A Fashion For Independence

In granting the Bank independent control over interest rates, Gordon Brown, the chancellor, has shown himself a dedicated follower of fashion.

Since the late eighties more than 25 countries have increased the legal independence which their central banks enjoy and the UK is the last of the group of seven (G-7) leading industrial nations to embrace this received wisdom.

The theoretical justification for central bank independence is straightforward. Governments and electorates are assumed to desire both low inflation and high employment.

If the government promises to deliver low inflation, this encourages employees to accept modest pay settlements in the belief that the real value of the wages they bargain will not be eroded by unexpected price increases.

 

Unfortunately, once these wage contracts have been signed, it is in the governments interest to break its promise. By cutting interest rates and pushing up inflation, it can reduce the real value of pay settlements and increase employment temporarily. Unfortunately, employees will soon come to realise this and demand higher pay settlements in advance to compensate for the inflation they have learned to expect. Their expectations thus become self-fulfilling.

The political cycle causes a similar problem. In the run-up to elections governments may be tempted to cut interest rates or to avoid raising them in order to put money in the pockets of voters with floating-rate mortgage debts. Because interest rate changes take 18 months or so fully to affect economic activity and prices, the inflationary side-effects can usually be postponed until well after polling day.

Professor Kenneth Rogoff, at the University of California (Berkeley), argued that these problems could be resolved by handing control of interest rates to an unelected central bank with a longer-term time horizon and greater hostility to inflation than either voters or politicians.

Appointing an independent central bank should have three consequences for a countrys economic performance. First, inflation should be lower, because an independent central bank will not be tempted to bribe the voters or spring inflationary surprises on wage bargainers. Second, economic growth should be stronger, because inflation supposedly deters investment and makes the economy work less efficiently by obscuring changes in relative prices. Third, an independent central bank should be able to reduce inflation at less cost to jobs and incomes because wage bargainers will believe its promises and moderate their pay demands more quickly.

To test whether these theoretical predictions are borne out in reality, economists have compiled indices to measure the independence of particular central banks. These are compiled from various criteria, such as the tenure of the central bank governor and the services it has to provide the finance ministry. Studies looking at the relationship between indices of central bank independence and economic performance have yielded a number of conclusions, not all of which accord with the theory.

First, independent central banks do seem to preside over lower inflation. According to one study of industrial countries in the eighties, inflation averaged less than five per cent under the three most independent central banks and more than 15 per cent under the three least independent.

But various economist have warned that this association does not necessarily imply casualty. Low inflation may be the result of enthusiasm for price stability on the part of the electorate or a powerful financial sector, which in turn creates political pressures for central bank independence. But in the absence of these prior factors, boosting central bank independence may have little effect.

Assume, for the sake of argument, that central bank independence does cause low inflation. What impact does this have on long-term economic growth? Precious little, according to the empirical evidence. There is no significant difference between the growth rates enjoyed by countries with independent central banks and those without.

Advocates of independence conclude that depoliticising interest rate setting offers a free lunch, achieving lower inflation at no cost to real economic performance. But where does this leave the argument that we should pursue low inflation precisely because it stimulates investment and growth?

Unfortunately, as Michael Sarel of the International Monetary Fund has demonstrated, there is no evidence that reducing inflation below eight per cent or so improves long-term growth.

The failure of independent central banks to stimulate growth may be disappointing and at odds with economic theory, but one might argue that their ability to produce lower inflation is reason enough to adopt them. Remember, though, that reducing inflation has a temporary cost, as unemployment has to be raised above its so-called natural rate for as long as it takes wage bargainers to reduce their expectations of inflation.

People should reduce their expectations of inflation more quickly under an independent central bank because they will have greater faith in its promises than in those of a government grubbing for votes.

Nonetheless, four out of five recent studies have found that the temporary cost of reducing inflation is higher under independent central banks than dependent ones. That counter-intuitive finding is mirrored by evidence that independent central banks also preside over deeper recessions.

So much for a free lunch. If international evidence is anything to go by, Mr Browns decision to abdicate responsibility for interest rates to the Bank will mean that more people have to lose their jobs in order to achieve his inflation target than if he did the job himself.

The benefits of central bank freedom are by no means clear cut, says Robert Chote