Merits and Drawbacks of Central Bank Independence - Essay Example

Merits and Drawbacks of Central Bank Independence By The topic of central bank independence is current and highly significant thus the need to focus on it in academia. In any country, central banking is highly imperative because of the critical roles assigned to it including creation of money. Money is important in the economy of a country due to the several functions it serves. Since central banks are charged with critical roles, it becomes challenging for most countries to decide whether the mandate of the central bank should fall under the control of the executive or whether the institution should operate autonomously and independently. This paper discusses focuses on the independence of central bank and discusses the merits and drawbacks that are associated with an independent central bank. The theoretical case for central bank independence is founded on the notion that price stability is critical and is the main objective of any monetary policy (Friedman 1968). However, politicians of a country are mainly not interested in fully safeguarding this major objective of the monetary policy since their concern is focused on the short term and politically dependent central banks. To address this, it becomes vital that the main objective of monetary policy is entrusted to agents that have a long term focus and who are not politically elected by the masses. Theoretically, central bank independence is considered to a solution to three major problems. First, this is considered to have the capacity of making it difficult for fiscal authority and policy to have relative dominance on the monetary authority and policy. Additionally, based on the models of political business cycles and partisan cycles, central bank independence is considered to provide protection to society against the distortions that business or partisan cycles can result into. Finally, basing on the dynamic inconsistency theory, central bank independence is considered an effective way of addressing dynamic inconsistencies in monetary policy (Schwodiaueur, Komarov and Akimova 2006). A major merit of central bank independence is based on the aspect of inflation. According to Eijffinger and Haan (1996), countries with independent central banks exhibit a lower level of inflation compared to their counterparts that have no independent central bank. It is possible to explain this situation based on public-choice argument. The public-choice argument holds that there are strong political pressures that face monetary authorities forcing them to act according to the government preferences. Since monetary tightening impacts negatively on government budgeting, thus government might prefer easy money and this is exemplified by the Federal Reserve in the U.S. which is considered to sometimes act in accordance with the preferences of the president and the Congress (Eijffinger and Haan 1996). Another merit of central bank independence based on the aspect of inflation invariability is that it may result in a decrease in the level at which the monetary policy of a country is manipulated in the period before political elections. This way, central bank independence contributes to lower variability in inflation mainly through stability in the growth of money that it results into. Another way in which central bank independence reduces inflation invariability is through its consistency and failure to change its policy every time a new government comes into office. According to Lacker and Weinberg (2007), if central bank is controlled by government, this would mean that each new government would manipulate monetary policy to suit its objectives with regard to inflation and employment rate, e.t.c. According to Alesina and Summers (1993), central bank independence means the institution is free from political manipulation, this allows for a highly reduced level of variability in inflation, as shown in figure 1. Alesina and Summers (1993) calculated a measure of central bank independence using specific countries between 1955 and 1988. Consistent with their previous study results, they found a negative correlation between the level of central bank independence and inflation invariability as shown in figure 1. The results also indicated that a high level of central bank dependence leads to a high level of inflation invariability, as shown in figure 2 (Pollard 1993). Central bank independence is also considered to result in economic growth of a country and this is in different ways. First, as seen above, central bank independence means that there will be less manipulation of the monetary system by political authorities. Therefore, an independent central bank is capable of behaving in a manner that is predictable. This way, a country is more likely to experience an increase in the level of its economic growth and contribute to a more stable economy. Central bank independence as seen also reduces the level of inflation hence promoting economic growth in a country. When inflation level is high, it might have an adverse effect on price mechanism thus hindering economic growth in a country. Even moderate levels of inflation according to most economists, has an adverse effect on the economy and society as a whole (Williams 2007). Overall, the economy of a country is able to prosper when inflation level is low and there is a low level of inflation invariability, and these can be achieved through central bank independence. On the contrary, Hayo and Hefeker (2001), argue that central bank independence is not a necessary condition for an economy to achieve low levels of inflation since there exist other instruments such as fixed exchange rate as monetary policy that can be used to regulate the level of inflation Before Alesina and Summers (1993), Grilli, Maeciandaro, and Tabellini (1991) had developed two indices that could be used to measure central bank independence and one was based on economic measures while the other on political measures of independence. The data used comprised 18 OECD countries in the period between 1950 and 1989. Results indicated that for this period, there was a significant negative relationship between central bank independence and inflation. The figure 3 below indicates this relationship. Thus, the higher the level of central bank independence, the lower the inflation level. Figure 3: Inflation and central bank independence as measured according to an index developed in Grilli, Maeciandaro, and