The aims of central bank independence The aim is to insulate monetary policy from political interference andfrom electoral pressure to deliver short-term economic growth at the expense of longer-term inflationary cost. Independence from the fiscalauthority is particularly important as a protection against monetization of debt. A credible government commitment to central bankindependence is deemed to lower the cost of reducing inflation, because it is not necessary to raise interest rates so much.There are two main models: “goal” and “operational” independence. In the former, the bank has the power to set the objectives of monetary policy, such as price stability along with an inflation target. The supreme example is the European Central Bank, whose independence is enshrined in treaty.At the other end of the spectrum is the Bank of England. Its monetary target is set by the chancellor of the exchequer, and it is accountable to both the executive and legislature. Governments can exert pressure through appointments to the bank.These attempts to achieve the discipline of the gold standard by othermeans have in recent years staved off inflation but failed to prevent extreme financial instability. That, along with the central banks’ encroachment on fiscal policy through measures such as quantitative easing, has brought independence under attack from financial conservatives.Accountability is also becoming a more pressing issue, not least in Japan. Nobuyuki Nakahara, a former member of the Bank of Japan’s monetary policy board, says: “In Japan, there are two governments: one, the central government; the other, the Bank of Japan, with no democratic legitimacy.”

Central banks should be in a position to decide the timing and pace of the inevitable normalisation without being unduly constrained by these pressures. What is ultimately at stake is their credibility in fulfilling their mandates.

Central Bank Independence

A Federal Reserve that is insulated from short-term political pressures but accountable to public concerns is more likely to pursue policies that align with its congressional mandate to promote stable prices, full employment, and moderate long-term interest rates. Introduction

The Federal Reserve has a number of responsibilities, but its most visible role is the formulation of monetary policy. While the Federal Reserve's Board of Governors is appointed by the President and approved by the Senate, and the chairman of the Board reports to Congress bi-annually, the Fed conducts monetary policy without further legislative or executive branch involvement. A consensus has evolved among economists that a politically insulated Fed is more likely to pursue policies that align with its congressional mandate, last revised in 1977, to promote the goals of moderate long-term interest rates, maximumemployment, and stable prices.

Elected governments in a democratic society potentially face incentives to pursue accommodative monetary policies that promote output and employment for political gain in the short run, even when those policieswould eventually lead to inflation. Independent central banks can bettermaintain credibility for consistently pursuing price-level stability than those that do not enjoy independence. That independence is necessarily limited, however, as a central bank serves a public purpose and must be accountable to the government.

Economic Arguments for Independence

The arguments in favor of independence derive from a central bank's monopoly over money creation. This monopoly carries with it certain powers that elected governments may be tempted to misuse for short-term benefits at the cost of rising inflation over time. Resisting such temptations requires a degree of commitment on the part of the central bank, and without independence, that commitment might be difficult to maintain.

Two broad incentives might lead a government-controlled central bank to abuse its money-creation powers. First, money creation that leads to unexpected inflation reduces the real value of nominal liabilities, suchas interest-bearing debt. In turn, this relieves the government of the need to increase taxes or reduce spending to balance its budget. Second,a surprise monetary expansion can increase output and employment in the short run, permitting governments to engineer expansions in an effort toincrease their popularity.

The temptation for governments to use money creation to inflate away thereal value of nominal liabilities has been studied by Columbia

University economist Guillermo Calvo (Calvo 1978 ) and University of Chicago economists Robert Lucas and Nancy Stokey (Lucas and Stokey 1983

), among others. For instance, take a case of extreme lack of policy commitment in which decisions are made with no regard for past

promises. If there is nominal debt outstanding, then ignoring the costs of inflation, the government might choose to produce a monetary expansion large enough to eliminate or greatly reduce the real debt. Over time, though, the public would come to expect such behavior and this would result in ever-higher inflation and nominal interest rates.This vicious cycle can be forestalled only through a commitment to future low-inflation policies. An independent central bank helps to provide such commitment because the formation of monetary policy occurs outside the day-to-day demands of government finance and the sphere of political influence.

