央行的政治经济学

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THE NEW POLITICAL ECONOMY OF CENTRAL BANKING

Sylvester C.W. Eijffinger

CentER for Economic Research,

Tilburg University,College of Europe andHumboldt University of Berlin

Paper to be presented at the conference \"Monetary Theory as a Basis for Monetary Policy\"organized by the International Economic Association in Trento, Italy on September 4-7, 1997

Correspondence to: CentER for Economic Research,

Tilburg University, P.O. Box 90153, 5000 LE TILBURG, The NetherlandsPhone:+31-13-4662411Fax+31-13-4663042E-mail:s.c.w.eijffinger@kub.nl

1. THE POLITICAL ECONOMY OF CENTRAL BANK INDEPENDENCE

1.1 Inflation

Many observers believe that countries with an independent central bank have lower levels ofinflation than do countries with a central bank that comes under direct control of the government.Why would central bank independence, ceteris paribus, yield lower rates of inflation? The literature(for a survey, see also Eijffinger and De Haan, 1996) provides three answers to this question:public choice arguments, the analysis of Sargent and Wallace (1981) and arguments that are basedon the time inconsistency problem of monetary policy.

According to the `older' public choice view, monetary authorities are exposed to strong politicalpressures to behave in accordance with the government's preferences.1 Monetary tighteningaggravates the budgetary position of government: the reduction in tax income brought about by atemporary slowdown of economic activity, possibly lower receipts from `seigniorage', and theshort-run increase in the interest burden on public debt all worsen the deficit. Thus, the governmentmay prefer `easy money.' Indeed, some evidence exists that even the relatively independent FederalReserve caters to the desires of the President and/or the Congress. This evidence is either based onclose inspection of the contacts between the polity and the central bank (see e.g. Havrilesky, 1993,2and Akhtar and Howe, 1991) or builds on tests to determine whether monetary policy turnsexpansive before elections as predicted by Nordhaus's (1975) political business cycle theory (seee.g. Allen, 1986), or diverges under administrations with different political orientation, as predictedby Hibbs's (1977) partisan theory (see e.g. Alesina, 1988). At this stage, it suffices to conclude

As Buchanan and Wagner (1977, pp. 117-18) put it: \"A monetary decision maker is in aposition only one stage removed from that of the directly elected politician. He willnormally have been appointed to office by a politician subject to electoral testing, and hemay even serve at the pleasure of the latter. It is scarcely to be expected that persons whoare chosen as monetary decision makers will be the sort that are likely to take policy stancessharply contrary to those desired by their political associates, especially since these stanceswould also run counter to strong public opinion and media pressures ... `Easy money' isalso `easy' for the monetary manager ..\".

Havrilesky (1993) even argues that \"the contemporary view is that the Administration,while granting significant leeway to the Fed, when necessary obtains the monetary policyactions that it desires\" (p. 30).

that, of course, the more independent a central bank is, the less it will be under the spell of politicalinfluences as outlined above. It will be clear that this argument of Buchanan and Wagner relatesprimarily to personnel independence.3 Personnel independence refers to the influence thegovernment has in appointing procedures. The level of this influence may be discerned by criteriasuch as government representation in the governing body of the central bank and governmentinfluence in appointing procedures, terms of office, and dismissal of the governing board of thebank.

A second argument to explain why central bank independence may tear on inflation. This argumentwas first put forward by Sargent and Wallace (1981) who distinguish between fiscal and monetaryauthorities. If fiscal policy is dominant i.e. if the monetary authorities cannot influence the size ofthe government's budget deficit money supply becomes endogenous. If the public is no longer ableor willing to absorb additional government debt, it follows from the government budget constraint that monetary authorities will be forced to finance the deficit by creating money. If, however,monetary policy is dominant, the fiscal authorities will be forced to reduce the deficit (or repudiatepart of the debt). It is clear that the more independent the central bank is, the less monetaryauthorities can be forced to finance deficits by creating money. It is clear that this argument relatesto financial independence. Financial independence refers to the ability given to the government tofinance government expenditure either directly or indirectly through central-bank credits. Directaccess to central-bank credits implies that monetary policy is subordinated to fiscal policy. Indirectaccess may result if the central bank is cashier to the government or if it handles the management ofgovernment debt.

A third, and indeed, the most prominent argument for central bank independence is based on thetime inconsistency problem (Kydland and Prescott, 1977; Calvo, 1978; Barro and Gordon, 1983).Dynamic inconsistency arises when the best plan currently made for some future period is no longer

Neumann (1991) emphasizes the personnel independence of the governing board of thecentral bank: \"The conditions of contract and of office would have to be set such that theappointee frees him- or herself from all former political ties or dependencies and accepts thecentral bank's objective of safeguarding the value of the currency as his or her professionalleitmotif. We may call this a `Thomas-Becket' effect.\" (p. 103). Waller (1992b) develops amodel for appointments to the central bank in the context of a two-party political system, inwhich the victor of the last election is allowed to nominate candidates, but the losing partyis given the right to confirm the nominees. An interesting outcome of the model is that ifsociety wants to minimize partisan monetary policy, it should increase the length of officeof central bank policy board members relative to the length of the electoral interval.

optimal when that period actually starts. Various models have been based upon this dynamicinconsistency approach (see e.g. Rogoff, 1985; Cukierman, 1992; Eijffinger and Schaling, 1993band Schaling, 1995). Basically, in these models the government and the public are drawn into somesetting of the prisoner's dilemma. The various models differ in their assumptions with regard togovernment incentives. Following McCallum (1995a) the central insights of these models can beexplained as follows. It is assumed that policymakers seek to minimize the following loss function:

L(πt) = wπ2 + (yt - kyn)2

where 01, whereas output is driven by:

yt = yn + β(πt - πet + ut)

where π is inflation, πe is expected inflation, yt is output, yn is the natural output and ut is a randomshock. We assume here that deviations of employment from its natural level are positively related tounanticipated inflation. This follows from the existence of nominal wage contracts in conjunctionwith a real wage that is normally above the market-clearing real wage. Policymakers have anobjective function that assigns a positive weight to stimulating employment (e.g. because of re-election considerations, or for partisan reasons) and a negative weight to inflation. Policymakersminimize (1) on a period by period basis, taking the inflation expectations as given. This gives:2 β(k - 1)yn β2βe + - utπt =22πtw + βw + β2w + βWith rational expectations inflation turns out to be:2β(k - 1)ynβ - utπt = ww + β2If policymakers were to follow a rule taking into account private rational expectational behaviour,inflation would be:-β2πt = 2utw + β4

