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10.13 Policy Implications of Politico-Economic Models: An Independent Central Bank?

In introducing ‘The New Monetary Policy Framework’ for the UK economy

on 6 May 1997, which established ‘operational independence’ for the Bank

of England, Chancellor Gordon Brown, in an official statement, provided the

following rationale for the government’s strategy (Brown, 1997, emphasis


We will only build a fully credible framework for monetary policy if the longterm

needs of the economy, not short-term political considerations guide monetary

decision-making. We must remove the suspicion that short-term party political

considerations are influencing the setting of interest rates.

Chancellor Brown’s decision to grant much greater independence to the Bank

of England had its origins in a 1992 Fabian Society paper entitled ‘Euro

Monetarism’, written by Ed Balls, Brown’s economic adviser. As a former

student of Larry Summers at Harvard, Balls was familiar with the empirical

work on central bank independence produced by Alesina and Summers (1993).

In a visit to the USA in March 1997, Shadow Chancellor Brown and his

economic adviser met both Alan Greenspan and Larry Summers. And so was

born the strategy to go for immediate greater central bank independence if


The general debate on the relative merits of rules versus discretion in the

conduct of fiscal and monetary policy was given a new stimulus by the

research surveyed in Chapters 5 and 7. Since the non-optimal use of monetary

and fiscal instruments lies at the heart of the various strands of the

political business cycle literature, most of this work points towards the desirability

of establishing a policy regime which curtails the incentives policy

makers have to engage in destabilizing policies. The new classical contributions

of Kydland and Prescott (1977) and Barro and Gordon (1983a), which

highlighted time-inconsistency, credibility and reputational issues, have provided

extra weight to the case for monetary rules associated with the work of

Friedman (1968a). The politico-economic literature has also shown how strong

partisan or opportunistic behaviour can generate a non-optimal outcome for

aggregate variables. However, in order to make policy rules credible, some

sort of enforcement mechanism is required. For this reason many economists

in recent years have argued in favour of institutional reform involving the

establishment of an independent central bank (see Goodhart, 1994a, 1994b).

The assumption lying behind this argument is that such an institution (at least

in principle) is capable of conducting monetary policy in a manner free from

opportunistic and partisan influences. In addition, fiscal policy will also be

subject to a harder budget constraint, providing the independent central bank

is not obliged to monetize deficits (see Alesina and Perotti, 1995a). Greater

central bank independence was also one of the objectives contained in the

Maastricht Treaty, which sought to bring about some fundamental changes in

national banking legislation in anticipation of European monetary union (see

Walsh, 1995a, 1995b).

The case for central bank independence is usually framed in terms of the

inflation bias present in the conduct of monetary policies. Such an inflation

bias is evident from the relatively high rates of inflation experienced in

industrial countries in the 1970s and early 1980s. Because a majority of

economists emphasize monetary growth as the underlying cause of sustained

inflation (see Lucas, 1996), it follows that prolonged differences in countries’

rates of inflation result from variations in their rates of monetary expansion.

Any plausible explanation of these ‘stylized facts’ must therefore include an

understanding of central bank behaviour (Walsh, 1993). In particular, we

need to identify the reasons why monetary policy is conducted in a way that

creates a positive average rate of inflation which is higher than desirable.

There are several reasons why monetary authorities may generate inflation.

These include political pressures to lower unemployment in order to influence

re-election prospects, partisan effects as emphasized by Hibbs and

Alesina, dynamic inconsistency influences and motivations related to the

financing of deficits. The last is particularly important in economies with

inefficient or underdeveloped fiscal systems (see Cukierman, 1994).

The theoretical case for central bank independence in industrial democracies

relates to a general acceptance that the long-run Phillips curve is vertical

at the natural rate of unemployment. This implies that although monetary

policy is non-neutral in the short run, it has little effect on real variables such

as unemployment and output in the long run. With no exploitable long-run

trade-off, far-sighted monetary authorities ought to select a position on the

vertical Phillips curve consistent with a sustainable objective of price stability

(see Goodhart, 1994b; Cukierman, 1994).

