Not all economists are in agreement that an increase in central bank independence is beneficial to the economy and there are a number of costs that can be associated with this policy. One obvious concern is the actions of the MPC itself. A potential issue is whether they react too quickly to short term economic indicators and forecast deviations from the inflation target, which could lead to detrimental long term effects and potentially depress economic activity unnecessarily when inflationary pressures emerge. There needs to be confidence in the MPC that this is unlikely to occur and that they will consider all indicators and consequential actions thoroughly. Though, even if were the case, Milton Friedman’s view is that money is too important and should not be left to central bankers and unelected officials. It could be argued that the MPC has insufficient expertise in areas of industry and the labour market as it is made up of academics and bank ‘insiders’ who have limited ‘real – world’ experience. In this vein of thought another concern could be raised over the government’s commitment to the independence process. With the measure put it in place the Chancellor has a great deal of influence over who is appointed to the MPC and could therefore fill it with political sympathisers whose decisions could therefore be heavily influenced.
Policy conflicts may be regarded as a major concern when deciding on whether an independent bank is ideal or not. With the Bank dictating monetary policy independent from the government, co-ordination between monetary and other government policies could become more difficult. It is possible that a result of the Bank having operational independence would be to impart a deflationary bias to policy as the Bank has an overriding concern with hitting the inflation target and these actions may not benefit the whole economy. Therefore, it may be the case that giving the Bank a degree of independence is no guarantee of macro-economic stability in the long run; particularly as in solving one problem others may be created. For example, a low level of inflation which is caused by a restrictive monetary policy may have a detrimental effect on investment and therefore on economic growth as a result of high interest rates. Rogoff (1985) suggests that whilst and independent and inflation-averse bank will reduce average inflation it will also increase output variability at the same time, making for a more unstable economy. Grilli et al. (1991) and Alesina & Summers (1991) found that central bank independence did not appear to have a detrimental effect on growth, but nor did they conclude that it was beneficial either, estimating that its effect on output growth was generally insignificant. These findings are also supported by those of Cukierman, Kalaitzidakis, Summers and Webb (1991) who found that in industrialised countries output growth was unrelated to central bank independence, suggesting, therefore, that it did not create extensive benefits to the whole economy.
Another possible issue could arise if there is extensive multiplicity of functions for the Bank in that it makes it harder for the public to judge the Bank’s overall performance. Another example as to how this could be a problem is that if there are some failures of banks which reflects badly on the central banks’ regulatory competence then its ability in conducting monetary policy could be brought into question. However, the current Labour government did take some measures that help to alleviate this concern, for example, the Bank’s role as the government’s agent for debt management has transferred to the treasury, and, whilst the Bank will remain responsible for the overall stability of the financial system, the Securities and Investments Board is now responsible for prudential supervision and conduct of business rules.
However, despite these concerns and potential costs of a more independent bank the Bank of England’s record since it was made independent in May 1997 has been a strong one, managing to keep close to the inflation target. This is in keeping with the findings of Alesina (1988) who discovered that there was generally an inverse relationship between inflation levels and the level of central bank independence within a country. Parkin (1987) and Alesina & Summers (1991) gave further support to this view, also concluding that those countries with a more dependent bank under direct control of the government experienced higher and less stable levels of inflation.
Another obvious benefit of the Labour government policies concerning the Bank of England is that a more independent bank will be influenced less by politics. This means that these arrangements can be considered superior to the previous regime in enhancing the credibility of monetary policy, as before it was possible for the Chancellor to try and extract the maximum political advantage from the process of setting interest rates. For example, one temptation for politicians may be to inflate the economy with the incentive that this may help achieve short run reductions in unemployment, even though this would not be beneficial in the long run based on theory of the Philips curve. If the monetary policy was used in this way to achieve short run goals then inflation variability would essentially be relatively high, especially if there was a regular change in government as they will all try to meet their own objectives. So it can be said that central bank independence is very useful in reducing pre-election manipulation of the monetary policy, resulting in more stable growth in the economy and less inflation variability, thus enhancing the credibility of UK monetary policy as a result.
