This chapter will focus on the economic imperatives driving institutional design and reform, imperatives which have their genesis in both theory and in empirical evidence. Chapter
3
will focus on the political economy of central banking.In
part the rationale for developing the argument in this way rests on a distinction between a technical/ economic analysis, and a political economy approach - in the former central bank independence is treated as exogenous, whereas in the latter the determinants of particular institutional arrangements are explored (Bowles and White,1994: 241).
The technical/ economic analysis, "reduces complex institutional structures to a single variable, 'central bank independence"', while the political economy approach," ... examines the relationship between the various politico-economic forces and interests which act to constitute and maintain institutions .... The political economy approach ... stresses that the evolution of the status of the central bank is not ordained by natural factors, nor can it be explained in terms of simplistic imputations about the behaviour of governments, but is rather the outcome of more complex and dynamic political processes" (Bowles and White,
1994: 241).1
For the purposes of the discussion in this and the following chapter we draw a distinction between the literature (or a 'technical/economic' analysis) and a approach. Clearly however the conceptual boundaries between the disciplinary domains of economics and politics are indistinct, and the fact that the normative import of the former - as regards institutional design - is given practical effect in the latter suggests that the arbitrary imposition of disciplinary boundaries will be limiting.2
1 The rationale is also reflected in part by the distinction that has been drawn between a 'social welfare' and a 'political' approach to central bank behaviour:
"The recent literature on monetary policy games has given two competing interpretations to the objective function of monetary policymakers ... One part of the literature regards this function as a social welfare function and the central bank as a benevolent social planner ... The other part views the central bank as a mediator between different interest groups that try to push monetary policy in various, not necessarily consistent, directions ... " (Cukierman, 1 992: 43-45).
2 Moreover, within the discipline of economics, while 'rational economics' constitutes the prevailing orthodoxy - and has, in a normative sense informed the institutional design of central banks - a range of contesting or heterodox positions have also been advanced, induding from economists of a Post Keynesian persuasion (see for example the minisymposium in the
As we noted in the preceding chapter, at the level of the formal institutional arrangements there are quite marked differences in the statutory provisions that obtain in the Australian and the New Zealand jurisdictions. Whatever the reasons for the formal institutional divergence - and that is the issue to which the balance of this work is directed - the New Zealand arrangements are clearly consistent with the prevailing economic paradigm, and there are, by contrast, resonances with an earlier macroeconomic disposition in the Australian arrangements. The distinction between the prevailing orthodoxy and the earlier 'Keynesian moment' rests on the latter's assumption of an exploitable Phillips Curve relationship between inflation and employment - that policymakers faced a choice between higher inflation and lower unemployment, with any trade-off being both durable and stable over time. The expectations augmented Phillips Curve demonstrated that any such trade-off was neither durable, nor stable over time. And the implications for policymakers were manifold - with, arguably, there being no trade-off over the long-run, a rate of unemployment below the 'natural' or 'non-accelerating inflation rate of unemployment' (NAIRU) would result in accelerating inflation. Moreover there were two further implications for the design of institutions and the conduct of monetary policy - monetary policy was neutral in its effects on the real economy over the long-run, and should be exclusively directed to stabilising prices in the economy.
The analysis that follows seeks to further illuminate aspects of the prevailing paradigm, the implications for the design of monetary policy institutions (including relations between politicians and non-elected policymakers), some of the caveats that may constrain the case for institutional design, and the challenges posed by institutional design and the conduct of policy within democratic polities. The institutional prescription places a premium on a rules based over a discretionary policy regime. And the essence of the normative case is the advocacy of central bank - a set of institutional arrangements within which the conduct of monetary policy is undertaken independently of elected policymakers.
In this chapter the focus is on the of central bank independence, and the theoretical and empirical underpinnings of central bank independence as an institutional prescription. To rehearse the argument that is developed below, the conduct of monetary policy is subject to a 'dynamic inconsistency' constraint, which results from a combination of politicians implementing monetary policy according to a Downsian calculus (Downs,
1957), lags in the implementation of policy, and adaptive
behaviour on the part of price setters in markets. The institutional resolution is seen inin independent central banks and bankers, and operating policy within a medium to long-term framework.