As the same level of output pertains in both cases, the latter outcome is clearly superior. No matterwhat exactly causes the dynamic inconsistency problem4, in all cases the resulting rate of inflation issub-optimal.5

So in the literature devices have been suggested to reduce the inflationary bias. Barro and

Gordon (1983) conclude that the best solution for the time inconsistency problem consists of theintroduction of fixed rules in monetary policy, i.e. the authorities commit themselves to certainpolicy rules. Once uncertainty is introduced and the level of output is affected by shocks, the casebecomes one for a feedback rule, in which monetary policy optimally responds to shocks. Theproblem with rules, however, is the absence of some higher authority to enforce a commitment.Handing over authority to the central bank by political authorities may help here, since it can beregarded as an act of partial commitment (Rogoff, 1985; Neumann, 1991 and Cukierman, 1992,chapter 18). By delegating some of their authority to a relatively apolitical institution, politiciansaccept certain restrictions on their future freedom of action.6

The degree of central bank independence, of course, plays a meaningful role only if the

central bank puts a different emphasis on alternative policy objectives than does the government.The literature points to two main differences (Cukierman, 1992, chapter 18). One relates to possibledifferences between the rate of time preference of political authorities and that of central banks. Forvarious reasons, central banks are often more conservative and tend to take a longer view of thepolicy process than do politicians. The other difference concerns the subjective weights in the

Other sources of the time inconsistency problem originate with the public finances. Thedynamic inconsistency of monetary policy may first arise, because the incentives for thegovernment to inflate change before and after the public has settled for a nominal interestrate, taking into account its expected rate of inflation. Before the public commits itself, thecentral bank has an incentive to abstain from making inflation. After positions ingovernment bonds have been taken, policymakers have an incentive to create inflation(Cukierman, 1992). Another source of the inconsistency problem also originates in thefinances of government and may be referred to as the `revenue' or `seigniorage' motive formonetary expansion (Barro, 1983). The dynamic inconsistency of monetary policy ariseshere, because incentives for the government to inflate change before and after the public haschosen the level of real money balances.

This conclusion generally also holds in models with incomplete information. Cukierman(1992, chapter 18), for instance, provides a model in which the public is not fully informedabout the shifting objectives of the political authorities and in which there is no perfectcontrol of information.

An alternative solution to the time inconsistency problem is reputation building (Canzoneri,1985). Fratianni and Huang (1994) show, however, that the case of asymmetric informationgives no assurance that reputation may work for the central bank in the Barro-Gordonmodel.

objective function of the central bank and that of the government. It is often assumed that centralbankers are relatively more concerned about inflation than about other policy goals such asachieving high employment levels and adequate government revenues. If monetary policy is set atthe discretion of a conservative central banker, a lower average time-consistent inflation rate willresult.7 The foregoing analysis makes it clear that this argument for central bank independence isprimarily related to policy independence. Policy independence refers to the maneuvering roomgiven to the central bank in the formulation and execution of monetary policy. As pointed out byFischer (1995), it may be useful to distinguish between independence with respect to goals andindependence with respect to instruments.

The best way to illustrate the argument is to present a `stripped' version of Rogoff's model.

In Rogoff's (1985) model, society can sometimes make itself better off by appointing a centralbanker who does not share the social objective function, but instead places a higher weight on pricestability relative to output stabilization. In this simplified version, output is given by equation (2), inwhich the natural level of output is put at zero and the parameters at one. The timing of events inthe Rogoff model is as follows: first πte is set (nominal wage contracts are signed), then the shock utoccurs, and finally the central banker sets πt (see figure 1).Figure 1. Timing of events in the Rogoff model

Society's loss function is given by12χˆt)2Lt=πt+(yt-y22where the weight on output stabilization χ > 0 and y,^ > 0, so that the desired level of output, y,^, is above the natural level. Rogoff shows that it is optimal for society to choose an independent

Waller (1992a) analyzes the appointment of a conservative central banker in a model that

distinguishes between sectors that differ in their degree of competitiveness of the labormarket. The main result of this paper is that, although agents in both sectors have the samepreferences over inflation and output stability, in equilibrium nominal wage rigidity in thenon-classical labor market causes output in this sector to be more variable than in theclassical sector. Consequently, if the classical sector were allowed to choose the`conservative' central banker, it would choose a more vigorous inflation fighter relative tothe non-classical sector's choice.

(conservative) central banker who assigns a higher weight to price stability in his loss function:It=1+ε2χˆt)2πt+(yt-y22where ε, the additional weight on the inflation goal, lies between zero and infinity (0 < ε < ∞).Substituting and taking first-order conditions with respect to πt and solving for rational expectations,we obtain:

Install Equation Editor and double-click here to view equation.

Policy rule (8) shows that the introduction of a conservative central banker (ε > 0) leads to a lowerinflationary bias and a lower variance of inflation. The variance of output is, however, anincreasing function of the conservativeness of the central banker. So there is a trade off betweencredibility and flexibility in the Rogoff model. It can be shown that the optimal value for ε, in termsof social loss function (6), is positive but finite. This implies that it is optimal for society to appointa conservative central banker.

Rogoff makes the crucial assumption, that the central banker is completely independent and

cannot be overridden ex post, when the inflationary expectations πte have been set and the policy isto be carried out. This can lead to large losses for society when extreme productivity shocks utoccur. Lohmann (1992) introduces the possibility to override the central banker at a strictly positivebut finite cost. Therefore, society's loss function changes to

12χˆt)2+δcLt′=πt+(yt-y22where δ is a dummy that takes on the value of 1 when the central bank is overridden and 0otherwise; and c is a cost that society incurs when the central bank is overridden. The centralbank's loss function (7) stays the same.

The timing of events in the Lohmann model is as follows: In the first stage the central

banker's additional weight ε on the inflation goal is chosen as well as the cost c of overriding thecentral banker. Then the inflation expectations are set. In the third stage the productivity shockrealizes. Then the central banker sets the inflation rate, which is either accepted or not. If it is notaccepted, society overrides the central banker, incurs the cost c and resets the inflation rate. Finally,inflation and output realize (see figure 2).