Grilli, Masciandaro and Tabellini make the following statement that “having an independent central bank is almost like having a free lunch; there are benefits but no apparent costs in terms of macroeconomic performance”. This belief conflicts with some of the views and findings that I have discussed previously. However, Tabellini (1986) explains that one of these benefits is the possibility that central bank independence may improve the size of the government budget deficit. There is always a strong incentive for governments to use surprise inflation when they are faced with high levels of public debt as this reduces the real burden of servicing the debt. Therefore, with the Bank in control of reaching inflation targets there is a credible commitment not to inflate away the debt or provide monetary financing of the deficit, which, in turn, can increase the government’s incentive to balance its budget. This is supported by statistics which show that, during the period 1979-89, whilst most countries had rapidly growing budget deficits, those countries with an independent central bank experienced smaller increases in their deficit.
Many economists believe that having a central bank with a precise inflation objective is important to the economy as even moderate rates of inflation can impose significant economic costs on society. Both Grimes (1991) and Fischer (1991) conducted studies supporting the view that too much inflation is harmful to economic growth. In addition to these findings Alesina & Summers (1993) concluded that more independence did not lead to more variability of growth or unemployment and therefore brought about low inflation at no apparent ‘real’ cost. De Long and Summers (1992) also had findings to support these views. They specifically looked at the relationship between central bank independence levels and output per worker and thus found a positive relationship between independence and economic growth.
It may also be argued that a high level of bank independence with a specific aim to restrain inflation is an important institutional device to assure price stability. For instance, if people believe price inflation is under control, this will be factored into wage negotiations and helps to control wage inflation within the labour market. Countries that have a more dependent central bank may not be successful in achieving price stability as other considerations may interfere with this objective such as employment levels. Therefore central bank independence makes a monetary policy dedicated to low levels of inflation more credible.
There is no straightforward answer as to whether enhancing the Bank of England’s independence is an ideal situation or not as there is a lot of evidence, arguments and support both for and against the Labour government adopting this policy. It seems that an independent and inflation-averse central bank delivers two main benefits in reducing inflation and eliminating politically induced output variability, which, in turn, have further positive effects on the economy. The general assumption seems to be that a bank less prone to political manipulation will behave more predictable, thus enhancing both economic stability and growth. In addition it appears that monetary policy under this regime has also proved to be more open and transparent than previously. But in contrast to this you also face the potential problems of policy conflicts and concerns over the competence of those chosen to be part of the MPC among others, as problems in these areas could lead to a less than optimal outcome for the economy. However, it is clear that the Bank of England have been successful to this point in achieving their objective set out for them by the current Labour government so, despite the general opinions on central bank independence, these institutional arrangements could be just as the Chancellor described them; ‘a British solution for British needs’.
- “How Independent Should the Central Bank Be?” 3 papers from the American Economic Review, Papers and Proceedings, May 1995, 85 (2)
- Bank of England, “Changes at the Bank of England”, Bank of England Quarterly Bulletin, August 1997
- De Haan, J., Sturm, J.E., “The Case for Central Bank Independence”, Banca Nazionale del Lavoro Quarterly Review, September 1992
- De Haan, J. Amtenbrink, F and Eijffinger, S. (1999), “Accountability of Central banks: Aspects and Quantification”, Banca Nazionale del Lavoro Quarterly Review, Vol. LII, No. 209, June
- Hall, M.J.B., “All Change at the Bank”, Butterworth’s Journal of International Banking and Financial Law, July 1997, 12(7)
- Lewis, M.K., Mizen, P.D., “Monetary Economics”, Oxford University Press, 2000
- Pollard, P.S., “Central Bank Independence and Economic Performance”, Federal Reserve Bank of St Louis Review, July/August 1993
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De Haan, J., Sturm, J.E. “The case for central bank independence” p316
Bank of England “Changes at the Bank of England” p241