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This section will discuss some empirical findings on the relation between CBI and macroeconomic outcomes of inflation and output. The empirical literature in this area relied on the major indices that tried to quantify CBI as discussed earlier. The remainder of the chapter will analyse the degree of central bank independence in the sample of countries studied in the thesis.

CBI is often put forward as a costless solution to the time-inconsistency problem; CBI is associated with low inflation with no trade-off in terms of output growth or employment. Most of the empirical literature points to a negative correlation between CBI and inflation (Alesina, 1988 and 1989; Grilli, Masciandaro and

Tabellini, 1991;12 _{Cukierman, 1992; Cukierman, Webb and Neyapti, 1992, and}

Alesina and Summers, 1993 are widely cited), while it does not have any significant effect on output growth or employment (Alesina and Summers, 1993; Eiffinger, Van Rooij and Schalling, 1996; De Haan and Kooi, 1997; Akhand, 1998).

As research have repeatedly ascertained the negative correlation between CBI and inflation, other studies have tested the robustness of that correlation by examining the relation over different time horizons and country samples and including control variables such as, degree of openness to trade, exchange rate regime, political instability and proxies for labour market structures. Most of these studies suggest that the relationship between CBI and inflation remains robust, even with the inclusion of control variables (Brumm, 2000; De Haan and Kooi, 2000; and Jacome and Vasquez, 2005). The following section will present the findings of some of those empirical studies in some detail.

Jacome and Vasquez (2005) found strong support for the negative relationship between CBI and inflation in a sample of 24 countries in Latin America and the Caribbean during the 1990s. They used panel data estimation techniques and controlled for international inflation, banking crises, and exchange rate regimes. Their results were also robust to the inclusion of an index of broader structural reforms that may have had an impact on inflation in those countries during the 1990s. The study used three different measures of CBI, which ensured the robustness of the empirical results. They used the GMT index, Cukierman (1992),

and a modified version of the latter which included additional indictors on the appointment of the central bank’s board members, the degree of CBI in the conduct of exchange rate policy, the role of the CB as lender-of-last-resort (LOLR), and legal requirements of central bank accountability and transparency.

However, few studies have found conflicting evidence. The statistical significance of the impact of CBI on inflation may vary with the sample selected even among industrialised countries (Cargill, 1995) and could be eliminated when other variables are added to proxy for the structure of the labour market (Jenkins, 1996). Campillo and Miron (1997) and Fuhrer (1997) showed that the statistical significance of CBI disappeared when additional control variables are included for the degree of openness in the business environment, political stability, the history of inflation and the debt burden.

Posen (1998) suggested that the correlation between CBI and low inflation is due to a third factor that causes both low inflation and encourages the independence of the central bank. He introduced the concept of financial sector opposition to inflation (FOI) as the driving force behind the conservatism embodied in an independent central bank. FOI then leads to both a high degree of CBI and low inflation. He constructed a measure of FOI and found a positive relation between his index of FOI and CBI as proxied by Cukierman’s legal independence indicator and a statistically significant negative relation between FOI and average inflation. Also, in Posen’s regressions, Cukeriman’s CBI index lost significance when FOI is included. The regression results were significant for developing countries, although they were stronger for industrialised ones.

Although Posen’s results showed strong empirical evidence for the negative correlation between FOI and inflation, they have been challenged by several authors on the grounds that they were valid only when that particular measure of CBI was used, namely Cukierman’s legal index. Other authors did not find evidence supporting the FOI hypothesis as a decisive factor in explaining variations in the degree of CBI nor inflation across countries (Campillo and Miron, 1997; De Haan and Kooi, 2000; Sturm and Haan, 2001).

Nevertheless, all of the studies that cast doubt on the robustness of the negative correlation between CBI and inflation have used Cukierman’s index of legal

independence, which is a poor measure for actual independence, especially in developing country samples as discussed earlier. Brumm (2000) challenged those studies as he cast doubt on the validity of the use of OLS as an estimation technique in Campillo and Miron’s (1997) study, which controlled for political stability, the history of inflation and the debt burden. He showed that if an alternative methodology of covariance analysis is applied and Cukierman’s TOR and political vulnerability indicator are added, a strong negative correlation between CBI and inflation is restored. As with his criticism of the methodology used by Campillo and Miron, Brumm (2000) challenged Posen’s results on the grounds that OLS is an inappropriate technique, given the measurement errors embodied in using legal proxies for CBI in place of actual independence.

In his study, Brumm (2000) argued that measurements of legal CBI are ‘noisy’ indicators of the underlying actual CBI. He showed that if the measurement errors are not accounted for in the econometric technique used, then erroneous results can be obtained. Brumm applied the analysis of covariance structure instead of OLS to test the relationship between CBI and inflation. He also used measures of actual independence as well as legal independence, namely the governor turnover rate and a measure of political vulnerability. His results confirmed the strong negative correlation between CBI and inflation, suggesting that measures of actual CBI should be used instead of legal measures.

