Research & Policy Briefs From the World Bank Malaysia Hub No. 53 November 30, 2021 Why Central Bank Independence Matters Mahama Samir Bandaogo Deep economic crises—the global financial crisis and the COVID-19 pandemic—have put some strains on, and rekindled an older debate about the costs and benefits of central bank Independence. Central banks have been accorded more independence since the 1970s, which has helped bring down and keep inflation low and reduced the risk of fiscal crises. However, as their interventions in the economy with unconventional policies expand further beyond their original mandate, especially those pertaining to financial stability, critics have called for more oversight of their activities. That is because some of the central banks’ newfound responsibilities such as financial stability do not have a precise and unambiguous target or measure, making accountability difficult. The evidence in support of central bank independence remains strong, as highlighted in this Brief. However, in light of the expansion of central banks' power, reforms should aim to institute oversight of the newfound powers. The Bias toward Inflation and Pressures on Central independence was introduced by Cukierman (1992). The author Bank Independence combined central laws and statutes with survey responses from various central banks to assess their legal independence from political Monetary policy is one of the two main pillars of macroeconomic interference. policy; fiscal policy is the other. Monetary policy must contend with a built-in political-economy bias towards inflation. That is, due to Because legal measures of central bank independence do not distortions such as taxes and market imperfections that keep output indicate the degree of actual independence, Cukierman, Webb, and below its potential, the government has an incentive to deviate from Neyapti (1992) argue that a better proxy for actual (or de facto) its commitment over time and raise inflation to expand output and central bank independence is the turnover rate of central bank lower unemployment. This tendency—the so-called time governors. inconsistency problem of monetary policy—has highlighted the Figure 1 depicts these various measures. As the figure shows, importance of putting an independent central bank free from political central banks have become more independent. Panels a and b present pressure and interference in charge of the conduct of monetary the legal independence index from Garriga (2016) and Bodea and policy. Hicks (2014). The average measure of legal CBI was around 0.4 in Kydland and Prescott (1977), and then Barro and Gordon (1983), 1970, but reached 0.6 in 2012, according to the data from Garriga were the first to put forth the time inconsistency theory as an (2016). The same trend is apparent in data from Bodea and Hicks explanation for the high inflation observed in the 1970s. (2014). Similarly, as shown in panel c, the average turnover rate over Subsequently, Rogoff (1985) showed that the inflationary bias a five-year period of central bank governors has fallen from well over stemming from the time inconsistency problem can be reduced if the 1 to about 1 from 1965 to 2020. Given that the average tenure of conduct of monetary policy is left to an independent and conservative central bank governors is five years, this is an indication that most central bank. Conservative in this case means that the central bank governors are now able to complete their term without being puts a larger weight on stabilizing inflation than output because it is removed. more averse to inflation. Without political interference, independent central banks are then able to commit to a clear monetary policy, Some of the Criticisms of Central Bank Independence anchor expectations, and better control inflation. The increase in both legal and de facto central bank independence In recent years, with extended periods of ultra-low inflation rates in does not necessarily mean that frictions or conflicts between the advanced economies, the prescription had shifted—at least before government and central banks have been completely eliminated. the COVID-19 pandemic—toward the need for more liberal central Times of deep economic crises have often been sources of immense banks that would boost average inflation. But whether the central challenge for central bank independence as governments look for bank pursues conservative or liberal policies, its policy effectiveness cost-effective ways to finance their stimulus spending. And in crises remains linked to its degree of independence from political where monetary and fiscal policy coordination is not straightforward, interference. In countries such as Argentina, Turkey, Venezuela, and like in times of supply shocks, this pressure on central bank Zimbabwe, the erosion of central bank independence (CBI) due to independence can be exacerbated. Moreover, when the central constant political interference has led to sustained periods of bank’s response to an inflationary development is to significantly raise relatively high inflation. the interest rate—making it more costly for the government to finance its deficit—this decision could lead to some frictions. Assessing Central Bank Independence Central bank independence came under more scrutiny following The first attempts to measure central bank independence appeared in the 2008–09 global financial crisis, when governments expanded the Bade and Parkin (1978, 1988) and were squarely based on laws and core tasks and responsibilities of central banks beyond their original statutes governing central banks and their operations. These mandate in an effort to contain the crisis (Balls, Howat, and Stansbury measures have been referred to as legal measures of central bank 2018; Rogoff 2019; Dall’Orto Mas et al. 2020). In terms of financial independence. Variants of the legal measures of central bank stability, for instance, before the crisis, central bank mandates mainly independence were also developed by Alesina (1988) and Grilli et al. concerned the supervision of banks, which was done at the individual (1991). However, the most cited