CENTRAL BANK INDEPENDENCE IN DEVELOPED COUNTRIES
A COMPARATIVE ANALYSIS
CHIEF B. A. OKE.
The issue of central bank independence is as old as central banking and has remained an important issue throughout the evolution of central banking. Prior to the establishment of national central banks, most, if not all the industrialized countries had for reasons of facilitating government financing permitted a large number of individual private banks to issue national bank notes. The over-issue of such notes frequently led to instability in their domestic financial systems. The earliest central banks were therefore set up not only to provide financing for governments, but also to develop the financial system, often by bringing order to the note issue.
First, governments began to realize that, they could gain some financial and other advantages in supporting a particular bank in various ways. Such favouratism often backed by legislation, either took the form of granting monopoly of note issue to a private bank (e.g. the Bank of England) or the establishment of a state bank (e.g. the Russian State Bank). Some early central banks (e.g. in Switzerland, Italy, and Germany) were founded specifically to unify the note issue system, manage and protect the metallic reserve of the country and improve the payments systems. However, other economic benefits and political advantages, especially, access to seigniorage revenue activity in particular banking institution.
With its privileged legal position as currency issuer and as banker to government these early central banks began too developed into “bakers’ banks”. The monopoly position as a supplier of currency and as banker to government led to a concentration of the banking system. This in turn enabled individual banks to econ0omise on their own cash holdings and to depend on the central bank for temporary liquidity accommodation when required. Resulting from its position as the ultimate source of domestic liquidity for banking system as well as the state of monetary conditions in the economy in general. As a result of perceived conflict between these broader concern and their commercial banking operations in direct competition with commercial banks, central banks eventually had to move out of commercial banking activities and concentrate on the “true” central banking functions. In this regard, the Bank of England and the Banque de France led the way in the second half of the nineteenth century. For similar considerations, most of the central banks established in the twentieth century, central banks took on the responsibility for protecting the stability of the financial system and the external value of the century.
The development of the monetary policy function of the central bank is relatively recent dating back only to the abandonment of the gold standard. In the absence of an external standard of value, the key determinant of the exchange value of money became the rate of expansion of paper money itself. Government thus became faced with the need to manage their currency; to some extent at least, on discretionary basis. In the 1930s and 1940s – in the Great Depression and the Heyday of the Kenesian revolution, monetary policy objectives and legislated central bank mandates were stated to include monetary stability and the promotion of full employment and maximum levels of production. In the 1960s and 1970s when inflationary forces in the system gathered strength, the focus of monetary policy shifted to the maintenance of the domestic value of the currency.
The initial concern about central bank independence from government arose from the government’s ability to fund itself throughsiegniorage and the need to limit this inflation-prone source of financing. Subsequent event have elevated the importance of central bank independence, particularly, the general recognition that price stability is an important pre-condition for a sustainable growth while its attainment represents a major contribution monetary policy can make to macroeconomic management, in an environment in which monetary policy formulation is insulated from undue political pressures. Empirical evidence has continued to build up in support of the view that central bank independence helps to promote macroeconomic stability especially price stability and that countries with independent central banks have lower and more predictable budget deficits.
On the practical plane, there has been growing interest in increasing the independence of central banks in the formulation and implementation of monetary policy. Within the last decade, for example, the central banks of Chile, France, Mexico, New Zealand and Venezuela have their legal independence enhanced. Several other countries in Eastern Europe are studying specific proposals with a similar purpose and the major industrial countries of the European Economic Community are not left out of the move towards more independent central banks. In particular, the Mastricht treaty requires national central banks participating in the European Monetary Union to meet a prescribed standard of independence.
The rest of this presentation reviews major aspects of central bank independence. Section II represents the case for central bank independence. Section III attempts to provide some objective measures of central bank independence. Section IV reviews some of the empirical efforts to establish between central bank independence and economic performance.Section V represents some comparative analysis of the independence of the central banks in eight industrial countries. Section VI draws some lessons, from the theoretical, empirical and comparative analysis as a guide for institutional reforms relating to central banking especially in less developed countries.
II THE CASE FOR CENTRAL BANK INDEPENDENCE
Central bank independence from government does not mean that the central bank should be divorced completely from government. After all, a central bank is inherently a public sector institution performing specific statutory functions and it is thegovernment that hold final responsibility for the economic and financial policy of the country. Nevertheless, the degree to which the central bank is independent within the public sector can make a great difference to the conduct of monetary policy as will be revealed from the following arguments:
Central bank’s currency issue and lending functions should not be subjected to the financing and borrowing functions of the government as this may jeopardize its monetary policy function. The government may tend to become imprudent in borrowing from the central bank and would be reluctant to pay a relatively high current market rate of interest when it has authority to fix the rate. Accordingly, an independent central bank is required to curb governments’ temptation to inflationary deficit financing.
