By Jan Fredrick Cruz and Aaron Salvan
The importance of central banks, such as our very own Bangko Sentral ng Pilipinas (BSP), cannot be overemphasized. The government can influence economic activity through either fiscal policy (spending and taxation) or monetary policy (controlling the money supply and setting the interest rates), and central banks usually have the privilege of wielding the latter. Even if someone is not interested in money matters and financial investments, he is still affected by the decisions of the central bank especially when the latter makes inflation-targeting (e.g. determining how much is the overall price level increase).
With such an impact on the lives of many, it is no wonder that there is initial suspicion about the idea of central banking in its early history. Just look at the experiments the United States has done with central banking. The First Bank of the United States (the earliest predecessor of today’s US Federal Reserve System) lasted for only twenty years, after getting disbanded in 1811. After five years, another one was established – the Second Bank of the United States. Nevertheless, its charter got dissolved in 1836 after former US President Andrew Jackson denounced the central bank as an institution of corruption and vetoed the renewal of the Second Bank’s charter in 1832.
It’s no wonder, too, that there are still debates about who exercises power over the management of central banks. Should the central bank be allowed to conduct policy-making decisions on matters of national interest without the same level of accountability as with other agencies and offices of the government? This is the question often raised by critics of central bank independence. On the other hand, must vital and long-term decisions, with respect to monetary policy, be left to politicians motivated by short-term interests of winning elections? This is a point commonly raised by the “pro-independence” advocates vis-à-vis management of the central bank.
But, what exactly do we mean by “independence” in this context? In fact, we can assign two meanings to “independence” in the context of central banking. One is goal independence, which is the ability of the central bank to determine its goals. In inflation targeting, for example, goal independence means how much freedom the central bank is in deciding whether to aspire for a 3% or a 5% inflation rate. Instrument independence, on the other hand, is the freedom of the central bank in exercising monetary policy instruments. Suppose the central bank decided to aim for 3% inflation, instrument independence means how free the central bank is to select from a menu of policy instruments, e.g. open market operations, discount window, and reserve requirement rates, in order to achieve that goal.
More and more central banks have joined the trend of switching to independence at present. On the other hand, other economists, such as Nobel Prize winner Joseph Stiglitz, are critics of it. This begs the question: what are the effects of central bank independence on economies? This has bothered economists for years. It is difficult to categorically state that central bank independence works for or against an economy. In theory, central bank independence should work for the economy – this may be the reason why it is so desired by many economies. However, as with any field of science, the theoretical does not always agree with the empirical.
As the goal of any central bank is to keep the economy stable, it is worth looking at the effects of their independence on inflation. In theory, central banks that are more independent should result in economies with lower rates of inflation. This held true in France, Germany, Sweden and Denmark; countries with central banks with higher levels of independence with low to moderate levels of inflation. However, the exact opposite was true when it came to developing countries. Even if Armenia, Hungary, Poland, and Romania had very independent central banks, a study found that they had higher than average inflation rates. Hence, it was hypothesized that central bank independence was connected to manageable inflation in developed countries while the effect it had on developing countries was different.
If inflation is controlled, will it result in reduced output? This too does not have a definite answer. Some studies have shown that central bank independence did not affect the economic growth. Another study, which involved the relation of central bank independence to the output per worker, found a positive correlation between central bank independence and economic growth. Another study contradicted this by stating that output growth in industrialized countries was not affected by central bank independence. The same was true for legal independence. In contrast, it was concluded that the turnover rate for central bank governors negatively impacted economic growth. Thus, it is difficult to determine the effects of central bank independence on
Empirical evidence supporting or disproving the theory is further complicated by the ambiguity of available literature. Indices of central bank independence tend to disagree with one another. A central bank that is deemed independent by one index may be regarded as dependent by another. This happened in a study where Japan was ranked the second lowest in level of independence whereas it was ranked much higher in another study. Moreover, a study evaluated eight indices of central bank independence and determined that they were not “perfect substitutes”.5 Hence, it is important to have clear definitions of what constitutes an independent central bank before evaluating its effects.
In conclusion, the ambiguity of the empirical versus the theoretical effects of central bank independence has been echoed in academic literature. Whether the independence of a central bank is beneficial for an economy cannot be answered with a universal yes or no. A number of factors must be taken into account before such a conclusion can be drawn.
Mishkin, Frederic S. “The Structure of Central Banks and the Federal Reserve System.”Understanding the Economics of Money, Banking, and Financial Markets. Low Price ed. Jurong: Pearson Education South Asia Pte, 2007. 311-32. Print.
Pollard, Patricia. “Central Bank Independence and Economic Performance.” Federal Reserve Bank of St. Louis Review 75.4 (1993): 22, 25. Web. 15 Feb. 2013.
Dumiter Florin, Cornel. “Empirical Approach Upon The Relationship Between Central Bank Independence And Inflation In Developed And Developing Countries.” Annals Of The University Of Oradea: Economic Science 1 (2012): 803. Directory of Open Access Journals. Web. 15 Feb. 2013.
Jafari-Samimi, Ahmad, Saeed Rajabi, and Simin Abdolalizadeh Shahir. “The Impact Of Central Bank
Independence On Economic Growth: A Cross-Section Analysis.” Australian Journal Of Basic & Applied Sciences 4.10 (2010): 4823-4831. Academic Search Complete. Web. 15 Feb. 2013.