University of California, Santa Barbara economist Finn Kydland and Arizona State University economist Edward C. Prescott (Kydland and

Prescott 1977 ), as well as Harvard University economist Robert Barro and Clemson University economist David Gordon (Barro and Gordon 1983

have studied the interaction between lack of policy commitment and inflation. In their analyses, monetary policy can affect the real economy only through expansions that come as a surprise to the public. These expansions are tempting to pursue if there are inefficiencies in the economy that make real activity undesirably low. For example, labor or product markets may not be perfectly competitive, and some wages and prices may be inflexible.If monetary policy is controlled by a government that cannot commit to its future policy behavior, then such surprise expansions would result in a high inflation rate but no benefit in terms of real activity — overtime the public would no longer be surprised by the monetary expansions.But if monetary policy is conducted under commitment, the economy can benefit from lower inflation with the same level of real activity (Wolman2001). Insulating the central bank from short-term political pressures can facilitate such commitment.

Independence in japan

The new government in Tokyo wants to see more aggression from the Bank of Japan.

The monetary prong of its legislative program calls for a higher inflation target and also an open-ended commitment on the part of the BOJ to expand its balance sheet.

It will get its way too, as perhaps a democratically-elected government should. Indeed, it has threatened to strongarm the BOJ with legislation but

may not have to go so far. The current BOJ governor, Masaaki Shirakawa, will come to the end of his term in April. It will probably be far easier to appoint an independent successor who will decide, independently, to deliver what the politicians want.So, is central bank independence more broadly just another pillar of pre-crisis finance destined to topple in our post-crisis world?

The argument in its favor is well known and essentially runs like this: if yougive the politicians (even if you voted for them) the monetary reins, they just won't be able to help themselves. As surely as rivers run to the sea, thescoundrels will pursue the election-winning goal of short-term employment withexcessively expansive policy. They'll buy today's boom with tomorrow's bust and hope tomorrow will be some other politician's problem.

No, no, much better that a sober, independent central bank rises above narrow political concerns and pursues a longer-term policy, with the predictability bond markets like as an added bonus.

That's the theory. The practise was rather different. Independent central bankpolicy may not have stoked the sort of short-term imbalances to which politicians are supposedly addicted. Instead, it stoked the long-term ones that pushed the entire financial system off the cliff.

Now, you may still think that one near-fatal central bankers' global crisis every couple of decades is better than a succession of smaller, politicians' ones every couple of years. But even then you'd have to concede this is hardlya black and white argument for independence.

And just look at the central banks' mandates. Of the explicit inflation targeters, the Banks of Japan and England have missed their inflation guidancefor years now. The Fed is supposed to be helping the U.S. generate full employment and the European Central Bank is meant to be implementing monetary policy in the best interests of the entire euro zone. Ask the Spanish or the Greeks how it's doing.

They've all missed to some degree. It's tempting to suggest that a non-independent central bank can miss a mandate just as convincingly as an independent one.

So, in the end we are left with one basic question. For all the arguments in its favor, has independent central banking been such a success in the recent past as to demand it remains ring fenced from such issues as national defense,healthcare policy, education and all the other grave issues with which we entrust our elected representatives? And the answer has got to be no.

Benefits of Central Bank Independenceby Tejvan Pettinger on January 9, 2008 in finance

Monetary Policy used to be the preserve of the Government. The Government would change interest rates to meet its various economic objectives. At different times the Government would give priority to:

lower inflation higher growth targeting exchange Rate and even balance of payments.

For example, in the early 1980s, the Thatcher Government increased interest rates to reduce inflation.In 1987, after a stock market crash, interest rates were cut to boost economicgrowth. In 1992, interest rates were increased to 15% to try and maintain the value of the £, which was then in the Exchange Rate Mechanism ERM

Arguments for Central Bank Independence1. It was argued that the governments tended to make poor decisions about

monetary policy. In particular they tended to be influenced by short term political considerations.

2. Before an election, the temptation is for a government to cut interest rates. This increases economic growth, reduces unemployment and increases the political support of the party. However, this expansionary monetary policy maylead to inflation and boom and bust economic cycles. Therefore arguably, it isbetter to take monetary policy out of government’s hands.

3. People have more confidence in the Central Bank, therefore this helps to reduce inflationary expectations. In turn this makes inflation easier to keep low.

Bank of England’s Independence 1997In 1997, the Labour party gave the Bank of England full independence in setting Monetary Policy. However, the government did give the Bank of England an inflation target of RPI 2.5% +/-1 (now CPI 2% +/-1)

If the inflation rate goes outside this range the Bank of England has to writean explanatory note to the chancellor.

Between 1997-2007, the Central Bank did a reasonably good job in keeping inflation low, and enabling a long period of economic expansion. From 2007-2011, the Bank struggled with the combination of credit crunch, deep recessionand cost push inflation.