Cukierman (1992) tried to shed some light on the direction of causality between CBI and low inflation; does CBI ‘cause’ inflation or does society’s aversion to inflation encourage CBI. He empirically investigated the possibility of simultaneity bias stemming from the two-way relation between CBI and the inflation rate, using measures for both legal and actual CBI. Actual CBI is proxied by the governor turnover rate (TOR). Cukierman argued that a frequent turnover of governors before the completion of the legal tenure can be used as a proxy for the actual degree of CBI. Therefore, a high turnover rate (or low tenure in office) indicates a low degree of actual CBI. He then tested the causal relation between inflation and actual CBI. High inflation may reduce the authority of the governor resulting in a high turnover of governors and thus lower CBI. He used both OLS estimation and instrumental variables (IV) methods to examine the impact of legal and actual CBI on inflation. He found that although the overall goodness of fit for the regressions

deteriorated when IV is used rather than OLS, the coefficient on the turnover rate remained highly significant. This led to the conclusion that the significant impact of actual CBI on inflation rates is unlikely to stem solely from causality running from inflation to turnover. Cukierman also examined the direction of causality using bivariate autoregressive processes for inflation and turnover. The results supported the presence of two-way Granger causality between inflation and actual CBI. High and persistent inflation rates negatively affect the degree of current CBI. Similarly, a continued lack of CBI (proxied by high lagged turnover rates) contributes to high inflation. Low CBI and high inflation reinforce each other.

Cukierman and Webb (1995) assessed the impact of the political vulnerability of the central bank on inflation. They developed a refined TOR index to distinguish between the politically motivated dismissal of governors and the normal end-of- tenure turnover and found that political vulnerability has a significantly positive impact on inflation and its variability. They also found that the distinction between industrial and developing countries disappears once the TOR indicator is broken down into its components of political and non-political turnover. They concluded that political vulnerability fully accounts for the significance of the relationship between inflation and TOR in the original index.

Eijffinger, Van Rooij and Schaling (1996) used an innovative approach to assess CBI and tried to arrive at an empirical classification of CBI in ten OECD countries by estimating their reaction functions and analysing the response of money market interest rates to inflation, growth and the current account surplus. The reaction functions showed a tendency to raise interest rates in response to both inflation and growth. The authors arrived at a ranking of the central banks in their sample by ordering countries decreasingly from that with the strongest interest rate reaction through to the central bank with the weakest reaction. They arrived at a ranking that puts Germany and the Netherland at the top and Italy and UK at the bottom. Using their empirical classification, they found a significant negative relation between both inflation and interest rates on one side and CBI on the other. They also found that there is a strong correlation between their empirical ranking and the widely used legal measures of CBI. Thus the main contribution of their paper was to ascertain that legal indices of CBI embody some information on the actual independence as measured by the behaviour of the central banks classified. The

authors support GMT’s argument that CBI does approximate a ‘free lunch’ since in their study there was no impact of CBI on economic growth.

Sylvester and Schaling (1997) empirically tested the determinants of CBI. They adopted Rogoff’s definition of independence and in their model CBI is defined as the degree of conservativeness of the central bank, while the optimal degree of independence depended on the balance between credibility and flexibility as discussed by Lohmann (1992). The model was tested for 19 industrial countries. The empirical results showed that the optimal degree of independence is higher, the higher the natural rate of unemployment, the greater the benefits of unanticipated inflation, the less inflation-averse society’s preferences and the smaller the variance of productivity shocks. Intuitively, the results show that as the benefits of creating inflation increase - to stabilise output and to meet society’s preferences for higher employment - both the time-inconsistency and the credibility problems of monetary policy increase, thus creating a greater need for commitment to low inflation through higher independence of the central bank. Debelle and Fischer (1995) argued along opposite lines and concluded that the optimal degree of independence increases with society’s aversion to inflation and decreases with society’s preference for output stabilisation. Thus, in some situations the most independent central bank might not be socially optimal.

Crosby (1998) examined the relation between CBI and output variability as a determinant for CBI. Crosby suggested that countries experiencing low levels of output variability should establish more independent central banks since the major cost of CBI is associated with increased output variability as shown by Rogoff (1985). Crosby tested this hypothesis in 44 industrial and developing countries using Cukierman’s legal CBI and including control variables for the variance of the terms of trade and a measure of political stability. He found that CBI is inversely related to the magnitude of real shocks in the entire sample, but the results did not hold for developing countries. He found no support for the hypothesis that political stability influences CBI.

In empirically identifying the determinants of CBI, researchers have pointed to the importance of the historical context and social characteristics in which the central bank operates. Sylvester and Schaling (1997) argued that what they had identified as the determinants of CBI, including the natural rate of unemployment, society’s

preference for unemployment stabilisation relative to inflation stabilisation, the variance of productivity shocks and the slope of the Phillips curve, reflect the economic and political structure of a country and also the underlying relationship between institutional design and society’s collective preferences. Hoogduin (1997) pointed to the importance of the historical context that may promote the establishment of independent central banks, such as hyperinflation. Similarly, Crosby (1998) was able to show empirically that for industrialised countries, positive reforms in the economic structure that reduce inflation and output variability also increased the desirability of central bank autonomy. Lybek (1999) put forward a similar point of view and argued that perhaps the political will for economic reform encourages sound monetary policy and introduces the institutional reform that ensures low inflation.