The empirical case for central bank independence is linked to cross-country

evidence which shows that for advanced industrial countries there is a

clear negative relationship between central bank independence and inflation

(see Grilli et al., 1991; Cukierman, 1992; Alesina and Summers, 1993;

Eijffinger and Keulen, 1995; Eijffinger, 2002a). It should be noted, however,

that this negative correlation does not prove causation and fails to hold for a

larger sample of countries which includes those from the developing world

(see Jenkins, 1996). Poor countries with shallow financial markets and unsustainable

budget deficits are unlikely to solve their inflation problems by

relying on the creation of an independent central bank (Mas, 1995). However,

at least as far as advanced industrial democracies are concerned, the theoretical

and empirical work suggests that monetary constitutions should be designed

to ensure a high degree of central bank autonomy.

Although the success of the independent German Bundesbank in delivering

low inflation over a long period of time inspired other countries to follow

its example, it is also clear that some important problems emerge with the

measurement, form and consequences of central bank independence. First,

the whole question of independence is one of degree. Although before May

1997 the Federal Reserve had much more independence than the Bank of

England, it is clear that legal independence does not (and cannot) completely

remove the influence of ‘monetary politics’ (see Mayer, 1990; Havrilesky,

1993; Woolley, 1994). For example, Chappell et al. (1993) show how partisan

influences on the conduct of monetary policy can arise through presidential

appointments to the Board of Governors of the Federal Reserve. Through

these ‘political’ appointments and other forms of presidential signalling (moral

suasion) the Federal Reserve’s monetary policy making can never be totally

independent of political pressures. Nevertheless, considerable research effort

has been made in recent years to measure the extent of central bank independence

in a large number of countries (see Cukierman, 1992; Eijffinger

and Keulen, 1995; Healey, 1996). According to Cukierman, four sets of

indices can be used to identify the degree of independence of a central bank:

(i) legal indices; (ii) questionnaire-based indices; (iii) the turnover of central

bank governors; and (iv) the political vulnerability of the bank. However,

such studies and their implications have come in for considerable criticism

(see Jenkins, 1996).

In discussing the form of central bank independence, Fischer (1995a,

1995b) introduces the distinction between ‘goal independence’ and ‘instrument

independence’. The former implies that the central bank sets its own

policy objectives (that is, political independence) while the latter refers to

independence with respect to the various levers of monetary policy (that is,

economic independence). Using this framework the Bank of England was

granted instrument (economic) independence but not goal (political) independence

in May 1997. The distinction between goal and instrument

independence can be used to illustrate the difference between the two main

models of independent central banks which have been developed in the

theoretical literature. The first model is based on Rogoff’s (1985) ‘conservative

central banker’. In this model an inflation-averse conservative central

banker is appointed who ensures that inflation is kept low in circumstances

where it would otherwise be difficult to establish a pre-commitment to low

inflation. Rogoff’s inflation-averse central banker has both goal and instrument

independence. The result is lower average inflation but higher output

variability. The second model, associated with Walsh (1995b), utilizes a

principal–agent framework and emphasizes the accountability of the central

bank. In Walsh’s contracting approach the central bank has instrument independence

but no goal independence, and the central bank’s rewards and

penalties are based on its achievements with respect to inflation control.

However as Walsh (1995a) notes:

An inflation-based contract, combined with central bank independence in the

actual implementation of policy, achieves optimal policy outcomes only if the

central bank shares social values in trading off unemployment and inflation. When

the central bank does not share society’s preferences, the optimal contract is no

longer a simple function of inflation; more complicated incentives must be generated

to ensure that the central bank maintains low average inflation while still

engaging in appropriate stabilization policies.

While the New Zealand Federal Reserve Bank, which was set up following the

1990 reforms, resembles the principal–agent model, the German Bundesbank,

before EMU, comes close to the conservative central banker of the Rogoff

model. In Fischer’s (1995a) view, the important conclusion to emerge from this

literature is that ‘a central bank should have instrument independence, but

should not have goal independence’.