In 2010 and 2011, the Bank had to tolerate inflation going above target (e.g. CPI inflation 5.2% in October 2011) because of the risk of pushing the economyback into a double dip recession. However, it was a difficult economic situation, and there were few alternatives to their policies.

Bank of England and Quantitative EasingThe 2009 recession was so serious that cutting interest rates failed to boost economic growth, therefore the Bank of England pursued unconventional monetarypolicy ofquantitative easing. This involved creating money and buying government bonds. The aim was to reduce interest rates and increase money supply. It is quite controversial because

Involves creating money ‘printing money’ with risk of creating future inflation

Makes the bank more political, e.g. decision to buy government bonds arguably helps the government to borrow more at a lower interest rate cost.

Benefits of quantitative easing mainly go to top financial firms and bankers. Only small fraction of extra money filtered through into loans for small companies.However, the policy helped to offset the deflationary impact of government spending cuts. It gave the UK greater flexibility compared to Eurozone

Independence and governance are two key terms relates to central bank.Independence refersto the ability of the central bank to use the instruments of monetary control withoutinstruction, guidance or interference from the government (Henning, 1994). On the otherhand, according to Amtenbrink (2004), the three pillars of central bank governance are: i).central bank independence, ii). central bank accountability, and iii).central bank

transparency. So, it means good governance in a central bank is a function of its independence

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Target independenceFundamental target independence – the right to choose its own fundamental objective or objectives – is possessed by no central bank.  Even the most independent of all central banks, the ECB, has its multiple fundamental objectives laid down in an external document – the Treaty Establishing the European Community.  Article 105 states that“The primary objective of the ESCB shall be to maintain price stability. Without prejudice tothe objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4.”Article 2 of the Treaty states: “The Community shall have as its task, by establishing a common market and an economic and monetary union and by implementing common policies or activities referred to in Articles 3 and 4, to promote throughout the Community a harmonious, balanced and sustainable development of economic activities, a high level of employment and of social protection, equality between men and women, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance, a high level of protection and improvement of the quality of the environment, the raising of the standard of living and quality of life, and economic and social cohesion and solidarity among Member States.”I still think it will come as a surprise to ECB Executive Board member Jürgen Stark that one of the objectives of the ECB is to promote equality between men and women – albeit without prejudice to the objective of price stability.The Bank of England’s monetary policy objectives are laid down in the Bank of England Act 1998.  They are to deliver price stability and, subject to that, to support the Government’s economic objectives including those for growth and employment.The Fed has a triple mandate, given in Section 2a. of the Federal Reserve Act: “The Board of Governors of the Federal Reserve System andthe Federal Open Market Committee shall maintain long run growth of

the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.Of all leading central banks, only the ECB sets its own quantitative operational targets.  It defines price stability is an annual rate of inflation (measured by the HICP index) below but close to two percent.   The Bank of England’s operational is set by the Chancellor of the Exchequer.  It is currently a two percent annual inflation ratefor the HICP  (known in the UK as the CPI).  The Fed has no quantitative target for any of its three fundamental objectives.  Under Chairman Ben Bernanke, it has been edging slowly towards an implicit inflation target, captured by the average or median 3-years ahead inflation forecasts of the members of the FOMC.  Whether this implicit inflation target is defined in terms of the CPI or the consumer expenditure deflator, and in terms of the headline inflation rate or the core inflation rate is unclear.Operational IndependenceOperational independence is the freedom or ability of a central bank to pursue its objectives (regardless of who sets them) as it sees fit, without interference or pressure from third parties. It is not a binary variable but a matter of degree. Operational independence from an elected, sovereign government is not easily achieved.It requires political independence: the central bank cannot seek or take instructions from any government/state body or other institution/body.It requires technical independence: the central bank must have the tool(s) to do the job. It means that the central bank cannot be coerced or induced to extend permanent financial assistance to the government or to private agents – it cannot be raided by government or private actors. It requires financial independence, that is, a separate budget and a secure capital base. It requires security of tenure and of terms of employment;this can be achieved through a minimum term of office, removal from office only for incapacity or serious misconduct (and not for gross incompetence), and pay and other conditions of employment that cannot be manipulated by outsiders. Finally, it requires that there be some other independent body, e.g. a court, to settle disputes between the central bank and the government.This list suggests that operational independence is not a binary variable but a matter of degree, that a high degree of operational independence is difficult to achieve and that, if it is achieved, the central bank is, almost by definition, not substantively accountable to any other agency.

