A Critical Assessment of Measures of Central Bank Independence

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I. INTRODUCTION

The institutional relationship between central banks and government has been a subject of considerable interest ever since David Ricardo showed in the early nineteenth century how the close relationship between the Bank of England and government led to inflation and depreciation of the pound. As long as central banks adhered to the gold standard and eligibility rules for discounting, price stability would be achieved; however, as monetary systems shifted from commodity to fiduciary systems, the relationship between price stability and central bank institutional design became a more important policy issue especially during the past three decades. Financial liberalization, greater acceptance of long-run inflation as a monetary phenomena, and rejection of the long-run tradeoff between inflation and unemployment elevated the discussion of central bank institutional design and price stability. As a result establishing or extending central bank independence occurred in a wide number of countries: New Zealand (1989); Colombia, Italy, and Portugal (1992); Korea, Japan, and the United Kingdom (1997); and Sweden (1998). The 1992 Maastricht Treaty adapted formal independence as the foundation for the European Central Bank. The International Monetary Fund adapted independence as a policy goal and used the 1997 Asian Financial Crisis, especially in Korea, to encourage greater central bank independence for countries needing assistance.

Support for more independent central banks has in significant part been based on correlations between inflation and measures of central bank independence over time and across countries, frequently based on single-variable regression models. Measuring central bank independence and using the measures to predict monetary policy outcomes was first proposed by Bade and Parkin (1978, 1982, 1988); (1) extended by Cukierman (1992) as well as Cukierman, Webb, and Neyapti (1992); and has evolved into a substantial body of literature claiming their exists a statistically significant inverse relationship between inflation and measures of central bank independence. Klomp and de Haan (2010) provide perhaps the most extensive investigation to date. They combined 59 studies in a meta-regression analysis and concluded there is a negative and significant relationship between inflation and central bank independence for Organization for Economic Cooperation and Development countries.

Two studies typify the literature--the frequently cited study by Alesina and Summers (1993) and a study by Carlstrom and Fuerst (2009) updating Alesina and Summers (AS) using a comprehensive and recent set of measures of central bank independence developed by Fry et al. (2000). AS constructed measures of central bank independence for 16 industrial countries over the period from 1955 to 1988, estimated correlations between the average inflation rate and measures of independence over the period from 1955 to 1988, and concluded their results verified what others found: "a near perfect negative correlation between inflation and central bank independence" (1993, 154). Carlstrom and Fuerst (2009) extended the AS study: first, they estimated the relationship between the average inflation rate and Fry et al. (FJMRS) measures of independence for 26 industrial countries over the period from 1988 to 2000 and second, they estimated the relationship for the pooled AS and FJMRS measures of independence for a total of 42 industrial countries. Carlstrom and Fuerst concluded the relationship has remained stable over the entire period from 1955 to 2000 and 63% of the decline in the average inflation rate from the period from 1955 to 1988 period to the 1988 to 2000 period can be attributed to increased central bank independence. (2)

The measurement literature has been influential. The literature has supported efforts to enhance central bank independence and to quantify the conventional wisdom that more independent central banks generate better price stability outcomes. …