Another advantageous point to not allowing Government control over the ECB is that there are no politicians manipulating the economy in their favor. As it would be apparent the most popular politician is one of who brings about low unemployment and high output. Consequently politicians may wish influence the central banks decisions regarding interest rates at strategic times, such as re-election in order to make the economy seem as though it is favorable, these policies turnout to be short term and ultimately reflationary. However “even if the Government does not pursue secret inflationary policies, inflationary expectations will reflect the risk that it might” (www.res.org.uk). This inflationary bias will be reflected in a need for higher interest rates, and since inflationary expectations are usually self fulfilling, in higher inflation.
Because of this alleged urge on the behalf of the politicians to mismanage the economy for personal gain, it seems reasonable that power should be taken away from them and given to an independent central bank. As the most important tool for combating inflation is monetary policy by taking this away from the Government one would expect to have lower inflationary expectations and to require lower interest rates to implement monetary policy.
Germany’s Bundesbank is perhaps the most successful example of an independent central bank to date. Twice in the early 20th century Germany was subjected to hyperinflation, where bags of notes were being carried around and in some cases the money was worth less than the paper it was printed on. Consequently Germany has adopted a very anti- inflationary stance. The choice to give independence to the Bundesbank meant the German government was able to concentrate on fiscal policy in order to meet their objectives, and since then Germany has enjoyed an un precedented level of success.
However, there is the ‘problem of causality’, cause and effect can be difficult to detach. Is it that countries with independent central banks have low inflation, or is it countries with low inflation having independent central banks.
Research published in the March issue of the Economic Journal overwhelmingly supports the idea of an independent central bank. Suggesting that it helps smooth out the economic cycles of boom and bust.
The study, conducted by John Maloney, amongst others, reveals that central banks that can set their own monetary objectives, something the Bank of England as of yet cannot do, are exceptionally good at creating a stable business environment.
Economists have been scepticle about the advantages of an independent central bank when it comes to the business cycle. This research demonstrates “clear 'political business cycle', in which the economy is destabilised by the proximity of elections, and an equally clear mitigation of this cycle when an independent central bank takes monetary policy away from politicians”.()
According to another version of the business cycle, the ‘rational partisan theory’, the economy is affected not by governments changing their policy as an election is coming up, but the private sector changing its behaviour in view of the uncertain result.
Suppose your union is negotiating a wage deal to cover the next 12 months, but knows there is going to be an election halfway through. Suppose one of the parties likes monetary growth at 10% a year, while the other aims for 2%. Rational workers will hedge their bets and go for an intermediate pay rise say 6% as an example. Then if the more anti-inflationary of the parties gets in, you will have 6% pay rises colliding with 2% monetary growth: a rise in unemployment ensues. If the ‘10%’ party wins, then, by equal and opposite reasoning, it starts its term with a boom.
Analysis of 20 countries over the period 1960-98 Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, the UK and the United States confirms this theory.
On the basis of their study, the researchers conclude that the government should give more independence to the Bank of England, and possibly let it choose an inflation target for itself.
The disadvantages of an independent central bank on the other hand paint a considerably different picture.
Some critics of central bank independence argue that although the averse relationship rate of inflation and the degree of central bank independence are negatively correlated, this relationship does not reflect any casual link from low inflation to central bank independence. The example of the Bundesbank in Germany can once again be implemented here, as the Germans were to afraid of inflation, having seen its impact, they are more likely to want to keep it down, whereas another country would not be so shy as to flirt with a higher inflation rate. Thus this view of central bank independence suggests that the average inflation rate is caused by history, and the “preferences of a country’s inhabitants with causality running from inflation to the institutional structure.”() According to this view, attempts to impose an independent central bank and with it a more purposeful anti-inflationary stance in a country tolerant of inflation, are destined to fail.
This argument is seemingly water tight, however when looked at with the example of New Zealand it is apparent otherwise. For most of the post war period New Zealand had one of the least independent central banks in the entire world. But in 1998 this all changed, the Government relinquished its powers to the central bank, and soon afterward the inflation rate dropped from double figures to below 2%.
Another separate argument against the autonomy of the central bank is that they form part of the overall economic policy and that there can be no meaningful separation between monetary, fiscal, labor and trade policies. This theory suggests that through such a separation there becomes a conflict between policy objectives, ultimately damaging the economy. It is clearly true that a conflicting set of policies is damaging to the economy, however it can be argued that these conflicts are inevitable in the short run, as long as central banks have the power to control inflation. However over the long term, stable financial conditions promote “ sustainably higher growth rates, increased welfare and more employment opportunities”. (www.bis.co.uk)
The main criticism against autonomous central banks is more of a political argument, rather than economical. This theory suggests that handing over the power to set interest rates, handle currency, make decisions about the exchange rate and other monetary matters to a body of unelected officials is both foolish and undemocratic. “in a democratic society all decisions should be subjected to scrutiny by the elected members of the legislature and the concept of an autonomous central bank is therefore not acceptable”()
In the case of the ECB the case for independence is explained under Article 7 of the statute, “When exercising the powers and carrying out the tasks conferred on them by this Treaty and this Statute, neither the ECB, nor a national bank, nor any member of their decision making bodies shall seek or take instructions from community institutions or bodies, from any Government of a member state or from any other body”()
If the central bank is put in charge of keeping down inflation the government will consider that controlling inflation is someone else’s job. This means that the government can pursue expansionary fiscal policies, or other inflationary policies, without fearing that it will be blamed for the consequent inflation. The clearest example of this is the period of German unification after the fall of the Berlin Wall. The government pursued German unification and a large budget deficit, while the Bundesbank was expected to keep down inflation.
The consequence of this argument is that, given that many policies which cause inflation are popular apart from their inflationary consequences, since the consequent inflation can be blamed on someone else an inflationary bias is introduced into the system precisely by having an independent central bank. That is, having an independent central bank leaves the government an incentive to pursue inflationary policies.
In conclusion I feel I have set out a balanced piece, demonstrating both the advantages and disadvantages of a system such as the ECB. Both arguments have merit to them, but after looking at the research I feel that the successful conclusion for this debate is to implement independent central banks as the power to spend money should most definetly be taken away from the power to create and control it.
Bibliography
Eijffinger, Sylvester CW
“Independent central bank and economic performance” 1977
Mishkin, Frederik S
“The Economics of Money, banking, and Financial Markets” 2003, 6th ed