Central Bank Independence and Macroeconomic Performance - Seminar on The Future of Monetary...

8/14/2019 Central Bank Independence and Macroeconomic Performance - Seminar on The Future of Monetary Integration in

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Table of ContentsList of Abbreviations .............................................................................................. II

List of Illustrations ................................................................................................. III

List of Tables ......................................................................................................... IV

1 Abstract .............................................................................................................. 6

2 Introduction........................................................................................................ 6

3 Historical Evolution of Central Bank independence ......................................... 7

3.1 Changes in Central Bank Independence ...................................................... 7

3.2 Reasons ...................................................................................................... 12

4 Central Bank independence and Inflation........................................................ 13

4.1 Theoretical predictions ............................................................................. 13

4.1.1 Impact of Inflation ................................................................................ 13

4.1.2 The Credibility Problem ....................................................................... 14

4.1.3 The Solution: Conservatism and Independence ................................... 16

4.2 Empirical findings .................................................................................... 17

4.2.1 Measuring Central Bank independence ............................................. 17

4.2.1.1 Legal Central Bank independence ................................................... 17

4.2.1.1.1 Criteria for legal Central Bank independence ............................. 17

4.2.1.1.2 Variable aggregation ................................................................... 19

4.2.1.2 Governor turnover rate (TOR) ......................................................... 20

4.2.1.3 Questionnaire on Central Bank independence ................................. 20

4.2.2 Modeling the relationship .................................................................. 21

4.2.3 Results and interpretation ................................................................... 21

4.2.4 Central Bank independence and Inflation variability ......................... 24

5 Central Bank independence and real macroeconomic variables ..................... 25

5.1 Central Bank independence, GDP growth and investment ...................... 25

5.2 Central Bank independence and interest rates ......................................... 26

5.3 Central Bank independence, wages and unemployment .......................... 28

6 Criticisms of Central Bank independence ....................................................... 296.1 Methodological issues .............................................................................. 30


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6.2 Subjectivity .............................................................................................. 32

6.3 Robustness................................................................................................ 35

6.3.1 Control Variables ............................................................................... 35

6.3.2 Observation Periods ........................................................................... 38

6.4 Causality .................................................................................................. 39

6.5 Disinflationary credibility ........................................................................ 44

6.6 Wage demands ......................................................................................... 47

6.7 Alternatives .............................................................................................. 48

6.7.1 Forms of exchange rate fixation ......................................................... 48

6.7.2 Inflation contracts ............................................................................... 49

6.7.3 Inflation targets .................................................................................. 50

7 Conclusion ....................................................................................................... 50

References.............................................................................................................. 52


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List of Abbreviations

GDP Gross Domestic Product

EEC European Economic CommunityECB European Central Bank

CBI Central Bank independence

LCBI Legal central bank independence index

TOR Turnover rate of central bank governor

GMT Legal central bank index by Grilli, Masciandaro, Tabellini (1991)

A/PD Legal central bank index by Alesina (1988) based on Parkin and

Bade (1985)

CWN Legal central bank index by Cukierman, Webb and Neyapti (1992)

QCBI Central bank independence index based on a questionnaire

IQ Institutional Quality

FOI Financial opposition to inflation


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List of Illustrations

Figure 1: The evolution of central bank independence and inflation ....................... 9

Figure 2: Average Aggregate Index of Legal Independence, in Chile and 9 Latin

American Economies .............................................................................. 10

Figure 3: Legal Central Bank Independence in Selected Former Socialist Econo-

mies ......................................................................................................... 11

Figure 4: Partial relation of Inflation to the Legal Independence and to the Turno-

ver Rate of Governors of Central Banks in Industrial and Developing

Countries ................................................................................................. 22

Figure 5: Relation between legal CBI and inflation in two different periods ....... 23

Figure 6: Scatterplot: Central Bank independence and Average Real GNP Growth

................................................................................................................ 26

Figure 7: Scatterplot: Central Bank independence and Average Real Interest Rate

................................................................................................................ 27

Figure 8: Scatterplot: Central Bank independence and Variance of Real Interest

Rate ......................................................................................................... 28

Figure 9: Scatterplot: Central Bank independence and Average Unemployment . 29

Figure 10: Varying independence rank of the United Kingdom ........................... 34

Figure 11: Correlation between CBI and FOI and CBI and Average Inflation ..... 40

Figure 12: Inflation aversion for 10 core EU countries and average inflation rates

................................................................................................................ 43

List of Tables

Table 1: Institutional determinants of CBI in the literature .................................. 32

Table 2: Correlation coefficients between different measures of CBI ................. 33


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1. Abstract

This paper critically analyzes the historical evolution of central bank independ-

ence, its theoretical foundations and the empirical studies on its impact on infla-

tion and real macroeconomic variables. The results show that to date, no reliable

confirmation of the favorable effect of central bank independence on price stabil-

ity has been provided. Moreover, several aspects of the underlying theory remain

questionable. The impact of central bank independence appears to be contingent

upon other factors that have yet to be explored in detail.

2. Introduction

The recent events surrounding the financial crisis in Greece and its bailout by the

European Central Bank in violation of article III-183 of the Maastricht Treaty

which states that The union shall not be liable for or assume the commitments of

central governments raises the question whether central bank is really independ-

ent from political influence. This, in turn, raises also the question whether central

bank independence is an important aspect of the monetary system.

Throughout the last decade, central bank independence, defined by The New Pal-

grave Dictionary of Economics as freedom of monetary policymakers from di-

rect political or governmental influence in the conduct of policy has gained in-

creasing popularity among economists and politicians around the globe.

The aim of this paper is to present the theoretical foundations and empirical find-

ings which have led to the widespread acceptance of independence as a funda-

mental element of central bank design. This work is organized as follows:

Chapter 3 outlines the institutional changes that have occurred over the last twenty

years and discusses the reasons for the shift towards higher degrees of central

bank independence.


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Chapter 4 illustrates the theoretical foundations and predicted benefits of central

bank independence and presents empirical evidence for the negative relation be-

tween central bank independence and the average rate of inflation.

In Chapter 5 the relation between central bank independence and real macroeco-

nomic variables such as GDP growth and unemployment are analyzed.

Chapter 6 provides a survey of major points of criticism in literature and thorough

evaluation of them.

Finally, Chapter 7 summarizes the preceding chapter and draws a conclusion.

3. Historical Evolution of Central Bank Independence

3.1 Changes in Central Bank Independence

Today, central banks legal and actual independence is considerably higher than

20 years ago. Before the 1990s, central banks autonomy did not seem to be that

needful for maintaining price stability and economic welfare. At that time, most of

central banks did not even have legal autonomy or instrument independence, lim-

iting their scope of action by being just a department of ministries of finance.

Nevertheless, it cannot be merely affirmed that legal and actual independence did

not exist at all. In fact, in some developed countries such as Japan, UK, USA and

West Germany, central banks possessed a certain degree of legal autonomy, with

price stability being one of their main objectives. However, unlike in our days, inthe majority of countries price stability did not receive special attention from the

central bank, belonging thus just to a group of several objectives such as steady

growth, higher levels of employment or the financing of the governments public

expenditures. It must be also noted that in another group of countries central bank

did not even possess instrument independence so that price stability was main-

tained merely by the ministry of finance. ( Cukierman , 2006)


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Although some central banks possessed a certain degree of legal autonomy, the

level of actual independence was basically lower than the level indicated in the

law, particularly in developing countries. In other words, actual independence

showed wide deviations from legal independence ( Cukierman , 2006).