Another argument stresses the need for monetary policy to be insulated from thepolitical process because the political process is inherently short-run oriented and there exist short-run benefits from inflationary monetary policy even though the long-run effects are harmful to the economy. Inflationary monetary policy that is to some extent unanticipated will temporarily increase employment because of the short-run Philips curve tradeoff between employment and inflation. Even anticipated inflationary policy is capable of redistributing income to politically favoured sectors of the economy because of rigidities such as non-indexed tax rate or interest rate ceilings. Thus an independent central bank limits the opportunity for the political process to influence monetary policy in ways that are decidedly harmful to society.
Another case for central bank independence is that monetary policy “credibility” and hence its ability to achieve and maintain longer-run price stability within minimum real economic costs, would be improved if policy is formulated by an independent authority that can take a longer-term view. The conceptual basis of this view is formulated in terms of “dynamic inconsistency” or time “inconsistency” in monetary policy. Dynamic inconsistency is described as the inconsistency between the optimal policies that the authority would carry out once the public had acted on the basis of expectations (Fischer 1994 pp 31 – 34). To illustrate if elected policy makers have both inflation and unemployment objectives they may have an incentive to seek short-run output gains by reneging on previously announced non-inflationary monetary policy. On the basis of the governments’ earlier announcement of its commitment to fighting inflation, the private sector responds by signing contracts that embody a low expected inflation by discounting the authorities’ earlier pronouncements accordingly.
Equilibrium in this game theoretic model occurs at the point where the inflation rate is sufficiently high that the marginal cost of higher (surprise) inflation is just equal to the marginal benefit of lower employment it will produce. But this equilibrium inflation rate is higher than it needs to be, because output is at the same level (he natural rate) as it would be at lower inflation rate. All that keeps inflation rate from being lower is the authorities’ inability credibly to promise (or precomit) not to create surprise inflation at lower inflation rates. Thus, an inflation risk premium expectation will decline only slowly, if at all. Thus any device or institutional change that persuades the private sector that the government will create surprise inflation at lower inflation rates will reduce inflation rate. An independent central bank is regarded as one of the mechanism that can deal with inflation bias arising from monetary policy.
A corollary to the above view is that the acceptance of central bank independence by government will be tantamount to political recognition of the need for safeguards against the misuse of the potentially unlimited financing powers of the government though the “printing press”. Such a recognition of the central bank’s independence, backed by a mandate for maintaining price stability is a means by which government can chose the strength of its commitment to price stability.
Another argument for central bank independence, raised with respect to the Federal Reserve Bank of the United States, but of the general applicability (Clifford 1965 p. 34) is that the area of money and banking acquire a specialized and erudite knowledge usually not expected of government.Cargil, (1989 p 2) argued that independence permits the central bank to provide “outside” input on government policy questions, because those responsible for monetary policy possess an extensive overview of domestic and international economic conditions and thus can offer meaningful input into government policy discussions. The opinion of a more independent central bank would be given weight in such discussions.
III ASSESSING CENTRAL BANK INDEPENDENCE
Measuring central independence is not simple. Most proponents of central bank independence regard the issue as one of placing the central bank somewhere on a continuum of independence bounded by two points: at one end is the central bank which must formulate and execute monetary poly in strict accordance with general government policy and at the other end is the central bank that can formulate and execute monetary policy without major consideration of government, even if the effects of monetary policy conflicts with general government policy. The comparative analysis reviewed in this study below suggest that, two least independence central banks are the Bank of England and the Bank of France, while the two most independent are the Budesbank and the Swiss National Bank. In between them are the a large number of central banks with varying degrees of independence. Even then the distinction between different degrees of independence in necessary vague, so since no one argues that a central bank should be or could be, completely isolated from its institutional environment, and no one has devised a meaningful index of independence that is time and country invariant. Thus, we can only meaningfully discuss different degrees of central bank independence either for a given economy overtime or for different economies at the same point in time.