Figure 2. Timing of events in the Lohmann model

In equilibrium, the central banker will not be overridden. In the case of an extreme

productivity shock he will set the inflation rate so that society is indifferent between overriding ornot. Rogoff's model is a special case of Lohmann's, where c=∞. Lohmann shows that the optimalcentral bank institution is characterized by 0 < ε* < ∞ and 0 < c* < ∞.

An important result from the Rogoff model is that the reduction in the equilibrium inflation

rate resulting after appointing a conservative and independent central banker generally comes at theexpense of greater output variability from supply shocks, since the central banker offsets outputshocks to a lesser extent than would governments.8 Nevertheless, gains from lower inflation exceedlosses due to decreased stability. Therefore, on net, society is made better off by appointing aconservative central banker. It is, however, not optimal in the Rogoff model to appoint a centralbanker whose only concern is low and stable inflation.

The Rogoff-model has been criticized by McCallum (1995a), who contends that it is

inappropriate simply to presume that the central bank behaves discretionary rather than setting theconstant term and πet coefficient in equation (3) equal to zero and thereby eliminating theinflationary bias while retaining the desirable countercyclical response to the shock ut. All that isneeded for avoidance of the inflationary bias is for the central bank to recognize the futility ofcontinually exploiting expectations that are given for the moment while planning not to do so in thefuture, and to recognize that its objectives would be more fully achieved on average if it were toabstain from attempts to exploit these temporarily given expectations. McCallum (1995b, p. 18)argues that \"there is nothing tangible to prevent an actual central bank from behaving in this\"committed\" or \"rule-like\" fashion, so it is my contention that some forward-looking banks will infact do so. Analytical results that presume non-committed or discretionary behaviour may thereforebe misleading\". Although McCallum has a point, the problem of course with a highly dependent

Recently, Alesina and Gatti (1995) have introduced another source of output variability in aRogoff-type model, namely variability introduced in the system by the uncertainty about thefuture course of policy. This uncertainty is due to uncertain electoral outcomes in case thereare two contending parties with different preferences over inflation and unemployment.Now the overall effect of central bank independence on output variability is ambiguous.

central bank is that it may not be able to behave in such a way.

Apart from a legislative approach to create by law an independent central bank and to mandate it,also by law, to direct its policies towards achieving price stability, other mechanisms have beensuggested to overcome the incentive problems of monetary policy. This so-called contractingapproach regards design of monetary institutions as one that involves structuring a contract betweenthe central bank and the government.The optimal contract is an application of ideas from theprincipal-agent literature. In this application government is viewed as the principal and the centralbank as the agent. The principal signs a contract with the agent according to which the bank issubject to an ex post penalty schedule that is linear in inflation. The nature of the contract will affectthe incentives facing the bank and will, thereby, affect monetary policy (Walsh, 1993). Persson andTabellini (1993) suggest a targeting approach, in which the political principals of the central bankimpose an explicit inflation target and make the central bank leadership explicitly accountable for itssuccess in meeting this target. Such a system exists since 19 in New Zealand, where the governorof the Reserve Bank can, under certain circumstances, be dismissed if the inflation rate exceeds twopercent.

It is interesting to note that it follows from the analysis of Persson and Tabellini (1993) that

the optimal contract with the central bank implies no loss in terms of stabilization policy. As pointedout above, this results contrasts with the outcomes of most models where monetary policy isdelegated to an independent central bank, where credibility is increased at the expense of an optimaloutput stabilization policy. Walsh (1993, 1995) and Persson and Tabellini (1993) show that theoptimal central bank contract may serve to eliminate the inflation bias, while still preserving theadvantages of stabilization. This conclusion holds even if the central bank has private information.9From the foregoing analysis, it will be clear that the contracting approach is clearly related toinstrument independence, but not to goal independence.

The contracting approach has also been criticized. For one thing, although they perform a

useful function as benchmarks, social planners do not exist in practice. Hence, government has tobe relied upon to impose the optimal incentive schedule on the central bank ex post. Governmentsare also subject to an inflationary bias and usually to a greater extent than the central bank

Walsh (1995) also considers the situation in which candidates to head the central bank differin their competency, the central bank's monetary policy stance is not observable, and theinformational content of a publicly observable signal about an aggregate supply shock isaffected both by the central bank's competency and by its implementation of given policies.In this model the principal can induce the central bank to behave as demanded by using acontract that resembles an inflation targeting rule with a reporting requirement.

(Cukierman, 1995). McCallum (1995a) argues that if government cannot commit to the optimalpenalty schedule before various types of nominal contracts are concluded the optimal contract willnot be credible. A contract does not overcome the motivation for dynamic inconsistency; it merelyrelocates it.

Svensson (1995) has recently shown that when the objective function of the central banker

differs from that of society with respect to desired inflation (rather than with respect to the relativepreference for price stability) delegation of authority to a central banker with the `right' desiredinflation level or target achieves the same results as the optimal contract. This implies that thesocially optimal level of welfare can be achieved through delegation of authority to a central bankerwith a suitable desired level of inflation rather than via an incentive contract for the bank. Aspointed out by Cukierman (1995), the big advantage of the first institution is that it does not have torely on the ex post implementation of the optimal contract by inflation bias ridden governments. Itwould appear, therefore, that Svensson's result implies that it is possible to reach the socialoptimum simply by delegating authority to an appropriately chosen type of central banker. Apractical difficulty, that may prevent the implementation of such an institution, is that the politicalprincipals may not be able to identify ex ante the desired levels of inflation of potential candidatesfor the central bank. Svensson suggests that this problem may be circumvented by giving the bankonly instrument independence, but not goal independence, so that the target or `desired' rate ofinflation in the Bank's loss function is mandated by government.1.2 Inflation variability

The preceding analysis suggests that central bank independence may reduce pre-electionmanipulation of monetary policy. In that case, central bank independence may also result in morestable money growth and, therefore, less inflation variability. A related argument exists to explainwhy central bank independency may lead to less inflation variability. Politicians not only strive toremain in office as long as possible, they are also partisan and wish to deliver benefits to theirconstituencies (Hibbs, 1977). Some evidence indicates that the pattern of unemployment andinflation tends to be systematically related to the political orientation of governments. Whereasright-wing governments generally are thought to give a high priority to lower inflation, left-winggovernments are often supposed to be more concerned about unemployment. Alesina (1988) reportsthat the unemployment rate in the US is generally higher under Republican administrations than it isunder Democratic administrations, whereas the inflation rate is lower in case of a Republicanpresident. Similar results have been reported by Tabellini and La Via (1987) and Havrilesky (1987).

