This article reviews the empirical evidence and theoretical arguments for central bank independence, including political economy considerations. It concludes that the optimal institutional framework to keep inflation lastingly under control is based on granting independence to central banks and establishing price stability as the overriding objective of monetary policy. This framework--combined with appropriate appointment procedures, a sound governance structure and a well-defined monetary policy strategy of the central bank--would ensure price stability. Finally, public support for central bank independence also matters. In this respect, the central bank has a special role in nurturing a stability-oriented culture in society.
Keywords: Central bank independence; credibility; monetary policy; stability culture
JEL classifications: E42, E50, E58
"And I think we should preserve the independence of the ECB. The independence of the central bank in our monetary union is a huge asset that has provided us with price stability and low interest rates, and we think, I think that all of us, Commission, Council and Member States, should respect this independence [...]."
EU Commissioner Almunia, 21 November 2005
Today it is universally accepted that stable money, i.e. price stability, is a common good for the benefit of society. The key question however remains: what is the best institutional device to guarantee price stability? The immediate consensual answer seems clear: to ensure price stability, the power to create money should not be left to the will of persons and the discretion of the political authority responsible for monetary policy. In principle, there are three ways to achieve this. The first is to introduce a commodity standard, such as the gold standard. The second is to adopt a fixed rule for money growth and enshrine it in legislation or even a constitution, as proposed in the past by the advocates of the monetarist philosophy. (1) The third is credibly to constrain the discretionary use of power to create money by appropriate institutional mechanisms; establishing an independent central bank whose mandate is first and foremost to maintain price stability is the prominent example.
The first two options are, for different reasons, no longer seen as proper solutions. The last option, however, is widely supported. There is by now a broad consensus that, in our times of paper-money regimes, the task of keeping the value of money stable should be assigned to an independent central bank. There are two interrelated but conceptually different reasons for this. The first results from the insight that, following decades of macroeconomic instability, an independent central bank is an effective barrier to the emergence of inflation which in most cases was triggered by accommodating the financial needs of the Government. The second is related to the notion that monetary policy can be made more effective in credibly anchoring inflation expectations of the private sector if the central bank is taken out of the political cycle and thereby not distracted by other, short-term political and electoral objectives.
Over the past one and a half decades, there has been a sustained trend towards central bank independence. In fact, numerous governments across the globe have recently made their central banks independent. This trend marks a fundamental institutional shift from previous practices. While, during the 1980s, only a few countries passed legislation aimed at enhancing central bank independence, the number of independent central banks has been increasing considerably since then. (2)
What are the motives behind this impressive institutional shift? It is reasonable to assume that the recent trend towards granting central banks independence has received a major impetus from the Maastricht Treaty, which sets up the institutional framework for monetary policymaking in the Euro Area. According to Article 105 of the Treaty, the Eurosystem--which is the ECB plus the national central banks of those countries that have adopted the euro--has received a clear mandate to maintain price stability as the primary objective. To fulfil its mandate in the most efficient way, the Eurosystem has been granted considerable independence from political interference. Article 108 of the Treaty states unambiguously: "When exercising the powers and carrying out the tasks and duties conferred upon them by this Treaty and the Statute of the ESCB [European System of Central Banks], neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body." Thus, the independence of the Eurosystem has gained quasi-constitutional status. In the same vein, according to Articles 101 and 102 of the Treaty, central bank credit to the public sector and the latter's privileged access to financial institutions are prohibited.
However, the foundations of the Maastricht Treaty go back further. The strong constitutional position of the Eurosystem would have been hardly conceivable without a fundamental change in the theory of central banking and in the public attitude towards central bank independence and without the successful model of the Bundesbank. In the field of monetary policy, the painful experience with inflationary policies in the 1970s provoked new economic and political thinking. (3) In the search for a solution of how best to keep inflation lastingly under control, the notion of delegating monetary policy to an independent and inflation-averse central bank gained increasing prominence in the economic literature of the 1980s. For Europe, the model of the Bundesbank played a key role in designing the Treaty, as its success in delivering a stable currency on the fundament of its independence de facto excluded any alternative to the adoption of a statute 'a la Bundesbank'. (4) In fact, in most European countries there was no independent central bank at the time of the negotiations on the Treaty.
But what is meant by central bank independence? How robust is the consensual
view on the relationship between central bank independence and price stability? Why should one trust central bankers more than politicians? Why have governments decided to make central banks independent? And what role do the preferences of society play in this context?
