Central Bank Independence and Economic Performance: What Does the Evidence Show? (CRS Report for Congress)
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| Release Date |
June 6, 2007 |
| Report Number |
RL31955 |
| Report Type |
Report |
| Authors |
Mark Labonte and Gail Makinen, Government and Finance Division |
| Source Agency |
Congressional Research Service |
Summary:
Keeping an economy growing over the long run at rates sufficient to provide full employment for labor and capital with low inflation or a stable price level has been an important goal for economic policy. Money and monetary policy have figured importantly in achieving this goal. Currently, it is argued, central bank independence is important to achieving this end.
Many small factors contribute to central bank independence, and so the literature does not yield a consistent definition of it. Rather, the emphasis is on three aspects of independence, the degree to which
(1) the governing board of the central bank is isolated from the political process;
(2) central banks can refuse to finance government budget deficits; and
(3) price stability has primacy as the ultimate goal of central bank activity.
Various indices of central bank independence have been compiled and used in empirical work to see how closely independence is related to such important performance characteristics of an economy as the rate of inflation, the growth of output, investment, and real interest rates.
For industrial countries, central bank independence indices embodying definitions (2) and (3) appear to be closely related to low inflation and low variability of inflation without having any effect on output and its variability, investment, and real interest rates. In particular, factor (2) seems to be driving the results, and the various measures of factor (1) have a negligible effect, a finding that the authors tend to neglect. Since the Federal Reserve cannot directly finance the U.S. government, factor (2) is not an issue for Congress. However, the results obtained with an index embodying (3) are of relevance to the conduct of monetary policy in the United States. These results may be used to support efforts to redefine the objective of monetary policy to focus it exclusively on price stability.
Critics of these studies point to three major methodological problems and one empirical problem. First, causation may be opposite to that posited. The desire for economic stability, for example, may lead to independent central banks. Thus, causation should run the other way around (or it may run in both directions). Second, central bank independence may arise because an important and influential constituency in a democratic society favors low inflation. Thus, the ultimate reason why inflation is low in some countries is the strength of important constituencies who favor low inflation. And these studies fail to measure this pressure. In a sense, they have captured only the proximate reason for low inflation, not the ultimate reason. Third, questions have been raised about the way that the authors transform non-numeric characteristics of independence into quantitative results. Finally, the data on which some of these empirical estimates are based are tainted in the sense that the samples commingle observations from the fixed and flexible exchange rate periods. The performance of central banks is quite different in each regime regardless of how its stated objective reads. This report will be updated periodically.
