Regulation Initiative Working Paper series Number 37. Regulator Independence: Measurements and Effects. Paul Levine. Neil Rickman.

Transcription

1 Regulation Initiative Working Paper series Number 37 Regulator Independence: Measurements and Effects Paul Levine Neil Rickman Francesc Trillas London Business School July 2000

2 REGULATOR INDENDENCE: MEASUREMENTS AND EFFECTS Paul Levine, Neil Rickman and Francesc Trillas 1. Introduction The case for making public bodies independent and taking them out of the day-to-day political process is widely accepted in many areas of policy. One area where academics have contributed to this consensus is in the area of monetary policy. The theoretical literature on the credibility problem and empirical cross-country econometric studies on the effects of central bank independence (CBI) have undoubtedly contributed to the world-wide trend towards the greater independence of these institutions. The question we pose is whether regulation economists can have a similar impact. In regulation the credibility problem has two main sources: first, in a complete information context where there are no asymmetries in the information between regulators and regulated, there is still the incentive for the regulator to lower prices once the sunk costs of investment have been incurred. This is the classic timeinconsistency problem posed by Kydland and Prescott (1977) and the equilibrium outcome is under-investment. Where information asymmetries exist an incentive to ratchet up the targets as information emerges creates a further credibility problem in the form of the ratchet effect. Currie et al (1999) show how delegation to an independent regulator who is more pro-rent than the government can ameliorate this situation in an analogous way to the delegation of monetary policy to inflation-averse ( conservative ) bankers. Levine (1999) tackles the under-investment problem is a similar way. Theoretical research is continuing on other possible benefits of regulator independence, e.g., the delegation to regulators who are more far-sighted than the government (Levine and Rickman, 2000). To test the predictions of this theory we first need to measure the degree of regulator independence across countries and industries. Much can be learned from how this has been done for central banks. The following is a brief survey of different measures of CBI, based on Wagner (2000). 1

3 2. Measures of Central Bank Independence The empirical substantiation of central bank independence is based on studies which see a "free lunch" in the existence of an independent central bank. On average, countries with more independent central banks realise comparatively low inflation rates without real economic costs in terms of lower economic growth or higher output volatility. In fact, many empirical studies on the relationship between central bank independence and inflation confirm a negative correlation between inflation and central bank independence. The derivation of these findings is based on the use of the following measures of central bank independence. 2.1 Early Attempt to Measure CBI A starting point for further research was without doubt the construction of two indices by Bade and Parkin (1988, henceforth BP). The authors differentiate between an index for political independence and one for financial independence. We will be looking below at the index for political independence only because the differentiation between political and financial independence in the definition of financial independence selected by BP has not been followed in the academic literature on this subject. To describe the extent of political independence BP examined the legal provisions of 12 countries for the period with regard to the three following criteria: (+) Is the central bank the final policy authority? (++) Are more than half of the policy-board appointments made independently of the government? (+++) Is there a government official (with or without voting power) on the policy board? As BP only permit yes/no decisions, eight (2 3 ) policy types can be distinguished. However, the authors find that just four types occur in reality. Accordingly, the index values run in integers from 1 to 4, where a higher value characterises greater political independence of the respective central bank. This procedure stands in contrast to the indices in Grilli, Masciandaro and Tabellini (1991) and Cukierman (1992), examine below, which also take into account whether price stability or low inflation are referred to explicitly as goals of monetary policy in the central bank law. In contrast to this, BP regard the question of the exchange rate system so decisive that they do not analyse the period of the Bretton-Woods system. 2

4 Alesina (1988, 1989) has extended the BP index by considering additional industrial countries. They take into account, that both the central bank and the government might have some but incomplete policy authority. 2.2 Grilli, Masciandaro and Tabellini (GMT) Grilli, Masciandaro and Tabellini (1991) have developed legal indices which, in comparison to BP, permit a more extensive consideration of details. The authors distinguish between economic and political independence. Economic independence is defined as the ability of the central bank to determine the use and the choice of its monetary policy instruments autonomously and without interference from the government. 1 Economic independence may be adversely affected by central bank s obligations to finance the government budget, to supervise commercial banks and by a lack of freedom to set interest. In addition, the question of who (the government or the central bank) is in charge of exchange rate policy has to be addressed in this context. Political independence is defined as the ability of the central bank to choose monetary policy goals autonomously and without interference from the government. The basic determinants for this ability are found in personal independence (e.g. procedures for appointing and dismissing central bankers, terms of office), in the government's rights to give instructions to the central bank as well as the right to veto, to suspend or to defer central bank s decisions, and its right to be present on the central bank board. Furthermore the degree of political independence depends on the formal responsibilities of the central bank. In this context, however, different interpretations are placed on the role of statutory requirements that the central bank pursues price stability. GMT, and Cukierman (1992) see an explicit mandate for the central bank to restrain inflation as a strengthening of central bank independence. In contrast to this, Debelle and Fischer (1994) and Fischer (1995a, 1995b) characterise this as a reduction of the central bank's "goal independence". The reason for these deviating interpretations is found in the different emphasis on two aspects: the latter authors emphasise that the central bank s discretionary powers may be restricted, while GMT and Cukierman (1992) mainly stress the partial commitment of the government. 1 This definition of economic independence is very similar to the meaning of instrument independence introduced by Debelle/Fischer (1994). Debelle/Fischer distinguish between instrument independence and goal independence. For more details see pp. 28f. of this paper and Debelle/Fischer (1994), p

