The authors used information on 316 central bank governor appointments in 57 countries between 1985 to 2020, drawing on biographical information on relationships with the executive and perception surveys of international press and independent academic experts. They combined this information into an index, Governor Appointment Index (GI), of whether the governor was more or less independent of the executive. They then compared it with three canonical models of de jure independence like specific institutional reforms targeting appointments, terms of office, and dismissal of governors.
The figure below shows no discernible relationship between the GI and measures of de cure independence in models which control for country fixed effects.
Clearly de jure independence does not translate into de facto independence.
The authors also find,
Not only have central bank governor appointments not become more independent on average, but our results further show that they may have become more political as central banks are given more operational independence. The relation between our governor appointment index and legal reforms that aim to insulate the governor from political interference turns strongly negative when central banks are given more policy or financial independence, and their operations become less transparent... Our results illustrate that legal independence is not sufficient to guarantee that the central bank is not captured by political interests... As central bank powers increase, it is likely that incentives to appoint political allies, with the explicit or implicit aim to affect future central bank policies, will increase.
Some observations:
1. This is a great example of what Lant Pritchett has described as isomorphic mimicry. It's one more addition to the long list of best practice reforms where transplantation of the form of reform does not translate into actual outcomes. The de-jure and de-facto diverge.
2. The construction of the GI is most certainly flawed. For example, while prior employment in executive is a negative for central bank independence, the opposite can be argued in many contexts. The perceptions of international press and western academics are invariably prejudiced and cannot be a reliable measure of actual independence. The example of The Economist's derisive ad hominem about the current Governor of the Reserve Bank of India as a "pliant insider" is only an illustration of ignorance and prejudice.
3. There is a more important aspect of central bank independence that the paper glosses over. As much as independence from the executive, the governor (and members of the rate setting committees) also need to have independence from market vested interests and should be free from personal conflicts of interest. Unfortunately regulatory capture and personal conflicts of interests are not uncommon, especially in the western economies. In an earlier post here I had illustrated on some of these problems.
4. Given the nature of their role and critical importance of central bank decisions on the economy as a whole, it's only natural that central banks are accountable to the political executive. After all, especially in democracies governments are elected and reposed the ultimate responsibility of managing the economies.
However, there is an endogeneity between the institutional independence of the central bank and its political accountability. The former is critically dependent on the latter. The problem is that the latter is difficult to define or prescribe in clear terms for the activities that engage central banks.
In democracies, central banks are ultimately accountable to the legislatures, and therefore to the executive, albeit within the boundaries of their statutory mandates. This becomes especially relevant as most central banks have the dual mandate of inflation control and economic growth. Given the difficult to comprehend and even more difficult to manage trade-off between inflation and growth, monetary policy responses in all but a few occasions of rising inflation is not about application of models but an exercise of human judgement. And academicians and technocrats do not have any superior expertise or exposure to be able to exercise better judgement on such trade-offs.
There is also the issue of real-world imperatives of governments in democracies which cannot be glossed over. It's true that governments generally don't prefer restrictive monetary policy because output collapse appears more politically unpalatable than higher inflation (which experience tells that even when high will generally be in the high single digits or low teens). Central banks should be cognisant of their government's concerns and accommodate where possible, but only where possible. However, in cases where there is a strong belief that accommodation is counter-productive, the central bank should be firm in politely declining the government and proceeding with its preferred course of action. Accommodate if you can, but proceed if you cannot.
5. Given the difficulties of managing the relationship between central banks and governments even with just two variables, the problems get compounded if central banks are entrusted other mandates. Consider the scenario where central banks have a role in mobilisation of climate finance and regulation of digital currencies. In both areas, democratically elected or otherwise sovereign governments can have legitimate preferences that can conflict with narrow technocratic considerations in both realms. Issues of inter-generational equity and national security are best left to sovereign governments than unelected technocrats. It's therefore important to be clear about the expectations from central banks if they are entrusted these additional responsibilities.
6. The onus is as much on the central bank as on the government in managing the relationship between central banks and the executive. This means communication between the two sides is as much important as the central bank's forward guidance communications. In case of difficult decisions, it's always useful for central bank governors to actively engage and communicate informally with the political and bureaucratic leadership in the executive about their reasons.
In some respects, I would argue that the most important relationship in central banking is that between the Governor and the political and bureaucratic leaders in the Finance Ministry. Most often, it's not the decision per se that generates discontent in the executive but the manner in which it was taken and the general breakdown of relationship between the two sides. A good relationship and effective communications can most often (not always) de-risk even harsh and politically unpalatable decisions, and thereby central bank independence itself.
7. It has been the practice in recent years to bring outsiders, mostly academicians, as central bankers. A narrative has been created that the markets will perceive the central bank insiders or bureaucrats as pliable and therefore not likely to be independent. This practice comes from the belief that central banking is a technocratic activity and academicians are the best possible technocrats. Both these assumptions are questionable.
Central bank rate setting decisions are hardly about models, but an exercise of judgement. And even among technocrats, economists working with financial institutions are likely to possess the required combination of practical experience and technical expertise than academic economists. But they come with the general conflicts of interest problems associated with revolving doors.
I'll therefore argue that, in general, insiders and bureaucrats with technical expertise and integrity are more likely to be effective than either academic or market economists. Apart from their technical competence, they also have the attributes of experience of being associated with the management of such situations which enhances the quality of their judgement, and their superior ability at effective but credible informal relationship management.
8. Finally, central bank independence is endogenous to political accountability in so far as antagonisation of the political executive will invariably result in a backlash where the political executive will generally prevail. This is a hard reality of life. I know this can appear to be a condonation of the political executives, but the idea is to be aware of this reality and exercise judgement accordingly. Carry the executive with you if you can, but proceed with firmness if you cannot.
In other words, central bank independence depends on the nature of the relationship between the two sides. If the latter becomes strained, it's more likely that the former will become compromised. Given the importance that the central banks associate with the former, it's only natural that it works extra hard to ensure the latter is harmonious.
Update 1
The political consequences of Fed's actions are enormous. A good example is, as this NYT article writes, the outcome of the next US Presidential election which could depend very deeply on Fed's actions and their outcomes. It points to the assessment of Ray Fair, a Yale Professor who has been predicting presidential and congressional elections for decades. He writes,
An optimistic story is that the Fed will raise interest rates a little more, thus contracting the economy some, but by the end of 2023 inflation will be back near 2 percent and the Fed can ease off. This is a positive story for the Democrats retaining control of the White House in 2024. Going into 2024 inflation will have been licked and output growth will have started to pick up. By November 2024 the economy will have been growing for three quarters and inflation will be under control. A pessimistic story is that inflation will not go gently and the Fed will have to keep interest rates high and possibly rising into 2024. Inflation might still be higher than the Fed wants in the summer of 2024 and the Fed will still be tightening or at least not easing off. Output growth in 2024 might be sluggish because of the Fed’s tightening. This is, of course, negative for the Democrats: high inflation and low growth... The Fed’s main goal at the moment is to get inflation down to 2 percent, not to help one political party. But the political consequences of its actions are huge.
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