Existing evidence lends support to the view that the redistributional consequences of inflationprovide an incentive for the left to endorse expansionary policies and for the right to fight inflation(Alesina, 19). This implies that if the government changes regularly, inflation variability may behigh especially if the monetary authorities are dominated by elected politicians. However, arelatively independent central bank will not change its policy after a new government has beenelected. Central bank independence thus, may reduce inflation variability (Alesina, 1988).

Milton Friedman (1977) named another reason why central bank independence may affect

inflation variability. Friedman wanted to explain why a positive correlation exists between the levelof inflation and the variability of inflation across countries and over time for any given country. InFriedman's analysis a government may temporarily pursue a set of policy goals (output,employment) that leads to high inflation, which subsequently elicits strong political pressure toreduce the debasing of the currency. The relationship between the level and the variability ofinflation has been extensively investigated. Recently, Chowdhury (1991) reexamined this issue for asample of 66 countries over the 1955-85 period. His results indicate the presence of a significantpositive relationship between the rate of inflation and its variability.1.3 Level and variability of economic growth

With respect to the effect of central bank independence on the level of economic growth twoopposing views have been expressed in the literature. Some authors have argued that the realinterest rate depends upon money growth; they assume that the Fisher hypothesis does not hold dueto the Mundell-Tobin effect.10 A low level of inflation that is caused by restrictive monetary policyresults in high real interest rates, which may have detrimental effects on the level of investment, andhence on economic growth (Alesina and Summers, 1993). There seems to be some evidence insupport of the first part of the argument: countries with a low level of inflation have high ex postreal interest rates (De Haan and Sturm, 1992).

Other arguments, however suggest that central bank independence may further economicgrowth. First, as outlined above, an independent central bank may be less prone to politicalpressures and therefore behave more predictably, which may enhance economic stability and reducerisk premia in interest rates, thereby stimulating economic growth (Alesina and Summers, 1993).

A rise in expected inflation will lead, according to Mundell (1963), to substitution of liquidassets by long-term financial assets and, according to Tobin (1965), to substitution of liquidassets by physical capital goods, lowering the marginal efficiency of capital and, thereby,also the expected (ex ante) real interest rates.

Second, high levels of inflation may obstruct the price mechanism; it is likely that this will hindereconomic growth. Many economists, especially those involved in central banking, believe,however, that even moderate rates of inflation impose significant economic costs on society(Fischer, 1993).11 Recently, Grimes (1991) and Fischer (1993) have provided evidence in support ofthe view that inflation harms economic growth.12 One channel through which this effect may operateis increased inflation uncertainty. As pointed out previously, a strong link exists between the leveland the variability of inflation. Strong variation may lead to high inflation uncertainty which, inturn, may damage economic growth. If central bank independence reduces the variability ofinflation and promotes less inflation uncertainty, economic growth may prosper. Empirical studieson the links between inflation variability and inflation uncertainty, and economic growth provide,however, only mixed support for this point of view. Using annual data for 24 countries, Logue andSweeney (1981) find no evidence for a significant negative impact of inflation variability on realgrowth. A similar conclusion is reached by Jansen (19). Engle (1983) found little evidence for alink between the relatively high rates of inflation experienced by the United States in the 1970s andinflation uncertainty. Cukierman and Wachtel (1979), however, report a positive correlationbetween the rate of inflation and the dispersion of inflation forecasts gathered from the Michiganand Livingston inflation surveys. Furthermore, Evans (1991) has published evidence consistent withthe point of view that uncertainty about the long-term prospects for inflation is strongly linked to theactual rate of inflation.

Concerning the impact of central bank independence on the variability of economic growth, varioustheoretical positions have again been delineated. On the one hand, if the central bank introducesrestrictive measures to combat inflation it is likely to provide recessions. In this view inflation hasbecome too high, since in previous periods the monetary authorities were too lax. An independentcentral bank striving for price stability will not that easily let inflation run out of control, andtherefore will not follow such a stop-go policy. Consequently, fluctuations in real output will besmaller (Alesina and Summers, 1993). On the other hand, the models of Rogoff (1985) andEijffinger and Schaling (1993b) conclude that when the central bank gives priority to price stability,

Fischer (1994) points out that the relationship between inflation and economic growth maybe non-linear. Furthermore, the link between inflation and growth for low levels of inflation(1-3 percent) is difficult to determine empirically.

See, however, also Karras (1993) who argues that the correlation reported by Grimes(1991) is a consequence of the cyclical character of both variables.

the variability of income will be greater than in the case where the central bank also strives forstabilization of the economy.

2.THE DETERMINANTS OF CENTRAL BANK INDEPENDENCE

The question arises which factors ultimately determine the degree of central bank independence. Itis quite remarkable that the literature dealing with this question is, so far, hardly developed. Beforediscussing some determinants of central bank independence in greater detail, we will first review therecently developed theory. Cukierman (1994) presumes that the delegation of monetary policy to(partly) independent central banks is used as a `(partial) commitment device.' By specifying theobjectives of the central bank more or less tightly and by giving it broader or narrower powers,politicians determine the extent of their commitment to a policy rule. Such policy action leads tomore credibility of monetary policy which, in turn, is reflected in lower inflationary expectationsand, thereby, lower (capital market) interest rates and more moderate wage demands. From thepolitician's viewpoint, the costs of an independent central bank consist mainly of the loss offlexibility in monetary policymaking. The balance between flexibility and credibility, depending onthe relevance of various economic and political factors to delegate authority, determines the optimaldegree of central bank autonomy in a country. Based on these or other theoretical considerations,various economic and political determinants of central bank independence have been formulated.Such determinants can be categorized as follows:131.2.3.4.5.6.7.

the equilibrium or natural rate of unemployment;the stock of government debt;political instability;

supervision of financial institutions;financial opposition to inflation;public opposition to inflation; andother determinants.

