Is Central Bank Independence Always A Good Thing?
University of Pittsburgh – Department of Political Science
Georgetown University – McCourt School of Public Policy
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June 22, 2016
Central bank independence (CBI) solves the time inconsistency problem faced by policymakers with respect to monetary policy. However, it does not solve their underlying incentives to manipulate the economy for political gains. Unable to use monetary policy, and often limited in their ability to use fiscal spending, governments can resort to financial deregulation to generate short term economic benefits. Drawing on case studies and large-N tests, we show that governments systematically weaken financial regulations in the aftermath of CBI. The financialization of the economy and the growing political power of the financial industry could therefore be a by-product of central bank independence.
Is Central Bank Independence Always A Good Thing? – Introduction
In 1997, Gordon Brown decided to grant the Bank of England independent control over its interest rates. Brown “emphasised the need to make interest rate policy `free of political manipulation’.”
Governments that control monetary policy might be tempted to use this power to surprise markets and in ate the economy for electoral purposes (Hibbs, 1977; Alesina and Stella, 2010). Central bank independence (CBI) offers a solution to this time inconsistency problem (Blinder, 1998).2 In this light, Brown’s move was statesmanlike. Indeed, he was lavishly praised for doing so. The Economist, for instance, described the decision as an “astonishingly bold start for the new chancellor.”3 The conventional wisdom, then, is that CBI is desirable, not least because it leads to price stability (Alesina and Summers, 1993). Blinder (1998, 75) summarizes the conventional wisdom: “[CBI] is a fine institution that ought to be preserved where it exists and emulated where it does not.”
This paper challenges this conventional wisdom. We do not question the benign effect of CBI on inflation. Instead, we ask whether granting a central bank more independence has undesirable side-effects. The motivation for this question is the following. While CBI solves the problem of using monetary policy for political reasons, it does not on its own solve the underlying incentives for policymakers to manipulate the economy to their advantage. CBI removes a tempting tool from a government’s arsenal, just like global debt markets constrained their ability to use fiscal policy (at least to some degree). The last major weapon remaining in such a situation is financial deregulation. By deregulation, we mean policies and reforms that encourage less oversight of, and more risk-taking by, the financial sector. Weakening financial regulations can generate short term political gains that are comparable to those from public spending and lax monetary policies.
Empirically, we test this idea in two ways. We then test these hypotheses in a large-N framework. We find that CBI is consistently followed by a weakening of financial regulations. Banks are privatized, entry for foreign banks is made easier, liabilities are transferred from the banking to the public sector, and capital openness is increased. While the point estimates vary, an increase of CBI by one standard deviation generally increases the main deregulation index by one quarter of its standard deviation. We also find that the effect of CBI only materializes in countries in which the central bank does not control banking regulation. That is, deregulation only happens when the government still has some degree of control over financial supervision. This reduces concerns that we are capturing a more general trend toward deregulation. The effects are extremely robust and more pronounced for democracies.
The limitations of these results is that we need to rely on broad indicators to compare countries. There might therefore be some measurement error, for instance if governments use very different deregulation tools in different regions. To reduce concerns about this, and to provide more detailed evidence in support of our argument, we make extensive use of qualitative evidence from Europe, the US, and Latin America. European and Latin American countries have both undergone phases in which higher degrees of CBI was granted by authorities over a fairly short period of time. We show that this was systematically followed by attempts to weaken financial liberalization in order to maintain the support of key constituencies. In the case of the US, with its relatively independent central bank, we show that lawmakers engaged in financial deregulation whenever the Fed refused to support the economy. For instance, this was the case when the Fed started fighting in ation in
Our immediate contribution is to the literature on the costs and benefits of CBI. Macroeconomists have long suggested that independent central banks have all kinds of desirable properties (Cukierman, 2008). Push-back mainly came from observers worried about the democratic deficiency of independent central banks (Eijffinger and De Haan, 1996; McNamara, 2002). More recently, political scientists and economists have begun to look more carefully at the way central banks – whether independent or not – function in practice (Keefer and Stasavage, 2003; Bodea and Hicks, 2015; Adolph, 2013). Adolph (2013) argues that who runs a central bank matters as much as its institutional degree of freedom. Ainsley (forthcoming) disputes the belief that CBI always leads to lower inflation. In times of high uncertainty, she argues that the opposite can happen. Our paper finds additional reasons to doubt that CBI is necessarily a good thing. But instead of looking at institutional design or economic outcomes, we embed the debates about CBI in the broader political-economic game in which central banks operate. The second contribution of this paper is to add to the literature on the financialization of the economy and of our political systems. Banks play an increasingly important role in the welfare of citizens and voters. Access to affordable credit is a well-known determinant of poverty (Bolton and Rosenthal, 2005). Jorda, Schularick, and Taylor (2016) show that mortgages represent an increasing share of the balance sheets of financial institutions. Increasingly, banks have become political actors. Johnson and Kwak (2011) document how the banking sector shapes policymaking in the US. The reasons that have led policymakers to let deregulation happen, however, remain unclear. Rajan (2010) claims that policymakers accepted deregulation because it would boost credit and therefore hide stagnating wages. Rajan focuses on the US and yet similar processes occurred in many countries. Our view is that deregulation is most useful when monetary policy is taken away from governments.
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