As an illustration of the problems standing in the way of operational independence of the central bank, consider the issue of its financial independence. The ability of the central bank to pursue its price stability mandate or, operationally, to achieve its inflation target, is constrained by its financial resources. Unlike the Treasury, the central bank does not have the power to tax. The asymmetry is even stronger when hen one realises that among the entities the Treasury can tax is the central bank. Frequently, the Treasury is also the legal owner of the central bank.In the UK, for instance, the Treasury owns all the common stock of theBank of England. This raises the question: how independent can you be of the party that owns you and is able to tax you at will? The answer is that this depends on the ability of the Treasury to commit itself not to deplete the financial resources of the central bank, whether bycalling for extraordinary dividends, through a forced share re-purchase, by taxing the central bank or by raiding its gold reserves. The credibility of that commitment is determined by the same politicalfactors that prompted the delegation of monetary policy to an operationally independent central bank in the first place. It is an open issue.The financial independence of the ECB is due in no small measure to the fact that the ECB does not face a single controlling owner, or a single fiscal actor (Treasury or Ministry of Finance) capable of taxing it. The ECB is owned by the National Central Banks of the European Union. These in turn are owned (with a number of exceptions) by their national Treasuries/Ministries of Finance. Raiding the financial resources of the ECB would effectively require the unanimousagreement of the Finance Ministers of the EU. In addition, the ECB would be able to appeal the matter to the European Court of Justice. Very few conventional central banks facing a single national Treasury are in the same comfortable position.

i n d e p e n d e n c e o f t h e b a n k o f e n g l a n d

In May 1997 the Government granted the Bank of England operationalindependence allowing it to set domestic interest rates. It should be remembered thatthe government retains control of the final objective of monetary policy - theGovernment sets the inflation target within which the Bank must operate when carryingout monetary policy decisions.

The Bank of England's record since it was made independent in May 1997 has been astrong one. Underlying inflation has stayed remarkably close to the official targetmeasure of 2.5% (plus or minus 1%). On no occasions has the Governor of the Bank ofEngland been required to write an open letter to the Chancellor explaining either aninflation over-shoot or an under-shoot.

Gordon Brown's Statement on Bank IndependenceNow is the time for long-termism. This is the time to set the British economy on a newlong-term course that will deliver high levels of growth and employment throughlasting stability.

Price stability is, as I have said, an essential precondition for the Government’sobjectives of high and sustainable levels of growth and employment. The question ishow to achieve the long-term stability that we seek?

Hawks and DovesAttitudes within the Monetary Policy Committee have been characterised as beingbetween the ‘hawks’- members that are consistently more in favour of higher interestrates than others, and the ‘doves’ – those who favour a more relaxed policy. Hawkstend to hold somewhat pessimistic views on the inflation risks facing the Britisheconomy. As a result they tend to favour slightly higher interest rates in a bid tokeep control of domestic demand. Doves, on the other hand, argue that structuralconditions in the economy have changed - and that the economy can continue to grow ata healthy pace without triggering an acceleration in inflation.

What is the Monetary Policy Committee's main responsibility?The Bank of England Act 1998 formally sets out the role and constitution of the MPC.In relation to monetary policy, the objectives of the Bank of England shall be –(a) to maintain price stability (ie continued low inflation), and(b) subject to that, to support the economic policy of the Government, including itsobjectives for growth and employment.

The Inflation TargetThe inflation target the MPC has been given by the Chancellor since 1997 has been a2.5% increase, over the previous twelve months, in the retail prices index excludingmortgage interest payments RPI(X). The MPC has operational freedom how it meets thattarget. Decisions on what actions need to be taken to achieve the target are taken bythe MPC, on the basis of a majority vote. The MPC's main role each month is to makedecisions on the base rate of interest - the benchmark for the Central Bank's dailyoperational of monetary policy in the UK

Monetary Policy ActivismUp to August 2001, the MPC has taken fifty-one interest rate decisions and of thesetwenty changed the rate. On nine occasions the rate was raised and reduced eleventimes. On seventeen occasions the change was a 0.25% change and three times it hasbeen a 0.5% change. This total suggests that the Monetary Policy Committee prefers tomove in a series of small steps when changing the overall direction of policy. So,when monetary policy is being tightened, the MPC is likely to increase rates graduallyrather than in larger steps.

