Central bank independence : a critical view
AbstractWhile expansive literature on central bank independence contains some criticisms to the independent central bank quasi-paradigm, few critical analyses have been undertaken in the years between Friedman (1962) and Posen (1994). The author extends Posen's analysis to developing countries, discussing more broadly and systematically the reasons why merely instituting an independent central bank may not bring about its professed benefits, especially in developing countries. The author argues that widely reported empirical tests that are purported to support the central bank independence proposition are plagued by potential problems of simultaneity, reverse causality, missing variables, and measurement errors. Yet one can not make positive recommendations about institutional arrangements for central banks if causality relations are not well established. Institutions are shaped by a country's record of and preferences for inflation and may have little influence on them. The author also argues that the purported benefits of an independent central bank may be eroded by conflicts between fiscal and monetary policy and by inherent problems of central bank institutional design (especially mechanisms for board appointments, public accountability, and budgetary control). If these institutional problems are not solved, problems of dynamic inconsistency traditionally associated with monetary policy are not eliminated,but merely transformed. The author suggests that the benefits of central bank independence are less likely obtained in less developed countries with shallow financial markets. Accordingly, central bank independence should be granted at a later stage in a country's financial sector development. If a less developed country seeks to establish a low-inflation path, it should concentrate on instituting financial policy reforms (such as liberalization and privatization) that bolster opposition to inflation rather than easily reversible and practically meaningless changes in legal and institutional structures. This will better ensure the sustainability -- and hence the credibility -- of the government's anti-inflation stance. Fiscal policy is often at the root of macroeconomic disturbances in developing countries. Fiscal policy is more deserving of special protection from politics because of fiscal dominance over monetary policy and its greater vulnerability to private interests. The author suggests that the solution might be to make fiscal policy less susceptible to political pressures by creating an independent fiscal board. Tying the fiscal hands of government may seem a far-fetched idea. But would it not make more sense to force discipline on fiscal policy directly rather than indirectly through monetary policy?
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Bibliographic InfoPaper provided by The World Bank in its series Policy Research Working Paper Series with number 1356.
Date of creation: 30 Sep 1994
Date of revision:
Economic Theory&Research; National Governance; Banks&Banking Reform; Economic Stabilization; Macroeconomic Management;
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