A discussion of how higher levels of central bank independence are associated with lower and more stable rates of inflation and why central bank autonomy is critical in a world where most governments are unwilling to hold themselves publicly accountable for price stability.Banks and banking, Central ; Federal Reserve System - Independence

Owen F. Humpage

English

Research Papers in Economics

April 1, 1994
eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland
Central Bank Independence
by Owen F. Humpage
Ao many Americans, the idea that a
central bank should make crucial eco-
nomic policy decisions with no direct
political accountability either to the citi-
zenry or to their elected representatives
seems the antithesis of democracy. Cen-
tral bank independence, however, is but
one solution to a problem endemic to
fiat money.' Because fiat money has no
intrinsic value, the willingness of individu-
als to hold it depends solely on their faith
that the government will not depreciate its
purchasing power. Uncertainty about the
long-term value of money arises because
inflation generates government revenues
and, according to some economic theories,
can lead to a temporary surge in employ-
ment and output.
Economists have long recognized that es-
tablishing an independent central bank is
not the only solution to the problem of
guaranteeing the value of money, and
many contend that it is not the best solu-
tion. Nevertheless, it is a proven ap-
proach, born out of the unwillingness of
elected governments to make themselves
otherwise accountable for a clear, legally
mandated price-level objective.
• The Problem with Fiat Money
Money has value because people gener-
ally accept it in exchange for goods
and services and as payment for debts.
Consequently, money greatly reduces
the costs associated with economic ex-
change. For one thing, it eliminates the
time and expense associated with barter.
If, for example, a research economist
had to find a restaurant willing to trade
lunch for an economic consultation, he
might very well go hungry. Moreover,
because it is widely accepted, money
also condenses the amount of informa-
tion an individual requires in order to
undertake informed transactions. One
need only know the money prices of
commodities to make comparisons of
value. Without money, one would need
constantly to remember the units of
each item that trade for every other.
Money also has value as a temporary
store of purchasing power when indi-
viduals' receipts and outlays are not
synchronous. It eliminates the difficul-
ties of shifting wealth into and out of
less-liquid assets.
People generally take the benefits of
money for granted, or simply associate
them with the fact that our government
regulates its use. This perception, how-
ever, is an illusion. The extent to which
any asset functions as money ultimately
depends on the stability of its purchasing
power. When people lose faith in the
value of money, they attempt to reduce
the amounts they hold and use." As the
use of money becomes circumscribed,
the economic efficiencies that it promotes
are correspondingly lost.
Throughout history, mankind has devel-
oped various customs and institutions
to instill confidence in the purchasing
power of money. Until fairly recently,
for example, governments defined
money in terms of intrinsically valu-
able assets like gold or silver and per-
mitted people to exchange money for
the assets that backed it. Today, how-
ever, money is pure fiat. Its value lies
solely in the willingness of others to ac-
cept it and ultimately only in the faith
that the government will not create ex-
cessive amounts.
Recent economic studies have confirmed
that higher levels of central bank inde-
pendence are associated with lower and
more stable rates of inflation. The
autonomy of central banks is critical in
a world where governments have an in-
centive to generate inflation—and thus
depreciate the purchasing power of
money—as a potential trade-off for tem-
porary output and employment gains.
• The Incentives to Fuel Inflation
Most people realize that when govern-
ments face a crisis—such as war—they
often resort to the printing press to fi-
nance their survival. Yet many of these
same incentives operate under normal
circumstances as well.
Economists recognize inflation as a
form of taxation, which governments
can impose outside the normal legisla-
tive process. Basically, the sequence is
as follows: A government can print
money virtually for free to finance its
expenditures at an initial set of prices/
As individuals then re-spend this
money, prices rise, reducing the real
purchasing power of the balances that
they hold. The government, however,
as the initial issuer of money, then has
acquired real resources from the pri-
vate sector as if through a tax. The tax
rate is proportional to the rate of infla-
tion, and the tax base is the stock of
money balances that the public holds.