Monetary policy in the UK is now much more open and transparent than it was underprevious regimes. Minutes of MPC meetings are published with a two week delay. And theBank sets out its latest forecasts for inflation as well as a detailed assessment ofmacroeconomic conditions in the UK and overseas through the publication of a QuarterlyInflation Report.

All of Britain's main political parties now accept that the Bank of England shouldremain independent. The Conservatives changed their policy stance on this issue wellbefore the 2001 General Election. The Liberal Democrats have always supported grantingthe BoE full independence in setting interest rates.

The Gains From IndependenceFall in long term interest rates - long term rates incorporate expectations of futureinflation - Investors require a rate of interest that will take into account theexpected rate of inflation. If this falls then the rate of interestrequired by investors also falls. A fall in long term interest rates reduces the costof borrowing for companies, the government and also mortgage payers. Indeed by August2001, mortgage rates were at their lowest levels for forty years.

Inflation has continued to surprise people - the rate of underlying inflation sinceearly 1999 has persistently under-shot the mid range of the target level. In part thisis due to the sustained strength of the sterling exchange rate, particularly againstthe Euro since it was launched as a traded currency in January 1999. The Bank ofEngland has also been helped by a very benign global inflation environment. Consumerprice inflation in the G7 and OECD countries has been falling over the last ten years.

The general perception is that the Monetary Policy Committee has worked in aharmonious manner (there have been few if any public disagreements between MPCmembers) and that their deliberations have been genuinely free from politicalinfluence. Many industrial lobby groups, trade unions and other organisations seek toinfluence the MPC in the immediate run up to MPC meetings through the broadcast andprint media. And although the Bank might, on occasions be seen to have acted in parton the basis of special pleading - there is little substance to this as a criticism.

Inflation expectations have fallen in Britain. The Bank of England can claim somecredit for this - if people believe that price inflation is under control, this isfactored into their wage negotiations and helps to control wage inflation throughoutthe labour market.

CONCERNS ABOUT AN INDEPENDENT BANK

Monetary "fine-tuning" is an inexact science. Giving the Bank a degree of independenceis no guarantee of macro-economic stability in the long run. A recent study from theNational Institute of Economic and Social Research (NIESR) claimed that had the Bankkept interest rates at 6% during the first two and a half years of its life as anindependent bank, the final outcome in terms of output and inflation would beenbroadly similar from the actual out-turn.

MPC may react too easily to short-term economic indicators - it should engage in moreresearch about long-term economic trends (and structural changes in the economy) toaid its decision-making

If the BOE is too pessimistic about inflation risks in the economy - higher interestrates can impart a deflationary bias in the economy and risk an economic recession andhigher unemployment

Overly aggressive cutting of interest rates might also be de-stabilising for the UKeconomy in the medium term 

The Bank cannot determine inflation - only influence it in the medium term (the timelags involved are uncertain)

The Monetary Policy Committee has insufficient expertise in the areas of industry andthe labour market. It is dominated by Bank "insiders" and academics withinadequate real-world experience

Why did the New labour Government Grant Operational Independence to the Bank of England? INTRODUCTION One of the first acts of the New Labour government on coming to power in May 1997 was to grant operational1independence to the Bank of England. An independent Monetary Policy Committee (MPC) was set up within the Bank with responsibility for setting interest rates to meetthe government’s stated inflation target. This move arguably constituted one of the most significant institutional changes in the practice of UK economic policy in the last 60 years. However, given that interest rates are a powerful economic instrument and policy-lever, why did the government choose to cede these powers? 1 Within the central-bank literature, a distinction is made between goal and instrumental (or operational) independence. If a bank has goal independence then it can set the objectives of monetary policy, such as price stability or growth. If a central-bank has instrumental independence then the objectives of monetary policy are set externally but the bank is given the freedom to control the means by which to achieve its objectives. My objective in this dissertation will be to provide an answer to thatquestion. My approach will be to use two different strands of ‘new institutional’ theory to provide two different explanations. The first, based on rational choice institutional theory, provides what has come to be accepted as the ‘traditional’ theoretical explanation for central-bank independence. In brief outline, it contends that immediately before an election, office-seeking politicians motivated by their desire for reelection, manipulate the economy to create economic conditions favourable with the electorate but with negative long term consequences for the economy. The result is a political