With a view to answering these questions, the structure of this paper is as follows. Section 2 presents some basic considerations concerning the concept of central bank independence. Section 3 briefly recalls the main empirical findings on the relationship between central bank independence and macroeconomic performance. Section 4 covers the theoretical foundations for central bank independence, with a particular focus on political economy considerations in Section 5. Based on empirical and theoretical insights, which make a strong case for central bank independence, Section 6 reflects on the relationship between society's preferences and central bank independence. Section 7 concludes.
2. What is meant by central bank independence?
Central bank independence is a concept that comprises many dimensions and is difficult to quantify. (5) In fact, there is no single definition or measurement of central bank independence. However, several attempts in the literature to categorise the different notions of central bank independence have enhanced the understanding of this multi-faceted concept. In broad terms, central bank independence can be defined as institutional independence, implying a set of legal provisions that guarantee that the central bank carries out its tasks and duties without political, and more generally, external interference.
The distinction between goal independence and instrument independence helps to clarify further the contours of independence. (6) There is widespread consensus today that the central bank should not be goal independent, while the central bank should be given full independence in setting monetary policy in order to fulfil its mandate. Retaining the goal setting within legislature is straightforward. In a democratic society, it cannot be left to an independent institution and its unelected officials to decide on its own goal. The decision on the ultimate goal of monetary policy must be left to citizens and set by their democratically elected representatives via legislative procedure. To remove any uncertainty about the mandate, those preferences should then be enshrined in law or even a constitution. Keeping the goal setting within the ongoing political process would expose the mandate for monetary policy to exactly those influences which are intended to be excluded by making the central bank independent.
Consistently with this view, the Maastricht Treaty--which was signed in 1992 by twelve governments, ratified by their respective parliaments and, in certain cases, even backed by referenda--has set a clear goal for the single monetary policy, establishing that the primary objective of the European Central Bank is price stability. Many other central banks around the world have been given a similar goal by national legislature.
Furthermore, to substantiate the institutional independence, a distinction can be made between functional, personal and financial independence. Functional independence implies that the central bank applies its own judgement in setting the policy instruments with the aim of achieving the objective specified in the mandate. A key element of functional independence is also a definitive prohibition of direct monetary financing of budget deficits. Only an independent central bank that can and even must, at any time, reject requests for the direct monetary funding of budget deficits is capable of retaining lasting control over the money supply and, thereby, the price level in the medium term. As regards personal independence, key provisions include transparent appointment and dismissal procedures and predefined terms of office of the members of the governing body. Finally, financial independence, which is the central bank's autonomy over its financial resources and income, is an important factor in that it helps the central bank to perform its functions efficiently, thereby contributing to its credibility. (7)
The insulation from politics and electoral concerns that these provisions are geared to ensure is not intended to push the central bank into a political vacuum. This would be detrimental for the overall macroeconomic performance. Therefore, regular exchanges of information and views between the central bank and other policy actors about matters of mutual interest are highly desirable and compatible with the concept of central bank independence. However, dealing with such matters is a delicate balancing act. On the one hand, it is essential that the central bank is clear about the mandate it received, its strategy to achieve the assigned mandate and its reading of the current macroeconomic situation. A continual and systematic explanation of the analysis underlying monetary policy decisions and actions is indispensable in that it helps other policy players to understand better and broadly anticipate how monetary policy reacts to observable data and indicators--and to their own policies. On the other hand, too close a policy cooperation with other policymakers, which translates into a form of ex ante policy coordination between monetary and fiscal policy, is unlikely to be successful and is thus not desirable. (8) Such an arrangement might create severe credibility and communication problems vis-a-vis the general public and financial markets, as it might distort the incentives and blur the responsibilities of different policymakers to achieve their statutory goals, thereby endangering stability.
Finally, closely related to the concept of independence are the notions of accountability and transparency. As a quid pro quo for their independence, central banks in a democracy must be held accountable for their actions. This implies first and foremost the obligation for the independent central bank properly to explain and justify its policy decisions to the public and its elected representatives. In this respect, a high degree of transparency plays a key role, as it enables the public to monitor closely the central bank's ability to attain its policy goal. By virtue of this mechanism, transparency plays an invaluable role in reinforcing public support for central bank independence and fostering discipline on the part of monetary policymakers.