Table 1 summarizes empirical studies on the determinants of central bank independence. The secondcolumn shows the measure(s) of central bank independence used. The third and fourth columnspresent the sample of countries and the estimation period, respectively. The last column contains theeconomic and political variables examined in these studies.

Of course, these seven determinants are not mutually exclusive and may (partly) overlap.

2.1The equilibrium level of unemployment

The first determinant of central bank independence may be the average employment-motivatedinflationary bias in a country. This inflationary bias can be approximated empirically by theequilibrium or natural rate of unemployment.14 Cukierman (1994) shows that the larger the averageemployment-motivated inflationary bias in a country is, the higher are the costs for the governmentto override the central bank, and therefore, the more independent the central bank will be.15 Becausein the case of nominal wage contracts unexpected inflation has positive effects on the level of bothproduction and employment, a higher equilibrium or natural rate of unemployment implies thatsurprise inflation is more valuable for the government.

In this case the natural degree of unemployment is referred to as the non-acceleratinginflation rate of unemployment or, briefly, NAIRU. Of course, this implies that the desiredunemployment rate is being held constant and, thus, that the inflationary bias is driven bythe difference between the desired and natural unemployment rate. This assumption isquestionable.

Similarly, Eijffinger and Schaling (1995) suggest that the higher the natural rate ofunemployment is, the higher the optimal degree of central bank independence will be. Theintuition behind this proposition is as follows. A higher natural rate of unemployment leadsto a higher time-consistent rate of inflation and, consequently, to an increase in society'scredibility problem. Hence, with an unaltered relative weight placed on inflationstabilization versus unemployment stabilization, the monetary authorities' commitment tofighting inflation is now too low.

Table 1. Empirical studies on the determinants of central bank independence

Study:

Cukierman (1992)Posen (1993a)

Measure(s)used:LVAU andLVAWLVAU

Countries:14 middle in-come countries17 OECDcountries19 (16) OECDcountries21 (18) OECDcountries

Estimation period:1972-1979 and1980-191950-19

Variablesexamined:political instability(party and regime)financial opposi-tion to inflation(FOI)

natural rate ofunemployment(NAIRU),

government debtratio,

frequency of (sig-nificant) govern-ment changes,banking super-vision, universalbanking,

very long-terminflation

four types of poli-tical instability(high and lowlevel)

political instability(party and regime)political systemindex (PSI), stand-ard deviation ofoutput growthNAIRU, relativenumber of years ofsocialist (left-wing) government,variance of outputgrowth, compen-sation of employeespaid by residentproducers

De Haan and Van 'tHag (1995)GMT, LVAUand SUMLV

1980-1988

1980-19

17 OECDcountries16 (13) OECDcountries

Cukierman andWebb (1994)

politicalvulnerability

OECD anddevelopingcountries43 developingcountries22 OECDcountries

1950-18

1900-19401950-19

De Haan andSiermann (1995)Moser (1994)

TORaverage ofGMT andLVAWAL, GMT, ESand LVAU(latent variablesmethod)

1950-19 andsubperiods1967-1990

Eijffinger andSchaling (1995)19 OECDcountries

1960-1993 (forNAIRU: 1960-1988)

De Haan and Van 't Hag (1995) have tested this hypothesis, using two measures of

Cukierman (LVAU and SUMLV)16 and the index of Grilli, Masciandaro and Tabellini (GMT).Proxies for inflationary bias are the equilibrium rate of unemployment, as estimated by Layard,Nickell and Jackman (1991) for nineteen OECD countries, and the difference between the actualand the equilibrium rate of unemployment during the 1980s. In simple cross-country regressionswith each measure of central bank independence as a dependent variable, the coefficients of bothproxies proved to be insignificant. Eijffinger and Schaling (1995) employed a latent variablesmethod (LISREL) in order to distinguish between the actual (legal) and optimal degree of centralbank independence in these countries. As measures for actual central bank autonomy, the indices ofAlesina, GMT, Eijffinger-Schaling (ES) and Cukierman (LVAU) were chosen. These authors alsofound an insignificant coefficient for the natural rate of unemployment. We may therefore concludethat empirical studies provide no support for any relationship between the equilibrium or naturalrate of unemployment and the degree of central bank independence.2.2 Government debt

The stock of government debt is another potential determinant of central bank independence. Thelarger the sum the government wants to borrow on the capital market, the more weight is placed onlower inflationary expectations and, thus, on lower nominal capital-market interest rates. Thebenefits of a once-and-for-all reduction of the real value of government debt by unexpected inflationdo not outweigh (in this case) the costs of permanently higher interest payments as a consequence oflower credibility. Cukierman (1994) has argued that the larger the debt, the more politicians tend todelegate authority to the central bank and the more independent the central bank will be. Thishypothesis has been empirically investigated by De Haan and Van 't Hag (1994) for severalmeasures of independence (LVAU, SUMLV and GMT) during the period 1980-19. Using grossgovernment debt as a percentage of GDP in their regression analysis, these authors found nosignificant coefficient for the debt ratio.

The index SUMLV measures the total score of sixteen legal variables of Cukierman (1992)with respect to (1) the appointment, the dismissal and the term of office of the central bankpresident, (2) the solution for conflicts between the government and the central bank, (3) thepolicy goals of the central bank, and (4) the legal limitations for the government to borrowwith the central bank.

2.3 Political instability

The influence of political instability on central bank independence is, at first sight, less obvious thanthe impact of the other factors discussed so far.17 It could be argued that when politicians in officeare faced with a greater probability that they will be removed from office, they have a strongerinterest in delegating authority to the central bank as an apolitical institution, in order to restrict therange of policy actions available to the opposition if the latter would come into office. This impliesthat greater political instability leads to a more independent central bank. Conversely, we mightargue that the incumbent politicians will fortify their hold on the central bank, if there is a greaterprobability of government change, and will eventually overrule central bank decision making. Theshort-term benefits of surprise inflation can, thereby, exceed their long-term costs. It follows thatgreater political instability would result in a more dependent central bank.

