Central bank independence

Since the 1980s, we have witnessed a worldwide process of granting independence to an increasing number of central banks. Indeed, independence was the precondition for national central banks to join the European System of Central Banks in order for their countries to (eventually) join the euro area. The statute of the European Central Bank incorporates the idea of an independent central bank and even in many develop- ing and emerging market economies such as Turkey, South Africa or Zimbabwe, central bank independence (CBI) has become a central issue of economic governance reforms (see Acemoglu et al., 2008). Up until the global financial crisis that erupted in 2008, central bank independence was part of what has been dubbed the "great moderation": a reduction of inflation and output volatility since the 1980s allegedly due to structural market reforms, monetary reforms (including central bank independence) and "luck" (see Bernanke, 2012). Independent central banks appeared to be part of the solution to the time-inconsistency and political-business-cycle problems to which discretionary economic policy is prone.

Central bank independence relates to the restrictions imposed on a central bank to define and pursue its own policy goals. Accordingly, independence is a relative concept comprising different dimensions:

(1) Goal independence refers to the fact that a central bank may choose its own objectives, may have to accept objectives given to it, or something in between.

(2) Instrument or operational independence refers to the freedom for a central bank to choose among the monetary policy instruments under its control and to deter- mine their calibration and timing that the central bank deems necessary in order to achieve its goals.

(3) Financial and personal independence are also often mentioned in order to limit the potential for indirect channels of influence or subordination.

Many attempts have been made to measure the relative independence of central banks by producing composite indices such as the most commonly used CBI indices presented by Grilli et al. (1991), Cukierman (1992), and Alesina and Summers (1993), ranging from 0 (subordinate) to 1 (entirely independent).

Policy interventions of a Keynesian type have always been confronted with problems that came to be known as time inconsistency and political business cycles. Economic policy makers such as central bankers might find themselves pursuing a sub-optimal monetary policy from the point of view of social welfare when they can freely choose their policy goals, might find themselves caught in a non-cooperative game with other policy makers pursuing interdependent policy goals, or may simply be pushed to act in favour of certain interests. Instrument independence and the assignment of a single goal (price stability as defined by a given inflation target) is seen as a device to credibly tie the hands of central bankers. Although monetary policy in mainstream economics is considered to be neutral with respect to real economic variables such as GDP growth and employment in the long run, short-run deviations from "natural" positions may be caused if nominal or real rigidities can be realistically assumed. Therefore, operational central bank independence (but not goal independence) will be associated with lower inflation rates and lower inflation volatility without any real cost; to wit, it comes as a "free lunch". Many empirical studies supported these postulates, which became almost conventional wisdom in the 1990s.

From a heterodox point of view, central bank independence has received a more mixed welcome: while some authors (Wray, 2007) questioned the democratic legitimiza- tion of CBI, highlighting the fact that not all societal interests are equally represented in the governing bodies of central banks, others (Fuhrer, 1997) disputed the clear-cut correlation between CBI and price stability as well as the "free lunch" postulate. Yet others (Heise, 2009), building on the post-Keynesian postulate of money non-neutrality in the short run as well as in the long run, support CBI in principle because a credible, non-accommodating policy stance is the prerequisite for avoiding the economically least favourable non-cooperative Nash equilibrium in "policy games" with fiscal authorities and wage-bargaining actors. Moreover, an institutional setting - such as CBI - that helps to reduce the range of possible future events, including the valuation of goods, services and assets, must be seen as contributing to containing fundamental uncertainty (ibid.).

The era of the "great moderation" has come to an abrupt end with the global financial crisis that burst in 2008 and that independent central banks were not able to prevent. Although massive regulation failures appear to be closer to the origin of the global financial crisis than the actual conduct of monetary policy and its institutional basis, CBI has come under scrutiny again. Are independent central banks able and willing to pursue a monetary policy stance that allows for sustainable fiscal policies in the age of massively increasing public indebtedness? Or have central banks already effectively lost their operational independence?

It is not only during periods of crisis, however, that CBI has been challenged. One basic problem with the empirical work of the impact of CBI on inflation and real variables is that several methodological weaknesses in forming an adequate CBI index have been detected. Mangano (1998) mentions an "interpretation spread", a "criteria spread" and a "weighting spread", which heavily influence the robustness of the established empiri- cal results. Further, the channel of causality has been challenged by indicating that price stability and CBI can both be attributed to social attitudes and cultural norms (Posen, 1998). Finally, a growing literature (see Iversen, 1999; Pusch and Heise, 2010) has pointed out the link between institutional frames in interrelated policy areas such as monetary, fiscal, and wage policies. The impact of CBI on real and nominal variables, therefore, is not linear but depends on alternative regimes that form different market constellations.

See also:

Central bank credibility; European Central Bank; Financial crisis; Monetary policy instruments; Monetary policy objectives; Time inconsistency.