3. Empirical evidence on central bank independence and macroeconomic performance
Although the attempt to grade all possible facets relevant for measuring the degree of central bank independence is a daunting task probably doomed to fail, the interest in conducting empirical tests on the effect of central bank independence on macroeconomic performance has led a number of researchers to devise ways to try to overcome this problem. The indicators of central bank independence that have been put forward in the literature can be broadly divided into two categories according to the emphasis they place on the legal and statutory provisions regulating the central bank versus proxies of the 'actual' degree of independence that the central bank enjoys. (9) Although these indicators are all imperfect measures of central bank independence, they cover many aspects of the concept of central bank independence and, particularly when evaluated together, can provide valuable insights.
Over the past one and a half decades, the empirical literature has undergone substantial shifts in its assessment of the relationship between central bank independence and macroeconomic performance, almost resembling a U-shaped pattern. Early studies were unanimous in finding a close negative relationship between central bank independence and inflation. (10) In particular, juxtaposing, for a number of countries, indicators of central bank independence and inflation performance revealed that the higher the degree of independence of a central bank, the lower the average rate and variability of inflation. This result holds particularly true for industrial countries. As expected, Germany came top in the degree of central bank independence, according to the indicators used in such studies. Reassuringly for the conventional theories underpinning the benefits of central bank independence, Germany was also the country with one of the most stable currencies in the world.
Subsequent studies have questioned such findings. (11) It has been emphasised that available indicators of central bank independence are imprecise measures and are based on some degree of arbitrariness, as different available indicators assign different weights to each single legal provision regulating the central bank. Furthermore, it is argued that legal provisions could be easily circumvented in countries where law enforcement is difficult to ensure due to a lack of sound political and legal systems. At a more general level, it was shown that empirical results are sensitive to the set of countries included in the estimation, the sample period and the use of alternative control variables to take into account cross-sectional features and variations over time.
Evidence from more recent literature seems to have overturned these conclusions and reconfirmed the original assessment that central bank independence and inflation are significantly negatively correlated. The source of the apparent contrast seems to rest partly on the different number and especially on the type of countries included in the estimation. Early studies focused predominantly on a relatively small and homogeneous group of industrial countries, while subsequent analyses, retaining the assumption that central bank independence could be gauged by 'legal' indices, have expanded the set of countries included in the analysis. However, Temple (1998) shows that the presence of a few outliers and particularly the inclusion of very high inflation countries can entirely drive the results and lead to the insignificance or inexistence of the relationship between central bank independence and inflation. (12) An additional explanation for the lack of robustness reported by some studies has recently been documented by Brumm (2000), who shows that it arises mainly from the failure adequately to take into account in the estimation the imprecision in measurement inherent in available proxies of central bank independence.
The relationship between central bank independence and economic growth has been less thoroughly investigated. Certainly, the aforementioned early finding of a negative correlation between central bank independence and inflation immediately provoked the question of whether or not a country with an independent central bank and good inflation performance would inevitably have to compromise on other goals, in particular economic growth. Available empirical evidence on this issue suggests that central bank independence does not harm economic growth and is not correlated with output variability. On the contrary, there are strong reasons to believe that central bank independence yields several benefits for society at no cost, leading some authors to describe central bank independence in terms of a 'free lunch. (13)
Importantly, the finding that there is no correlation between central bank independence and real economic activity should probably be seen as a 'lower bound' on the extent of the true relationship. Most studies were based on the assumption that all countries are equal in their growth potential. However, by taking into account the effect of differences in the initial stage of development, there is evidence of a positive correlation between central bank independence and economic growth. (14)
4. Theoretical underpinnings of central bank independence
The main theoretical underpinnings for central bank independence rest on the credibility or time-inconsistency problem of monetary policy. (15) Two interesting approaches were developed to address these challenges. One is Rogoff's concept of delegating monetary policymaking to a conservative central banker. (16) The other is Walsh's proposal to design the appropriate incentives by means of an explicit contract for central bankers. (17) Both approaches have significantly improved the understanding of some key problems of monetary policy. However, they have also prompted criticism. (18)
A viable solution to these problems would seem to be the following institutional design which rests on three basic elements: first, delegation of the conduct of monetary policy to an independent central bank in order to protect it from political and external influence; second, a mandated primary objective of price stability in order to remove the temptation to engineer short-sighted policy actions pursuing inappropriate objectives; and third, enshrining the monetary policy framework in legislation, or even a constitution, to fortify its credibility. (19)
However, the question arises of whether or not the emphasis placed on price stability would lead to higher output variability. Several arguments actually suggest the opposite. Better protection of the central bank from political and external influences would insulate monetary policy, as discussed in the next section, from uncertainty about electoral cycles, thereby decreasing output variability. Also, trying to stabilise output directly, or to fine-tune the economy, would not only distract monetary policy from its goal of price stability, but lead in the end to higher output variability. In this context, taking into consideration the role of uncertainty about the measurement and even the concept of the output gap and about the structure of the economy, several studies have shown that a clear focus on price stability can foster stability by minimising unnecessary policy-induced variability in the economy. (20) Furthermore, recognising the need for the private sector to understand correctly, also ex ante, monetary policy actions suggests that a proper institutional design setting up the framework for monetary policy should not be seen in isolation, but together with the actual monetary policy strategy adopted by the central bank to achieve its objective.
