Theoretical aspects of Central Bank independence

One aim of a central bank is to try to influence the supply and demand situation in financial markets in order to provide stability and a stable base for sustainable economic growth. How this aim will be achieved, depends inter alia on the institutional structure of the global financial system. In this section I will look at the institutional framework of monetary system and thereafter the theoretical principles for central bank independence and democracy.

A general framework for monetary policy

The institutional framework for a monetary system consists of the exchange rate regime and the liquidity and reserve requirement systems. Also a key role is played by the degree of capital flow control; that is how independently the financial flows can cross national borders. The autonomy of the monetary policy is largely a measure of how a country can implement monetary policy that substantially differs from that of other countries (Aaltonen, Aurikko, Kontulainen, 1994). In the long run the possibilities for doing are usually much weaker than in the short run. The autonomy of a monetary policy depends to large extent on the existing exchange rate regime, the state of capital flow control and the state of financial sector regulation. All these factors have changed in Finland in the past decade and this has naturally changed the working of the central bank.

Until the mid 80€s the national financial markets were state controlled in Finland as in many other countries. It was easy for the central bank to control the money supply, because it could directly alter the interest rates and the amount of money in circulation. There was very little interaction between the national financial markets.

In the past two decades markets have experienced profound structural changes. The direction for changes has been set by increasing internationalisation and technological innovations. Nowadays, capital can freely move from one country to another. The exchange rate in Finland has been fixed for most of the time but is continuously tested by currency traders that keep testing its compatibility with the country€s economic capability. In case of fixed exchange rates interest rates must be used to maintaing the exchange rate and for assuring sufficient foreign exchange reserves. Within this framework a central bank cannot on its own guarantee the objectives of a monetary policy.

It is important to understand that the driving forces behind this development are growing globalisation and liberalisation. As the world€s economies become more open and transparent they simultaneously converge in economic terms. The level of interest rates will be defined by the fundamental economic conditions and these will continuously be judged by rating agencies and financial intermediaries. In these circumstances also government spending and other fiscal determinants play a crucial role in interest rate determination and price setting.

The independence of a central bank

In this section I will explain the development of the idea of central bank independence, concepts of independence and different ways of measuring independence. In this context independence does not mean independence from the global financial market that has vanished with globalisation, but independence in relation to the democratically elected institutions of a nation state.

The idea behind moderate monetary policy and thus central bank independence can be derived from the change in the relationship of employment and inflation in the 70€s. Until that time it was held in industrialised nations that there exists an inverse relationship between inflation and employment. Maintaining high inflation in an economy would help in achieving high employment. In the 70€s this view dramatically changed as high inflation no more guaranteed the employment. The theoretical principles of this view were established in the economic theory of Keynes that in general also supported the idea of the state having an active role in the operations of the economy.

Experiences from the past two decades have shown that by allowing high inflation one cannot achieve lasting advantages in terms of sustainable growth, employment, and economic well-being. Inflation begun to be seen as the reason for severe problems and expenses to the economy. Those problems have been seen more clearly as the world has become evidently more transparent and international. This (often called monetarist) point of view that monetary policy should only help in maintaining inflation at a low level has paved the way for central bank independence. It is also accompanized with the ideology of a free market economy.( Intrestingly the British who are main the supporters of the monetarist economic policy and who have in comparison to other European countries a very liberal economy have trouble in granting more independence to the central bank. Ks. Busch 1994). Many economists agree that for "fuelling the economy", for maintaining space for adjustment there should exist an incremental inflation of 2-5% (Pekkarinen, Luentomuistiinpanot 1997).

Esa Kaitila: The independence of Central Bank seem to be something to achieved cause of maintaining the inflation level low and to prevent politicians to use monetary policy for their own short term benefits. How ever one can still argue if the political control would be any good or why there would not be anyway low inflation if the political control over the Central Bank would take a place.

Another level of the theory for explaining the way monetary policy should be organised consists of explanations of central bank independence. The two main strands that have added precision to the argument point out the different forms of central bank independence (Fischer, 1995, s. 201). The conservative central banker approach points to goal independence and the principal-agent approach points to instrument independence. Goal independence is commonly understood as the possibility of a central bank to only state its target inflation rate and not to completely define its objectives. By instrument independence it is understood that a central bank can freely choose the means for achieving its objectives.

Esa Kaitila: The consepts a) goal independence and b) instrumental independence remained a bit difficult to understand althought there was an explanation after them.

In the conservative central-banker theory a central banker weights the deviations of both output and inflation from target levels in setting monetary policy. He can both set the goal and choose the instruments he wants for maintaining and supporting a low inflation target. A central banker has to be independent to ensure that his preferences rather than the preferences of the society determine monetary policy in a context where precommitment to optimal policy is impossible. The best overall performance in the model is achieved by a conservative central banker and when the central bank has the possibility to develop a reputation.

Esa Kaitila: Why a CONSERVATIVE central-banker theory. What kind of theory would be the liberal or democratic central-banker theory?