Nevertheless, we may still reasonably ask, what do we mean by central bank independence and how do we know it when we see it, recognizing of course, that de jure measures of independence may not fully reflect de facto independence? Some major features of central bank are summarized as follows:
One way of assessing independence is to determine the extent to which a central bank is free to carry out the objectives or goals set put for it by legislation. Central banks with greater formal independence tend to have a clearly stated statutory objective with somewhat narrower focus, emphasizing stability in the domestic and/or external value of the currency e.g. Germany, Netherlands, New Zealand and Chile. On the other hand, central banks that have a little policy independence tend to have statutory objectives that are more broadly defined of defined in terms of functions, rather than goals. For example, in the case of the Bank of England which is legally subordinate to the Treasury, the legislation refers only to promoting the “public good”.
Monetary Policy Independence
A second way of assessing independence is to determine the extent to which the central bank enjoys freedom from government in formulating and implementing its policies. A key component of this measure of independence is the degree of freedom the central bank has to change official interest rates and select the mix of policy instruments and techniques it uses in undertaking open market operations. Freedom in the determination of interest rate is also closely related to freedom in determining the exchange rate under a floating exchange rate regime. Monetary policy independence could be seriously impaired if the central bank does not have the freedom to manipulate policy as it sees fit, and without the need for approval by the government.
Limits on Financing Government
A third measure of central bank independence is provided by limitation imposed by the ability of the central bank to lend to the public sector, both by law and by actual practice. Such restriction specify the instruments, volume and maturity of the reference variables. Other things being equal, absolute cash limits are more binding than limits defined in terms of central bank liabilities, or of government revenue. The most accommodative limits are those which are specified in terms of government expenditures. Furthermore, central bank laws that prohibit the central bank from buying government securities on the primary market enhance the autonomy of such a bank. By contrast, when the fiscal authority chooses the deficit level and forces the central bank to finance it, the central bank has no effective independence.
Similarly, when the fiscal authority determines the rate if interest on government debt instrument, the central bank has no effective independence and can hardly conduct effective monetary policy. In some extreme cases such as Chile and Austria, the central bank cannot lend to government under any guise – indicating a high degree of independence.
Appointment and Dismissal of Directors and Management
A fourth way to assess independence is to look at the procedure in place for the appointment and dismissal and the terms of office of the Board of Directors and Chief Executive of a central bank. Governments generally control the appointment of the top management of central banks, even where the central banks have considerable statutory independence. Nevertheless, in banks that have a greater degree of independence, the government’s appointment and dismissal powers generally have more limitations. Such limitations include a proportion of non-governmental appointments or non-governmental nomination of candidates, appointment of terms of office that are relatively longer than the electoral cycle, and staggered to reduce the ability of government to place their own appointees in dominating position.
A fifth way to measure central bank independence has to do with the way the central bank finances itself i.e. budgetary independence. A self-financing central bank is considered more independent that one dependent on government for annual budgetary appropriations or that has to present its annual budget to government for approval. A potential concern in relation to budgetary independence is that a government could indirectly extert undue influence on the bank’s policy by restricting it access to funds. Thus, budgetary independence insulates the bank from pressures that might otherwise flow from the power “power of the purse”.
Most of the measures of the central bank independence indicated above have focused largely on the formal relationship between the central bank and the government as defined by laws and rules establishing the central bank. Reliance on legal indicators of autonomy alone can misrepresent the degree of central bank independence. Central banks that appear to have considerable formal independence may very well be more dependent on government than central banks that have less formal independence. In the first place, the laws cannot specify explicitly the limits of authority between the central banks and the political authorities to meet every contingency. The NO IDEA that emerge are filled by either tradition at best, or power politics at worst. It is observed for instance that countries with a traditional sentiment towards controlling the financial power of the national government – such as is usually found in federations and confederations like the Federal Republic of Germany, the USA, Austria and Australia, among others – have central banks with high independence. In the second place, even when the law is explicit, actual practice may deviate from it. The spirit of the law and its application in practice and generally more importance the letters of the law. Consequently, actual, as opposed to the legal independence, depends not only on the law, but also on other less structured factors such as the personalities of key individuals in the bank and in the rest of the government, the respect for the rule of law with regard to the observance of legislation, the quality of the bank’s advice and the formal and informal arrangements between the bank and other arms of government. All these factors combine with the legal provisions to shape the actual level of a central bank’s independence.
SOME EMPIRICAL EVEIDENCE ON CENTRAL BANK INDEPENDENCE AND PRICE STABILITY
Empirical evidence on the relationship between central bank independence and economic performance focus largely on the relationship between central bank independence and price stability. This is based on the assumption that the primary responsibility of a modern central bank is the control of inflation or the maintenance of price stability. (Cargil 1989 and Fischer 1994).