But things are different today. Throughout the last 20 years, most central banks

have substantially increased their levels of statutory independence. Nowadays,

central banks main objective is to ensure price and financial stability. There is

much evidence confirming the dramatic increase of legal central bank independ-

ence in the 1990s worldwide.

This statement is based on a number of legal indices developed by different au-

thors such as Cukierman (1992) and Cukierman, Webb , and Neyapti (1992), on

updates of the Grilli, Masciandaro , and Tabellini (1991) index, and the index of

Cukierman, Miller , and Neyapti (2002) regarding twenty-six former socialist

economies in the 1990s. Additionally, it has been also taken into account the work

by Jacome and Vazquez (2005), which provides an index for twenty-four Latin

American and Caribbean countries ( Cukierman , 2006).

Figure 1 displays the evolution of central bank independence from the 1980s to

2003 for 69 countries, separately for OECD and non-OECD countries. As the

graphic shows, the majority of central banks have become more independent. As

an example, OECD countries have on average experienced a reduction in average

inflation by 15 percentages while CBI has on average increased by 0.30.

( Markwardt and Hielscher , 2011)


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Source: Markwardt and Hielscher, (2011). Indicators of central bank independ-

ence are taken from Cukierman et al. (1992) and Crowe and Meade (2007). Coun-

tries with inflation rates above 50% are excluded from the figure.

In addition average inflation rates have decreased in almost all countries, both

OECD and non-OECD countries alike.

Furthermore, the Maastricht Treaty signed by the European Economic Communi-

ty (EEC), has enabled the European Central Bank (ECB) to pursue monetary poli-

cy independent of national governments. For this reason, all the countries that

joined the European Monetary Union have upgraded their level of legal independ-ence to that of the Bundesbank since the 1980s. In the same manner, the United

Kingdom granted the Bank of England full autonomy in 1997. ( Cukierman , 2006)

Figure 2 shows the evolution of average legal independence in Chile (dark bar)

and nine Latin American countries (light bar) during the last fifty years based on

the legal Central Bank Independence Index (CWN Index) by Cukierman et al.

(1992).


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Source: Cukierman , (2006). Calculations based on data from Cukierman, Webb

and Neyapti (1992) and Jacome and Vazquez (2005).

1

The graphic shows that on average, legal independence has increased over the

years. After around forty years of relative immobility in central bank legislation,

the level of legal independence took a quantum leap in the 1990s, not only in de-

veloped countries but also in developing countries ( Cukierman , 2004).

Chile shows a similar trend to that of the other countries, but the level attained

over the 1990s is higher than the average level of the other Latin American coun-tries.

Although Jacome and Vazquez (2005) did not take into account every country for

their study, it illustrates that in general, CBI increased steadily over the years.

1 Notes:The figure combines data on the aggregate index of legal independence, CWN, from table A1in Cukierman, Webb and Neyapti (1992) for the forty years between 1950 and 1989 with dataon the same index for the 1990s from Appendix II in Jacome and Vazquez (2005) for Chile andfor nine other Latin American countries, namely Argentina, Bolivia, Colombia, Honduras, Mex-ico, Nicaragua, Peru, Uruguay and Venezuela.


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Figure 3 presents the average value of the legal CBI index (CWN) for six Former

Socialist Economies, namely Croatia, Hungary, Macedonia, Poland, Romania and

Slovenia. The legal reforms they instituted, mainly in the early 1990s, represent

about a tripling of the CWN index developed in Cukierman, Webb, and Neyapti

(1992). ( Cukierman , 2006)

Source: Adapted from table 1 in Cukierman, Miller and Neyapti (2002). 2

The bar for period 1 reflects the average level of legal independence in those

countries prior to the central bank reforms of the nineties. The bar for period 2

reflects the average level of legal independence in those countries after the last

central bank reform between the early nineties and 1997. ( Cukierman, Miller and

Neyapti , 2002).

The former socialist economies had two central bank reforms in the 1990s at in-

tervals of about five years, in order to incorporate a uniformly higher level of in- 2 Notes:The figure shows the average value of the CWN index (see remark to figure 1 fordetails) for six Former Socialist Economies which were not part of the Soviet empireand had, consequently, central bank laws prior to the downfall of the Soviet Union.


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dependence. This fact supports the view that the trend toward legal independence

intensified in the 1990s (Cukierman, Miller and Neyapti, 2002).

In summary, the sources cited above appear to support the conclusion that legal

independence levels experienced a sustained increase in the 1990s worldwide.

3.2 Reasons

The indicators showing the tendency towards increased central bank independence

(CBI) in the last 20 years were presented in the previous section. But why did

central bank independence level actually rise so much since the 1990s? According

to Cukierman (2006), this quantum leap of legal independence was the result of a

combination between global and regional factors. The following reasons were put

forward by Cukierman (2006) and try to explain the reasons for this increase.

The stagflation of the 1970s and the poor economic performance of high-inflation

countries in Latin America in comparison to the good performance of low-

inflation countries such as Germany or Japan increased a worldwide quest for

price stability.

In addition, as mentioned above the low inflation level achieved by the highly

independent Bundesbank and the Central Bank of Japan until the 1980s seemed to

give evidence that central bank independence could be an effective tool to achieve

price stability.

Complementarily, new theories such as Rogoff s work The Optimal Degree of

Commitment to an intermediate Monetary Target (1985) suggested a relation

between central bank independence and the level of inflation.

Furthermore, regional treaties like the Maastricht Treaty signed by the European

Economic Community (EEC) in 1992, helped to raise the central bank independ-

ence since a precondition for membership in the European Monetary Union

(EMU) was the upgrade of their central banks independence.

Finally, globalization increased foreign investment by dismantling controls oncapital flows. The incentive for investors to enter new foreign markets raised the


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necessity of governments to maintain price stability, in order to capture the big-

gest quantity of private investment.

According to Cukierman (2006) these events finally led to the general acceptance

that inflation deteriorates the economy and price stability should be placed as the

most important goal for central banks. To achieve fiscal stability and consequently

a superior economic performance, central bank independence could be the accu-

rate tool.

These factors explain at least in part the significant development of central bank

independence outlined in chapter 3.1.

4. CBI and Inflation

4.1 Theoretical predictions

4.1.1. Impact of Inflation

Experience has shown over the years that high and volatile inflation can have

dramatic economic and social consequences. High inflation if it is not controlled

on time- can lead to a breakdown of the economy, being therefore inflation and

output growth negatively correlated in high-inflation countries ( King , 2004).

It is relevant to mention that the impact of inflation depends partly on whether

inflation is anticipated or unanticipated. As a principle feature of the anticipated

inflation, it can be pointed out that economic agents begin their protection by

making predictions about future inflation rates. For instance, in case of a steady

inflation increase, labour unions may negotiate with employers to increase thewages level in order to protect their real wages. They would basically try to main-

tain their real living standards. As a result, companies costs would rise, forcing

employers to settle a higher selling price so that no changes in their profits are

produced. Consequently, this would create further pressure on wages. This pro-

cess is known as wage-price spiral which results in further inflation or even

unemployment. ( Fischer , 1982)


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On the other side, unanticipated inflation refers to the difficulty of economic ac-

tors to predict correctly the rate of inflation in the near future, especially if infla-

tion is volatile every year. This can result in errors in their inflation forecasts, los-

ing, as a consequence, part of their real income. This is the so called money illu-

sion. Here, the economic actors confuse nominal and real values and make bad

decisions regarding their financial plans. ( Riley , 2006)

Additionally, from an investors point of view, budgeting becomes more difficult

as a result of the constant rise of prices and costs. Price instability could therefore

demotivate them to invest in some countries. It should not be forgotten that lower

investment has a negative effect on the economys long run growth potential.

