The dominant discourse of central bank independence

Abstract

The period from 1960 to 2000 saw a major evolution in monetary policy and institutions. This dissertation makes the claim that there is a better explanation of these events than the typical narrative, or dominant discourse.

The typical narrative is that a relationship between inflation and unemployment (the Phillips Curve) was proposed around 1960. One interpretation of the relationship was that increasing aggregate demand would reduce unemployment with some acceptable inflation. Milton Friedman then stated in 1968 that, in the long run, this practice would entrench inflationary expectations and there would be no useful employment benefits. This was accepted by the economics profession, especially by the mid-1970s, around the time of the first oil shock. This period also saw the rise of stagflation and the countries that managed the inflationary outbreak best were those where independent central banks were able to withstand politicians’ short term instincts. Economists attributed this to a commitment concept; if governments could override their central bank only at the cost of legislation or constitutional change, then monetary policy would focus more on long term expectations, rather than the political short term. Empirical work in the 1990s established this relationship and many countries made their central banks more independent during this decade.

A better view acknowledges some features of this narrative. For example, Milton Friedman’s theory of expectations was very influential. (Chapter 2). But there is reduced evidence for the rest of this narrative. For example, the Federal Reserve did tighten monetary policy after 1982 compared with the period before 1979, but this appears to have been through placing less emphasis on output instead of being more inflation averse. Further, policymakers in the late 1960s and 1970s underestimated the level of unemployment at which inflation started increasing. (Chapter 3). Politicians were generally involved in disinflations, but their role and visibility decreased as legal inflation and central bank independence (CBI) increased. This suggests that, in practice, legal independence bestows the disinflation role on the central bank (Chapter 4). The role of politicians, however, is not fully clear because the proportion of elections where a voter backlash against inflation occurred was small. Therefore, the political dynamic against inflation may have occurred through elites, rather than popular opinion (Chapter 5). Finally, there was not a strong correlation between CBI in developed countries because the literature made errors of omitted variable bias and not examining whether CBI was endogenous. Inflation in the 1970s and 1980s was more clearly related to economic factors such as currency performance, output, past inflation, oil prices, and a time trend (Chapter 6).

The weakness of CBI theory is that, by excluding politics, it overstates the costs of overriding a central bank. If there is little popular support for disinflation, then the costs of overriding the central bank will be low, regardless of the legal arrangements in place. Central banks perceive this and deliver policy within the politically palatable decision set. Show more