The ability of individuals to contract their
money balances limits the revenues
ISSN 0428-1276raised from inflation. For some devel-
oping countries, the inflation tax has
been a significant revenue source, but
for most industrialized nations, the con-
tribution is fairly small, approximately
1 percent of gross national product.
If the tax structure is not indexed for in-
flation, other taxes augment the infla-
tion tax. Inflation raises the nominal
income of individual and corporate tax-
payers, propelling them into progres-
sively higher tax brackets and transfer-
ring purchasing power to the government.
A similar problem results when the
government taxes nominal rather than
inflation-adjusted capital gains.
Governments also benefit from unan-
ticipated inflation when, as is typically
the case, they have outstanding debts.
Holders of government securities ex-
pect repayment in money with a pur-
chasing power equal to that which they
lent, plus a small profit to cover the op-
portunity cost of making the loan. By
generating a higher rate of inflation
than its bondholders anticipate, the gov-
ernment reduces the real resource cost
of servicing its debts. Again, real pur-
chasing power is transferred to the gov-
ernment from private-sector creditors.
The Keynesian economic paradigm pro-
vides a different type of incentive for gov-
ernments to generate an unanticipated
inflation. This model assumes that re-
sources are typically underutilized and
that prices respond only slowly to
changes in aggregate demand. Conse-
quently, an unexpected expansion of the
money supply can result in a temporary
increase in output and employment. Ac-
cording to some political economists, the
possibility of trading more inflation for
greater short-term output and employ-
ment encourages elected representatives
to promote inflation, especially just prior
to elections.'
• The Private Costs of Inflation
In addition to transferring purchasing
power from the private sector to the gov-
ernment, inflation generates costs in
terms of misallocated resources. When
people anticipate an increase in the price
level, they will take steps to protect the
real value of their wealth by finding in-
vestments that compensate for future
inflation and by reducing cash balances
that earn no interest. Individuals will
also index contracts to the expected
rate of inflation, or will upgrade prices
and wages frequently. While these ad-
justments may seem fairly innocuous,
all of them involve costs, including the
alternatives to which people could have
put their time, energy, and resources. More-
over, to the extent that these adjustments
do not transpire quickly and simultane-
ously across all goods and services, they
introduce temporary distortions to the
price structure that affect decisionmaking.
Relative price distortions, which pose
the greatest costs, are much more com-
mon and destructive when inflation is
unanticipated. For instance, when the
price of corn rises relative to that of
other goods and services, it indicates
that the commodity is becoming rela-
tively more scarce. The price hike sig-
nals farmers to plant more corn and en-
courages consumers to buy more
wheat. In this way, such relative price
changes swiftly and efficiently convey
information vital to the smooth func-
tioning of the economy. Distorting rela-
tive price signals—as the communist
countries eventually discovered—can
create serious gluts and shortages.
If inflation is unexpected, people may
confuse a general price rise stemming
from an overabundance of money for a
relative price change, as described
above. Uncertain about the nature of
price signals, they might then make
production, investment, employment,
and consumption decisions based on er-
roneous perceptions about relative scar-
cities and might incur substantial losses.
Once burned, people tend to become
twice cautious, devoting more resources
to predicting inflation and protecting
themselves from its effects. They will
seek investments with quick payoffs
and will avoid lengthy commitments
that could leave them exposed to future
inflation. The long-term investments
that inflation fears tend to discourage
are often those most necessary for the
promotion of economic growth.
• Credibility, Accountability,
and Independence
The surest means by which a government
could acquire a credible commitment to
maintaining the value of its money is by
legally mandating price stability as the
sole objective for monetary policy and by
holding its central bank accountable for
attaining that objective. In so doing, a
government eliminates the uncertainty
that it might resort to an inflation tax or
sacrifice price stability for temporary out-
put and employment objectives. New
Zealand is currently attempting such an
approach: Its parliament now sets an in-
flation objective and holds the central
bank's Governor accountable for achiev-
ing it. Similarly, Mexico has adopted a
constitutional amendment requiring its
central bank to maintain price stability.