5 Table 1: The Grilli/Masciandaro/Tabellini index of political independence Political Independence (P1) Governor not appointed by government * (P2) Governor appointed for >5 years * (P3) All the Board not appointed by government * (P4) Board appointed for >5 years * (P5) No mandatory participation of government representative in the Board * (P6) No government approval of monetary policy formulation is required * (P7) Statutory requirements that central bank pursues monetary stability amongst its goals * (P8) Legal provisions that strengthen the central bank s position in conflicts * with the government are present Overall index of political independence, constructed as the sum of the asterisks Table 1 above shows the criteria of political independence of the central bank. The GMT index of political independence corresponds to the number of all fulfilled criteria from (P1) to (P8). Criteria (P1) and (P3) assume that central bankers behave independently if they are not appointed directly by the government. Long terms of office (P2) and (P4) are aimed at preventing the government from carrying out short-term changes to the composition of the decision-making body. Criteria (P5), (P6) and (P8) refer to the relationship between the government and the central bank with regard to the formulation and implementation of policies. Monetary policy decisions are naturally no longer independent of the government if government representatives have voting rights or if the government must approve monetary policy decisions. Criterion (P7) has to be seen against the background of the definition from GMT of political independence as being the ability of the central bank "(..) to pursue the goal of low inflation". With this definition the authors cover more than the independence of the central bank from the government. It is true that a legal mandate for monetary stability is supposed to reduce the possibility of short-run political considerations leading to 4

6 changes in the objectives of monetary policy. But at the same time this restricts the discretionary power of the central bankers with regard to the choice of the monetary policy goals. It cannot be concluded from the concrete formulation of criterion (P7) that price stability must be the sole goal of monetary policy. The ability of the central bank to choose its own monetary policy instruments without interference from the government is measured by GMT s index of economic independence. Table 2. The Grilli/Masciandaro/Tabellini index of economic independence Economic Independence (E1) Direct credit facility: not automatic * (E2) Direct credit facility: market interest rate * (E3) Direct credit facility: temporary * (E4) Direct credit facility: limited amount * (E5) Central bank does not participate in primary market for public debt * (E6) Discount rate set by central bank * (E7) Banking supervision not entrusted to the central bank (**) or not entrusted to the central bank alone (*) (**) (*) Overall index of economic independence (being the sum of the asterisks) Criteria (E1) to (E4) refer to characteristics of the direct central bank credit to the government. Under the aspect of preventing a direct financing of budget deficits, in particular close limits (E4) on credit facilities or a complete prohibition of direct central bank credits to the government appear to be effective. Criterion (E5) refers to the purchase of government bonds in the primary market, but not to sale and purchase in the secondary market. Therefore, even if (E5) is fulfilled the central bank could finance budget deficits (indirectly) through purchases of government bonds in the secondary market. 5

