EMU members OECD Ex-EMU Non-OECD Austria 1998 Greece 1997 Argentina 1992 Belgium 1993 / 98 Hungary 1991 Chile 1989 France 1993 / 98 Japan 1998 Colombia 1992 Finland 1998 Korea 1998 Ecuador 1992 Germany 1993 /94 /98 Mexico 1994 Egypt 1992 Ireland 1998 New Zealand 1989 Honduras 1995 Italy 1992 /93 /97 Poland 1991 /97 Indonesia 1998 Luxembourg 1998 Sweden 1998 Pakistan 1994 Netherlands 1994 /95 /98 Turkey 1989 Peru 1992 Portugal 1990 /95-98 UK 1998 Philippines 1993 Spain 1994 / 97 South Africa 1989 Uganda 1993 Venezuela 1992 Source: Cottarelli and Giannini (1997); Cukierman et al (1992); Maxfield (1997); and national central banks Delegation to an independent central bank is designed to increase the credibility of monetary policy. Game theory studies of the mid-1980s demonstrated the importance of credibility for monetary policy, modelling it as a repeated game between rational, forward-looking actors (Persson and Tabellini 1994). Time inconsistency arguments were combined with rational expectations to show that discretionary monetary policy was Game theory and time inconsistency 51

3 Central Banking Problems with empirical analysis A subjective process ineffective for raising real output, as private actors factored inflation into their expectations creating an inflationary bias in society (Barro and Gordon 1983). An institutional mechanism was needed which made political promises to pursue price stability credible to private actors (Cottarelli and Giannini 1997). Monetary authorities needed to build a reputation for price stability, to increase the transparency of policy or to delegate control of monetary policy to an independent entity. These options led to the adoption of explicit mandates of price stability, the enumeration of inflation targets and the trend in the operational independence of central banks. One commitment technology was having an independent central bank which increased credibility by precommitting politicians to an anti-inflationary monetary policy (Neumann 1991). This arrangement could be improved by including an escape clause in central bank legislation allowing a political override under extreme circumstances (Lohmann 1992). As a strategy for achieving credibility, delegation was preferred to reputation building, which was perceived as time consuming, costly and dependent on the existence of an efficient financial system. Alternative commitment technologies are the adoption of an exchange rate peg, the establishment of a currency board or the formation of a currency union. The importance of the debate over central bank independence is a function of its perceived impact on economic performance, particularly the negative association with inflation. Statistical studies sought to quantify the concept of independence by creating legal indices based on the coding of central bank statutes (Alesina 1989; Bade and Parkin 1978; Cukierman, Webb, and Neyapti 1992; Eijffinger and Schaling 1993; Grilli, Masciandaro, and Tabellini 1991). A well-documented weakness of these indices is the lack of an agreed definition of independence, with different authors assigning greater weight to either goal independence or instrument independence (Debelle and Fischer 1994). In addition to conceptual problems, the index approach has been discredited due to operational weaknesses such as sample size, selection bias, multicollinearity and the robustness of the indices themselves (Banaian, Burdekin, and Willett 1998; Forder 2000; Temple 1998). For practitioners, the greatest shortcoming is that coding legal documents measures de jure independence but does not reflect de facto independence. Nor does legal independence guarantee that central banks will be free from government pressure. Even the Bundesbank and the Federal Reserve have been shown to respond to signalling or threats from politicians. 2 Independence is multidimensional and coding legal independence is a subjective process (Kenen 2000). This caveat should be kept in mind when considering the ranking of central banks and the results of statistical studies. Legal indices generally agree on the most independent and dependent central banks, but there is a worrying lack of agreement for intermediate cases such as the central banks of Australia, Canada, Greece (pre-1997), and Japan (pre-1998). Turning to the empirical results, even 2 For the Bundesbank see Lohmann (1998). For the US Federal Reserve see Havrilesky (1993), Hetzel (1990), Willett and Keen (1990) and Woolley (1984). 52