Moreover, at least until exchange rate mechanisms adjust relative prices, a loss in

international competitiveness is caused whenever a country experiences a higher

rate of inflation than another, resulting in a worse trade performance. For the

country in question this causes a higher unemployment. ( Ci kowicz and Rzo ca ,

2010)

Furthermore, the consequences of inflation on society are considerable. After an

increase in inflation a redistribution of income normally takes place. There is a

negative impact of inflation on savers. As a result of a rise in the price level, mon-

ey loses its value; thus savers will lose money if nominal interest rates are lower

than inflation rate since it leads to negative real interest rate. ( Mankiw , 2008)

Based on the reasons presented above, it seems to be of extreme importance to

have inflation continuously under control. The task for the government is to find a

monetary institutional structure that stabilizes prices. Nowadays, governments aremore aware of this matter, paying special attention to the causes, consequences

and solutions for inflation. Theories and facts appear to show a negative relation

between inflation and central bank independence, suggesting as a remedy for high

inflation rates the increase of central bank independence.

4.1.2. The Credibility Problem


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This section analyses the theoretical foundations the effect of central bank inde-

pendence on inflation.

Barron and Gordons theory (1983) is maybe the strongest influence for all later

central bank independence developments. They based their studies on the work of

Kydland and Prescott (1977) and the time-inconsistent behavior explained in it.

Barron and Gordon (1983) consider a social welfare maximizer who has complete

control over the rate of inflation and whose goals are determined over employ-

ment and inflation. They assert that any deviation from prefixed employment and

inflation target levels causes increasing marginal benefits that outweigh marginal

losses from increased inflation.

For instance, inflation reduces real wages due to the fact that nominal wage con-

tracts are fixed over a period of time. Inflation would however create more output

since it would be cheaper for employers to contract additional workers and in-

crease output. Furthermore, monetary stimulation of the economy through lower

interest rates and consequently higher investment thanks to lower capital costs

would be more effective, as labor costs remain unchanged until the expiration of

the wage contracts. This would result in higher output and lower rates of unem-

ployment, goals favored by the government especially in times of election.

For that reason, although the central bank announces an inflation target, there is

always an incentive for the welfare maximizing government to exercise influence

on the central bank and its monetary policy so that it lets the inflation rate rise

above the announced rate in order to attain higher output. This incentive increases

especially once wages are set ( Hayo and Hefeker , 2007).

Because private agents are assumed to be forward-looking, they recognize the

welfare maximizers incentive to increase the money supply beyond the an-

nounced target, and incorporate this expectation in their wage demands. ( Barron

& Gordon , 1983).

Consequently, there is an increase in the inflation rate as well as in the wage level.

In other words, no output and no employment gain will be produced, but just a

positive rate of inflation which lies above the natural rate. This is the so-calledinflationary bias ( Hayo and Hefeker , 2007).


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Therefore, a mechanism should be devised which makes policy announcements

credible again and eliminates the inflationary bias.

4.1.3 The Solution: Conservatism and Independence

In order to solve the credibility problem, Rogoff (1985) suggested the appointment

of a conservative central banker and the granting of independence to the central

bank.

Society can make itself better off by selecting an agent to head the independentcentral bank who is known to place greater weight on inflation stabilization (rela-

tive to unemployment stabilization) than is embodied in the social loss function.

( Rogoff , 1985). According to him, Central bank independence can be conducted

firstly by nominating a conservative central banker and giving him the authority to

apply arbitrarily any monetary policy. In other words, to nominate a central bank-

er who presents a stronger ant-inflationary attitude than the rest of the society and

granting him independence from government influence.

The mechanism suggests appointing someone whose preferences are known to

diverge from those of the welfare maximizing authority. If someone who puts

more relative weight on avoiding inflation than unemployment were to set mone-

tary policy, the rate of inflation would be lower ( Hayo and Hefeker , 2007).

The reason is that wage setters would no longer need to anticipate a higher infla-

tion rate above the announced inflation targets since government would no longer

exercise influence on the monetary policy in order to increase output and em-

ployment. Knowing the inflation target -fixed and carried out by the conservative

central banker- wage setters do not have the necessity to demand higher wages

than needed since they do not have to fear that the conservative central banker

will renege on his announced target rate ( Hayo and Hefeker , 2007)


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Thus, appointing a conservative central banker can help to reduce the inflation

bias, although the possible decisions taken by the Central bank are not always the

most accurate solutions from a social point of view ( Rogoff , 1985).

4.2 Empirical findings

In pursuit of a confirmation of the theoretical assumptions, since the beginning of

the 1990s several economists conducted empirical studies regarding the real effect

of CBI on average inflation, the most prominent of them being Parkin and Bade

(1988), Alesina (1988), Grilli, Masciandaro and Tabellini (1991) and Cukierman,

Webb and Neyapti (1992), in the order of their publications.

Before a relation between CBI and inflation can be established, a method to

measure CBI has to be devised first. The following section will explain the ap-

proaches of the aforementioned authors. For the sake of conciseness and to avoid

redundancy, we limit our illustration of the methodology to the work of Cukier-

man, Webb and Neyapti (1992). We believe that this is justified for two reasons.

First, the 4 studies used very similar approaches and reached the same conclu-

sions. Second, a wider sample of countries and a new measure for central bank

independence, the turnover rate of the central bank governor is used. Third, the

study of Cukierman et al. (1992) is the most recent of the named studies, so it

should take into account possible methodological issues occurred in previous pub-

lications.

Subsequently, the results will be analyzed.

4.2.1 Measuring Central Bank Independence

4.2.1.1 Legal Central Bank independence

4.2.1.1.1 Criteria for legal Central Bank Independence

Defining a measure for central bank indepedence is not a self-evident task. As

Cukierman, Webb and Neyapti (1992) put it: Unavoidably, there were subjectiveor arbitrary decisions in coding, classifying, and weighing. Other authors made


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similar remarks 3, each showing the difficulty of finding an appropriate measure

that reflects CBI. The closest proxy the authors find for representing a banks in-

dependence are the statutory rules encoded in the law, which would be the first-

best solution if they were followed exactly in reality. The CBI indicator based on

legal provisions is often referred to as the legal indicator.

To compose their legal indicator, Cukierman, Webb and Neyapti (1992) created 4

different groups of legal characteristics. The first cluster regards the person of the

central bank governor. Each countrys laws were scrutinized to find out how the

highest executive authority can be influenced by the government, namely through

his appointment, dismissal and term of office. If the government has great influ-

ence on deciding about the person of the governor, it is more likely to see a gov-

ernor appointed that acts in line with the governments expectations. If the theory

holds that the central bank is more inflation-averse than the government, the pow-

er of the government to select the governor could compromise any objective of

the bank to hold prices stable.

Similarily, a relatively short term of office could induce the governor to fulfill the

governments monetary desires, in the hope that he will not be replaced. Long

terms of office, especially relative to the politicians terms of office, can in turn

increase independent behaviour by the central bank governor, as he can define and

apply his own monetary policies without the risk of being penalyzed by dismissal.

Moreover, the possibility for the central bank governor to hold other offices in

government can compromise his independence, so this aspect too is included in

this group of characteristics.