In the alternative principal-agent model anti-inflation approach for the central bank is guaranteed by constructing a contract that imposes costs on a central bank when the inflation deviates from the optimal level. In this model the goal is negotiated between central bank and the government but instrument arsenal will be decided solely by central banker.

Katja Heinonen: Has there been any suggestions what these costs for the central bank might be like?

Central bank independence can be measured in many ways. Legal independence is a reasonable proxy for independence, if there is sufficient respect for the rule of law in the country. It has been suggested that in less developed countries more behaviourally oriented proxies could be useful ( Cukierman, 1992, s. 1438). Such proxies are based on the actual turnover of the CB governor, on the likelihood that he will be removed from office following a political transition and questionnaire based indices. The general conclusion of empirical analyses is that when the appropriate indices are used for a certain group of countries, then inflation is negatively correlated to central bank independence in both industrial as well as in developed countries. One study presented in Central Bank Independence and the Westminster Model p.58 by Busch. Central bank independence is plotted against average inflation rate€s for years 1973 -1986 for a group of industrialised countries. The resulting regression coefficient is -0.80.

Esa Kaitila: In the paper version of the presentation there is quite clarifying figure of "the Degree of independence of the central bank and rates of inflation 1973-1986"

Another interesting result in the empirical studies is the apparent free lunch provided by central bank independence. Interestingly there seems not to be a trade off between long term economic growth and central bank independence. The variance of inflation and the variance of output growth appear on average to be lower for countries that have more independent central banks ( Fisher, 1995, s.205). Price stability as a target for an independent central bank also seems to be justified according to several studies (Cukierman, 1995, s. 1444). These studies suggest that price stability strengthens financial stability. Many times sharp fluctuations in interest rates and exchange rates are linked with financial disruptions and crises. This phenomenon can also be used to explain the situation in Finland in the end of the 1980€s.

A credibility aspect is also connected to the issue of reaching moderate inflation. Much of a central bank€s ability to achieve price stability in the long run is dependent on institution credibly working to maintain low inflation. A central bank has to earn its position of authority in eyes of the public and prove that it is credibly engaged in achieving its goals. Also transparency in the implementation of policy guidelines is very important. For the functioning of the modern financial markets it is important that different market participants can easily analyse the decision making of the central bank so that they know what ideas lie behind the decisions. However, the monetary policy operations and their preparation are by their nature very sensitive so such policies must be prepared in secret and made available to all the participants at the same time. This needs to be kept in mind while discussing the transparency of monetary policy implementation.

Many economists summarise the existing theories and empirical results by stating that a central bank should have instrument independence but should not have goal independence. It should be given a clearly defined set of goals and powerful means for achieving those goals. In addition a central bank should be held accountable for its actions. Accountability is needed for two reasons: first to set incentives for the central bank to meet its goals and second, to provide democratic oversight of a powerful political institution ( Fischer, 1995, s.202).

Democracy of an independent central bank

In this section I will analyse central bank independence in the light of democracy at the general level. Already Milton Friedman(Friedman, 1962) had recognised this important question in his search for a monetary constitution when he wrote " is it tolerable to have so much power concentrated in a body free of direct effective political control ? " Usually economics scholars have approached this issue by assessing the question of how the central bank should behave as a part of an economy€s necessary institutions, what is the optimum policy and what are the optimal instruments for its use.

Political scholars have analysed central bank independence as a part of democratically functioning society. How well particular institutions fit together with basic principles of democracy. Teivainen (Teivainen, 1996) argues that in the world there exists the tendency to build new constitutions. This can be seen in the tendency to take socially important institutions out of public control. The dominant social forces are currently favouring privatisation, the selling of state owned enterprises and in insulating governance functions from the oversight of representative institutions and placing them in the hands of unaccountable technocrats.

Esa Kaitila: It would be interesting to mention in the first hand the different point of views of France and Germany in the Central Banks political control.

Politically relevant decisions are increasingly made in economic institutions and economy is one of the most important factors influencing democracy. With this development in mind a thought should be given to what is the necessary level of interaction between these two branches. In the case of an independent central bank this means that thought should be given to the extent that the objectives and procedures of an institution can be removed from the hands of the decision makers and insulated from changing conditions.

What constitutes the democracy of an institution such as central bank ? One can see its democracy in institutional ties to the public and democratically elected decision making organs and in its ability to adjust to changing conditions of the surrounding world. This in turn is reflected by the degree of independence, by the forms of transparency and accountability of the institution and irreversibility of the arrangement that the operation is based on.

Transparency is a measure of the ways decision making procedures can be evaluated from outside, which bodies are able to survey the state of affairs and if anybody has the right to veto decisions. Accountability is also an important form of democratic oversight. Who is responsible for what and for whom. It also serves as an incentive for executives to meet desired goals. It is critical to survey what is the responsibility of the decision makers for poorly implemented policy decisions. What kinds of incentives will be constructed and what other goals the top ranking civil servants could have in their sights. For the democracy of an institution the irreversibility of the arrangement is also meaningful. In case of the European Central Bank, what is the relationship between national law and international treaty and through what kinds of procedures amendments could be made to the arrangement