Posen (1998) examined empirically the impact of CBI on the credibility of monetary policy and found no support for a direct link between independence and disinflationary credibility. Disinflation appeared to be more costly and no faster in countries with independent central banks. In fact, the empirical results showed a positive correlation between the cost of disinflation and the degree of independence. Also, both wage and price rigidities examined in the paper appeared to be similar across countries with different degrees of CBI. The paper concluded that CBI does not confer any credibility bonus in terms of changing the behaviour of the private sector (lower wage rigidity); nor does it contribute to less costly disinflation. From the above results, Posen also concluded that the observed positive connection between disinflation and CBI does not operate through the wage setting channel since that behaviour appears to be invariant to the degree of CBI, thus CBI increases the cost of disinflation irrespective of the wage setting arrangement. A similar result was put forward by Debelle and Fisher (1995), wherein they found a positive relation between CBI – as measured by GMT (1991) – and the output losses during recessions. They also explicitly addressed the question of the interaction between monetary and fiscal policy within the institutional framework of an independent central bank. They concluded that CBI is optimal if the central bank is more inflation-averse than the fiscal authority and pre-commits to an inflation path, provided that fiscal policy is disciplined enough. If the fiscal authority is irresponsible and able to determine the size of the deficit to be financed

by the central bank, society would be worse-off with a more conservative central bank. The paper stressed that freedom from deficit finance is of critical importance for CBI. This conclusion points to the importance of monetary and fiscal policy coordination, whose absence could seriously undermine the credibility of monetary policy, especially in developing countries. This conclusion was also stressed by Fry (1998) as will be detailed later.

De Haan and Kooi (1997) made a new contribution to the understanding of CBI as they examined the concepts of autonomy and conservatism separately and tried to distinguish between the two, which are often assumed to be synonymous in most of

the literature. Using two of the major de jure indices of CBI (GMT and Cukierman

legal independence index), the authors attempted to isolate the conservatism components as indicated by the degree of commitment to low inflation stipulated in the central bank law. The other components of the indices were indicative of autonomy, such as personnel, financial and instrument independence. The regression results showed that instrument independence is critical for inflation performance, while conservatism and other aspects of CBI are less important. The impact on the variability of inflation also showed similar results, while there was no significant impact on growth performance. According to these results, instrument independence is the single critical factor for achieving low inflation.

A similar result was obtained by Banian, Burdekin and Willet (1998) who argued that inflation can be predicted more accurately using a simple policy autonomy index based on the central bank’s freedom to formulate monetary policy rather than using more complex indices. They showed that when using a simple measure of policy independence, the more complex indices of GMT and Cukierman lose their significance. Oatley (1999) also concluded that the simplest measures of independence provide the most statistically significant correlation between CBI and inflation.

Posen (1998) also examined the impact of CBI on seigniorage since the degree of budget deficit monetisation is the main contributor to long-run average inflation. The results showed no evidence that CBI contributed to lower reliance on seigniorage revenues. The paper concluded that limiting the government’s access to central bank credit does not seem to be the mechanism through which CBI contributes to low inflation. However, the criticisms put forward by Bramm (2000),

and discussed earlier, regarding the use of legal independence index to measure CBI would still apply to this conclusion and cast doubt on this result as well. Forder (1998) argued that the reason for the failure to observe any credibility bonus for CBI was that such credibility can in fact be achieved by elected governments, especially when the rational policymaker understands the futility of trying to exploit a non-existent trade-off between inflation and unemployment; the policymaker would simply refrain. In practice, governments were able to disinflate successfully during the 1980s without granting independence to their central banks. This observation does not deny the existence of a genuine time-inconsistency problem or credibility problem; it simply points to the success of the existing political- economic arrangements in overcoming them without recourse to CBI. Forder (1998) also pointed to the literature (eg. Goodhart and Huang, 1998) that suggests that the transmission time lag of monetary policy is often longer than the average wage contracts in OECD countries, which significantly reduces and perhaps eliminates altogether the time-inconsistency problem. This may explain the lack of a credibility bonus from CBI documented by Posen, since there is little or no credibility problem for CBI to solve in the first place.

One of the few studies that focused on CBI in developing countries was Fry, Goodhart and Almeida (1996) who studied CBI in 44 developing countries using a questionnaire administered to the central banks in the sample to self-assess their degree of independence. Later, the self-assessment was regressed on various objective indicators of independence. Using regression analysis, self-assessment of CBI was explained reasonably well using: a) the statutory objective of price stability, and b) the rate of CB governor turnover. There was a positive and marginally significant relationship between the number of government officials on the board of the CB and the self-assessment of independence. The authors proposed cooperation between the government and the central bank as an explanation for this