The importance of the central bank's monetary policy strategy reflects the notion that even the soundest institutional framework cannot guarantee that the desired outcome in terms of price stability will ultimately be achieved. The success of the central bank in meeting the mandated objective largely depends on the public perception of the central bank's actions. Moreover, it is by now also widely recognised that monetary policy is not just a sequence of single and independent moves, but rather an interaction over time between the central bank and the public. (21) Systematic and consistent responses to macroeconomic contingencies would, over time, create regularities that can facilitate understanding and the learning process on the part of the public. The more systematic a monetary policy is, the more effective it is in anchoring inflation expectations. Emphasis on the systematic conduct of monetary policy implies a considerable move from a Rogoff-type paradigm--which implies the idea that a 'conservative' central banker conducts monetary policy in a fully discretionary manner by re-optimising every period--towards more rule-like behaviour.
The ECB monetary policy strategy, for instance, has provided a quantitative definition of price stability, a comprehensive analytical approach and a medium-term orientation. (22) In particular, the quantitative definition of price stability can provide an anchor for private sector inflation expectations and a clear yardstick for central bank accountability. The analytical approach of the ECB--its 'two-pillar' strategy--reflects the need for a comprehensive assessment of the risks to price stability, which takes into account all relevant information in a consistent manner by means of cross-checking the indications coming from the economic analysis with those stemming from the monetary analysis. Finally, the medium-term orientation of its policy helps to avoid introducing unnecessary volatility into the economy when responding, for example, to economic shocks that tend to move inflation and prices in opposite directions. Such a strategy thus complements the institutional framework for monetary policy in the Euro Area, as enshrined in the Treaty.
5. Political economy considerations and central bank independence
Having isolated key features that should allow the institutional framework for monetary policy, once supplemented by a sound monetary policy strategy, to provide the basis for a successful monetary policy, a number of questions still remain, in particular regarding political economy considerations. Traditional analysis of central bank independence does not cover important aspects of the functioning of modern democracies such as the interplay between political parties and voters, the role of interest groups in influencing government decisions and the effects of specific details of appointment procedures.
In the attempt to incorporate these features into the analysis, the literature has tried to go deeper into the foundations of central bank independence by explicitly modelling preferences, incentives and constraints faced by the different economic and political players. In this respect, it has become standard to consider politicians as being first and foremost interested in winning the next election campaign and therefore mainly driven by the desire to please their voters in the short term. By contrast, unelected independent officials are seen as being motivated by their individual career prospects, which--as discussed below--must not imply that officials would act against the interests of their institution. Finally, interest groups are seen as lobbying politicians to influence the distributional effects of the inflation tax. Given the vulnerability to inflation of people on low incomes, who find it more difficult to use instruments to hedge against the adverse effects of inflation, there is in particular a distributional issue. This is consistent with the ample evidence that inflation and income inequality move together. (23) This indeed represents an important argument in favour of shielding monetary policy from political factors.
According to this type of analysis, the interaction of such forces introduces an additional level of instability and uncertainty in the economy which is driven entirely by political factors rather than by the traditional economic disturbances. As shown for example in the paper by Alesina (1987), political parties may differ in their preferences for active stabilisation policies and the desired degree of monetary stability and try to influence monetary policy in order to get the desired outcomes. Assuming the presence of two parties, the rate of inflation expected to prevail after the election--on which agents base their decisions--will be a weighted average of the inflation rate desired by the different parties, whereby the weights are given by the likelihood that a given party will win the election. After the election, inflation or disinflation will occur, depending on which party wins. This leads to business cycle fluctuations with costly distortions and misallocation of resources in the economy. The associated heightened uncertainty would also lead agents to devote resources to hedging against possible unfavourable outcomes rather than to use them for more productive purposes. The lack of a clear medium-term direction of monetary policy would also give more room to interest groups and lobbies who would find it easier to influence policies.