4 Monetary Policy Frameworks the link between independence and inflation has been challenged by a number of studies which reported no statistical relationship. 3 In addition no studies have established a firm link between central bank independence and GDP growth, while a number have shown a positive relationship with the sacrifice ratio. 4 These challenges raise the possibility that the orthodoxy underpinning central bank independence may one day fall apart. Bank of Japan Table 2: CBI and economic performance, Dependent variable Significant No relationship Mixed Total relationship depending on choice of index No. % No. % No. % No. Inflation Inflation variability GDP growth GDP variability Sacrifice ratio Source: Author s calculations. Full results available upon request. Despite challenges to the orthodoxy, the trend towards legislating greater operational independence for central banks grew throughout the 1990s. One puzzle which remains unanswered is explaining the timing of these changes. Statistical studies employing the status of the central bank as the dependent variable reached inconclusive results (Eijffinger and Haan 1996). An alternative method to explaining the timing of changes is to study individual central banks in order to compare the cross-national experiences. This section reviews explanations from the political economy literature, highlighting a set of hypotheses for explaining when the central bank legislation is reformed. Two main explanations focus on the role of interest groups and the power of economic ideas. Interest group arguments have both a supply-side and a demand-side, with the former viewing Puzzle over timing 3 Studies which have questioned the link with inflation include Campillo and Miron (1997), Capie et al (1994), Cargill (1995), Chang (1998), Eijffinger and Keulen (1995), Forder (1998), Hayo (1998), Mas (1995) and Posen (1993). 4 The literature on the sacrifice ratio is referenced in Baltensperger and Kugler (2000) 53

5 Central Banking Supply-side explanations Bank of Greece Protection from Socialist governments Eliminate a source of political instability politicians acting out of self-interest while the latter emphasise direct or indirect pressure from interest groups, principally the financial sector. Supply-side explanations of central bank independence view politicians as primarily concerned with re-election. The literature on political business cycles sees politicians using control of macroeconomic policy to increase their popularity around elections, despite the negative consequences for price stability (Hibbs 1977; Nordhaus 1975; Tufte 1978). However politicians may delegate control of interest rates to an independent central bank when this strategy provides political gains. Three variations of this tying-the-hands argument can be found in the literature. Goodman s (1991) study of European central banks concluded that politicians with an expected short time frame in office grant independence to the central bank in order to tie the hands of their successors. Political incumbents wish to keep control of monetary policy for electoral purposes, but will delegate responsibility for interest rates to the central bank when facing a change of government. This reform reduces the room to manoeuvre of the incoming government and preserves the existing line of policy, which is particularly important following a change from a right-wing to a left-wing government. Goodman s view has been lent support by research which found that developed countries with independent central banks did not show any evidence of a political business cycle (Clark 1998). Professor Charles Goodhart of the London School of Economics focuses on the relative gains available to left-wing governments to explain why they may wish to tie their own hands. Hibbs (1977) documented how politicians exhibit partisan biases. Left-wing governments prefer employment to price stability, and are expected to be more interventionist using budget deficits to fund counter-cyclical policies and wealth redistribution. This reputation leads financial markets to charge left-wing governments an interest rate premium on their borrowing relative to right-wing governments (Garrett 1998). Goodhart (1997) argues that it may be rational for a left-wing government to give independence to the central bank in order to reduce this interest rate premium. [Current] game theory would suggest that, since financial markets are more suspicious of left-wing governments, such prospective governments might have more to gain by allocating the control of inflation to an independent agency (Capie et al. 1994, p. 61). This view suggests that left-wing governments will tie their own hands upon taking office, rather than inheriting this change from a right-wing government. Bernhard (1996) explains why politicians on both sides of the spectrum may benefit from tying their hands. Politicians view central bank independence as a mechanism for increasing cabinet stability and durability, by removing intra-party conflicts over monetary policy. With a 54