7 Criteria (E6) and (E7) concern the independence of monetary policy from an administrative fixing of the discount rate (E6) and from influences which can arise from bank supervision (E7). The total index for central bank independence results from the sum of the index values for political and economic independence. 2.3 Cukierman s Measure of CBI. The most detailed indices for measuring the legal independence of central banks have up to now been developed by Cukierman (1992) and Cukierman,Webb and Neyapti (1992). Indices LVAU (unweighted index of legal independence) and LVAW (weighted index of legal independence) take into account 16 characteristics for central bank independence which are divided into 4 clusters. LVAU and LVAW differ from each other through their different weighting of some components. The main groups cover characteristics of the personal independence of the chief executive officer (term of office, appointment, reasons for dismissal), aspects of the central bank's policy independence (policy formulation, resolution of conflicts), the final objectives laid down in the central bank statute and the legal restrictions on the ability of the government to borrow from the central bank. In contrast to GMT, graded evaluations are provided for with detail questions as well. For example, there are six possible ratings for the question concerning the objective of the central bank, according to the weight given to price stability compared with other stated objectives. In concurrence with GMT, here too a statutory mandate to pursue the goal of price stability is seen against the background that delegating monetary policy to an independent central bank is aimed at mitigating the credibility problem. In Rogoff s (1985) terminology, the objectives variable measures the strength of the 'conservative bias' of the bank s charter. 2.4 Comparison of Indices. The table below, taken from Eijffinger and De Haan (1996), shows the numerical index values for 22 industrial countries. The indicators have similar outcomes (the Swiss National Bank and the German Bundesbank are consistently classified as comparatively independent), but along with detail differences there are also extreme differences (see the classification of the Bank of Japan). The selection and weighting of criteria and the interpretation of statutes are responsible for deviations. It can be said roughly that the indices from Alesina (1989), and Eijffinger and Schaling (1993) each place a smaller weight on the central bank's economic independence than the indices from GMT and Cukierman (see Eijffinger and De Haan 1996 in particular Table 4, p. 24). 6

8 Table 3. Legal indices of central bank independence 2 Country Alesina Grilli, Masciandaro, Eiffinger- Cukierman and Tabellini Schaling (LVAU) Australia 1 9 (3) Austria - 9 (3) 3* 0.58 Belgium 2 7 (1) Canada 2 11 (4) Denmark 2 8 (3) 4* 0.47 Finland 2-3* 0.27 France 2 7 (2) Germany 4 13 (6) Greece - 4 (2) Iceland Ireland - 7 (3) Italy (4) Japan 3 6 (1) Netherlands 2 10 (6) New Zealand 1 3 (0) 3* 0.27 Norway 2-2* 0.14 Portugal - 3 (1) 2* - Spain 1 5 (2) 3* 0.21 Sweden Switzerland 4 12 (5) United Kingdom 2 6 (1) United States 3 12 (5) Except for Denmark, the ranking of these seven countries refers to central-bank laws adjusted during the last ten years. Source: Eijffinger and De Haan 1996, p The Alesina index runs from 1 to 4, the Eijffinger/Schaling index from 1 to 5, the Grilli/Masciandaro/Tabellini overall index from 0 to 16 (index for political independence alone is shown in parentheses) and the Cukierman (LVAU) index from 0 to 1. Higher index values signify greater central bank independence. 7

9 The subjectivity of the indices has led among other things to different indices being combined. A legendary example of this is the work of Alesina and Summers (1993), in which an average was formed from the Alesina index and the GMT index. 2.5 Indicators based on actual behaviour 3 To identify differences between actual and legal central bank independence Cukierman (1992) and Cukierman, Webb and Neyapti (1992) calculated the actual turnover rates for central bank governors for the period This indicator is based on the assumption that a higher frequency of change of central bank governors indicates a lower level of central bank independence. A longer term of office does not necessarily imply greater independence, but actual terms of office that are shorter than the electoral cycle, lead to the suspicion of personal dependence. The turnover rate is defined as the average change of central bank governors per year. Because the electoral cycle is four to five years in the most countries, the threshold turnover rate is between 0.2 and For 21 industrial countries in the period referred to there was a maximum turnover rate of 0.2 (Japan and Spain), while the turnover rates for 27 of 50 developing countries were over 0.2 with the maximum of 0.93 for Argentina. The authors conclude from this that the turnover rate is a reasonable but noisy proxy for the lack of central bank independence in developing countries. Cukierman and Webb (1995) develop an indicator of political vulnerability, defined for each country as the fraction of political transitions that are followed promptly (within 6 months or within 1 month) by the replacement of the central bank governor. For the period 1950 to 1989 they find for a sample of 67 countries (24 industrialised and 43 developing countries) that on average the turnover rate is significantly higher shortly after political transitions than in any other period. Once again, there are considerable differences between groups of countries, but also within groups, for different forms of political transitions. The authors differentiate between the following four types of political transitions: a) change of regime (from democratic to authoritarian and vice versa); b) change from one authoritarian government to the next; c) change of party without a change in regime; and d) change of the head of government. In the case of developing countries vulnerability (within 6 months) is on 3 For the questionnaire-based index which is based on judgements about behaviour, see Cukierman (1992; 1996). 8

