Independence

Theoretical analyses and empirical evidence indicate that central bank independence is conducive to maintaining price stability.  According to Article 108 of the Treaty establishing the European Community (the Treaty) neither the ECB nor the national central banks, nor any member of their decision-making bodies, are allowed to seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body when exercising the powers and carrying out the tasks and duties conferred upon them.  The Community institutions and bodies and the governments of the Member States have to respect this principle and must not seek to influence the members of the decision-making bodies of the ECB.  There are also other provisions to safeguard the independence of the Eurosystem and the decision-making bodies of the ECB.  Article 101 of the Treaty prohibits the ESCB from providing credit to government.  The ECB has its own budget, and its capital is subscribed and paid up by the euro area NCBs.  Long terms of office for the members of the Governing Council, protection from dismissal prior to fulfillment of their terms and a rule stipulating that members of the Executive Board cannot be reappointed, also contribute to preventing potential political influence on individual members of the ECB’s decision-making bodies.

Economic theory offers a variety of approaches to explaining the reasons for central bank independence.  One approach examines the weight of monetary policy among all economic policy instruments, the objective of monetary policy and the question how tightly a monetary policymaking authority should be linked with other economic policymakers.  Under this approach, the institutional setup of the central bank is considered an instrument to achieve economic policy objectives.  A second approach investigates why the degree of central bank independence has varied across countries and over time.  Here, the central bank is understood as an endogenous variable which is explained by other developments but which itself is not an explanatory variable.  A third approach analyzes how the institutional status of central banks and various other (global) economic and social developments influence each other in the form of feedback mechanisms.

1 Central Bank Independence as an Instrument to Achieve Economic Policy Objectives

Public choice theorists were the first to put forward the case for taking monetary policy out of government’s hands. Since politicians seek reelection, it is argued, they are inclined to take measures to stimulate the economy before upcoming elections.  Such policies push the economy beyond its potential output, but they also fuel inflation to the same extent.  Consequently, measures to cool the economy are needed after elections.  Eventually, this incentive structure generates political business cycles (compare Nordhaus, 1975[1]).  The fact that the inflationary impact of monetary policy action becomes fully effective only with a lag of up to two years, and thus after elections, enhances the incentive for short-term monetary expansion even further.  Hence, the question arises how these distortionary incentive structures can be corrected.  One possibility would be the commitment of monetary policymakers to fixed monetary policy rules.  Alternatively, monetary policymaking may be put into the hands of authorities that are not subject to public elections, i.e. independent central banks. 

The understanding of macroeconomic processes and the role of monetary policy has further improved as it has become clear that the response patterns of economic agents are not rigid but may be affected by current economic policies and policy expectations.  Against this background, monetary policy has come to be considered a “strategic game” between the monetary authority, economic agents (businesses, trade unions) and, sometimes, the government as the fiscal authority.  Kydland and Prescott(1977)[2] as well as Barro and Gordon (1983)[3] eventually brought about the broad acknowledgement of the advantages of independent central banks.  They showed that discretionary monetary policymaking entails the incentive of stimulating the economy beyond its potential output, regardless of previous announcements. Moreover, they argued that rational economic agents anticipate such behavior, however, since the latter know the monetary policymaker’s incentive structure and account for it in their price- and wage-setting behavior. A pre-announced stability-oriented policy would therefore suffer an inherent lack of credibility and cause inflation to run above the level which, in the absence of the credibility problem, would be its social optimum without generating positive real effects.

Various approaches have been put forward to solve this time inconsistency problem.  First, monetary policy may be committed to a reliable external anchor. Many small open economies, including Austria and a number of other EU countries, successfully made use of this option over the past two decades. Larger economies may essentially choose between two options:  One would be to bind monetary policy to fixed rules.  The downside to this option, however, is the fact that it entails abandoning the flexibility in responding to economic shocks, which was achieved only after the collapse of the Bretton Woods system.  For this reason, the preferred option has been to delegate monetary policymaking to an independent central bank committed to price stability; this seems to be the appropriate institutional solution to avoid an otherwise inevitable trade-off between credibility and – to some extent – flexibility.  Central banks, for their part, hold more credibility than governments as their managers are considered more "conservative" (i.e. believed to give higher priority to price stability than to other economic policy objectives such as growth and employment) and  because the primary objective of price stability can be incorporated in the statute of an independent central bank and in the employment contracts of the central bank management. 