legal measure of central bank institution level. But the global financial crisis highlighted the Affiliations: Macro, Trade and Investment Global Practice, World Bank Group. For correspondences: mbandaogo@worldbank.org Acknowledgements: The author thanks Souleymane Coulibaly, Richard Record, Tito Cordella, Shafaat Yar Khan, Steven Pennings, and Mark Mackenzie for their valuable insights, comments, and suggestions. Objective and disclaimer: Research & Policy Briefs synthetize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Why Central Bank Independence Matters Figure 1. Evolution of Central Bank Independence Central bank independence has been increasing around the world. a. Legal CBI as measured by b. Legal CBI as measured by c. De facto CBI as captured by the Garriga (2016) Bodea and Hicks (2014) governor’s turnover rate measured by Dreher, Sturm, and De Haan (2010) 1.5 1.5 1.0 1.0 1.0 CBI CBI 0.5 0.5 0.0 0.5 0.0 1966-70 1971-75 1976-80 1981-85 1986-90 1991-95 1996-2000 2001-05 2006-10 2011-15 2016-20 1972 1990 2014 1970 1990 2012 Source: Author’s illustration based on data from Garriga (2016); Bodea and Hicks (2014); and Dreher, Sturm, and De Haan (2010). Note: Panels a and b show interquartile ranges. CBI = Central Bank Independence. importance of monitoring sources of systemic risks, so central bank’s Why Central Bank Independence Matters mandates in many countries were greatly expanded to include the Central bank independence and inflation. The first measures of legal broader objective of financial stability. This development, some argue, CBI were accompanied by attempts to assess its impact on various have made accountability of central banks more difficult because macroeconomic outcomes— specifically, inflation because it is part of unlike price stability—which can be defined by a clear indicator such the central bank’s mandate to stabilize inflation. As early as the late as an inflation target of 2 percent—financial stability has no clear and 1980s, a first batch of papers documented the negative relationship defined indicator (Balls, Howat, and Stansbury 2018). between central bank independence and the inflation rate. Notably, The ongoing COVID-19 pandemic has reignited the debate and Bade and Parkin (1988) show that legal CBI and inflation are negatively related. Other more recent studies have arrived at the same concerns about central bank independence. On the one hand, there conclusion (Brumm 2002, 2011; Garriga and Rodriquez 2020). These has been concerns about some governments exerting pressure on studies are all based on measures of legal CBI. The causal effect of de their central bank to enact specific policies to mitigate the economic facto measures of central bank independence, as captured by impact of the pandemic. In addition, inflationary pressure during governors’ turnover rate, on inflation has been harder to document. recovery from the pandemic could further strain central bank This because in a country with a high turnover rate of governors, independence. In the early 1980s, the Federal Reserve (Fed) had to inflation can be high due to political interference by the government, raise interest rates close to 20 percent to combat inflation, but then leading to a more frequent firing of the central bank governor. But it public and private debt levels were relatively low, which limited the can also be the case that the governor is fired because he/she could fiscal impact of the Fed’s policy. Given the inflationary risk, a not keep inflation low. Despite this complication, an overview of the post–COVID-19 environment could be characterized by high inflation, literature on central bank independence provides enough evidence high private and public debt levels, and persistent unemployment. As that the negative relationship between central bank independence such, central banks’ decision to raise interest rates high enough to and inflation is quite robust (Berger, de Haan, and Eijffinger 2001; curb inflation will likely not be without government and/or social Klomp and de Haan 2010); and that indeed more independent central discontent (Goodhard 2020). On the other hand, tasks and banks do deliver and maintain lower inflation, compared to less responsibilities that had become part of central banks’ expanded independent ones. In some countries such as Argentina, Turkey, mandate following the global financial crisis have suddenly become Venezuela, and Zimbabwe the erosion of central bank’s independence more urgent following the outbreak. To safeguard financial stability and credibility has led to high inflation rates. And once the conduct of monetary policy is greatly influenced by politics and the government, amidst the current economic downturn, central banks have enacted a it is very difficult for the central bank to establish independence and wide range of policies such as blanket loan moratoriums that can have credibility (Rogoff 2019). long-term implications for governments balance sheet. Figure 2, panels a and b, plot measures of legal CBI against the Furthermore, widening social inequities have led to the rise of inflation rate, as measured by the consumer price index (CPI). The populists leaders who have vowed to place more oversight over negative correlation between the two variables is very apparent. central banks and their operations. For instance, narrowly defeated Estimations from a fixed effect model and a dynamic panel model legislation in the US Congress, would have required the Fed to set confirm the negative relationship between inflation and central bank interest rates according to a predetermined rule and make monetary independence (technical details available upon request). Based on the policy decisions go through a congressional review (Bernanke 2016). fixed effect model, the results show that an increase in the CBI index This would have significantly diminished the Fed’s independence. by 1 percent is associated with a 0.66 ppts decline in inflation rate. For 2 Research & Policy Brief No.53 Figure 2. Central Bank Independence and Inflation Higher degree of central bank independence is associated with lower inflation. a. Measure