The analysis of central bank legislations of 12 industrial countries by Barde and Parkin 1985 indicated the existence of a statically significant relationship between central bank policy independence and reduced inflation. For Western Germany and Switzerland which have central banks that are considered more independent than most central banks, the results showed that they had the lowest inflation rates. Parkin (1986) extended the analysis to investigate the way in which central bank independence influences the government’s budgertary process and came up with the conclusion that countries with more independent central banks had lower and more predictable deficit than the average.
Banian, Lancy and Willet (1983) focused on the reaction function approach to determining the relationship between central bank independence and macroeconomic performance of 12 industrial countries. The results show that in general, monetary policy less accommodative of government deficits financing in the countries with more independent central banks. NO IDEA and the United States illustrate the least accommodative monetary policy with respect to government budgetary deficit financing. On the relationship between central bank independence and inflation in 17 industrial countries, they found that while many of the regressors were not statistically significant at convetional levels of probability, the independent dummy variable representing the influence of central bank independence on the inflation process was highly significant and negative and concluded that the independence of central banks from government lowers price inflation rate. The three countries regarded as having the most independent central banks and represented by the dummy variable were Germany, Switzerland and the United States.
Masciandro and Tabelini (1988) applied a game-theoretic model of monetary and fiscal policy whose implications were similar to those obtained by Parkin, namely that the equilibrium size of the government deficit depends on the independence of the central banks in the sense that deficits tend to be smaller the less accommodative the central bank in the. Of the five countries covered and for the period 1970 – 85, they found that fiscal dominance was least in the United States, while the New Zealand had the highest degree of fiscal dominance. Canada was closer to the US fiscal dominance while Japan and Australia were closer to New Zealand. A comparison between fiscal deficit and other measures of macroeconomic performance and central bank independence suggested that the higher the degree of fiscal dominance the larger the fiscal deficit.
In more recent studies using the game-theoretic model, several empirical measures of the relationship between legal central bank independent and inflation have been carried out with the following results: Grilli, Mascindo and Tabellini (1991) calculated an index (GMT Index) for 18 industrial countries as a simple sum of 15 different legal provisions, grouped under five headings; (i) appointments (ii) relationship with government (iii) constitution (iv) monetary financing of the budget deficit and (v) monetary instrument. Under requirements, the central bank is more independent if government does not appoint the governor, the longer term for the governor etc. Two provisions appeared under the constitution to indicate whether there was a statutory requirement that the central bank pursues monetary stability among its goals and whether there was a legal provisions that strengthens the hand of the central bank in disoutes with government. There were also two criteria under the monetary instruments i.e. whether the central bank sets the rate and whether the central bank supervises commercial banks. The empirical results show that for average rate of inflation and central bank independence. The analysis pointed most strongly to the lack of goal and instrument independence as a key factors in determining the statutory bias in policy.
Fischer (1994) broke down the GMT index of central bank independence into three components in an attempt to isolate these effects. The first is the presence of a statutory requirement that the central bank pursue monetary stability among its goals, which is labeled INFOBJ. The second, EC6, consists of those measures relating to the central bank’s right not to finance the government, and to set the discount rate. The third is a combination of legal provisions relating to appointments and the central banks relationship with government, labeled POL7. He found that the two variables closely tied inflation performances are INFOBJ and EC6. EC6, was found to be most highly correlated with inflation, while POL7 was not significantly related to inflation. The most striking result of the empirical work is that central bank performance independence seems to have no adverse consequences. Thus, the improved inflation performance associated with increased central bank independence for industrialized countries did not come at a cost in terms of foregone growth.
Cukierman, Steven, Webb and Neyapti (1992), measuring the independence of central banks and its effect on policy outcomes covered 72 countries including 21 industrialized countries and 51 less developed countries (LDCs). They showed that this relationship which is very robust for industrialized countries did not extend to the whole 72 countries including the LDCs. For a cross-section of the 72 countries, there was a slightly positive relationship between inflation and central bank independence. For this group of countries, however, it was also found that inflation is positively and significantly correlated with the rate of turnover of central bank governors. The contrast between the results for the industrialized countries and the LDCs was attributed to the difference between actual and legal independence.
Evaluation of the Empirical Evidence
A number of reservations relating to the studies highlighted above have been made as follows:
Emphasis on formal rules that define the relationship between the central bank and the government to determine the degree of independence may not be reliable.