business cycle; periods of pre-election boom followed by periods of post-election inflation. Central-bank independence therefore, is argued to solve this economic problem, by insulating monetary policy from political opportunism. In this dissertation, I challenge this traditional view, arguing that evidence for the existence of politicalbusiness cycles based on monetary manipulations, both in the UK and for other countries is far from conclusive. I also find that the economic conditions that would have warranted operational independenceto the Bank of England in 1997 were seemingly absent. Critically examining the theoretical foundations of this argument, I argue that political business cycle models make a number of assumptions that can be challenged. Firstly, although advocates of the2

rational choice explanation argue that governments can and do instigate inflationary shocks to coincide with the timing of elections, evidence shows that this is actually very difficult to do, significantly increasing the risks attached to doing so and so making manipulations unlikely. Secondly, I argue that the ways in which voters are assumed to form expectations and assessments in political business cycle models are unrealistic. Thirdly, I argue that the assumption of an exploitable trade-off between inflation and unemployment, central to political business cycle models, has been called into serious doubt by the stagflation of the 1970s and the ‘rational expectations’ revolution. Given that the evidence for the traditional view is shown to be far from conclusive, why then did New Labour decide to grant operational independence to the bank of England? My second explanation to the question of this dissertation, based on normative institutionalism, argues that rather than being a solution to a functional economic problem, central-bank independence was actually a way of enhancing public trust and political legitimacy at a time when public opinion was hostile towards politics and politicians. Responding to the publicmood, key figures within the Labour Party developed certain values formore accountable and decentralised government which make it possible to explain the decision as the discharge of a duty to restore public trust. Furthermore, I argue that operational independence was carried out as a wider exercise in the ‘new public management’ that resulted in specific form of delegation and that this allowed the government tosimultaneously benefit from the legitimising properties of delegation,whilst retaining strategic control over monetary policy. From this perspective, although operational independence was dysfunctional economically, it was a highly functional in terms of the social, symbolic and political benefits it brought. The dissertation shall take the following form. Chapter one introducesthe ‘new institutionalism’ and sets it in an historical context. The basic premises and assumptions that underlie rational choice institutional approaches are then outlined before describing some of the important applications of the approach. Against this background, the ‘traditional’ rational choice institutional explanation for central-bank independence is set out. Chapter two formally outlines three theoretical assumptions of the Nordhaus model of political business cycles. These assumptions are then critically assessed and the empirical evidence for the existence of political business cycles reviewed. The final section of this chapter looks at inflation and inflation expectations in Britain in 1997. I find the theoretical and empirical evidence for the existence of political business cycles

based on monetary manipulations to be far from conclusive and the economic conditions that would have recommended operational independence in 1997 Britain to be largely absent. Chapter three 3 introduces normative institutionalism and sets it in its historical context. The basic premises of the theory are outlined and against this background the normative institutional explanation of central-bank independence is presented. Chapter four presents evidence for public trust and the existence of certain values within the Labour party in 1997 before operational independence is discussed in and compared with aspects of ‘new public management’ doctrines. Chapter five discusses the aspects of operational independence that rational choice institutional approaches are unable to explain before examiningthe wider implications of the normative institutional explanation. Thefinal section concludes.

“Independence signifies ignoring pressures, whatever its source. The independence of central banksgoes, ... beyond independence from political, executive and legislative power. For me it also equateswith independence from private or collective economic interests, autonomy versus the short term,frequently imposed by capital markets and, finally, freedom of action vis-à-vis the monetary policy ofother central banks.”Prime Minister Lionel Jospin. Paris, May 2000.1. IntroductionI am extremely pleased at this invitation to present this inaugural address in the Reuters Forum Lectureseries. This is an important initiative and I wish you well for the sustained success of this lectureseries.We have chosen to discuss the issue of central bank independence sincethe topic is both current andhighly significant. Incidentally when the Banque de France organised their bicentennial celebrations inMay this year, they chose the topic of central bank independence as the theme for the colloquium.At the said Banque de France colloquium, the Prime Minister of the French Republic, MonsieurLionel Jospin remarked that: “the increased power and influence of central banks, the greater visibility