6 Monetary Policy Frameworks coalition or minority government, there is always the risk that conflicts over policy will threaten the stability of a government. Raising interest rates is unpopular with politicians, making monetary policy a contentious political issue. Not only does monetary policy have wide ranging consequences for the electorate, it is also technically complex, poorly understood with information asymmetries and lack of transparency. These characteristics make it hard for partners in a government to verify that the executive is sticking to its promises - a political version of time inconsistency. If backbench legislators or partners in the ruling coalition can credibly threaten to bring down the government, the executive has an incentive to delegate monetary policy to an independent central bank as a means of removing this potential source of instability. Therefore politicians on both the right and the left may wish to tie their hands in order to scapegoat an independent central bank for unpopular policies (Hetzel 1990; Woolley 1984), or to minimise economic risks while maximising the probability of re-election (Elgie and Thompson 1998). Demand-side explanations of central bank independence adopt the public choice view where politicians deliver policies in exchange for the campaign contributions and electoral support of key interest groups. Inflation is a political issue, with well-documented distributional consequences that benefit some groups at the expense of others [Briault, 1995 #561; Fischer, 1994 #518]. For example, the Bank of Canada s anti-inflation policy during the early 1990s was blamed for the high interest rates and high exchange rates which hurt exporters and increased unemployment (Laidler 1997, p. 3). Interest groups that are disadvantaged by a current policy or institutional arrangement will be expected to lobby for either a change in policy or a change in the institutional arrangements governing that policy area. This interest group pressure to reform the legislation governing the central bank may be either direct, in the form of lobbying, or indirect acting through the financial markets. Goodman (1991) and Posen (1993, 1995) develop an explanation based on direct interest-group pressure, arguing that it results from the lobbying of interest groups opposed to inflation. For Posen, the most effective opposition to inflation originates in the financial sector, which is expected to lobby for greater central bank independence. The financial sector is also well placed to protect the independence of the central bank following a change in government, which might otherwise consider reversing earlier legislation. Maxfield (1997) argues that politicians respond to indirect pressure from the financial sector operating through the capital markets. She studied the trend in central banking independence in developing countries and argued that capital-poor governments need to increase their credibility with financial markets in order to attract foreign capital and to reduce the interest rate charged on their borrowing. Central bank independence is seen as a mechanism for signalling the anti-inflationary creditworthiness of governments to international investors. This signalling increases in importance when the government needs to finance a balance of payments deficit and when politicians have a long time horizon, as insecure politicians with short time horizons are more likely to want to stimulate the economy prior to elections. Demand-side explanations Pressure from financial markets 55

7 Central Banking The power of economic ideas The politics of independence A number of authors note the association between the status of the central bank and the reigning economic orthodoxy. 5 Capie et al (1994) argue that monetary institutions are profoundly influenced by the development of theories about their proper role. The process by which ideas influence monetary institutions occurs in three stages. First, there is a period of incubation during which pressures mount on the existing institutions and reigning conceptual models break down. Second, a crisis occurs which makes the need for reform explicit. And third, a consensus develops around a new monetary framework (Cottarelli and Giannini 1997). This pattern fits postwar history. The switch to Keynesian principles of managed money after World War II, the adoption of floating exchange rates and then monetary targets in the 1970s, and now the enthusiasm for central bank independence, all have owed much of their force to the power of academic ideas whose time has arrived. (Capie, Goodhart, and Schnadt 1994, p. 80). Clearly ideas are important for explaining the overall trend in central bank independence, but the difficulty comes from explaining the timing of legislative changes. How politicians react to academic ideas whether introduced by economic advisers or by the financial media is poorly understood, leading Maxfield (1997) to conclude that ideas alone provide an unsatisfactory answer for explaining the trend in central bank independence. This discussion has highlighted a number of plausible arguments for explaining when politicians change the legislation governing the central bank, based on the role of interest groups and ideas. By demonstrating the limits of discretionary policy through discussions of time inconsistency and inflation bias, ideas clearly played a central role in shaping the agenda and explaining the policy options for monetary reform. But ideas do a poor job at explaining the timing of such changes. Interest-group arguments show how delegation may provide politicians with important economic and political benefits in the form of improved economic performance, reduced premiums on government borrowing, the support of key interest groups, a scapegoat for unpopular policies, and increased stabity of a governing coalition. While providing a theoretical basis for interest-group pressure, these theories suggest contradictory or competing hypotheses that need to be examined in light of actual experience. The next article examines the reform of the Bank of England, introduced by New Labour within a week of being elected in May UK finance minister Gordon Brown gave operational independence to the Bank of England in the setting of interest rates while stripping the Bank of its responsibility for bank supervision and management of the government debt. Similar reforms proposed by former Conservative finance ministers and backbenchers on the Treasury Select Committee were resisted by both former Tory Prime Ministers Margaret Thatcher and John Major for 18 years. This resistance continued despite the existence of an academic consensus in favour of this proposal and the blow to the Conservative government s credibility following the ERM crisis. Why the Conservatives resisted such a move, and why New Labour adopted this reform will be made clear in the next article. 5 See Elgie and Thompson (1998), Fair (1979) and Goodhart (1995). 56

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