In the search for mechanisms that can protect monetary policy from damaging political influence, the literature has focused on specific aspects of the notion of central bank independence such as the role of appointment procedures, accountability framework and dismissal and reappointment provisions of the top officials delegated to run monetary policy. (24) The term of office of top officials should be longer than that of politicians. The involvement of parliament, for instance via a confirmation hearing for the envisaged incumbent, could exert beneficial effects in that it may help to prevent the Government from selecting an excessively partisan candidate. This could help to focus the selection procedure on more objective criteria like professional qualifications, as it would become harder for the opposition to block the appointment of a highly qualified nominee.
Structuring the decision-making body of the central bank in terms of a board whose members serve overlapping terms of office would provide a further effective barrier against political influence. Spreading over time the appointments of top officials implies that in all likelihood such appointments are made under different governments and/or parliamentary majorities. Importantly, a board-type structure with overlapping terms of office favours the development of a 'central bank culture' which fosters continuity. It also introduces powerful checks and balances in the functioning of the central bank, thereby reinforcing the incentives for individual board members to act in line with the public mandate assigned to the institution: board members would be subject to beneficial scrutiny not only from observers outside the central bank but also from their peers sitting on the board. Importantly, the combined effect of managing an institution with an unambiguous mandate and such an internal structure of the central bank should ensure that even if individual board members may strive for personal prestige or a career outside the central bank, they would probably feel that this individual objective is best achieved by verifiably fulfilling their public mandate. Under the impact of public expectations and peer pressure, the individual objective function of a central banker may thus change in a way which might even surprise the delegating Government. This process has sometimes been described as the 'Becket effect'. (25) Finally, a board structure obviously prevents excessive discretion that might otherwise emerge in a system that grants decision-making power to a single person only.
The aforementioned insights are reflected for instance in the Statute of the ESCB. Article 11 of the Statute foresees for example that, for the members of the Executive Board, the term of office shall be eight years. A member of the Executive Board cannot be removed unless he "no longer fulfils the conditions required for the performance of his duties or if he is guilty of serious misconduct".
Political economy considerations have also provided useful insights into a key question that has often contested theories that rely solely on the presence of time inconsistency to motivate the need for central bank independence: why have policies such as fiscal policy--unanimously considered to be afflicted by time inconsistency--witnessed little or even no delegation to an independent institution? In an attempt to answer this question, Alesina and Tabellini (2005) have recently provided a taxonomy of the tasks that it would be beneficial to delegate to independent bodies. They suggest that the main differences in nature between monetary and fiscal policy can be traced to the highly technical expertise requested for conducting monetary policy and the features of the goals to be achieved by the two policies. The goal for monetary policy can be formulated in terms of an aggregate variable such as inflation. The main goal for fiscal policy is instead usually seen as hinging on distributional issues and thus better dealt with by politicians, who have closer contact with citizens' preferences. It is argued that it would be too complex to formulate a delegation mechanism that specifies the details of the preferred income distribution among citizens. (26)
6. Society's preferences and central bank independence
Although theoretical investigations of the notion of central bank independence have progressed considerably over the past twenty years, knowledge is still limited on two important aspects: first, how to explain cross-country differences in the degree (and form) of central bank independence and especially the timing of adoption of reforms directed at granting independence, and second, how to quantify the actual extent of the time-inconsistency problem afflicting monetary policy. Traditional theories of central bank independence hinge on the presence of time inconsistency but little research has been conducted on the quantification of this problem in reality. The growing literature on general equilibrium models seems well suited to analysing this issue and providing valuable insights. (27)
It would also be worth devoting further attention to the benefits of central bank independence that complement traditional explanations based on the time-inconsistency argument. Eggertson and Le Borgne (2005), for example, have recently interpreted central bank independence, in the sense of delegation to independent officials with a term of office that goes beyond the electoral cycle, as the result of a cost-benefit analysis. One benefit is that the long term of office provides an incentive to put in more effort than an elected politician would do in carrying out highly demanding technical tasks such as the conduct of monetary policy. Due to learning effects, this will improve the quality of monetary policymaking itself. Another benefit is that politicians may find it difficult to go against public opinion, even if they have better information or a more complete picture of the economic situation, because they fear being proved wrong and being punished by voters at the next election. Central bank officials do not face the fray of short-term elections and are thus in a better position to take into account all relevant available information. The costs of delegation to an independent central bank are given instead by the possibility of having appointed an official with a long term of office--and thus being unable to remove him or her in case he or she turns out to be incompetent--and by the possibility that society's preferences change over time and there is no means to make the appointed official internalise this change. The insights coming from this analysis nicely complement the traditional results that call for an independent central bank with a clear focus on price stability. Moreover, the emphasis--in common with other political economy analyses--placed on the degree of instability in society's preferences may be key in understanding cross-country differences in the degree of central bank independence.