Cukierman (1992) argues that it is possible to combine both hypotheses into one single,

internally consistent hypothesis. In countries with a sufficiently high degree of national consensus,greater political instability may be associated with increased independence of the central bank,whereas the reverse may apply for countries with a relatively low level of national consensus.Cukierman has tested this combined hypothesis using two indices of political instability constructedby Haggard, Kaufman, Shariff and Webb (1991) for fourteen middle-income countries over the1970s and 1980s. The first index, party political instability, measures the degree of politicalinstability under a given regime and refers to a relatively high level of national consensus. Thesecond index, regime political instability, reflects the degree of political instability in case of arelatively low level of national consensus. Regression analysis by Cukierman for legal independencemeasures during the periods 1972-1979 and 1980-19 shows that the indices have the expectedsigns. This result may be questioned, however as legal measures of central bank independence maynot be a very good proxy for actual central bank independence in developing countries. Two studieshave recently employed non-legal measures of central bank independence.

Cukierman and Webb (1995) use a measure of political vulnerability i.e. the fraction of

times that political transition is followed by a change of central bank governor as a dependentvariable and four types of political instability as explanatory variables for a mixture of developedand developing countries during the period 1950-19. Only high-level political instability (change

For the effect of political instability on variables like the (increase of) the stock ofgovernment debt and seigniorage, see Persson and Svensson (19), Alesina and Tabellini(1990), Tabellini and Alesina (1990), Cukierman, Edwards and Tabellini (1992) and DeHaan and Sturm (1994).

in regime) and the dummy for developing countries proved to be significant.

De Haan and Siermann (1995) have estimated the relationship between central bank

independence and political instability. By using data on the turnover rate of central bank governorsfor 43 developing countries over four periods (1950-59, 1960-71, 1972-79 and 1980-) asprovided by Cukierman, Webb and Neyapti (1992). Proxies for political stability are the number ofregular and irregular government transfers (coups). In the regressions of De Haan and Sierman,only the variable `coups' exerts a significantly negative effect on central bank independence.

In a recent study, Cukierman (1994) states that the larger the political instability is, the

higher the degree of central bank independence will be \".... provided political polarization issufficiently large\" (p. 65). The intuition behind this proposition is that the ruling party prefers amore independent central bank, when the prospects for its re-election are slim. As the probability ofre-election shrinks, benefits of central bank independence increase in terms of restricting publicexpenditure by the other (opposition) party. This hypothesis of Cukierman is investigated by DeHaan and Van 't Hag (1995) for three different measures of central bank autonomy (LVAU,SUMLV and GMT) during the 1970s and 1980s with regression analysis based on industrialcountries. These authors used both the frequency of government changes, as well as the frequencyof significant government changes, i.e. in case another party or coalition comes to office, as indicesof political instability. For the first index all three measures of central bank independence showed asignificant, negative relationship; the second is not significant.

We may therefore conclude that the empirical results regarding political instability are

mixed, but the various studies are hard to compare properly, as they refer to different groups ofcountries, diverging measures of central bank independence and various proxies for politicalinstability.2.4

Supervision of financial institutions

A political-economic determinant of the degree of central bank independence can also be thesupervision of financial institutions (`banking supervision'). Goodhart and Schoenmaker (1993)analyzed the supervision of financial institutions in 26 countries. Table 2 shows that in approxi-mately half of these countries the central bank is also responsible for the supervision of financialinstitutions and, thus, that the function of supervisory agency is combined (C) with the responsibi-lity for monetary policy. In the other half of the countries there is a separated (S) responsibilitybetween the central bank and the Ministry of Finance, or other supervisory agencies.

From table 2, it may be inferred that the supervision of financial institutions has little impact on the

independence of central banks. Practical policy in these countries, as a matter of fact, does notallow clear-cut conclusions regarding the relationship between a combined or separated responsibi-lity for financial supervision and monetary policy, on the one hand, and central bank independence,on the other. Hence, we will discuss the main arguments for and against a separation of bothresponsibilities, according to CEPR (1991) and Goodhart and Schoenmaker (1993).

The first argument in favor of a separation of financial supervision and the conduct of

monetary policy is the possibility of a conflict of interests between both activities. A central bank,responsible for supervision of the financial system and, thus, also for failures of financialinstitutions, could be tempted to admit lower (money market) interest rates or higher money growththan would be desirable from the perspective of price stability, in order to avoid such failures.18 Aseparation of responsibilities could, thereby, increase the autonomy of the central bank. A secondargument to separate the authority on financial stability from that on monetary stability is the badpublicity usually associated with failures or rescue operations. This bad publicity could harm thereputation of the central bank in its function as a supervisory agency. A loss of reputation may alsoaffect the credibility of monetary policy. Separated responsibilities could, therefore, underpin theindependence of the central bank in practice.

The following arguments can be seen against a separation of financial supervision and the

conduct of monetary policy. First, the central bank plays a crucial role in the smooth operation ofthe payments system and the associated financial risks. To limit these risks, the central bank(reasonably so) wishes to supervise and regulate the participants of the payments system.Furthermore, the central bank has a function as `lender of last resort' for the financial system andhas in that capacity the task to supply instantly enough liquidity in the case of structural liquidityproblems or, even, rescue operations. This, again, would argue for a combined responsibility.

Goodhart and Schoenmaker (1993) refer to the recent `savings and loan crisis' in the UnitedStates and its influence on the policy of the Federal Reserve System as an example. It isalso stated that the Federal Reserve is smoothing interest rates because of financial stability.See, in this respect, chapter 7 of Cukierman (1992).

