Central Bank Independence-Economic and Political Dimensions

Article excerpt

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

I. Introduction

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. …