from Garriga (2016) b. Measure from Bodea and Hicks (2014) 30 30 CPI Inflation (percent) CPI Inflation (percent) 20 20 10 10 0 0 0 25 50 75 100 25 50 75 100 CBI CBI Source: Author’s illustration based on data from Garriga (2016); Bodea and Hicks (2014); and World Bank World Development Indicators. Note: CBI = central bank independence; CPI = consumer price index. instance, an improvement in the CBI index from 27 to 42, which is akin instance, Sikken and De Haan (1998) find a robust negative to Sudan’s CBI index in 2012, increasing to equal Ethiopia’s, is relationship between a de facto measure of central bank associated with a 9.9ppts decline in inflation rate. independence and monetary accommodation of deficits in a sample of developing countries. In a similar sample, Lucotte (2009) also finds Central bank independence and budget deficits and fiscal crises. There a significant negative relationship between central bank is also sufficient evidence to suggest that there is a negative independence and budget deficits. relationship between central bank independence and monetary finance of fiscal deficits. This boils down to the simple fact that less Due to the difficulty of measuring monetary financing of budget independent central banks are more subject to political pressure and deficits, I follow Lucotte (2009) and use budget balance/deficit as a interference, leading them to finance the government’s fiscal deficit proxy. Figure 3, panel a, shows that there is a slight negative more often and in greater amounts. This relationship was correlation between central bank independence and the documented as early as 1988 by Masciandaro and Tabellini (1988). government’s budget balance. However, when only countries and Since then, several studies have arrived at the same conclusion. For years with a budget deficit are considered, a positive correlation Figure 3. The link between Central Bank Independence (CBI) and the Budget Balance, Budget Deficit, and Public Debt Countries with more central bank independence run budget imbalances less often, run smaller deficits when they do, and accumulate less public debt. a. CBI and budget balance (surplus & deficit) b. CBI and budget deficit only c. CBI and public debt 30 0 200 20 −5 150 Budget deficit (% of GDP) Fiscal balance (% of GDP) Debt−to−GDP ratio 10 −10 100 0 −15 50 −10 −20 −20 0 0 25 50 75 100 0 25 50 75 100 0 25 50 75 100 CBI CBI CBI Source: Author’s illustration based on data from Garriga (2016) and the World Bank Development Indicators. 3 Why Central Bank Independence Matters emerges between central bank independence and the budget deficit central banks around the world have helped cushion the economic (see panel b). In other words, when countries run budget deficits, and social impact of the pandemic. Continued strategic coordination those with less independent central banks tend to be associated with between monetary and fiscal authorities is crucial to ensure both larger deficits. Since monetary financing is easier politically compared policy effectiveness and central banks’ autonomy (Cukierman 2020; to raising taxes on specific groups to finance deficits, larger deficits Bianchi, Faccini, and Melosi 2020). become more politically attractive when the central bank is less independent. Consequently, countries with less independent central The benefits of central bank independence from political banks are associated with higher public debt as a share of GDP (see interference are undeniable. For one, central bank independence has panel c), which can stem from a partial monetary financing of deficits. delivered low inflation rates in countries around the world. For another, more independent central banks contribute to debt Estimations from a fixed effect model and dynamic panel model sustainability and lower the risk of fiscal crises. However, the criticisms show that among countries running a budget deficit, those with a and challenges to central bank independence ought not to be ignored more independent central bank tend to run a smaller budget deficit. either. This result is in line with Sikken and De Haan (1998): less independent central banks are more likely to accommodate monetary finance of As already discussed, the powers of central banks have expanded budget deficits. Based on the dynamic panel estimation, an increase in beyond their original mandate. Plus, changes such as population aging the CBI index by 1 percent is associated with a 0.02ppts decline in the and the adoption of crypto currencies are likely to impact the country’s deficit (as a share of GDP). This means that a rise in the CBI effectiveness of conventional monetary policy, thus leading central index from .27 to .42 (Sudan to Ethiopia) is associated with a 0.3ppts banks to rely more and more on unconventional policies that have decline in the budget deficit. fiscal and structural implications. Moreover, a robust and negative relationship between central In light of that, perhaps it is time to rethink the current model of bank independence and fiscal crises emerges from a probit model central bank independence to keep central bank powers in check. But estimation where a fiscal crisis dummy is regressed on central bank what should a central bank for modern times look like? Balls, Howat, independence and some control variables (technical details available upon request). The fiscal crisis dummy is from Medas et al. (2018) and and Stansbury (2018) argue for a more nuanced approach in which is constructed based on four criteria: (1) credit events associated with operational independence of monetary policy and macroprudential sovereign debt such as outright defaults or debt restructuring; (2) policies is irrevocably conserved, while enhancing political large-scale financial support from the International Monetary Fund accountability concerning the setting of mandates, the appointment (IMF); (3) implicit domestic public default, for example via high of central bank officials, and the oversight of financial stability powers. inflation rates; and (4) loss of market confidence in the government. 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