If there is uncertainty about society's preferences--in the sense that society is in a state of unrest and preferences are quickly evolving--it might turn out to be extremely costly to delegate decisions to an independent institution. First of all, society itself might find it difficult to specify clearly the goals that should be established for an independent institution. If society nevertheless delegates some tasks, it is reasonable to foresee that preferences might shortly thereafter change and society would thus be unable to remove the officials.
This fits well with the notion that Germany's dreadful experience with two periods of hyperinflation in the first half of the 20th century has helped to shape deep-rooted preferences for stability, thereby building widespread public support for price stability in particular. Other countries experienced probably a higher degree of instability in their preferences for inflation and in their desired macroeconomic and redistributive goals.
The notion that deeply rooted social attitudes could play a bigger role than usually accounted for in explaining macroeconomic (in)stability has even led to the claim that these attitudes could be more important for price stability than the central bank's institutional arrangement itself. (28) This claim seems to rest on two pieces of evidence. First, many countries have witnessed a regime shift in their inflation dynamics towards lower and more stable rates before the actual implementation of reforms aimed at granting or increasing central bank independence. (29) Second, there is evidence that countries that display higher inflation aversion generally enjoy a higher degree of price stability. These findings would suggest, so the argument goes, that the driving force behind a high degree of price stability could be represented by the presence of a shared culture of monetary stability in society rather than by the institutional arrangement adopted by a country. (30)
A closer look at these findings reveals, however, that they do not weaken but actually confirm the notion that central bank independence is a necessary condition for lasting price stability. They suggest a distinction between achieving lower inflation, in the sense of pursuing a disinflationary policy to bring inflation down from high levels, and lastingly maintaining price stability with domestic control of monetary policy. Lower levels of inflation may be achieved in different ways. This requires a clear shift in society's preference against inflation convincingly communicated to politicians, who will then start adopting the necessary measures to control inflation. Many countries have successfully reduced inflation by fixing their exchange rate to that of a country with a high degree of central bank independence (e.g. many European countries pegged their currencies to the Deutsche Mark). But pegging the exchange rate--and even more adopting a currency board--means that a country relinquishes domestic control of monetary policy altogether. Importantly, this reinforces the notion that central bank independence is to date the only available practical solution for a country wishing to retain domestic control over monetary policy and at the same time maintain price stability in a lasting manner.
The importance of the institutional arrangement itself is also supported by recent experience in the United Kingdom. Spiegel (1998) analyses the impact of the change of the legal position of the Bank of England on 6 May 1997, when the Bank gained independence. Comparing yields on nominal and index-linked bonds with maturity between five and twenty years, he finds that such reform led to a drop of 60 basis points in expected average inflation over the lifetime of the bond, using a two-week event window. As it is unlikely that other factors, such as the attitude of the British public towards macroeconomic stability, witnessed a sharp change over such a short time horizon, this finding would suggest that institutional mechanisms can provide a powerful tool to entrench price stability.
The finding that society's aversion to inflation--and thus society's understanding of the negative effects of inflation--is higher in countries with central bank independence could also be explained by the efforts made by independent central banks to promote a stability culture and build up a constituency for low and stable inflation. Educational programmes carried out by the central bank, many of the speeches and remarks made by central bank officials in formal and informal gatherings and many central bank publications are examples of such efforts to explain time and again the adverse welfare effects of inflation on economic activity and the need for central bank independence from the political process. (31)
The efforts aimed at fostering public understanding and support for stability-oriented policies arise from the recognition that the public stance on the preferred economic policy priorities of society may facilitate or hinder the central bank's task. If the constraints imposed by stability-oriented policies are continuously not respected by all groups in society and the claims of different groups continually exceed the potential of the economy, macroeconomic (and probably social) stability will be at risk. Similarly, if public support for stability-oriented policies decreases, external pressure from government and interest groups will immediately rise. Conversely, if people trust the central bank, they will also support the central bank should there be political pressure. (32)
Such political pressure would usually be highly correlated with failures of fiscal and structural policies in delivering the needed reforms to correct distortions in the economy and improve its growth potential. In such times, characterised by large distortions in the economy, there would be an increased incentive for the Government to push output above its natural rate by stepping up its pressure on the central bank for an inflationary monetary policy. Or put more simply, in such times the central bank is an easy scapegoat for failures on the part of politicians.
