Is It Possible That an Independent Central Bank Is Impossible? the Case of the Australian Notes Issue Board, 1920-1924
Coleman, William, Journal of Money, Credit & Banking
The history of the Australian Notes Issue Board over the period 1920-1924 is presented. It is shown that the Board was created as a genuinely independent monetary authority, but was soon abolished, as its policies antagonised interests upon which the government depended. The episode illustrates the thesis that the possibility of a genuinely independent monetary authority is problematic.
SINCE 1980 there has been a surge in the view that ahe central bank should be independent of government (for example, Alesina 1989; Parkin 1978). This has been accompanied by a wave of legislation to confer independence on certain central banks (the Reserve Bank of New Zealand in 1990, the Bank of France 1994, the Bank of England in 1997, the European Central Bank from its creation in 1998).
However, the wisdom of attempting to increase the independence to the central bank has been questioned. Most of the debate has concerned the benefits of independence (see Cuikerman 1992 and Grilli, Masciandaro, and Tabellini 1991). But there is also a question of the feasibility of central bank independence. In 1960, well before the current debate, the issue of feasibility was raised by Milton Friedman (1960). Friedman reasoned that the possibility of genuine central bank independence is doubtful, since a central bank is the creation of the legislature. If one act explicitly confers independence, a later act can take that independence away. This suggests that a central bank will remain independent only as long as it does what legislative power wishes it to do: true independence is impossible.(1)
Central bank independence, therefore, appears to founder on the impossibility of a sovereign power tying its hands. The significance of this impossibility has been explored in a number of contexts in the well-known time-inconsistency literature (Kydland and Prescott 1977).(2) Yet the impossibility of a sovereign power tying its hands appears not to have been assimilated by literature on central bank independence (or central bank contracts).(3)
An advocate of independence may reply that this case for the supposed infeasibility of central bank independence is exaggerated. Independence of the legislature can be secured by investing the independence of the central bank in a constitution that cannot be changed by the will of the legislature.(4) This reply, however, is not entirely effective. In some countries the constitution is the creation of the legislature (for example, the United Kingdom). Further, even if the constitution is independent of the legislature, the investing of independence in a constitution cannot assure the central bank's independence: for what one constitutional amendment can do, a later can undo.(5) Finally, the appeal to constitutional independence is not relevant to the evaluation of the moves to independence that the world has seen in recent years. All these have been in terms of a legislature granting independence. And, since the date of their independence, these newly independent banks have commonly been subject to pressure to act in ways agreeable to government.(6)
An episode in Australian financial history provides a sharp and documentable illustration of Friedman's infeasibility thesis. In 1920 the control of the Australian note issue was transferred from the Treasury and invested in a distinct authority, the Notes Issue Board, that was intentionally made independent. The board used its independence in a way that made itself politically unpopular. In accordance with Friedman's thesis, the board was after four years replaced by an entity more responsive to the government's wishes.(7)
The paper begins by tracing the origins of the board to the desire, in the aftermath of the inflation of World War I, to establish a note issue independent of the government. Sections 1 and 2 explain how the board's adherence to the quantity theory money committed it to two innovations in the Australian money supply process. …