Table 2. Central banks and the supervision on financial institutions

Supervisory Agency

Country

CentralBank

AustraliaAustriaBelgiumBrazilCanadaDenmarkFinlandFranceGermanyGreeceHong KongIrelandItalyJapan

LuxembourgNetherlandsNew ZealandNorwayPhilippinesPortugalSpainSwedenSwitzerland

United KingdomUnited StatesVenezuela

Source: Goodhart and Schoenmaker (1993)

Banking and Finance Commission

Finance Inspectorate (Industry

Ministry)

Commission BancaireBundesaufsichtsambt für das

Kreditwesen

Ministryof Finance

Other

Combined

orSeparated

CSSCSSSCSCCCCSCCCSCCCSSCSS

XXXXXXXXXXX

Swedish Financial Supervisory

Authority

Federal Banking Commission

Comptroller of the Currency,FDIC and State Governments

Superintendency of

Banks

De Beaufort Wijnholds and Hoogduin (1994) distinguish between general or macro-21

supervision, and specific or micro-supervision. These authors consider the arguments for aseparation of responsibilities, such as a potential conflict of interest, to be applicable only to themicro-supervision situation because of the close contacts with individual banks. They conclude thatit appears possible to maintain central bank autonomy both when micro (prudential) supervision andmonetary policy are separated, as well as in cases where they are combined. The choice betweenseparation and combination depends on the structure of the banking system and the conduct ofmonetary policy in a country which is in turn associated with the relative size of its economy. Insmaller open industrial countries - e.g. the Netherlands - with an exchange rate target, theprobability of a conflict of interest between both activities seems, in their opinion, to beconsiderably lower than in the case of large industrial countries with a monetary target, such asGermany.

Empirical evidence on the relationship between financial supervision and central bank

independence provides no uniform conclusion. Heller (1991) compares the average rate of inflation(as a proxy of the degree of central bank independence) of countries with central banks which haveno, partial or complete responsibility for financial supervision. Central banks without anysupervisory authority generate, according to Heller, the lowest inflation and those with completesupervisory authority the highest inflation. Consequently, he favors a separation of bothresponsibilities. In contrast, De Haan and Van 't Hag (1995) find no empirical relationship betweentwo of the three different measures of independence and an index measuring the degree of bankingsupervision. This index is taken from Posen (1993a) and includes also the central bank restrictionson lending rates and on the amount of bank credit to the private sector. Only for one measure ofindependence there appears a significant, negative relation with the index for the degree of bankingsupervision. This result also contrasts with the view put forward by Posen, to which we will nowturn.2.5

Financial opposition to inflation

Posen (1993a, 1993b) advocates a new view of monetary policy and central bank independencewhich are, in his opinion, determined by the degree of financial opposition to inflation, and theeffectiveness of the financial sector to mobilize - through the political system - its opposition toinflation. According to Posen, the causal relationship between central bank independence and lowinflation is illusory. Posen maintains that central bank autonomy has no noticeable effect on cross-country differences in inflation rates. He argues that a third factor exists, which explains thenegative correlation between central bank independence and the level of inflation: financial

opposition to inflation (FOI) in a country.

Posen asserts that monetary policy is driven by a coalition of political interests in society,

because central banks will be prepared to take strong anti-inflationary actions only when there is acoalition of interests politically capable of protecting their anti-inflationary policy. In industrialcountries, the financial sector represents such a (powerful) coalition of interests. Therefore, Posendeveloped a measure of effective financial opposition to inflation, predicting both the degree ofcentral bank independence and the rate of inflation in the various countries.19 Posen tested fourpropositions regarding indicators that explain and measure financial opposition to inflation:1.2.3.4.

countries with financial sectors having universal banking are expected to have a strongerfinancial opposition to inflation than those without;

countries with less regulatory power (supervision) of the central bank over the financialsector are expected to have more financial opposition to inflation;

countries with federal systems of government are expected to have a more effectivefinancial opposition to inflation; and

countries with less fractionalization of the political party system are expected to have amore influential financial opposition to inflation.

According to Posen (1993a), these indicators constitute the ultimate determinants of central bankindependence and the level of inflation. He claims to have found clear statistical evidence thatsupports a causal link between FOI on the one side and central bank independence (i.e.Cukierman's LVAU) and lower inflation rates on the other, for the period 1950-19. However, DeHaan and Van 't Hag (1995) have tested the proposition of Posen on universal banking by means ofa dummy variable for the presence (1) or not (0) of a universal banking system. Only for one of thethree independence indices did they find a significant, positive relationship with the dummy foruniversal banking. As explained before, these authors report a similar finding with respect to therelationship between prudential supervision and central bank independence. So it seems that Posen'sconclusion is sensitive with respect to the measure of central bank independence used.

Cukierman (1992) states that countries with broad financial markets and a substantial

amount of financial intermediation are more likely to grant high levels of independence to theircentral banks.20 He argues that possible disruptions due to less central bank autonomy and more

As stated by Posen (1993a): \"This implies as well that CB independence and low rates ofinflation should occur together, without a causal link between them, because they both arereflections of effective FOI\" (p. 47).

See Cukierman (1992), p. 449. Of course, the broadness of financial markets and thedegree of financial intermediation are (strongly) associated with the depth of capital

inflation (uncertainty) in the process of intermediation between savings and investment areproportional to the size of the financial sector in a country. As a result, countries with largefinancial markets are more likely to have more independent central banks than do those with narrowfinancial markets. This conclusion is, according to Cukierman, supported by a comparison of thesize of financial markets and the ranking of central banks by overall independence (for DCs:LVAU, and for LDCs: LVAU and TOR) during the 1980s. Countries with well developed financialmarkets (for example France, Germany, the United Kingdom and the United States) have relativelyindependent central banks, whereas those with narrow (internal) financial markets (like most LDCs)have relatively dependent central banks. Nevertheless, we believe that a two-way causal relationshipexists between the size of financial markets and independence: high autonomy and low inflation willalso foster the development of financial markets.2.6

Public opposition to inflation

Another important determinant of central bank independence is public support for the objective ofprice stability or, analogous to the former determinant, the public opposition to inflation.21 It isquite obvious that this determinant should not be analyzed apart from the financial opposition toinflation as defined by Posen (1993a, 1993b), but that it has a much broader meaning. Theexperience of the public with extremely high inflation or even hyperinflation in the past is,generally, seen as the cause of such public opposition to inflation. This implies that a two-waycausal relationship can exist between central bank independence and the level of inflation: on theone hand, an independent central bank may foster low inflation in the medium and long run, but onthe other hand, high inflation may result in the very long run in the creation of an autonomouscentral bank. There seems to be a threshold value for the level of inflation, above which publicopposition to inflation in a country will be mobilized and taken into account by the politicians.Cukierman (1992) argues, however, that inflation, when sufficiently sustained, erodes central bankindependence after a while. Society becomes accustomed to inflation (wages are for instanceindexed), thereby reducing opposition to inflation and the public pressure for an independent centralbank.

markets.