Use of discrete measures of central bank independence in the form of dummy variable by Bade and Parkin (1985), Brain, Lancy and Willet (1983) may render the results sensitive to changes in model specification and trend to give heavy weight to the small number of countries that regarded as having independent central banks.
Cross-section data do not take account of difference among countries that can account for differences in macroeconomic performance.
The result could reflect either reverse causation from inflation aversion to central bank independence, or closely related the presence of a third factor that produces both economic stability and central bank independence.
However, Cargil (1989) and Fischer (1994) emphasized that, the above comments are not meant to imply that the empirical results are incorrect or that they lack intuitive appeal and further pointed out the following important outcome of the studies:
The central banks of Germany, Switzerland and the United States were revealed as the most independent.
The inflation rate represents an important element of relationship between central bank independence and macroeconomic performance.
Central bank financing of government deficit represents an important channel through which a less independent central bank contributes to inflation.
All the studies concluded that the more independent the central bank, the lower the rate of inflation and government deficit.
On average, economic performance was better in countries with more independent central banks.
V A COMPARATIVE ANALYSIS OF CENTRAL BANK INDEPENDENCE
This section represents a comparative analysis of the degree of independence enjoyed by central banks in eight industrialized countries, namely, Western Germany, Switzerland, United States of America, Austria, New Zealand, Japan, England and France. This is done by presenting a summary account of the legal provisions and established practices in each country, with emphasis on the criteria already indicated above for identifying the major elements of central bank independence or lack of it.
The Deutsche Bundesbank
The Deutsche Bundesbank is charged with the main goal “of safeguarding the currency” and it is required to support the general economic policy of the Federal Government, but only to the extent that is consistent with its primary responsibility of safeguarding the currency. In practice this is understood to mean that in the case of conflict, where supporting other government policy would impair the Bundesbank’s ability to pursue its priority objective, the commitment to practice stability would carry the day.
The bundesbank has full responsibility for the formulation and execution of monetary policy. The central bank Council, chaired by the President of the Bundesbank sets monetary policy by simple majority. The bank has full control over monetary policy and has the sole and unrestricted authority to use the traditional instruments of monetary policy, namely interest rate, rediscount policy, minimum reserve requirement, open market operations etc. although the Federal Government has the right to decide on the exchange rate regime, in practice, it subject to the approval of the Bundesbank. The Bank is also responsible for discretionary exchange rate intervention policy in the foreign exchange market.
However, the policy independence of the Bundesbank is not complete. Members of the government may attend and propose motions at meetings of the central bank Council, but they have no vote. They even have the right to ask Council decision be delayed for up to two weeks.
The Bundesbank’s legislation sets strict limits on credit to the government. The limits on direct Deutschebank credit to government are fixed in absolute deutsche mark and have not been changed since 1967. The Bank cannot acquire government paper on its own account but can do so in the course of open market operations. It is explicit that such secondary market purchases can only be for monetary control purposes.
The President of Bundesbank and not more than 10 Directors are appointed to an eight-year term (maximum) by the Parliament upon nomination by the Federal Government. The central bank Council is composed of this directorate plus the president of the eleven Lander (state) central banks which is somewhat analogous to District Federal Reserve Banks of the United States. The 11 Presidents are nominated by appropriate local authorities before being appointed by Parliament for an eight-year term, subject to re-appointment. Members of the Council cannot be removed from office.
Although the German Federal Government owns all the capital of the Bundesbank and receives any profit, it does not derive any further rights from the Bank. The Bank enjoys full budgetary independence. The Bundesbank is not formally accountable to any arm of government, but to the general public and submits an annual report to the Government. Monitoring by the public is facilitated by the publication and attainment of monetary aggregate targets since the mid-1970s, the publication of monthly reports, and the holding of regular press conferences.
The Swiss National Bank (SNB)
Probably the only central bank that can be ranked with the Deutsche Bundesbank in terms of institutional independence is that of Switzerland. The Swiss National Bank (SNB) is required by legislation “to regulate the country’s money circulation, to facilitate payment transaction, and to preserve a credit and monetary policy serving the interest of the country as a whole”. The SNB understands this primarily as a mandate for ensuring price stability with the instruments at its disposal Fischer (1994 p6).
The SNB and the Government must consult with each other on policy matters but approved before implementation by the other party is not necessary. A small Board selected by the Council from among its members directly manages monetary policy. The control of the bank by the Government is explicitly limited by law to such matters as determining the size of the Bank’s capital, the domination of the bank notes and the division of profiting among cantons. Formal government participation in monetary policy formulation is relatively minor.