To sum it up, the idea of the independent central bank arose from the fact that (1) price stability is considered to be a long-term prerequisite for favorable economic developments; (2) in the long run, there can be no trade-off between price stability on the one hand and growth and employment on the other hand; and (3) independent central banks are best suited to maintain credibility and keep inflation expectations at sustained low levels.  Ideally, an independent central bank which is trusted by the public thanks to its long-term stability policy has more leeway to be flexible in its monetary policy in the short run without challenging the credibility of its fundamental long-term stability orientation. 

2 Central Bank Independence as an Endogenous Variable

A different approach sees the central bank’s institutional status as an “endogenous” variable.  From the perspective of economic history, Capie, Goodhart and Schnadt (1994)[4] explain the trends against and in favor of central bank independence observed since the early 19th century (i.e. since the beginnings of modern central banking) on the basis of three possibly mutually nonexclusive factors.

The first such factor is major political movements: After the laissez-faire period of the 19th and early 20th centuries, the Great Depression and the widespread opinion that independent central banks had failed ushered in a period of interventionism and curtailment of central bank independence. After World War II, the period of Keynesian demand management policies contributed to the nationalization of numerous central banks.  However, when in the 1980s these policies failed to control stagflation the pendulum swung back to liberalism: less government and more autonomy for central banks.

The second factor according to Capie, Goodhart and Schnadt is short-term episodes with dramatic impacts on money.  For instance, central banks have repeatedly been forced to fund wars,  and periods of high inflation (e.g. hyperinflation in Germany) or deflation (e.g. during the Great Depression) prompted fundamental reforms of monetary constitutions. 

Finally, the three authors identify a relationship between the degree of the complexity of monetary policy and the degree of central bank independence.  While under the gold standard or Bretton Woods regime of fixed exchange rates the leeway for national monetary policymakers had been insignificant anyway, in the 1970s independent monetary policies became a viable option and thus the question of the optimum institutional framework gained attention. 

Similarly, Pollard (1993)[5] argues that both central bank independence and price stability are determined by a common factor: the degree of a given society’s inflation aversion.  This perception may even lead to the conclusion (see Posen, 1994)[6] that there is no institutional solution to the credibility problem of monetary policy.  In the end, amending central bank statutes will not suffice to achieve and maintain price stability; rather, a broad social consensus is required to accomplish this objective.  This theory is underpinned by the fact that the German public’s inflation aversion triggered by the currency devaluation experienced in the first half of the 20th century was key to the Deutsche Bundesbank’s successful monetary policy. Yet, this line of argument overlooks one crucial aspect which is central to the following – third – approach.

3 The Institutional Status of Central Banks in Interaction with Other Economic and Social Developments

The example of the Deutsche Bundesbank shows that the German inflation experience may indeed have provided a major impetus for laying down the central bank’s high degree of independence in the Bundesbank Act.  Furthermore, the people’s aversion to inflation may have provided the basis for the broad acceptance of the Bundesbank’s policies.  But how did the Bundesbank manage to maintain and consolidate this culture of stability throughout the decades?  Thanks to its consistent monetary policy as well as continuous and reliable external communications with the public, the Bundesbank successfully influenced the people’s inflation preferences and expectations to a considerable extent.  To sum up, the fact that the German monetary policy was successful both by objective criteria and in terms of public perception helped ensure the Bundesbank’s independence; it was maintained despite occasional political disagreement and its rather fragile legal foundation in the form of a federal law because it was broadly supported by the people. 

In other words, this approach explains the relationship between the central bank’s institutional status and the various other economic and social factors as a control loop in which central bank actions can influence public and political support for price stability and central bank independence through positive or negative feedback loops.  This approach emphasizes the central role of maintaining a sense of proportion in monetary policy and of the central bank’s continuous and extensive communication with the general public and economic policymakers. 

Elements of Central Bank Independence

Economic and legal literature suggests categorizations to precisely grasp the concept of central bank independence. In the legal convergence assessment process prior to the completion of EMU, categorizations served to identify those elements which determine whether the statutes of the national central banks meet the requirements for participation in monetary union (see EMI, 1998, and European Commission, 1998[7]).  On the other hand, empirical investigations used categorizations to quantify the degree of independence, make it comparable and thus available for econometric analysis.  Of course all these categorizations, in particular attempts to translate various elements of independence into quantitative measures of independence, can capture only a segment of reality.  In addition, it is vital to keep in mind the difference between formal and actual independence; this difference can be substantial and vary, depending on social movements, economic developments and the persons involved.  The following classification should be considered against this background. It is a synthesis of the various approaches to identifying the key components of central bank independence.

