The case for an independent central bank is by now becoming extremely familiar. Economic theory suggests that it is advantageous for the monetary authorities to commit themselves in advance to a credible monetary framework, thus encouraging private sector agents to expect permanently low inflation, and to build this expectation into their behaviour. The argument is that it is easier for an independent central bank to do this than for a democratically elected government, which always has an incentive to twist with the electoral wind.
Furthermore - and unusually in economics - there seems to be a body of unequivocal evidence in favour of this hypothesis. A study first published in 1990 at Harvard by Alberto Alesina and Larry Summers - by now one of the most quoted in the entire subject - makes the simple point that there is a close relationship between the degree of central bank independence (measured mainly by reference to the constitutional position of the central banks in the developed economies) and the rate of inflation.
The greater the independence, the lower the inflation rate. What is more, there is no relationship between central bank independence and unemployment or economic growth. So independence seems to provide the economy with something of a free lunch - lower inflation with no unemployment cost.
So far, I know of no study that has contradicted this finding, which is trivially easy to replicate for different groups of countries and for different time periods. Again unusually in economics, it turns out that the result cannot be torpedoed by excluding a couple of crucial countries from the data, or by dropping a couple of critical years from the time period covered. The correlation, for what it is worth, seems robust.
Yet Sir Terence Burns, the incumbent Permanent Secretary at the Treasury, recently described the evidence linking central bank independence with reduced inflation as 'weak'. How can such a strong correlation constitute only 'weak' evidence? In fact, there are several reasons.
One is that the data used to measure central bank independence are themselves quite uncertain. It is dubious whether the operating independence of a central bank can really be described by a few numerical variables based on items such as the term of office of the governor. Surely, many would claim, the degree of effective independence in the real world will vary with circumstances and personalities. (For example, Eddie George, Governor of the Bank of England, is clearly acting in a more independent way than his predecessor, though nothing in the Bank's constitution has changed).
Clearly, there is something in these criticisms, though it must be said that the various attempts made to place a numerical value on independence do not differ much from each other, or from a common-sense ordering of the central banks in question. This objection is therefore not decisive.
Of more importance is the question of whether the direction of causation perhaps runs the other way - from inflation to independence, rather than vice versa. The argument here would be that only those countries that can for some other reason sustain a low inflation rate can simultaneously tolerate an independent central bank.
For developing economies, there is some evidence recently published by the Israeli economist Alex Cukierman that the direction of causation is two-way. However, it is difficult to see how this can be the case for the developed economies, where there have until the last few years been no significant changes in central bank constitutions or in their modus operandi. Unless a society's aversion to inflation is extraordinarily deep-rooted in history, and unless this somehow manifested itself in the constitution of the central bank many decades ago, it seems difficult to maintain that the causation has run mainly from low inflation to bank independence.
It is possible, though, that some third factor explains variations in inflation, and that the apparent link with bank independence is either mere coincidence or is itself explained by this third factor. Two possible third factors suggest themselves - the structure of political institutions and the nature of the labour market.
I have recently conducted some empirical work to see whether political factors - such as party fractionalisation, the proportionality of the electoral system, the frequency of significant government changes, etc - affect the behaviour of inflation or unemployment, once central bank independence has been taken into account. The answer is 'yes, but not very much'. The instability of governments does appear to add slightly to inflation, but is not as important as the structure of the central bank.
What about the labour market? Here there does appear to be some evidence - as noted by Peter Hall of Harvard in the Independent on 21 January - that the more centralised the structure of the labour market (ie the more co-ordinated the wage bargaining process), the better the economic performance. When I add a measure of wage co- ordination to central bank independence in an equation explaining inflation differences between countries, both variables turn out to be highly significant.
At the very least, this would appear to lend weight to Professor Hall's warning that the results of making central banks independent may be very disappointing in countries where labour market institutions are not propitious. It may be much easier to reform banking arrangements than trade union structures, but the latter may be at least as important in determining economic performance. Transplanting the Bundesbank's constitution into Britain's messy labour market - or indeed into France's - may have less happy consequences than some have predicted.
One final worry is this. If an independent central bank does indeed increase monetary policy 'credibility' - and if this is the source of lower inflation - then we would expect to see corroborating evidence of increased credibility in other areas. For example, real interest rates should be lower in countries with independent central banks, reflecting lower risk premiums on government debt. In fact, they are not - independent central banks seem to have no systematic effect on the level of real interest rates.
Furthermore, if enhanced monetary credibility is important, we might expect disinflationary economic programmes to involve a smaller unemployment cost in countries with independent central banks. In other words 'sacrifice ratios' (which calculate the unemployment cost of reducing inflation by 1 per cent) should be lower. But when I tested this, I found that the expected link between sacrifice ratios and central bank independence did not exist; in fact, if anything, the relationship was perverse.
These question marks do not eliminate the importance of the strong link that has been established between low inflation and central bank independence. This is indeed a 'stylised fact' of impressive force. But as with most stylised facts, it may not be quite the whole story.
So, if we in Britain decide to make the Old Lady independent, as probably we shall, we should not enter the new era with the same burst of absurd over-optimism that marked the early days of our flirtation with the exchange rate mechanism. Setting monetary policy in an unsuccessful economy like ours will remain an extremely difficult task, whoever is formally in charge.Reuse content