What drives and derails central bank independence?

Davide Romelli of Trinity College Dublin has written a paper on the political economy of central bank independence.

LSE Business Review blog summarises the paper:

We then use a political economy framework to identify five sources of reforms: (i) status quo bias, (ii) external inducements, (iii) crises and shocks, (iv) ideology and political factors and (v) economic conditions. The results show that the lagged level of central bank independence or status quo, as well as regional pressures are important in the reform process, as countries with lower levels of independence or those that are further from their regional average are more likely to adopt reforms that increase their level of independence. An external pressure to reform also comes from international institutions, as countries receiving an IMF loan or becoming a member of a currency union adopt reforms that increase the independence of their central banks.

Reforms that increase the level of central bank independence also follow periods of high inflation rates, suggesting central bank institutional design is endogenous to the inflation dynamics of a country. On the other hand, other types of crises such as systemic banking crises, currency or sovereign debt crises are not followed by reforms that increase the level of central bank independence. The data also shows important heterogeneities depending on the level of development. For instance, government fractionalization, cabinet changes or economic growth matter for the reform process among advanced economies, while external pressures and inflationary episodes are more important in developing economies.

The index constructed also allows for a more granular analysis of the magnitude and direction of reforms. This highlights important differences in the reform process. For instance, we find that financial crises are generally followed by reforms that decrease the level of central bank independence, while external inducements, regional convergence and status quo bias matter for reforms that increase the level of independence, but not those that decrease it.

The results obtained reinforce some widely held conclusions, such as the importance of external inducements in reforming central banks, but also shed light on some ambiguities in the literature such as the role of crises. The new index constructed not only sheds light on the endogenous evolution of central banks, but also provides a useful time-varying instrument of institutional design.

Future of central bank independence is fraught with challenges:

The endogenous evolution of central bank design is an ongoing process and the index and methods proposed in this paper can be useful in identifying how new challenges faced by central banks will affect their independence. For example, in our robustness checks we show that an increase in nationalistic political parties is likely to be followed by reforms that decrease central bank independence. This increased political pressure faced by many central banks due to the rise of populist movements across the world could further threaten the hard-won independence of these policy institutions. A second challenge faced by central banks nowadays can arise from the extensive asset purchase programs undertaken to respond to the last financial crisis and, more recently, the COVID-19 global pandemic. The large amounts of government debt held by many central banks increase the risk of fiscal dominance, i.e., situations in which monetary policy could be undermined and interest rates pegged at low levels to reduce the costs of servicing sovereign debt.

Finally, the highly debated impact of climate change on the institutional design of central banks might influence reforms in the years to come. So far, no central bank around the world has formally changed their statute to include environmental and climate goals. However, governments are pressuring central banks to take actions in this direction. For example, in March 2021, Rishi Sunak, the Chancellor of the Exchequer, stated that the Bank of England will have to support the government’s efforts to make the UK economy greener and achieve zero greenhouse gas emissions by 2050. While reaffirming the Bank of England’s longstanding inflation target, Rishi Sunak also said that monetary policy should now “also reflect the importance of environmental sustainability and the transition to net zero” (Financial Times, 2021).


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