Among the major developed countries,
only Germany approximates this ap-
proach. The Bundesbank Act sets
"maintaining the value of the cur-
rency" as the primary objective of the
German central bank. Although the
Bundesbank generally views this lan-
guage as a mandate for domestic price
stability, it has been subject to differing
interpretations and thus seems less
binding with respect to price perform-
ance than the New Zealand method.
With a stated mandate for price stabil-
ity and with accountability clearly de-
lineated, the political and institutional
structure of the central bank becomes
of secondary importance.
Despite the attractiveness of this ap-
proach, few elected officials embrace
it. Increasingly, however, governments
seem willing to grant their central
banks greater political autonomy as a
way to enhance monetary policy credi-
bility. In recent years, Canada, Chile,
France, Mexico, and the United King-
dom have either adopted or begun to
consider laws granting their central
banks more political autonomy.
• The Mechanics of
Central Bank Independence
Central bank independence depends
rather imprecisely on a host of legal, in-
stitutional, and customary arrange-
ments. The structure of the Federal Re-Percent
14
12
10
FIGURE 1 CENTRAL BANK INDEPENDENCE AND ECONOMIC
PERFORMANCE, 1973-1988
Percent
35
AVERAGE INFLATION
a • Italy
.New Zealand
 SP
ai
n
Australia •
Sweden •Denmark
Norway/France I
U.K..
Belgium •
• Canada
• U.S.
Netherlands |
Japa"
Switzerland"
Germany
30
25
20
15
10
VARIANCE OF INFLATION
Italy
Spain
U.K.
New Belgium
D
• Japan
a France ,
New
. Zealand-
 Denmark« Netherlands
Sweden • Canada
Australia
• Norway
Germany
Swltzerlan
d
-0.5 0.5 1.5 2.5 3.5 4.5 5.5 -0.5 0.5 1.5 2.5 3.5 4.5 5.5
Average index of central bank independence
SOURCE: Alberto Alesina and Lawrence H. Summers, "Central Bank Independence and Macroeconomic
Performance," Journal of Money. Credit, and Banking, vol. 25, no. 2 (May 1993), pp. 151-62.
serve System, one of the world's most
politically autonomous central banks, is
illustrative. Although congressional bank-
ing committees provide oversight, no
agency establishes or directly supervises
the System's monetary policies. The Fed-
eral Reserve must foster the broad eco-
nomic objectives of the Humphrey-
Hawkins Act of 1978, but it is not
required to attain specific price, output,
or employment objectives; nor must it
implement policy in a specific way,
such as through an interest-rate target.
Although the Fed does conduct open-
market operations by buying and sell-
ing Treasury securities in the secondary
market, the Federal Reserve Act prohib-
its the central bank from making loans
directly to the U.S. Treasury.
Policy is formulated by the Federal Open
Market Committee (FOMC), whose
members have long and staggered ten-
ures. While FOMC membership reflects
regional considerations to some extent,
appointments are not made according to
political party, and the Committee is typi-
cally bipartisan. The U.S. President ap-
points, and the Senate approves, the
seven Federal Reserve Governors, all of
whom vote on the FOMC. Presidents
of the 12 Federal Reserve District Banks,
five of whom vote on the FOMC at any
particular time, are appointed (with ap-
proval of the Board of Governors) by
their respective District Bank directors,
who represent local banking, commer-
cial, and consumer interests. Neither the
President nor Congress can remove a
Governor or a District Bank president
without cause. To further preserve auton-
omy, the Federal Reserve is not subject to
a budgetary appropriations process.
These institutional characteristics of the
Federal Reserve System promote its
monetary policy autonomy. Presumably,
central banks with similar institutional
structures should foster price stability.
• Measuring Central
Bank Autonomy
In recent years, economists have at-
tempted to measure the relative inde-
pendence of the world's central banks by
quantifying various aspects of their insti-
tutional and political structures, and to
correlate the resulting numerical ranking
with various measures of economic per-
formance. These studies tend to confirm
that higher levels of central bank auton-
omy across countries are associated
with lower, more stable rates of infla-
tion.
 7 In figure 1, for example, as the in-
dex of central bank independence in-
creases (implying greater monetary
autonomy), price performance improves.