As in the case of Germany, the legislation sets strict limits on direct central bank advances to government, but allows government securities to be acquired by the Bank in open market operations for monetary control purposes. Of the 40 members of the Bank’s Council, 25 are appointed by the government cabinet for a four-year term while the remaining 15 are elected by bank stakeholders.
The Bank is constitutionally independent of the parliamentary body, but as in Germany it submits an annual report. Unlike West Germany, the Swiss Confederation owns no shares in its central bank. Stock is held by the cantons, cantonal banks, and the public. Shares are listed on the Swiss Stock Exchange.
The Federal Reserve Bank of the United States
When the Federal Reserve System was establish in 1913, the legislation defined three responsibilities: (i) to issue and redeem currency (ii) to function as a lender of last resort; and (iii) to supervise banking. There was no specific monetary policy stabilization role assigned to the Federal Reserve until after the Great Depression of the 1930s. Today it can be said that prices stability is the major goal of the Federal Reserve.
Monetary poly formulation is the responsibility of the 7 member Board of Governors. The Board sets the discount rate and reserve requirements. It also supervises and regulates the banking system, including the District Federal Reserve Banks. The 7 members of the board along with 5 members of the 12 District Reserve Banks’ presidents constitute the Federal Open Market committee (FOMC) which directs the system’s open market operations, and thereby the general course of monetary policy. The Board of Governors are appointment for a 14 year term by the President of the United States, subject to confirmation by the Senate. The appointments are staggered in such a way that only becomes vacant every even-number year.
There are no specific legal limits on the Federal Reserve Financing of government, but in practice the Federal Reserve does not subscribe to new issues of government securities but operates in the secondary market and purchase government securities and its own discretion in open market.
Other elements of the independence of the Federal Reserve include, budgetary independence, absence of Treasury representation on the Board of Directors since 1935 and the fact that the majority of its operations are not subject to audit by government accounting officers.
The independence of the Federal Reserve is further underscored by the fact that its decisions on monetary policy formulation and implementation do not have to be ratified by the President or any of his appointees I the executive branch of the government. Bu the Federal Reserve must report to the Congress and, therefore, to the people as a whole on its policies twice a year – in July and February. These reports focus on several monetary and credit aggregate targets, policy objectives, expectations about the performance of the economy, and the relationship of monetary objectives to the economic goals and policies of the administration and the Congress.
The National Bank of Austria (NBA)
The general provisions of the National Bank Act 1984 assign the bank the function of regulating the circulation of money in Austria and of attending to the settlement of payments with foreign countries. It is required to ensure with all the means at its disposal of the value of the Austrian currency is maintained with regard to both its domestic purchasing power and to its relationship with stable foreign currencies.
As is the case with the Bundesbank, NBA is charged with the responsibility for monetary policy and of supporting government’s economic policy to the extent permitted by its primary responsibility for the maintenance of the domestic and external value of the currency. The governing Board is charged with the supreme direction of the bank and the supervision of the Executive Directors, comprising a maximum of six persons who are responsible for the overall running of the Bank in accordance with the law and the directives issued by the Governing Board. The bank is encouraged to participate in the formulation of other national economic policy. Laws concerning economic matters have to be appraised by the Bank. It is also granted independence in the performance of its policy functions with a unique arrangement for conflict resolution.
Article 21 of the Act states that: ‘If the Governing Board feels impeded by’ the government’s supervision or if there is an infringement of any of the prohibitions for or any individual member of the Board may appeal to an Attribution Tribunal which has to give a final decision within three days. According to Article 40, Arbitration and four members, two of whom shall be composed of the President of the Supreme Court, who shall preside and four members, two of whom shall be appointed by the Federal Government and two by the Bank. Another provision of the Act that safeguards the Banks independence is article 42 which expressly states that no transaction may involve the granting of any loan or credit by the Bank to the Federal Republic.
The Governing Council consists of the Governor, two deputy Governors and eleven other members. The Governor is appointed by the President of the Federal Republic, the two Deputy Governors are appointed by the Federal Government while the other six are elected by the Bank’s general meeting. This reflects the fact the NBA is a joint stock company with half of its capital subscribed by the government and the other private interests. Not more than four active bankers are permitted on the Governing Board. The term of office is five years for all members; no dismissal is possible, except when the requirements for the appointment are no longer met a member is prevented for more than a year from performing his or her duties. The Governor is independent but accountable, not to the President nor to Parliament, but to the general public.