These considerations suggest that central bank independence, although necessary, would not generally be sufficient to guarantee macroeconomic stability and that the public attitude towards central bank independence cannot be taken for granted. (33) Social attitudes evolve over time and can be rather fragile. An independent central bank has an important role in creating a culture of stability--if it is not already widely shared in society--and in keeping it alive over time. Today, for example, there might be the risk that the public memory of inflation and its negative effects is fading away, in particular in the new generations growing up in a low-inflation environment.
Granting a constitutional status to central bank independence and to the primary objective of price stability may be seen as an ex ante insurance mechanism against future policy slippages: a sort of 'Ulysses and the sirens' self-constraining mechanism. If the status of the central bank and its objective can be changed too easily, it may not provide a credible framework and the needed insurance effect may fail to work. However, granting a central bank constitutional status can strike a balance between the need to uphold preferences for price stability (thus ensuring insulation from short-termism and fashion and fads in public debates and economic thinking, via the lengthier process and qualified majority needed to modify the constitution) and the opportunity to retain some flexibility (a constitution can also be modified).
Overall, central bank independence might be seen as a mirror of society. It reflects the determination of society to safeguard the value of its money. At the same time, central bank independence feeds back into society by influencing attitudes towards price stability. It forms the basis for trust and confidence. However, this trust must be earned and maintained through action over time. A clear allocation of political responsibilities between the central bank, on the one hand, and the Government and legislature, on the other, becomes essential to safeguard price stability.
Theory and practice have confirmed the importance of an appropriate institutional framework for the central bank based on independence and a clear focus on price stability, supplemented by a sound monetary policy strategy. They have also confirmed the importance of sound appointment procedures. Taken together, these elements should ensure that competent officials will be appointed and that, once in office, their preferences will be in line with the central bank mandate.
It must however be recognised that the 'stability culture' of society also matters. It can be regarded as one element that bolsters the central bank's efforts to maintain price stability. These considerations should serve as a reminder to policymakers that the stability culture of society cannot be taken for granted. It requires continuous efforts to build up and maintain a constituency for price stability. In this respect, the central bank has to play a leading role in its communication with the public and in enhancing the degree of economic literacy. These efforts should not be underestimated, as there are always attempts to question whether or not central bank independence is justified.
Ultimately, every society gets the rate of inflation it deserves. This does not mean that the institutional framework for monetary policy is a non-issue. On the contrary, given the permanent temptation inherent in the political process, the establishment of an independent central bank with price stability as its policy priority reflects society's strong determination lastingly to keep the value of money stable.
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(1) As early contributors to the debate, see for instance Simons (1936) and Friedman (1956).
(2) For instance, independent central banks were established in Japan, the United Kingdom and the Euro Area. Reforms of the central bank law have also been introduced in other countries, such as, for example, New Zealand, Australia, Mexico and South Africa to name only a few.
(3) For the discussion of the origins of the Great Inflation of the 1960s and 1970s, see for instance the contributions presented at a conference of the Federal Reserve Bank of St. Louis on 7 and 8 October 2004, 'Reflections on monetary policy 25 years after October 1979', in particular Meltzer (2005) and Romer (2005), as well as Issing (2005) on why the Great Inflation did not happen in Germany.
(4) On the 'Bundesbank model', see Issing (1993). The insight into the necessity of establishing an independent central bank in order to insulate monetary policy from political interest in inflation is a consequence of the experience with two hyperinflations in Germany in the first half of the last century.
(5) See for instance Buiter (2005), who argues that there "can be no such thing as an independent central bank". This concept, in his view, fulfils all meanings of a myth, ranging "from a fictitious story, fiction or half-truth, through a popular belief to the pattern of basic values and attitudes of a people.", pp. C1-C2. However, Buiter acknowledges that all the institutional arrangements currently understood under the 'independence' label can be helpful in delivering good monetary policy.
(6) See Debelle and Fischer (1995) for these two concepts.
(7) The analysis of the importance of financial independence for the credibility and thereby the success of monetary policy is a rather neglected field of research. See for instance Stella (2005) who provides a survey on this issue.
(8) See Alesina et al. (2001) and Issing (2002).