of their role and their leaders, have inevitably focused attention on their role, their efficiency, theprinciples underlying their actions and, in some cases, their place inthe democratic way of life.”Central banking is of cardinal importance in any country because of the legal right normally granted tocentral banks to create money. This money can serve as a means of payment, a unit of account and astore of value. One of the important issues immediately arising after granting this right to a centralbank, is whether this function should fall under the ultimate control of the executive branch ofgovernment - the cabinet and its administrative departments - or whether parliament should leave thisresponsibility to be freely executed by an independent, autonomous powerful institution run byunelected people.2. Advantages of an independent central bankThe traditional argument in favour of a strong, independent central bank is that the power to spendmoney should in some way be separated from the power to create money. Numerous episodes in theworld’s economic history testify to a government’s potential abuse of its power to create money.Around the third century AD in the Roman Empire, for instance, the silver coins collected by the taxauthorities were melted and combined with inferior metals, yielding many more coins to spend on theCaesar’s priorities than the initial tax take. With too much money chasing too few goods, the endresult was high inflation.Much the same has happened all too frequently with paper money systems. Many governments havegiven way to the temptation to reduce interest rates ahead of elections. This may boost spending andemployment in the short term, but ultimately it usually also causes higher inflation over the long term,unless the capacity of the economy can meet this higher level of demand. This higher inflation,however, only becomes apparent a couple of years later. An elected government concerned about itsimmediate popularity might be tempted to go for the short-term gains from lower interest rates, even at

BIS Review 88/2000 2the risk of promoting somewhat higher inflation further down the road,because some other politicalparty may then have to pick up the pieces.Central bankers normally operate on a longer-term time scale than politicians and therefore do not facethe same temptation to relax policy to achieve short-term objectives. By delegating decisions aboutinterest rates and other monetary matters to such an independent institution, with a clearly definedmandate, society can hope to achieve a better inflation outcome over the longer term.A number of studies have been undertaken to determine whether this argument is valid. These studiesall seem to come to the following three conclusions. Firstly, they provided evidence of a negativecorrelation between central bank independence and long-term inflation.A low inflation rate istherefore more likely to be found in countries with independent central banks than in countries wherethe central bank is subject to government control. Secondly, they showed that there is a negativecorrelation between central bank independence and the long-term budgetdeficit expressed as apercentage of a country’s gross national product. Countries with independent central banks tend tohave smaller budget deficits than those with government-controlled central banks. Thirdly, the studiesin general did not find any evidence of a correlation between the independent status of a central bankand production growth. It therefore does not follow that production oremployment will suffer as aresult of the independent status of the central banks over the medium to long term.3. Risks of central bank independenceSome critics of an independent central bank argue that although the average inflation rate and thedegree of central bank independence are negatively correlated, this relationship does not reflect anycausal link running from central bank independence to low inflation. They argue that countries wherethe electorate is particularly averse to inflation, are more willing to keep inflation down. These

countries are also more likely to have made their monetary authoritiesfunctionally independent so asto help preserve low inflation. Germany, affected severely by the hyperinflation of the WeimarRepublic, is an obvious case in point.Conversely, countries where the electorate are more tolerant of inflation, are also less inclined to seemonetary policy turned over to an autonomous central bank. These critics claim that average inflationis determined by history and the preferences of a country’s inhabitants with causality running frominflation to the institutional structure. According to this view, attempts to impose an independentcentral bank and with it a more purposeful anti-inflationary stance ina country tolerant of inflation, aredoomed to failure. The outcry against restrictive policies would simply be too great for the centralbank to withstand.This argument is not very convincing and does not seem to fit, for instance, the recent experience ofNew Zealand. For most of the postwar period the Reserve Bank of New Zealand was one of the leastindependent central banks in the OECD. However, in 1988 it was transformed into one of the mostautonomous, with a very clear mandate to fight inflation. This helped the inflation rate to plummetfrom double-digit levels to under 2%, which strongly suggests that thestructure of monetaryinstitutions together with the determination to combat inflation, can be highly successful.Another argument against the autonomy of central banks is that they form part of overall economicpolicy and that there can be no meaningful separation between fiscal policy, monetary policy, labourpolicy, trade policy or for that matter any other policy measures. If such a separation is attempted andif policies run at cross-purposes, then conflicting objectives will have to be solved one way or another.In the process, a conflict between the policies may inflict considerable damage on the economy. Thereis clearly substance in the argument that a tightly coordinated package of policies has a better chance