The Reserve Bank of New Zealand (RBN)
The legislation of the Reserve bank of New Zealand (RBN) was changed in 1990 with a view to setting up procedures having transparency and clarity and making the Bank more independent in the conduct of monetary policy. Prior to the change, the old legislation required the RBN to provide advice to government on monetary policy and to carry out the monetary policy of the government. The stated objectives of the monetary policy were mixed, imprecise and conflicting. They included the maintenance and promotion of social welfare, the promotion of trade, production, and full employment, and maintenance of stable internal price level. At times, the relative importance of the objectives was changed according to political whim or current political pressures. Apart from the inherent conflicts, absolute power in decision making was in the hands of Minister of Finance. These compelled with the rejection of Reserve Bank advice, by the government subsequently led to a disastrous outcome for the New Zealand economy in early 1980s. Fiscal deficit ballooned, inflation persisted, the fixed exchange rate became overvalued, the external deficit widened and external debt was growing. There was effective monetary policy applied and the pervasive direct controls were ineffective. The change in the Reserve Bank legislation and its relationship with government was a part of the structural adjustment programme to improve macroeconomic performance.
The major reforms of the new legislation made the following provision for:
The Bank to formulate and implement policy with the economic objective of achieving and maintaining stability in the general level of prices.
The Minister, before appointing any person as Governor to fix in agreement with that person, policy targets for the Bank during that person’s term of office;
The Bank when formulating and implementing monetary policy to have regard to the efficiency and soundness of the financial system and consult with and give advice to the government and others to achieve and maintain its economic objective.
The government may direct the Bank to pursue economic objective of monetary policy other than price stability for a period of not more than twelve months, with provision for extension.
The Bank to publish statements at least every six months explaining policies and objectives for the target period and reviewing its performance; and
The removal of the Governor from office due to, among other things, inadequate performance/in relation to the policy targets.
There is also a provision for a five-year Funding Agreement to be signed by the Minister and the Governor, specifying the maximum allowable expenditure by the bank over the period. The Acts provides for a maximum of ten directors, up to seven of whom will be outside directors. The principal role of the Board of Directors is to monitor the Governor’s performance. They have the power to recommend the Governor’s dismissal (in extrims) but do not participate in policy formulation. The Governor is the Chairman of the Board with the provision for two Deputy Governors, one of whom will be Deputy Chairman of the Board. Governors are appointed for five-year term and other directors for three years.
The changes brought immediate improvements in macroeconomic performance. The inflation rate are declined to 5 percent from range of 10 – 20 percent that had persisted throughout the 1980s.
The Bank of Japan (BOJ)
The Bank of Japan (BOJ) was established in 1882 and the only instance of major amendments in the Act was in 1942. It is one of the central banks usually cited as having more capital independence than is reflected in its legislative provisions. Others claim that BOJs ability to maintain low inflation without being independent of government belied the claim that central bank independence promotes lower inflation. The Government owns 55 percent of the stock of the BOJ and the reimagining 45 percent are held by individual investors. Unlike the Swiss National Bank, the shares are not listed but trading takes place in the over-the counter market. The BOJ is obliged to pay 5 percent annual rate of return to stock holders and a major part of its profit (about 94% in 1985) is transferred to the Government.
BOJ’s objectives are defined in broad terms to include the registration of the currency, the control and facilitation of the credit and finance, and the maintenance and fostering of the credit systems and the pursuant of the national policy in order that the general economic activities of the nation might adequately be enhanced. The overall objective is to be achieved by fulfilling the following functions: (1) the sole issue of bank (2) to function as a “bank of banks” (3) to function as a “bank of government” and (4) to enforce monetary policy through functions (1) – (3) (Cargil (1989) pp 22 – 23). The BOJ was neither assigned explicit responsibility for the formulation of monetary policy nor explicit supervisory role because the Ministry of Finance (MOF) is responsible for supervision and regulation of the financial system, while the BOJ merely contributes to the process. The BOJ itself as well as monetary policy formulation is under the control of the MOF.
The formal policy formulation of the BOJ is the 7-member Policy Board established in 1949. It consist of the Governor of the Bank of Japan, a representative of the MOF, a representative of the Economic Planning Agency (EPA) and four others, representing banking, commerce, industry and agriculture.
The representative of the MOF and EPA are non-voting members. However in practice, the Executive Board which consist of the Governor, Vice Governor, and several Executive Directors representing various functions within the BOJ have major responsibility for formulating monetary policy for the approval of the policy Board (Cargil 1989).