1 The Objectives of the Central Bank 

When discussing the objectives of the central bank, two aspects should be taken into account: First, is it the central bank itself which sets its objectives or are these determined by another player or factor, such as the legislator or “inflation targets” set by government?  Second, is the central bank committed to one single objective or a combination of various objectives (in addition to domestic price stability, for instance, exchange rate stability, growth, employment, etc.)? Put differently, how accurately is the overall objective defined?  If there are several goals to be achieved, is there a clear hierarchy of objectives?  Is the objective of price stability quantified or does it leave substantial room for interpretation?  According to the general opinion, central banks should not set monetary policy objectives themselves; rather, they should be independent agents, pursuing on behalf of a “principal” an objective which has been set by the latter.  In practice, however, there are many different interpretations of this principle.  In New Zealand and the United Kingdom, for instance, the government determines inflation targets, and the central banks are independent solely in achieving these objectives.  By contrast, the Federal Reserve is committed to a bundle of economic policy goals, including price stability, growth and employment. Under this regime, the central bank is free to determine its own objectives in detail; it is only required to account to Congress at regular intervals. 

The way in which the Eurosystem sets its objectives can be viewed as a mixture of both approaches.  The European legislator laid down the objectives in the Treaty and in the Statute of the ESCB and the ECB. There is a clear hierarchy between the prime objective of price stability and the secondary objective to support the general economic policies in the Community.  There has been repeated criticism that the objective of price stability is not quantified in the above documents.  This criticism can be countered by the argument that in contrast to the wording of most other central bank statutes, the term “price stability” is fairly clear and unambiguous in an ECB context.  In fulfilling its monetary policy functions and in interpreting the concept of price stability, the Eurosystem’s room for maneuver is thus rather limited; slightly positive inflation rates may occur because of mismeasured statistical data and because it is impossible to exactly attain a given inflation target. 

2 Functional Independence

This sphere comprises a range of aspects which influence whether the central bank can pursue its objectives without interference.  First, there is the question whether the central bank is authorized to independently take decisions on its monetary policy strategy (possibly a monetary policy intermediary target) and whether it has the instruments necessary to pursue this strategy at its disposal.  In general, most industrialized countries today meet this criterion.  A central bank which gears monetary policy toward an inflation target set by the government is obviously not free to define its monetary policy strategy autonomously.  Second, a major criterion is in how far exchange rate policy keeps a rein on a central bank’s monetary policy.  In most countries, exchange rate policy is within the competence of the government.  An external exchange rate anchor can considerably limit a central bank’s actual room for maneuver, depending on the rigidity of the exchange rate target or intermediary target.  Small open economies may deliberately use this instrument of self-commitment within the framework of a comprehensive stability policy.  This does not apply to large open economies like the euro area.  Third, a key criterion of functional independence is the question whether the central bank can be forced to give credit to the government, which the Treaty explicitly prohibits (Article 101). 

3 Personal Independence

Several questions need to be taken into account when measuring personal independence at a central bank: Who appoints the board of the central bank?  What are the criteria for appointment?  Do the members of the board have to perform their function as their chief occupation?  How long is the term of office for the members of the central bank board?  Are they protected from early termination of their terms of office?  Are their terms of office renewable?  Who defines the conditions of the board members’ employment contracts?  Are the members of the board explicitly protected from having to take instructions and from attempts to exert influence on them? Without discussing any details, it should be mentioned here that all members of the ECB Governing Council meet these criteria of personal independence to a high degree (considering political and practical circumstances and international standards).  This implies that the ECB Governing Council takes its decisions independently on the basis of objective criteria within the framework of the Eurosystem’s legal mandate and with a view to safeguarding the overall interests of the Eurosystem. 

4 Institutional Independence

This criterion mainly concerns the legal status of a central bank’s statutes.  The more difficult it is to amend the statutes, the better protected is the central bank’s independence.  The provisions of the Treaty ensuring the independence of the Eurosystem and its components have constitutional status at the European level.  Amendments require the unanimity of all Member States and are subject to a ratification procedure.  The independence of the Eurosystem is thus firmly entrenched,  which is evidence of the European legislator’s trust in the Eurosystem. 

5 Budgetary Independence

The central bank should have the financial means necessary to fully carry out its tasks. 

By international standards, the Treaty grants a very high degree of formal independence to the Eurosystem,  i.e. both to the ECB and the national central banks.  Hence, the Eurosystem can rely on an almost optimal formal legal basis for building up the credibility of its stability-oriented policy.  In light of the year-long process of preparation and convergence in the run-up to monetary union, it can be assumed that the political decision-makers generally subscribe to the concept of central bank independence and the delegation of monetary policymaking to the European level.