Tabellini (1991). Even though different studies and theoretical arguments are in favor of central bank independence, there remain major drawbacks that are associated with central bank independence. First, accountability of central bank is considered a major concern when the institution operates independently. Some authors have argued that the aspect of monetary policy is a part of economic policy, holding the same position as fiscal policy thus the conditions that apply to the determination of fiscal policy must also apply to monetary policy (Mas 1995). This implies that monetary policy must also be determined by representatives that are elected democratically. As it is, in most countries, the monetary policy is under the control of representatives that are elected democratically, hence it is expected that the central bank is under control and be held accountable to such representatives. For instance, in the United States, the legislation of central bank is among the responsibilities of the Congress (Sierra and Yeager 2004). In this regard therefore, a major argument is that central bank independence leads to lack of democratic accountability of central bank and this might result in the transformation of central bank to a bureaucratic body that might stop to pursue its main objectives including neglect of its role in economic policy in a country (Sousa 2015). Another drawback of central bank independence is based on the aspect of coordination of economic policies. There are different arguments about the confusion that might result when fiscal policy and monetary policy is controlled by the government and central bank respectively. Nonetheless, it is possible to address this issue through the Keynesian model, Keynesian-New Classical model and the New Classical model. Keynesian model holds that policy has an influence on inflation and productivity while Keynesian-New Classical model holds argues about the neutrality of monetary policy. Central banks form a major part of the economic policy of a country, thus impossible to separate different policy measures including monetary, fiscal, trade, and labour policies, since doing this would result in the policies running at criss-cross thus resulting in considerable confusion. As it is, conflicting policies are less likely to be successful. Nonetheless, basing on the explanations of these models, a major concern is that central bank independence results in absence of cooperation between fiscal and monetary authorities especially in the process when the policy is being implemented and this leads to undesirable outcome (Hornstein 2007). On the other hand, New Classical model holds that monetary and fiscal policies might have an influence only on inflation and not productivity, and that central bank and government are responsible for setting targets for inflation and output (Hornstein 2007). These models do not take into consideration trade unions or the public who can act as third party yet the public’s perception of policies has an influence on the policy’s outcome. Central bank independence means that the authority to make decisions on a country’s exchange rate, financial system, interest rates, and other monetary matters will lie in the hands of a few officials that are not even elected by the public. This therefore, in a democratic society would appear to be undemocratic at all levels. In all democratic societies, an elected members of the legislature are responsible for scrutinizing major decisions, thus an autonomous central bank contravenes this requirement. For this reason therefore, it is impossible for any central bank to be fully independent such that it is not accountable to anyone. In countries where the central bank is considered to be autonomous, it still reports to the legislature and the legislature still have power to make amendments to the laws that govern the central bank (Hayo and Hefeker 2001). In conclusion, this paper has shown that central bank plays a major economic role in a country and focused on the existing debate on central bank independence including its merits and drawbacks. Although central bank independence has considerable advantages to an economy, this too has drawbacks that might have adverse implications for a country. Overall, it can be argued that for central bank to ensure financial stability of a country, it must have some level of independence, since it has been proven that no central bank can be fully independent or autonomous. Central bank must be accountable to the legislature in order for it to execute its mandate effectively since independence of central bank from the legislature means a lack of accountability on its side, and this might have major implications for its performance. Accountability of central bank must also be to the public and this can be through a continuous and open communication between the central bank and the public as opposed to investors and market players only. Nonetheless, a degree of central bank independence is essential in any country as this contributes to financial stability, economic growth, and general development. References Alesina, Alberto, and Summers, L. H 1993, "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence". Journal of Money, Credit and Banking, 25(2):151-162. Debelle, G. and Fischer, S n.d., “How Independent Should a Central Bank Be?” Accessed from Eijffinger, Sylvester C.W. and Haan, J. 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Mas, I 1995, “Central Bank Independence: A Critical View from a Developing Country Perspective,” World Development, 23(10):1639-1652. Pollard, P 1993, “Central Bank Independence and Economic Performance,” Accessed from < https://research.stlouisfed.org/publications/review/93/07/Bank_Jul_Aug1993.pdf> 18 November 2015. Schwodiaueur, G., Komarov, V. and Akimova, I 2006, “Central Bank Independence, Accountability and Transparency: The Case of Ukraine,” FEMM Working Paper Series, No. 30. Sierra, G. E. and Yeager, T. J 2004, “What Does the Federal Reserves Economic Value Model Tell Us about Interest Rate Risk at U.S. Community Banks? Federal Reserve Bank of St. Louis Review, 86(6): 45- 60. Sousa, P 2001, “Independent and Accountable Central Banks and the European Central Bank,” European Integration online Papers (EIoP), 5(9). Williams, J. C 2007, “Inflation Targeting under Imperfect Knowledge. FRBSF Economic Review, Accessed from < http://www.frbsf.org/publications/economics/review/2007/er1-23.pdf> 18 November 2015 Read More