The second group of characteristics is concerned with monetary policy formula-

tion. It should be obvious that a high degree of participation of the government inthis process can lead to higher inflation if the government prefers an expansionary

policy while the central bank is committed to a more restrictive intervention in the

money market.

3 Alesina (1988): These tests require first a classification of the degree of of dif-

ferent Central Banks, which is not easy to compute.


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Beside policy authority, the second category also embraces an index for the reso-

lution of conflicts that may arise between government and the central bank during

the policy determination process. Who will have the final say in case no compro-

mise can be reached? If it is the central bank then the central bank can be assumed

to be more independent. On the other side of the scale, if the last word is with the

government, de jure policy setting authority will not influence de facto independ-

ence positively. Between the two, various shades of grey exist. A third character-

istic regarding the role of the central bank in the governments budgeting process

complements the policy index group.

Not less important than the previous two groups is the third, which covers the

banks objectives. Ceteris paribus, if a central banks statutes state price stability

as the only or most important objective, Cukierman, Webb and Neyapti (1992)

consider the central bank as more independent, compared to, for instance, a provi-

sion where economic growth or full employment is the primary goal and price

stability is subordinated, at best.

It might be surprising that the objective enters the CBI indicator, despite the fact

that from a logical point of view, the objective itself cannot be an indicator of

CBI, as the definition of CBI is the extent to which the objective (namely of low

inflation) can be attained. However, if the CBI is interpreted in a broader sense, as

the independence of the central bank in the pursuit of low inflation, the objective

of low inflation can be seen as a prerequisite and thus be included in the array of

indices that make up CBI.

The fourth and final group of legal independence indices addresses lending prac-

tices. Limiting the ability of the government to borrow directly from the govern-

ment, be it through absolute prohibition or clearly defined lending conditions suchas interest rate and maturity, can enhance CBI. If, on the other hand, the govern-

ment had carte blanche as far as borrowing from the central bank is concerned, a

tendency towards high inflation could be expected, provided that the government

resorted to this source of debt funding in an abusive manner.

4.2.1.1.2 Variable aggregation


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Once they have attributed a value between 0 and 1 to each particular index of the

groups of characteristics, with 1 being the value denoting the highest conducive-

ness to independence, the average of each group is created, before the groups are

weighted according to their presumed significance for independence, and summed

up to result in the legal CBI index.

4.2.1.2 Governor turnover rate (TOR)

In addition and in contrast to previous studies, Cukierman, Webb and Neyapti

(1992) not only relied on the legal CBI indicator, but also on two informal CBI

indicators, one of them being the turnover rate of the central bank governor.

The authors correctly recognized 4 that the legal CBI can only approximate real

CBI, either because legal provisions are incomplete and the void is filled by tradi-

tional conduct and the bank officials personal discretion, or because the laws are

not followed in practice.

To overcome the gap between legal CBI and real CBI, the authors use the average

actual term of office of the central bank governor as a proxy. The rationale behind

this measure is that with a high replacement frequency, the government has more

opportunities to place a person at the top of the central bank that endorses the

governments monetary policies, provided that their influence on governor selec-

tion is sufficiently high. Furthermore, if the term of office of the central bank gov-

ernor does not extend beyond the term of office of the elected government, this

may deter the former from implementing long-term policies focused on price sta-

bility. However, Cukierman et al. (1992) warn that caution should be applied

when interpreting a very low TOR, since it could imply the presence of either avery independent governor, or of a very subservient one.

4.2.1.3 Questionnaire on Central Bank independence

4 As an example, they offer the example of Argentina, where the governor resigns whenever thegovernment changes, despite the legal provision of a 4-year term of office (pp. 362-363)


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To complement the other two measures, Cukierman, Webb and Neyapti (1992)

created a third variable based on a questionnaire sent to a number of representa-

tive specialists on monetary policy in the central banks of various countries. Re-

spondants to this questionnaire had to answer questions on criteria similar to those

used to compose the legal CBI indicator, but which focus entirely on the actual

practice, thus providing another proxy for bridging the gap between statutes and

reality.

4.2.2 Modelling the relationship

In order to explore a possible relationship between the different measures of CBI

and average inflation, Cukierman, Webb and Neyapti (1992) used multivariate

regression analysis with various combinations of the CBI indicators on data from

72 countries and 4 periods from 1950 until 1989.

To avoid bias due to outlying countries with very high inflation, the authors em-

ployed the annual real depreciation rate D as relative, normalized measure:

(1) D = / +1 , resulting in a value between 0 and 1.

The transformed inflation rate D is then regressed on the various indices:

(2) D= *LCBI + TOR + *QCBI + i + C

where LCBI is legal CBI, TOR is the turnover rate of the governor, QCBI is the

CBI indicator based on the questionnaire, i is the intercept and C a number of

control variables for one-time period effects.

4.2.3 Results and Interpretation

The regression on the legal CBI variable and the TOR for the entire sample yield-

ed the following equation:


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(3) D= -0.02 LCBI + 0.28 TOR + 0.09 + C

(, and denote significance at the 10%, 5%, and 1% level, respectively).

Contrary to the expectations formulated in their hypothesis, and despite being

negatively related to the transformed inflation rate, the coefficient of the legal CBI

index is not significant.

The coefficient of the TOR has the expected sign and is highly significant at the

1% level.

Cukierman, Webb and Neyapti (1992) explain this result with the fact that the

relatively high inflation rates of the developing nations raise the average inflation

rate across the entire sample and thus render the comparatively small variations in

the rates of the industrialized countries insignificant. A similar domination effect

could explain the highly significant TOR. Figure 4 demonstrates this graphically.

(Source: Cukierman et al. 1992)

In each case, the upper line dominates the significance of the variable measured,

with a more horizontal slope reflecting an insignificant measure.

To overcome this masking issue, the authors split the sample into subsamples of

21 developed and 51 developing countries, respectively.

Regression with the developed countries only yielded the following result:


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(4) D= -0.06 LCBI - 0.08 TOR + 0.09 + C

With a significance level of 5% and a negative sign, the results seem to confirm

the hypothesis as far as the legal CBI index is concerned.

The TOR index, however, shows the opposite of the expected sign, while being

significant.

Attributing this to the anomalous case of Iceland (very high inflation rate, ex-

tremely low TOR), Cukierman, Webb and Neyapti (1992) dropped this country to

find that without it, TOR becomes insignificant and its coefficient positive.

The following scatter plot (Figure 5) illustrates the negative relation between

LCBI and inflation for two different periods:

(Graphic adapted from Walsh 1997)

As for the subsample of developing countries, the results show that TOR is is

highly significant and positively related to D, whereas the legal CBI index is in-

significant:

(5) D= 0.01 LCBI + 0.28 TOR + 0.11 + C

The authors also tested the effect of the introduction of the questionnaire index

compiled for a set of 22 countries, leading to the following regression equation:


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(6) D= 0.16*LCBI + 0.57 TOR + 0.46*QCBI + 0.27 + C

They conclude that with a 1% significance level and a negative sign, central bank

independence approximated by the questionnaire index results in lower inflation,

and the very significant TOR index shows that high governor turnover has an ad-

verse effect on inflation.

In summary, Cukierman et al. (1992) found that industrialized countries tend to

have a lower average rate of inflation when the corresponding central bank is rela-

tively independent, measured according to a range of legal determinants. The

turnover rate of the central bank governor seems to yield mixed results for that

group of countries. If the central bank governor is replaced more often, the infla-

tion rate tends to be lower, unless extremely anomalous nations are removed from

the sample, in which case the turnover rate becomes insignificant for the industri-

alized countries.