Some caution in interpretation, however,
is warranted. The evidence does not con-
trol for other variables such as the state of
economic development, the stability of
the government, and the exchange-rate re-
gime. Also, the sample shows at least one
interesting exception. Japan has a low in-
flation rate, but its central bank is not
fully independent of its Finance Ministry.
• The Bias against Inflation
Why should independent central bank-
ers be less prone to creating inflation
than elected officials? After all, central
banks are ultimately responsible to the
governments that sanction them. A cen-
tral bank's policy objectives and its im-
plementation of policy affect various
segments of society disproportionately.
Different political constituencies —
debtors and creditors, people with
fixed incomes, and those with variable
incomes — will attempt to influence
monetary policies. Among those af-
fected are other government agencies,
which may believe that monetary poli-
cies compromise their own policy ob-
jectives. Thus, no central bank is fully
politically autonomous.
One analyst, Adam Posen, has suggested
an important counterweight to this politi-
cal influence. Central banks interact di-
rectly with financial intermediaries when
undertaking all of their responsibilities.
Because financial intermediaries gener-
ally make loans with longer-term maturi-
ties than their deposits, unanticipated
inflation can reduce their net worth; thus,
they will seek low inflation policy from
central banks.
• The Inflation Game
The peculiar costs and benefits of infla-
tion pit the private and public sectors
against each other in an odd game, in
which the best outcome — the one that
fosters long-term growth — is to stabi-
lize prices and to eliminate the costs of
anticipating and hedging against infla-
tion. But once the private sector begins toplay as if it expects stable prices, the
government faces a growing incentive
to inflate. Realizing this, people have
historically required some type of
pledge that the government will not
generate inflation. One should view
central bank independence simply as
the best feasible solution to this game
in a world where money is fiat and
most governments are unwilling to
hold themselves publicly accountable
for price stability.
• Footnotes
1. Fiat money refers to currency that is not
convertible into coin or specie of equivalent
value.
2. Inflation expectations affect the demand
for real money balances through nominal in-
terest rates. See John P. Judd and John L.
Scadding, "The Search for a Stable Money
Demand Function: A Survey of the Post-
1973 Literature," Journal of Economic
Literature, vol. 20, no. 3 (September 1982),
pp. 993-1023.
3. More generally, governments will spend
in excess of their tax receipts and require
their central banks to acquire their debt obli-
gations either directly or in the open market.
When acquiring government securities, cen-
tral banks increase the money supply. Legal
tender laws force individuals to accept, and
to pay taxes in, the fiat money.
4. See Stanley Fischer, "Seigniorage and
the Case for a National Money," Journal of
Political Economy, vol. 90, no. 2 (April
1982), pp. 295-313.
5. On the so-called political business cycle,
see Douglas A. Hibbs, Jr., The American Po-
litical Economy: Macroeconomics and Elec-
toral Politics, Cambridge, Mass.: Harvard
University Press, 1987.
6. Although most economists believe that
high and variable inflation reduces invest-
ment and economic growth, cross-country
studies generally do not find strong evidence
of any relationship (positive or negative) be-
tween economic growth and either inflation
or central bank independence. David Altig
and Michael Bryan discuss these issues in
"Policy and Long-Run Output: A Sensitivity
Analysis," Federal Reserve Bank of Cleve-
land, unpublished manuscript, 1994.
7. See Patricia S. Pollard, "Central Bank In-
dependence and Economic Performance,"
Federal Reserve Bank of St. Louis, Review,
vol. 75, no. 4 (July/August 1994), pp. 21-36.
8. See Adam S. Posen, "Why Central Bank
Independence Does Not Cause Low Infla-
tion," Central Banking, vol. 4, no. 2
(Autumn 1993), pp. 51-63.
Owen F. Humpage is an economic advisor
at the Federal Reserve Bank of Cleveland.
The author thanks David Altig and James
Thomson for helpful comments and Lydia
Leovic for research assistance.
The views stated herein are those of the
author and not necessarily those of the Fed-
eral Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Central bank independence

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Central bank independence

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