See, in this respect, Neumann (1991), Bofinger (1992), Debelle (1993), Issing (1993,1994), Eijffinger (1994) and Fischer (1994). Issing (1993) notes that \".... it is nocoincidence that it is the Germans, with their experience of two hyperinflations in the 20thcentury, who have opted for an independent central bank which is committed to pricestability\" (p. 18).

Using cross-country OLS regressions with the average level of inflation between 1900 and

1940 as an explanatory variable of three different measures of central bank independence inindustrial countries, De Haan and Van 't Hag (1995) have shown that a significant positiverelationship exists between very-long-term inflation and independence.

Not referring to the very long run, but to the medium and long run, Eijffinger and Schaling

(1995), using their game-theoretical model, arrive at the following proposition: the strongersociety's preferences for unemployment stabilization relative to inflation stabilization are, the higherthe optimal degree of central bank independence will be. The underlying intuition of this propositionis as follows. If society becomes more concerned with unemployment, the time-consistent rate ofinflation goes up. Therefore, society's credibility problem becomes more pressing. With anunaltered relative weight placed on inflation stabilization, the balance between credibility andflexibility needs to be adjusted in favor of an increased commitment of the authorities to fightinflation. Eijffinger and Schaling have tested this proposition with the number of years of socialist(left-wing) dominated government over the total period studied as a proxy for society's preferencefor unemployment versus inflation stabilization. These authors found a positive relationship betweensociety's preferences for unemployment relative to inflation stabilization and the optimal degree ofcentral bank independence, although it was not significant.

In general, the conclusion may be drawn that central bank independence is strongly

associated with society's fundamental support for the objective of price stability. Notwithstandingthe theoretical and empirical arguments for an independent central bank as discussed before, notevery society and, thus, not every government will be prepared to accept such an autonomousposition of its central bank.2.7

Other determinants

Recent literature on determinants of central bank independence, also mentions economic andpolitical factors that cannot be categorized under the former headings. We will discuss thesedeterminants only briefly here.

Moser (1994) tries to identify the conditions under which an independent central bank can

be credibly supplied by politics. His model analyzes the interaction between a central bank and twopolitical decision bodies. Delegation is credible only if there are at least two veto players in thelegislative process and if they disagree to some extent about monetary policy. Moser constructs a

political system index that reflects differences in commitment ability of the political systems.22Controlling for a potential effect of external real shocks, he finds a significant, positive effect of hispolitical system index on an average of the GMT and LVAU measures of independence for 22OECD countries during the period 1967-1990. Apparently, countries with extensive checks andbalances are associated with more independent central banks.

Based on their game-theoretical model, Eijffinger and Schaling (1995) propose that the

higher the variance of productivity shocks, the lower the optimal degree of central bankindependence will be. The intuition here is that if the variance of productivity shocks increases,ceteris paribus, the economy becomes more unstable and, thus, the need for active stabilizationpolicy becomes greater. With an unaltered relative weight placed on inflation stabilization, thebalance between credibility and flexibility will shift towards more monetary accommodation by theauthorities. Eijffinger and Schaling tested this proposition with the variance of annual output growthto approximate the variance of productivity shocks. Distinguishing legal independence from optimalindependence with the latent variables method (LISREL), they found the expected, negative relationbetween the variance of productivity shocks and the optimal degree of central bank independencefor nineteen industrial countries during the period 1960-1993. However, the coefficient wasinsignificant.

Furthermore, Eijffinger and Schaling (1995) state that the steeper the slope of the Phillips

curve is, the higher the optimal degree of central bank independence will be. If the slope of thePhillips curve increases, then the benefits of unanticipated inflation rise. It therefore becomes moretempting for the government to inflate the economy and, ceteris paribus, society's credibilityproblem gains in importance. With constant relative weights on inflation stabilization, the balancebetween credibility and flexibility needs to shift towards more commitment to fight inflation. Thisproposition has been tested by Eijffinger and Schaling with the compensation of employees paid byresident producers as a ratio of GDP as a proxy for the slope of the Phillips curve. Using the latentvariables method, a significant positive relationship was found between the slope of the Phillipscurve and the optimal degree of central bank independence for nineteen industrial countries in theperiod 1960-1993.

This political system index ranges from a value of one for pure unicameral legislatures andbicameral legislatures with both chambers being equally composed to a value of four forstrong bicameral systems, i.e. systems with equal power and unequal composition. The lastare characterized by a high degree of federalism.

3.CONCLUDING COMMENTS

This survey has critically discussed, the theoretical literature on central bank autonomy.

Is the only good central bank one that can say `no' to the politicians?23 An independent

central bank is not a sufficient and/or a necessary condition for price stability. In accordance withthe theoretical literature, we must conclude, however, that a country with an independent centralbank, ceteris paribus, will have a lower rate of inflation than does a country where politicians cansteer the central bank's policy. Attaining lower inflation rates bears no costs in terms of lower long-term economic growth. So, in principle, we may answer the above-mentioned question positively.The tendency towards greater central bank autonomy which can, currently, be perceived in manycountries should, in our opinion, thus be regarded positively. Nevertheless, with respect to thisconclusion some important caveats are in order.

First, the absence of a significant influence of central bank independence on the rate of

economic growth can also be interpreted in a less positive way. Stable monetary policy aimed at lowinflation is, usually, considered to be an important condition for sustainable economic growth.However, most empirical studies (see Eijffinger and De Haan, 1996) show that central bankautonomy does not enhance economic growth and employment. Moreover, there is no proof thatcountries with a relatively independent central bank have lower costs of disinflation than those witha more dependent central bank. Indeed, most studies suggest that central bank independence isassociated with higher disinflation costs.

Second, the tendency towards central bank autonomy may conflict with the goal of

accountability of central banks. In the short run, there seems to be a trade off between central bankindependence and accountability. We believe that such a trade off, however, does not exist in thelonger run. A central bank, continuously conducting a policy which lacks broad political support,will sooner or later be overridden. At the same time, our conclusion underscores the importance ofbroad public support for a central bank's autonomy and its anti-inflationary policy. Although thedeterminants of central bank independence have only recently been investigated, current researchleads us to the conclusion that every society gets the central bank it deserves.

Quotation from The Economist of February 10th, 1990.

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