Regarding the developing countries examined in their study, they found that a

higher turnover rate results in higher average inflation, and that central bank inde-

pendence according to legal statutes is not an explanatory variable in that group of

countries.

The questionnaire index, although limited to a rather small subset of 22 countries,

equally shows that, if used as a proxy,central bank independence reduces average

inflation.

4.2.4 CBI and Inflation Variability

Because not only the level of inflation, but also its variation over time causes eco-

nomic costs ( Cukierman 1984), Cukierman et al. (1992) deemed it worthwhile

shedding light on the question whether CBI also has an effect on inflation varia-

bility. With a slightly modified model using the standard deviation S as dependent

variable in the model:

(7) S = *LCBI + TOR + *QCBI + i + C


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The results are similar to those obtained for average inflation. The legal CBI index

is completely insignificant in the entire country set, whereas the TOR shows sig-

nificance at the 1% level. As far as the subsample of industrial countries is con-

cerned, the probability that the coefficient of the legal CBI index deviated ran-

domly from zero is 10% but again shrinks to 5% when the outlier Iceland is re-

moved from the list.

In the case of the developing countries, the TOR has a highly significant (1%)

influence on the variability of inflation, whereas the legal indicator does not ap-

pear to explain variations.

5. Central Bank independence and real macroeconomic variables

This section explains briefly the relation between central bank independence and

economic performance in the areas of inflation, growth and investment, real inter-

est rates and the accommodation of wage and employment.

5.1 Central Bank independence, GDP growth and investment

Grilli, Masciandaro, and Tabellini (1991) find that real growth and central bank

independence do not present any relation in developed economies. Two years later

it was also corroborated by Alesina and Summers (1993) and Cukierman,

Kalaitzidakis, Summers , and Webb (1993).

Figures 6 reflects the relationship between central bank independence and the lev-

el of economic growth.

Figure 6 shows that countries like Switzerland, which has an extremely independ-

ent central bank show slower growth while countries such as Sweden and United

Kingdom shows the same level of economic performance. Another example is a

comparison between Denmark and Japan both of which possesses the same degree

of central bank independence but present an entirely different level of average real

growth. In conclusion, as the figure shows, no relation between CBI and average

real growth emerges. 5

5 Analogous results are obtained if one uses growth of GNP per capita (Alesina and Summer,1993)


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Source: Alesina and Summers (1993)

With respect to developing economies, there appears to be no link between legalindependence and growth rate per capita income. However, it should be men-

tioned that independence of a central bank - taking into account political vulnera-

bility of the central bank and related measures of turnover -has effectively an im-

pact on the growth rate. As supporting evidence, using data from the 1960s to the

1980s, Cukierman et al. (1993) found that high political vulnerability of the cen-

tral bank governor and related measures of turnover are effectively negatively

associated with per capita growth.

Additionally, Cukierman, Kalaitzidakis, Summers, and Webb (1993) present a

similar negative impact on the share of investment in GDP in some developing

countries. These results support the hypothesis that private investment is lower

under weak central bankers, reducing the long-run growth rate ( Cukierman ,

2006).

5.2 Central Bank independence and interest rates


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Alesina and Summers (1993) find that neither nominal nor real rates of interest are

negatively correlated with legal independence in developed economies. Figure 7

presents the relationship between central bank independence and real interest

rates.


They also show that, on the one hand, the average real return to depositors was

higher in developed economies when they presented higher levels of legal inde-

pendence. On the other hand, in developing countries, the variability of both nom-

inal and real deposit interest rates is positively associated with the turnover of

central bank governors. ( Alesina and Summers , 1993)

It should also be underlined that expansionary monetary policy may influence real

rates in the short run; however a systematically expansionary monetary policy

under a dependent central bank - operates to reduce average real rates over a long-

er period. In addition, as shown in Figure 8, there is a clear negative relationship

between central bank independence and the variability of ex post real interest

rates. ( Alesina and Summers , 1993)


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Based on these findings, the conclusion presented is that the variability of both

reald and nominak real interest rate is lower, and the average real return to deposi-

tors is higher, in countries with higher levels of independence ( Cukierman , 2006).

5.3 Central Bank independence, wages and employment

As can be seen in Cukierman, Rodriguez, and Webb (1998) central banks of in-

dustrial economies, which possess higher levels of legal independence, accommo-

date nominal wage increases to a lower degree than in economies with lower cen-

tral bank independence.

This finding in line with Rogoff s (1985) theory, which states that a more con-

servative and independent central bank accommodate wage increases to a lower

degree than any flexible central bank.

With respect to unemployment, it also does not seem to be related to the level of

central bank independence. This is related to the fact noted by Alesina and Sum-

mers (1993) who argue that the correlation between unemployment performance

and real GNP growth performance is also low.


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Figures 9 shows the analysis of unemployment in relation to central bank inde-

pendence. Here, it can be observed that average unemployment is not closely re-

lated to the measures of central bank independence.


6. Criticisms of Central Bank Independence

Given the apparent unanimity of theory and early empirical studies regarding the

favorable effect of CBI on inflation and its impact on institutional change in the

past two decades, various critics raised concerns regarding the unconditional case

for more independence. These criticisms range from doubts about the theoretical

foundation of the CBI influence on inflation to objections regarding the reliability

of the empirical findings.The following section will present a selection of these criticisms, along with a

critical evaluation of their relevance to the importance of CBI for achieving price

stability.


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6.1 Methodological Issues

Numerous empirical studies seem to confirm the hypothesis that CBI is negatively

related to price stability. 6

However, it is commonly known in the scientific world that the confirmation or

rejection of such a hypothesis highly depends on a number of (methodological)

criteria and a failure to translate the theoretical hypothesis into a mathematical one

is an immense source of bias. The results significantly depend on the selection of

the data set, its transformation and aggregation, and on the mathematical model

employed.

Forder (1999) critically analyzed whether this kind of methodological errors oc-

curred in the most prominent studies.

In the work of Cukierman, Webb and Neyapti (1992), for example, he noticed that

when their analysis yielded a result that did not confirm the initial hypothesis,

they split the country set into two subsets for developed and developing countries,

respectively, which then resulted in the desired confirmation that (at least) in in-

dustrial countries, legal CBI is significant.

Forder critizes this a posteriori data selection as being contrary to scientific re-

search principles, because such a modification could be conducted infinitely until

the desired outcome is reached. More importantly, he argues that Cukierman et al.

(1992) mistakenly draw the conclusion that just because legal CBI is not a signifi-

cant determinant of inflation in the industrial country group, and TOR not in the

developing country group, these measures are not determinants of independence

in their respective countries. Instead, so his argument goes, they have merely

shown that these measures are not related to inflation in their respective countries,which does not imply that they are automatically bad measures for CBI.

However, there are two important points that invalidate Forders argument. First,

there should be no restriction on using new pathes if during a study previous as-

sumptions are proven wrong (as in this case the assumption that the effect of legal

CBI is the same in both, developed and developing countries). Second, the authors

6 See Chapter 4.2


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provided plausible reasons for why the initial model did not work 7, and for the

theoretical underpinning of deviations in the importance of legal CBI in both

country groups.

Nevertheless, there are decisions in the analysis of Cukierman et al. (1992), which

cannot be neglected as easily.

Because of having Iceland in the list, the coefficient of the TOR is, contrary to the

theory, negative and statistically significant. This by no means can be a reason to

remove that country from the list, just to obtain the desired sign.