10 average 0.35 in comparison to 0.1 for industrial countries. Developing countries which alternate between democratic and authoritarian regimes ("mixed countries") have the greatest degree of vulnerability (0.39). In addition, vulnerability is also dependent on the type of political instability. For example, in the context of developing countries Cukierman and Webb (1995) give a value of 0.61 for vulnerability with type a) (change of regime), while a lower level of political instability (type d - change of head of government) receives a value of Cukierman (1996) sees in the political vulnerability of the central bank governor a noisy indicator for the actual independence of the central bank, which can be used in principle for an analysis of developing and industrial countries. The quality of this measure is comparatively better for countries and periods with many political changes. 4. Regulatory Independence A theory of regulatory independence that takes into account voting and lobbying should compare a regime where prices are determined by a voting cum lobbying model with a regime where prices are determined by a pro-industry regulator, to whom regulatory authority is delegated. Besley and Coate (2000) present and test a model where a regime where regulation is bundled with other policies is compared to a regime where regulation is decided by an elected regulator. The conclusions on the role of voters information as a determinant of regulated prices are similar to Trillas (2000). Besley and Coates paper show that voting and lobbying can be incorporated to a model that compares two different regulatory regimes. Their paper is also a good example of an empirical test of the effects of different regulatory regimes, and presents a useful survey of the empirical literature on the effects of regulation. 9

11 The model should take into account that both types of regulator (independent and politicized) can be subject to different commitment environments. To this extent, an important exogenous variable that should be taken into account should be the degree of discretion that any type of regulator faces. Cowen et al. (2000) make an interesting contribution to the literature on discretion which should be taken into account. The following table on telecommunications regulatory authorities in Spain, UK and Chile may help develop intuition for a systematic empirical work. United Kingdom Spain Chile Independence High Low Low Discretion High High Low Budget High High Low Casual evidence can be provided that these three dimensions (independence, discretion and regulatory budget) are of independent importance for a regulatory regime. Given the apparent overall success of privatization in Chile and the UK, it is quite remarkable that commitment can be achieved by such different regulatory regimes. In any case, a systematic research must take these different dimensions into account. It is not clear that the three of them are of equal importance for monetary authorities, where I think that it is assumed that monetary authorities have a large budget and hence there are no substantial differences in their knowledge of the economy across countries. But in regulation, the differences in regulatory budgets across countries are striking. 10

12 4. Research Proposal (i) Carefully select the appropriate criteria for Regulator Independence (RI), drawing on measures of CBI and Stern (1997). Trillas (2000) shows the consequences of not having regulatory independence for final prices and access prices in regulation. The description of politicization provided there hints at which elements may describe independence: career of the regulators, constraints on the revolving doors phenomenon, regulatory budget, regulator s salary. (ii) Gather data relating to these criteria to construct an index of RI for different countries and industries. The connections and knowledge of other members of the Regulatory Initiative will be of help here. (iii) Test hypotheses suggesting a causal link from RI and performance. A few performance indicators will be selected, taking into account previous empirical work and data availability (regulatory data is usually more difficult to obtain than macroeconomic data). Examples in the literature: -Fields et al. (1997). This paper examines the elected versus appointed commissioner dichotomy from a market value perspective. Previous empirical analysis tends to concentrate on rates rather than examining the impact on shareholders' wealth. The authors examine life insurance industry data during the period surrounding the passage of California's Proposition 103. The primary impact of the referendum on life insurers is to change the method of commissioner selection from appointment to popular vote. This implies that the change to a popular election of commissioners either increases the level of risk and/or decreases the expected cash flows of regulated firms. -Smart (1994). While the economic approach to the politics of regulation emphasizes the importance of organized economic interests in shaping policies, political 11

13 institutions in which regulatory agencies are embedded may also have significant effects. By including both economic influences and characteristics of political institutions in a model of price setting by state regulators, this paper demonstrates that both shape regulatory behavior in the telecommunications industry. Whether commissioners are elected or appointed, whether they face confirmation by a legislature, and whether a single party controls both executive and legislative branches of state governments influence the level of prices charged for basic services. (iv)test theories of why some regulators are more independent than other, using for example Spiller (1990), Spulber and Besanko (1992), and Levy and Spiller (1994 and 1996). REFERENCES Besanko, David; Spulber, Daniel F. (1992), Delegation, Commitment and the Regulatory Mandate, Journal of Law, Economics and Organization, 8(1), pages Besley, Timothy; Coate, Stephen (2000), Elected versus Appointed Regulators, CEPR working paper Cowen, Tyler; Glazer, Amihai; Zajc, Katarina (2000), Credibility May Require Discretion, not Rules. Journal of Public Economics 76: Currie, D., P. Levine & N. Rickman (1999), Delegation and the Ratchet Effect: Should Regulators be Pro-Industry?,Regulation Initiative and CEPR Discussion Papers. 12