of success than a set of conflicting ones. It can nevertheless be argued that such conflicts may beinevitable over the short term, as long as central banks have the primary responsibility for controllinginflation. However, over the long term, stable financial conditions promote sustainably highereconomic growth rates, increased welfare and more employment opportunities.The main criticism against making central banks autonomous entities isbased not so much oneconomic as on political arguments. The political argument is that turning over decisions about3 BIS Review 88/2000interest rates, exchange rates, the efficiency of the financial systemand other monetary matters to abody of unelected officials, is simply “undemocratic”. In a democraticsociety, it is argued, alldecisions should be subject to scrutiny by the elected members of the legislature and the concept of anautonomous central bank is therefore not acceptable. Although there are plenty of other areas ofnational life where decision making is delegated to independent unelected officials - the judiciary is aprime example - there is a fundamental confusion here between being independent and lackingaccountability. No central bank can be totally independent, in the sense that it is not answerable toanyone. Even the most autonomous central bank has to report in some form or another to thelegislature, which in any case also has the ultimate power to change the laws governing the centralbank. All the same, there is a difference between a situation where policy decisions are undercontinuous scrutiny, and an arrangement where the central bank reportsto the legislature periodically.The issue of independence and accountability also turns on the nature of the relationship between thegovernment and the legislature as the political authorities on the onehand and the central bank on theother. At the same colloquium mentioned above, Monsieur Jean-Claude Trichet, Governor of theBanque de France, observed that: “respecting independence does not mean a lack of dialogue, on the

contrary. However, it is true that an independent central bank is neither accountable to the executivepower, nor to parliament, nor any other political institution. In France this was decided by the lawmakers, and in Europe by the will of the people and the European Parliaments, which ratified theMaastricht Treaty.”In the case of the European Central Bank (ECB), the independence of the Bank is explained underArticle 7 of the Statute which says that: “When exercising the powers and carrying out the tasks andduties conferred on them by this Treaty and this Statute, neither the ECB, nor a national bank, nor anymember of their decision-making bodies shall seek or take instructionsfrom community institutions orbodies, from any government of a member state or from any other body.”The key issues here quite clearly are independence, accountability anddialogue with the politicalauthorities.In South Africa the Governor of the Reserve Bank must submit a report annually to the Minister ofFinance relating to the implementation of monetary policy. In terms ofSection 32 of the Reserve BankAct, the Bank must also on a monthly basis submit a statement of assets and liabilities and annually itsfinancial statements to the Department of Finance. These reports are then tabled in Parliament by theMinister of Finance.Moreover, Section 37 of the Act provides further that if at any time the Minister of Finance is of theopinion that the Bank has failed to comply with any provision of the act or of a regulation madethereunder, he may by notice in writing require the Board of the Bank to make good or remedy thedefault within a specified time. If the Board fails to comply with such a notice, the Minister may applyto the Supreme Court for an order compelling the Board to make good orremedy the default, and theCourt may make such order thereon as it deems fit.4. Conditions for independenceIn view of these risks involved in central bank independence, there are usually three preconditions for

central bank autonomy. Firstly, there should be a clearly spelled out legal and operational frameworkin which monetary policy is conducted. In the legal framework, the central bank’s independenceshould be defined to avoid any misconceptions of what the central bankis supposed to achieve. In themonetary policy framework, the central bank must indicate what it is attempting to achieve, whatoperational variables it will apply and what monetary instruments it will use to achieve its objective.Because credibility is usually not gained overnight, it is important that a longer-term programmeshould be drawn up to show how the central bank will fulfil its mission.A second condition for greater autonomy is transparency. The government and the public shouldcontinuously be informed of the monetary policy programme followed by the central bank. Regulardiscussions between the central bank and the government will be necessary and some form ofaccountability to parliament will have to be established. It is also important to explain monetary policyBIS Review 88/2000 4decisions regularly to the public, together with an assessment of the progress made in achieving statedobjectives. Priorities in the programme as well as operational instruments should be clearly spelledout, in order to keep the public well informed about developments and changes in monetary policy.The third condition for central bank autonomy is the creation of an efficient institutional frameworkwithin which decisions on monetary policy and on its implementation can be made, without undueinterference by political functionaries. This involves decisions regarding:(i) functional independence, which means the right to decide on all matters regarding monetarypolicy and price stability;(ii) personnel independence, which covers the selection and appointment of Board memberswith a high professional competence and without an obligation to yieldto political and otherpressures;

(iii) instrumental independence, which means control over the instruments that affect theinflation process, including in particular the prevention of any direct financing ofgovernment deficits; and(iv) financial independence, which requires the central bank to have access to adequate financialresources of its own and full control over its own budget.