Unlike the case of splitting the countries into two groups, Cukierman et al. (1992)

do not provide a reasonable explanation except for the fact that Iceland is an

anomalous case it can be assumed that if Iceland had been a positive outlier,

deviating the overall data towards confirmation of the hypothesis, the authors

would not have removed it from the list. Dropping that country from the data set

must therefore be interpreted as discretionary modification without justification

and must indeed lead one to question the validity of the results.

A similar point of criticism is brought up against Alesina (1988), who discards

financial independence as the right measure for CBI, only because Parkin and

Bade (1988) found no association whatsoever between financial independence

and inflation. Once again, Forder stresses the importance of distinguishing be-

tween a measure that is not related to inflation because it is a bad measure which

does not capture the empirical essence of CBI, and a measure that is not related to

inflation simply because the there is no relation between independence and infla-

tion. According to him, it was a flagrant methodological error to exclude a poste-

riori the financial independence as indicator for CBI, because it failed to showcorrelation with inflation. Researchers should verify a priori whether their meas-

ure captures the empirical notion of independence.

2 See Chapter 4.2.3


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6.2 Subjectivity

Closely related to the methodological issues presented in the previous section is

the issue of subjectivity. This type of bias comes in 3 major forms (criteria selec-

tion, criteria valuation and criteria weighing) [ Eijffinger and Schaling 1993;

Forder 1999; Maslowska 2007] and can significantly affect the outcome of a sta-

tistical analysis.

The first occasion for different measures and potentially different study outcomes

is the selection of indicators for CBI. The following Table 1 from Maslowska

(2007) perfectly illustrates how different the composition of the legal CBI index

for the most prominent indices is.

(Source: Maslowska , 2007)

There are various reasons that might cause different value attribution. Forder

(1999) proposes the closeness of the author to the Central Bank of a particular

country, which could provide him with insights other authors do not have access

to.

He also suggests that the wish to confirm a hypothesis subconciously influencesthe author in his valuation.


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Finally, it might be that different weighing is caused by different cultural back-

grounds and resulting perceptions of what factors are important and which are not.

Given these numerous sources of subjectivity bias, it is surprising that the studies

reach the same conclusion 8: central bank independence is negatively related to

average inflation and this relationship is significant.

Forder (1999) warns that this apparent mutual confirmation is deceiving. He con-

vincingly argues that although the different CBI indices are significantly related to

inflation, these results might be scientifically useless, since the measures em-

ployed possibly do not reflect CBI.

To support his thesis, he shows that once Germany and Switzerland, both coun-

tries whose central banks are widely accepted as being independent (Forder calls

it conventional wisdom), are removed from the indices, the correlation coeffi-

cients shrink to astonishingly low values. Table 2 illustrates the impact of remov-

ing Germany and Switzerland on the correlation coefficient.

(A/PB denotes the index of Alesina (1988) based on the work of Parkin and Bade

(1985), GMT the index of Grilli, Masciandaro and Tabellini (1991) and CWN the

index of Cukierman, Webb and Neyapti (1992))

Given that the low correlation coefficients simply reflect the fact that the coun-

tries, if ranked according to their independence, show very different orders,

Forder concludes that each of these rankings (measures) are little better than ran-

dom (p. 32). The case of England illustrates the problem. Figure 10 shows how

the rank (vertical scale) varies heavily depending on the legal index used (hori-

zontal scale), onscillating between 1 and 10 of 12 countries.

8 This affirmation does not embrace all existing studies, instead, the most prominent and mostoften cited ones. Furthermore, taking the study of Cukierman et al. (1992) into account, this islimited to industrial countries.


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(Source: Mangano , 1998)

Apparently, there appears to be no real consensus as to what countries are inde-

pendent, so Forder concludes that the measures do not measure central bank inde-

pendence, regardless of the fact that each of the measures is negatively related to

inflation. The causal chain factual independence measured independence infla-

tion could not be established.

The criticisms brought up by Forder are judged as being too extreme by Berger,

de Haan, and Eijffinger (2002).

They state that CBI is an unobservable concept, and therefore, any proxies created

to represent CBI are necessarily noisy indicators. Therefore, they argue, research-

ers should not focus on just one index, as it is done by many of them, but instead

rely on a mix of various CBI indices to test their hypotheses.

However, Mangano (1998, p. 482) warns that any combination of unreliable

measures, no matter how elaborate, is still an unreliable measure in itself.

Thus, the subjectivity bias cannot effectively be overcome by combining subjec-

tive and inconsistent measures.

Moreover, Berger et al. (2002) question the reasonability of Forder s (1999) ap-

proach of excluding Germany and Switzerland from the data to obtain more effec-

tive rank correlations between the different measures. They state that there is no

reason to exclude these countries instead of other, possibly low-independence

countries like Greece. However, they miss the point that unlike Greece, Germany

and Switzerland are considered as highly independent across all the studies inves-


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tigated. If they were to exclude Greece, they would have to exclude Portugal and

New Zealand as well.

To overcome the issue of subjectivity, Forder suggests the development of a

methodology of statute-interpretation, which would enable researchers to reach

consistent approaches to measurement.

Moreover, he proposes that the central banks be ranked anonymously, without

letting the person who conducts the ranking know which bank belongs to which

country.

These suggestions look quite appealing at the first glance, however, they could

proof to be hard to turn into reality.

Language is so complex that developing a framework for consistently interpreting

statutes can be just as difficult as the valuation of raw statutes.

As far as the anonymous ranking is concerned, it should be kept in mind that this

would require a translation of the statutes into a language that can be understood

by the person who is to rank the central banks. In this case, however, subjectivity

could occur already during translation, rendering this approach ineffective.

Forder therefore correctly concedes that it might be possible that the subjectivity

issues cannot be satisfactorily overcome.

6.3 Robustness

6.3.1 Control Variables

The fact that the most prominent studies showing a negative relation between CBI

and inflation, due to a lack of control variables, are also the most fragile ones in

terms of statistical robustness, soon raised the question whether they were subject

to omitted-variable bias. This is why subsequent studies on CBI tended to include

other variables in their models, variables that might have such a big impact on

inflation differentials that the CBI indices no longer would have a significant in-

fluence.


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The results of these studies do not generally invalidate the impact of CBI, howev-

er, they are not unanimous either.

Walsh (1997), for example finds that the CBI variable remains significant even

when various control variables are included.

The additional variables he includes are openness, the natural rate of unemploy-

ment, government budget deficit, and a dummy variable representing the degree

of conservativeness of the government.

The openness of a countries economy, measured by the share of imports in GDP,

is included because Romer (1993) asserts that inflation-aversion increases when

the importance of international economic exchange rises. This assertion is sup-

ported empirically.

The natural rate of unemployment is one of Walsh s control variables, because a

higher rate could induce the government to stimulate economic growth through

monetary expansion, which in turn leads to a higher inflation rate ( Walsh 1997).

Public deficit in terms of a share of GDP are included because Walsh expects the

government of highly indebted countries to seek a reduction of these debts

through devaluation. If this is the case, a positive relation should be expected.

Finally, conservatism of the government is included because such a government is

expected to support low-inflation policies, which reduces the importance of a con-

servative central banker.

On the other hand, a similar study conducted by Sturm and de Haan (2001) found

that the TOR index often is not a significant determinant of average inflation, and

when it is, only when high inflation countries are included in the sample. The con-

trol variables used are openness, political instability, the log of GDP per capita,

exchange rate regime, and debt-to-GDP ratio.

The different results could be due to the use of different control variables and theuse of an updated TOR dataset which contains a larger number of observations.