In recent years many countries have set about reforming the institutions of

monetary policy. Such countries include those of the former ‘Eastern bloc’ of

communist economies as well as those from Latin America and Western Europe.

Most have adopted some variant of the principal–agent approach whereby

the central bank is contracted to achieve clearly defined goals, provided with

the instruments to achieve these desired objectives, and held accountable for

deviating from the chosen path (see Bernanke and Mishkin, 1992; Walsh

1995a). In the New Zealand model the central bank governor is accountable to

the finance minister. This contrasts with the German Bundesbank, which was

held accountable to the public. In both Canada and the UK, emphasis has been

placed on inflation targeting. Failure to meet inflation targets involves a loss of

reputation for the central bank. In the case of the UK, the approach adopted

since 1992 has involved inflation targeting combined (since May 1997) with

operational independence for the Bank of England (see Chapter 7).

One of the main theoretical objections to central bank independence is the

potential for conflict that this gives rise to between the monetary and fiscal

authorities (see Doyle and Weale, 1994). An extensive discussion of the

problems faced by policy makers in countries where monetary and fiscal

policies are carried out independently is provided by Nordhaus (1994). In

countries where this has led to conflict (for example in the USA during the

period 1979–82) large fiscal deficits and high real interest rates have frequently

resulted. According to Nordhaus this leads to a long-run rate of

growth which is too low. The tight monetary–easy fiscal mix is hardly surprising

given the predominant motivations driving the ‘Fed’ and the ‘Treasury’

in the USA. Whereas independent central banks emphasize monetary austerity

and low stable rates of inflation, the fiscal authorities know that increased

government expenditure and reduced taxes are the ‘meat, potatoes and gravy

of politics’ (Nordhaus, 1994). In this scenario the economy is likely to be

locked into a ‘high-deficit equilibrium’. Self-interested politicians are unlikely

to engage in deficit reduction for fear of losing electoral support. These

coordination problems which a non-cooperative fiscal–monetary game generates

arise inevitably from a context where the fiscal and monetary authorities

have different tastes with respect to inflation. At the end of the day these

problems raise a fundamental issue. Should a group of unelected individuals

be allowed to make choices on the use of important policy instruments which

will have significant repercussions for the citizens of a country? In short,

does the existence of an independent central bank threaten democracy (see

Stiglitz, 1999a)? What is clear is that independence without democratic accountability

is unacceptable (Eijffinger, 2002b).

There is now an extensive literature related to the issue of central bank

independence. The academic literature has pointed to the various reasons

why industrial democracies have developed an inflation bias in which governments

are allowed discretion in the operation of fiscal and monetary

policies. In contrast to Rogoff (1985), Alesina and Summers (1993) point to

the empirical evidence which, for advanced industrial countries, shows that

inflation is negatively correlated with the degree of central bank independence

without this having significant adverse effects on real growth and

employment in the long run. Central bank independence seems to offer a

‘free lunch’! However, this issue is made more complicated by the causes of

output variability. Alesina and Gatti (1995) distinguish between two types of

variability which can contribute to aggregate instability. The first is economic

variability resulting from different types of exogenous shocks to aggregate

demand and/or supply. The second type is political or policy-induced and has

been the subject of this chapter. Rogoff’s conservative central banker does

not react much to ‘economic shocks’. However, Alesina and Gatti (1995)

argue that an independent central bank will reduce policy-induced output

variability. Hence the ‘overall effect of independence on output induced

variability is, thus, ambiguous’. It follows that in cases where policy-induced

variability exceeds that resulting from exogenous shocks, a more independent

central bank can reduce inflation and the variance of output, a result consistent

with the Alesina and Summers (1993) data. To the critics, central bank

independence is no panacea and the Alesina–Summers correlations do not

prove causation (Posen, 1995). In addition, the numerous domestic and international

policy coordination problems which independence can give rise to

could outweigh the potential benefits. In the face of powerful ‘economic’

shocks a conservative and independent central bank may not be superior to an

elected government.