(9) Measures of 'actual' central bank independence are constructed on the basis of the actual, as opposed to the legally mandated, turnover rate of central bank governors, or of political vulnerability (see Cukierman, 1992, and Cukierman and Webb, 1995). For developing countries, Cukierman (1992) pointed out that legal indices of central bank independence might be uninformative due to the likely gap between legal and 'actual' independence.
(10) See Grilli et al. (1991), Cukierman (1992), Alesina and Summers (1993).
(11) See Posen (1993), Neumann (1996), Fuhrer (1997), Forder (1996 and 1999), Mangano (1998), Campillo and Miron (I 997). Eijffinger and de Haan (1996) and Berger et al. (2001) provide extensive surveys of the empirical literature.
(12) Several recent studies focusing on a set of homogeneous countries have confirmed the existence of a close relationship between central bank independence and inflation. Eijffinger et al. (1998), focusing on OECD countries, systematically assess the effect of available indices of central bank independence and find a negative relationship between central bank independence and inflation for all indices. The negative relationship is confirmed, also after controlling for a broad set of indicators, for transition economies by Loungani and Sheets (1997), for Latin American and Caribbean countries by Jacome and Vazquez (2005), and for a large set of developing countries by de Haan and Kooi (1999), who, importantly, employ an index of 'actual' central bank independence.
(13) Grilli et al. (1991), p. 375.
(14) See De Long and Summers (1992) and Cukierman et al. (1993).
(15) See Barro and Gordon (1983a, b), who build upon the seminal work by Kydland and Prescott (1977).
(16) See Rogoff (1985) and the subsequent literature that has extended such a framework, for instance Lohmann (1992) and Alesina and Gatti (1995).
(17) See Walsh (1995) and for instance Persson and Tabellini (1993) and the analysis of Svensson (1997).
(18) This is beyond the scope of this contribution. See e.g. McCallum (1995) and Blinder (1998).
(19) This is in essence the heart of many current monetary policy frameworks and was pioneered successfully by the Bundesbank.
(20) See Gaspar and Smets (2002), Ehrmann and Smets (2003), Orphanides and Williams (2004 and 2005), Cukierman and Lippi (2005). See also Orphanides (2001).
(21) For instance, see Woodford (2003).
(22) For a comprehensive exposition of the ECB monetary policy strategy, see Issing et al. (2001), Issing (2003), and ECB (2003).
(23) See for instance Romer and Romer (1998).
(24) See Waller (1989, 1992), Alesina and Gatti (1995), Waller and Walsh (1996), Faust (1996), Fratianni et al. (1997).
(25) See Issing (1993), p. 27. So called because of the experience of Henry II of England when he appointed his close confidant and Chancellor Thomas Becket as Archbishop of Canterbury and had to witness how the presumed advocate of the King's interest became a guardian of the interests of the Church.
(26) However, this does not contrast with the formulation of goals for fiscal policy in terms of aggregate variables such as a balanced budget. The separation of aggregate quantities and distributional issues would help to provide a clear focus for policymakers and become a powerful driver in reducing uncertainty and fostering macroeconomic stability. Fiscal rules may help in this respect. For instance, by setting deficit and debt limits as reference values and establishing procedures for budgetary surveillance and control, such rules help to prevent imprudent fiscal policies and their adverse effects on inflation and expectations.
(27) See for example Albanesi et al. (2001) for such an attempt.
(28) See for example Hayo (1998) and Hayo and Hefeker (2002).
(29) See Muscatelli et al. (2000).
(30) Posen (1993, 1995), for example, challenges the notion of causality between central bank independence and low inflation, arguing that they are both explained by a third factor, the strength of the financial sector, as this sector would be heavily penalised by price instability. Recent empirical studies have however rejected this notion (see for example Temple, 1998, and Franzese, 1999).
(31) See Neumann (1998). The Eurosystem information kit entitled 'Price stability: why is it important for you?' (www.ecb.int/home/ html/educational.en.html) and similar programmes of other central banks are examples of such efforts.
(32) In their case study on the Bundesbank, Maier and Knaap (2002) illustrate for example that external pressure on the central bank is less important when public support is high. See also Berger (1997) and Berger and de Haan (1999).
(33) See Issing (1993) for an early discussion of this idea.
Ottmar Issing, Member of the Executive Board, European Central Bank. I would like to thank Wolfgang Modery and Roberto Motto for their valuable contributions. Contact e-mail: firstname.lastname@example.org.…