Two further studies that found no significant relation are those by Fuhrer (1997)

and Campillo and Miron (1997), both dismissed on the grounds that they employ

the legal CBI index on samples of developing countries, despite the fact that pre-

vious studies have shown that legal provisions do not have any significant impact

on inflation in those countries, a result that was corroborated with convincing the-oretical foundations ( Sturm and de Haan 2001, Berger et al. 2002).


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In another study, Klomp and de Haan (2010) investigated whether the contradicto-

ry findings of studies including control variables are due to heterogeneity among

the countries examined. Using a random coefficient model with the Hildreth-

Houck estimator, they found that CBI is only relevant in about 20% of the coun-

tries, leading them to the conclusion that specific conditions must be present in

order for CBI to have a significant effect on inflation.

Continuing this suggested path, in a recent paper Markwardt and Hielscher (2011)

investigated whether such an influencial precondition for the effectiveness of CBI

is the quality of political institutions. The authors claim that the gain in monetary

policy reputation, which, according to the model of Rogoff (1985), would reduce

the inflationary bias, can only be attained if the institutional environment, repre-

sented by political stability, rule of law, and democratic accountability, conveys

enough trust in the effectiveness of an independent central bank. Without high

institutional quality, CBI would not have any beneficial effects on credibility, and

consequently would not improve price stability.

To test their hypothesis, Markwardt and Hielscher (2011) use a regression model

of the form (8):

where represents the inflation differential, 80/89,i the initial level of average

inflation between 1980 and 1989, CBI the change in CBI, 0 a constant, an

error term, and IQ the institutional quality.

At the center of interest lies the effect of the interaction term IQ* CBI. An in-

crease in CBI will only have a significant effect, if the factor IQ is sufficiently

large.

They find that in case of developed countries, when control variables are included,

not only CBI and CBI^2 are significant variables, but also the interaction term

IQ* CBI. If political stability is used as a proxy to measure institutional quality,

the term is significant at the 10%-level, if democratic accountability is used as

proxy, the significance of IQ* CBI even reaches the 1%-level.


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As for the developing countries, the results show that neither CBI alone, nor the

interaction term is significant.

Markwardt and Hielscher (2011) conclude that the beneficial effect of CBI on

inflation is subject to two conditions: the change in CBI must be sufficiently large

and the level of IQ must be high enough.

Markwardt and Hielscher (2011) provide an interesting explanation as to why

CBI matters in some countries, and does not in others. Moreover, it provides an

enhancement to the explanatory power of the legal CBI based on statutes and the

term IQ*CBI could possibly be much closer to actual central bank independence

than CBI alone.

Nevertheless, a critical analysis of the study reveals some flaws.

On the methodological side, it appears odd that after finding that the interaction

term is not significant if control variables are omitted, and significant if they are

included, the authors decide to rely on the model with control variables during the

rest of their investigation, on the basis that it is the more robust model.

However, a robustness test is a means of verifying that the variables analyzed re-

main significant even if other supposedly significant variables are included in the

model. This implies that the analyzed variables should be significant without con-

trol variables, which is not the case in the model of Markwardt and Hielscher

(2011).

On the theoretical side, it should be expected that aspects of institutional quality,

such as rule of law, would improve the explanatory power of the legal CBI index

in case of developing countries. The reason why legal CBI was never found to be

a significant determinant of inflation was attributed to the fact that rule of law innot deeply embedded in those countries. Therefore, if rule of law is taken into

account, legal CBI can be expected to be relevant in developing countries, an as-

sumption that is not confirmed by the study of Markwardt and Hielscher.

6.3.2 Observation periods

Critics also voiced doubts regarding the consistency of the CBI inflation relationover different time periods. Berger et al. (2002) argue that it is perfectly normal to


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find a weaker impact of CBI under a fixed exchange rate system than under a

floating exchange rate system, a reasoning that is supported empirically by Walsh

(1997). Nevertheless, they point out that there is some noticeable effect even in

case of a fixed rate regime.

6.4 Causality

Already in the year 1995, Posen came forward with the idea that central bank in-

dependence might not be an exogenous variable. Instead of being the cause for a

certain degree of inflation, CBI would be the result of a third variable, the latter

also being the explanatory variable for inflation itself.

As a common source of both, CBI and inflation, Posen (1995) proposes an infla-

tion-averse society, more precisely inflation-averse interest groups with the ability

to effectively exert influence over central bank policy making and the political

process to bring about CBI.

Among several potential lobby groups like pensioners, importers and mortgage

holders, while each of them presenting a strong interest in price stability, Posen

singled out the financial sector as the most influential source of inflation opposi-

tion within a society.

Not only does this lobby group feature the properties necessary for effective col-

lective action, namely relatively low costs in relation to the potential gains, and

easy monitoring of the members participation ( Olsen, 1965), furthermore the

central bank and the financial sector are quite naturally interwoven, e.g. through

the sharing of a partly common labor pool and mutual supervision ( Posen , 1995).

To test his hypothesis, Posen (1995) constructed a composite index for effective

financial opposition to inflation (FOI) which draws on four different measures:

the degree of universal banking in a country, regulatory influence of the central

bank on the financial sector, fragmentation of a countrys political party system,

and the degree of federalism.


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A first hint towards such a relationship provides Figure 11, which shows the cor-

relation between FOI and CBI, and FOI and average inflation, respectively, in

OECD countries over the period 1950-1989.

Subsequently, regression analyses were conducted to determine the influence of

FOI on legal CBI, FOI on inflation, and FOI and legal CBI on inflation, respec-

tively.

The empirical findings are intriguing and appear to confirm Posen s hypothesis

that high FOI is the actual cause of low inflation.

In detail the data reveals that FOI is a highly positive (at the 1 %-level) determi-

nant of inflation, whereas legal CBI is not significant if used in the same regres-

sion.


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Posen (1995) therefore concludes that both, a society committed to price stability

and an independent central bank as vehicle to realize this preference are necessary

to bring about low inflation. Neither of them alone would suffice.

Berger, de Haan and Eijffinger (2002) criticize Posen s findings on the basis that

the legal CBI indicator was employed for developing countries, despite the fact

that earlier studies found it to be insignificant in that country group.

However, Berger et al. (2002) mistakenly neglect the fact the country sample used

by Posen only included low and medium inflation countries, thus excluding hy-

perinflationary countries for the reason that in case of steady hyperinflation, fi-

nancial institutions might adapt their business practices to be consistent with high

inflation, therefore eliminating their interest in low inflation and the need for an

independent central bank to implement corresponding policies.

Under this assumption, which Posen (1995) illustrates with the example of the

Brazilian financial sector, which exhibits business practices highly focused on

reaping profits in a high-inflation environment, there is no point to limit the va-

lidity of the legal CBI-argument to developed countries; instead, it provides a use-

ful element to explain the lack of correlation between CBI and inflation in coun-

tries with high rates of inflation.

Moreover, Berger et al. (2002) fail to recognize that legal CBI is not only insig-

nificant in the overall country sample if FOI is included as explanatory variable,

but also in the OECD-country sample.

Another study which apparently contradicts Posen s (1995) claims is the one pub-

lished by de Haan and Kooi in 2000. In this study, the authors find that CBI re-

mains a significant explanatory variable, even if FOI is included as regressor.However, instead of using the legal CBI, the TOR index is used, and the influence

of TOR only remains significant if high-inflation countries are included.

This finding, although appearing to be contrary to it, is in line with Posen s (1995)

findings that CBI becomes insignificant in low and medium inflation countries.