We open the discussion by examining the theoretical case for central bank independence, reviewing issues of dynamic inconsistency, credibility, and reputation; and then review some of the empirical evidence on Political Business Cycles. The discussion then turns to the notion of central bank independence, reviews some of the conceptual, definitional, and measurement issues, and concludes by noting some critiques of the standard measures of central bank independence. The next section reviews the literature on central bank independence and macroeconomic outcomes, and then turns to a consideration of two caveats to the prevailing orthodoxy - the neutrality of monetary policy at zero inflation, and the validity of the NAIRU (the non accelerating inflation rate of unemployment). The following section provides a reprise on the various institutional remedies to the inflation 'bias', and we then examine the challenges posed by remedies which risk sub-optimal outcomes.
The concluding sections of the chapter use the concept of central bank independence to exercise some leverage on the notion of central bank accountability, and a two-fold conception of accountability is introduced. The chapter closes with an assessment of the relationship between independence and accountability, and we suggest that a political economy approach may serve to further illuminate the determinants and consequences of both central bank independence and accountability.
Support for central bank independence has been nurtured and sustained by the contributions from the economic 'credibility' literature (Kydland and Prescott, 1977; Barro and Gordon, 1983b; Rogoff, 1985; Blackburn and Christensen, 1989; Swinburne and Castello-Branco, 1991; and the review in Argy, 1988). The literature makes assumptions about the preferences of monetary authorities under conditions of greater or lesser independence from short-term political imperatives. This work is premised on a number of assumptions. It is assumed that inflation is an economic bad. It is further assumed that monetary policy ultimately affects only the general price level, and that unexpected fluctuations in monetary policy can induce temporary effects on output and employment. When the assumption that increases in output are attractive to voters, and hence to politicians, is factored in, the result is an incentive for politicians to fool price setters by encouraging a reduction in expectations, and to then loosen
monetary policy (for example by way of a stance accommodating of some fiscal expansion) to produce electorally favourable economic circumstances by way of increased output (Capie and Wood,
1991:28).
Simply put, the game that politicians and voters play is as follows: politicians attempt to reduce expectations of future inflation such that price setters in the markets assume a future rate and lock that rate in. There is then an incentive for the government to engineer an electorally propitious set of circumstances in a pre-election period by way of stimulation that increases output, but also produces a 'surprise' inflation. The result is assumed to be a positive electoral outcome for the incumbent (depending of course on where the balance of electoral advantage rests - the extent to which the median voter is more responsive to a surge in output than a (subsequent) increase in the price level). The 'time inconsistency' constraint is a variation on the same theme. If it is assumed that private sector agents are able to calculate the government's incentives in advance, an announced commitment to price stability will not be credible since it is 'time-inconsistent' with the government's (Downsian) post-announcement incentives. Agents will then form positive inflationary expectations and factor these expectations into price setting and risk premiums. In a review of the rules versus discretion debate Argy illustrates the dimensions of 'time inconsistency' by way of the following example:
"The central bank announces for a given year a low money growth, low inflation target. Workers faced with this announcement have to decide what their wages policy should be for the year (say the annual contract). They have two options but there are four potential outcomes. Workers can opt for a low wage policy consistent with the announced money growth and expected inflation or they can opt for a high wage policy inconsistent with the announced money growth plan and implicit inflation. In turn the monetary authorities can (a) stick with the original game plan (b) modify their game plan in the light of actual settlements" (Argy,
1988: 169).
Turning to the normative or prescriptive import of the 'credibility' thesis, the cure for this malaise rests in a set of institutional arrangements through which the policy maker is constrained. Typically having a central bank independent of government is seen as an appropriate institutional constraint (Capie and Wood,
1991:28).
While in their seminal contribution Kydland and Prescott stop short of recommending a specific institutional form for central bank/government relations, the implications of their preference for rules based over discretionary arrangements are clear:"[T]he implication of our analysis is that policy makers should follow rules rather than discretion. The reason that they should not have discretion is not that they are stupid or evil but, rather, that discretion implies selecting the decision which is best, given the current situation. Such behaviour either results in consistent but suboptimal planning or in economic instability ...