14 Fields,-Joseph-A.; Klein,-Linda-S.; Sfiridis,-James-M. (1997), A Market Based Evaluation of the Election versus Appointment of Regulatory Commissioners Public-Choice; 92(3-4), pages Kydland, F.E. and E. C. Prescott (1977), Rules Rather than Discretion: The Inconsistency of Optimal Plans, Journal of Political Economy, 85, Levine, P. & N. Rickman (2000), Dynamic Regulation when Costs are Stochastic: How Far-sighted Should Regulators Be?, mimeo. Levine, P. (1999), Delegation and the Under-investment Problem, Regulation Initiative Discussion Paper. Levy, Brian; Spiller, Pablo T. (1994), The Institutional Foundations of Regulatory Commitment: A Comparative Analysis of Telecommunications Regulation, Journal of Law, Economics and Organization, 10, pages Levy, Brian; Spiller, Pablo T., Regulations, Institutions and Commitment. Comparative Studies of Telecommunications, Cambridge University Press. Smart, Susan. R. (1994), The Consequences of Appointment Methods and Party Control for Telecommunications Pricing Journal-of-Economics-and-Management-Strategy; 3(2), Summer 1994, pages Spiller, Pablo T.(1990), Politicians, Interest Groups and Regulators: A Multiple- Principals Agency Theory of Regulation, or ''Let Them Be Bribed,'' Journal of Law and Economics, Vol. XXXIII, pages Stern, Jon, What Makes an Independent Regulator Independent? Business Strategy Review, 8(2), pages Trillas, F. (2000), Regulating Utilities with Political Constraints, mimeo. 13

15 Other References on Measures of CBI Alesina, A. (1988), Macroeconomics and Politics, NBER Macroeconomics Annual, Cambridge, Mass., MIT Press, Alesina, A. (1989), Politics and Business Cycles in Industrial Democracies, Economic Policy 8, Alesina, A. and L. H. Summers (1993), Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence, Journal of Money, Credit, and Bade, R. and M. Parkin (1988), Central Bank Laws and Monetary Policy, mimeo, University of Western Ontario Ball, L. N. (1993), What Determines the Sacrifice Ratio?, in: Mankiw, N. G. (ed.), Monetary Policy, Chicago, Chicago University Press, Cukierman, A. (1992), Central Bank Strategy, Credibility and Independence: Theory and Evidence, Cambridge, Mass., MIT Press Cukierman, A. (1996), The Economics of Central Banking, Discussion Paper CentER for Economic Research, No Cukierman, A., and S. B. Webb (1995), Political Influence on the Central Bank: International Evidence, The World Bank Economic Review 9, Cukierman, A., Webb, S. B. and B. Neyapti (1992), Measuring the Independence of Central Banks and Its Effect on Policy Outcomes, The World Bank Economic Review 6, Debelle, G. and S. Fischer (1994), How Independent Should a Central Bank Be?, in Fuhrer, J. C. (ed.), Goals, Guidelines and Constraints Facing Monetary Policymakers, Boston, Federal Reserve Bank of Boston, Conference Series No. 38,

16 Eijffinger, S. C. W. and J. De Haan (1996), The Political Economy of Central-Bank Independence, Special Papers in International Economics No. 19, Princeton, New Jersey. Eijffinger, S. C. W. and E. Schaling (1993), Central Bank Independence in Twelve Fischer, S. (1995a), Central Bank Independence Revisited, American Economic Review 85, Papers and Proceedings, Fischer, S. (1995b), The Unending Search for Monetary Salvation, in: Bernanke, B. S. and J. J. Rotemberg (eds.), NBER Macroeconomics Annual 1995, Cambridge, Mass., Grilli, V., Masciandaro, D. and G. Tabellini (1991), Political and Monetary Institutions and Public Financial Policies in Industrialized Countries, Economic Policy 13, Rogoff, K. (1985), The Optimal Degree of Commitment to an Intermediate Monetary Target, Quarterly Journal of Economics, 100, Wagner, H. (2000), Central Bank Independence and Macroeconomic Performance: a Survey of the Evidence, in Healey, N. and P.Levine (eds), Central Bank Independence and Monetary Policy in Eastern Europe, forthcoming. 15