Moreover, the argument could be put forward that in hyper-inflation countries,

TOR might be an endogenous variable explained by high levels of inflation and

the resulting lack of trust in and dismissal of the central bank governor in office.


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(Figure 12 adapted from Hayo and Hefeker 2007)

Posen (1995) and Hayo (1998) present compelling arguments for the case that

inflation-aversion influences the level of CBI and the level of average inflation.

The idea that a nation must have an incentive to contain inflation is quite obvious,

as Posen (1995, p. 254) puts it: If there are distributive consequences, there is no

reason to assume that the adoption of CBI is self-enforcing. The preferences for

price stability embodied by CBI require political support. If CBI does not embody

such preferences, it will not affect inflation over the long run; if such preferences

were universally supported, independence would be unnecessary. Nevertheless,

it remains unclear how much of the inflation-aversion is channeled through CBI,

and how much of it affects inflation levels in other ways. The fact that Posen

(1995) found legal CBI to be insignificant when FOI is included as control varia-

ble, while being significant when examined alone, allows the assumption that

non-neglectable parts of the prime cause for low inflation are transmitted

through other channels. These channels or preconditions could be found in other


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institutional arrangements, as the study by Markwardt and Hielscher (2011) seems

to confirm. 9

Of the two theories, the one of Posen is the more convincing one, since the one of

Hayo at least indirectly contradicts the theoretical assumptions postulated by

Rogoff in 1985. According to Rogoff, CBI can reduce the inflation bias, if a con-

servative central banker is appointed, placing more emphasis on price stability

than the rest of the society. In this case, however, there is no reason for the society

to become supportive of monetary stabilization before legal CBI can have a sig-

nificant impact on price stability. The theories become compatible again if the

appointment of the conservative central banker is driven by a certain level of pub-

lic desire for a stable prices.

In any case, there is reason to believe that CBI is an exogenous, as well as an en-

dogenous variable, and CBI is most likely neither a necessary, nor sufficient con-

dition for price stability.

6.5 Disinflationary Credibility

The argument for central bank independence is mainly based on Rogoff s (1985)

prediction that CBI would lead to more credibility as far as monetary policy an-

nouncements are concerned, which in turn would approach the wage setters ex-

pected rate of inflation to the real inflation rate, ultimately leading to lower eco-

nomic costs in case of lower than expected money growth.

According to Posen (1995b), this change in credibility and the resulting change in

behavior of private agents constitutes an essential pillar of the theoretical con-

struct of CBI and its supposed benefits. He therefore investigated whether thechange in CBI really brings about the predicted credibility bonus for disinflation-

ary monetary policy. Without the existence of this link, so he argues, the CBI ar-

gument would be deprived of its theoretical foundations.

9 see Chapter 6.3.1


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Because disinflationary credibility is even more difficult to measure than CBI,

Posen (1995b) examines four empirically measurable effects that are to be ex-

pected as the result of higher credibility.

First, costs of disinflation should be lower in case of CBI, due to the fact that the-

se costs are caused by the deviation of actual from expected inflation. If increased

credibility due to CBI narrows the gap between actual and expected inflation, the-

se costs must be lower.

Second, nominal wage rigidity should be greater in case of CBI. Posen (1995b)

argues that with higher credibility and consequently lower inflation and less un-

certainty regarding inflation, wage setters would be less inclined to renegotiate

wage contracts very often, as they incur costs whenever they have to renegotiate.

The third effect is very similar but concerns the product market-price side. With

higher CBI and more credibility, suppliers should tend to stick to a certain level of

prices for a longer period of time. Posen (1995b) admits that too many other fac-

tors affect the prices of goods to be able to effectively measure the impact of cred-

ibility on it. However, using the New Keynesian approach from Ball, Mankiw and

Romer (1988), which states that good prices are more rigid under low inflation

(menu printing argument), Posen asserts more credibility comes along with higher

disinflation costs.

The final prediction regards the time span of the disinflation period. With credibil-

ity-inducing CBI, the central bank would make a bigger effort to correctly time

the implementation of the previously announced target rate. At the same time,

wage setters would renegotiate contracts to be in effect at the time the credibly

announced target rate would set in. Thus, the duration of disinflation would be

zero in case of a totally credible monetary regime 10 (Posen [1995b] based on

Fischer [1985]).To test each of the predictions, Posen mainly relied on OLS regression analysis

using the data of 17 OECD countries for the decades between 1950 and 1989 and

the CWN indicator.

10 Posen concedes that the duration would not be zero in reality, due to information imperfection.Nevertheless, a clear effect should still be noticeable. (p. 9)


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To his surprise, Posen (1995b) finds that all four predictions are largely rejected,

with only the fourth one regarding the disinflation time span showing mixed re-

sults, depending on which method for measuring the length of period is used.

CBI does not seem to reduce inflationary costs (instead, it appears to be increasing

them), reduce the length of the disinflation period, or increase nominal price rigid-

ities.

Even though a confirmation of two of the four predictions are subject to additional

conditions, the fact these predictions do not hold lead to the conclusion that an

increase in disflationary credibility due to CBI is not the mechanism that reduces

inflation. Posen (1995b) therefore argues that either the link between CBI and

inflation is missing, or the measures CBI indicator utilized does not capture actual

CBI correctly.

The former hypothesis could in part find corroboration in Posen s (1995a) analy-

sis of endogeneity. Credibility might not be the link assumed by the theoretical

literature (Rogoff 1985), but instead both CBI and low inflation are the result of

the financial sectors inflation-aversion 11 . The latter hypothesis is an equally suit-

able explanation for the failed confirmation of the CBI-credibility-inflation causal

chain, given the existing criticisms in literature regarding CBI indicators 12.

Posens (1995b) findings constitute a serious attack on the case for more CBI and

its beneficial effects. Void of its theoretical foundations, the argument for making

central banks more independent becomes weak, and even more so if the criticisms

regarding the proper measurement of CBI is taken into account.

With both, the theoretical and the empirical connection between CBI and inflation

contested, there is little ammunition left for the proponents of more independence.

Nevertheless, as is the case with other points of criticism, Posen s (1995b) find-ings cannot be regarded as an absolute and unconditional refutation of established

theories.

The author himself admits that at least two of his four predicted credibility effects

depend on the validity of other theories. On the one hand, higher product-price

11 see Chapter 6.412 see Chapter 6.1 & 6.2


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rigidity is based on the additional assumption that producers are less often in-

clined to adjust prices under low inflation than they would under higher inflation

( Ball, Mankiw and Romer , 1988). On the other hand, the disinflation period will

only be shorter as suggested by Fischer (1985), if monetary policy implementa-

tion and wage setting can be properly timed, which in reality is hard to assume if

implementation lags and imperfect information are taken into account. Moreover,

the higher disinflation costs due to nominal wage rigidity expected under higher

credibility would only occur if a low inflation environment would really induce

less frequent wage renegotiation, an assumption which is mainly based on negoti-

ation costs and which neglects laws and traditional practices.

In addition, none of the predicted results are sufficient conditions, they are neces-

sary conditions at best, provided that the additional assumptions hold. And again,

the question of the correct measurement arises: throughout his paper, Posen

(1995b) uses legal CBI measures, which themselves are already a major object of

criticism. On top of this, the measures for disinflation periods and nominal wage

rigidities are possible source of bias 13.

Therefore, the theory of the credibility enhancing effect of CBI has neither been

confirmed, nor refuted, even if Posens stresses the fact that all of h

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