The BOJ Governor is appointed by the Cabinet for a term of 5 years, while the remaining voting members are appointed by the Cabinet for 4 years and may be reappointed. The other members of the Executive Board are appointed by the Governor, subject to the approval of the MOF.
Although, the BOJ in the execution of monetary policy, has access to the same set of policy instruments employed by independent central banks, like the Bundesbank and the Federal Reserve – reserve requirements, discount policy, open market operations, as well as uniquely Japanese policy instruments, such as “window guidance” it is unlikely that the BOJ would undertake significant change in policy without prior discussion with the MOF.
The BOJ is under the broad control of the government. It is required to be on call to the Cabinet and one of the legislated responsibilities of the MOF is to supervise with the MOF’s role annual budget is subject to the approval of the MOF. Combined with the MOF’s role in selecting appointments to the Policy and Executive Boards, the law defining the BOJ clearly intends the central bank to be dependent on the government. Although the degree of MOF control over monetary policy is said to have declined since 1975, with BOJ exercising, more independence and getting involved in sharper conflict with the MOF on a number of issues, the MOF can potentially play a major role in the formulation and implementation of monetary policy.
The Bank of England
In view of the need for the central banks members of the European Monetary System (EMS) to enjoy considerable independence from their Governments before the introduction of a single European Currency and the European central Bank system, there is a lively debate in Britain over the desirability of making the Bank of England more independent.
The bank of England has no clearly defined goals. The legislation refers only to promoting the “public good”. Indeed there is a logical difficulty in specifying independent policy goals for a non-independent agency. In the United Kingdom, the Treasury and not the Bank has responsibility for monetary policy. In practice, the Treasury is in control of monetary policy and the Bank is the agent that implements monetary policy in close consultation with the Treasury. Monetary policy targets are announced by the Government. The Treasury has the power (so far apparently unused) to issue formal but unpublished directives to the Bank.
There are no specific legal limits on financing of the Government by the Bank but it formulates and manages its own internal budget; which is not subject to approval by the Treasury.
With no formal independence there is lack of strong accountability mechanism for the Bank, in relation to the direction of monetary policy. Rather, the Chancellor of the Exchequer and the Government as a whole bear responsibility for the formulation and implementation of monetary policy and parliamentary review proceeds accordingly. A parliamentary committee examines the Governor of the B of E and other officers of the Bank regularly with particular attention to report to and the periodic Inflation Report are the main formal instruments of accountability.
The Bank of France
The European Monetary System has improved financial and budgetary discipline in France in the last few years. It also probably influenced the inclusion of price stability objective in the amended Bank of France Act in 1993, but it has not significantly improved the Bank of France with the responsibility for ensuring price stability within the framework of government’s overall economic policy. This is similar to the Bundesbank mandate, but without the provision that the price stability mandate over-rides the obligation to support government’s economic policy.
In France, the Ministry of Economy decides on the stance of monetary policy. Formal monetary policy responsibility and independence is explicitly denied in the legislation of the Bank of France. Monetary policy targets are announced by the Government and not the responsibility of the Bank of France.
Limits on financing of the Government by the Bank of France are agreed upon between the Bank and the Minister and presuppose the approval of Parliament. The Bank has no budgetary independence. Its annual budget is subject to approval by the government. The Presidents appoints all the directors of the Bank, in consultation with the Cabinet, except that one is appointed by the staff.
The Directors have staggered six-year terms, and the Governor and its deputies are appointed for indefinite terms, which in practice are limited to 5 – 7 years. There is no limit on the President’s ability to remove incumbents.
As in the case with the Bank of England, the Bank of France has no formal accountability. The Minister of Economy and the Government as a whole bear responsibility for the formulation of monetary policy and parliamentary review proceeds accordingly. Such reviews are less frequent in France. The Bank’s annual report presented to the President through the minister is the main formal instrument of accountability.
VI SUMMARY AND CONCLUSION
This paper review the main relating to central bank independence. the introduction examines the evolution of central banking itself. Initially, the concern about central bank independence was a limit governments’ ability to finance itself through seigniorage. Developments in the course of time elevated the importance of central bank independence. the argument that central bank independence contributes to the attainment of price stability and better macroeconomic performance has been reinforced by a large volume of increasingly persuasive empirical evidence. In view of this, a number of countries with poor record of inflation e.g. Chile, Mexico, New Zealand and Venezuela have had the legal independence of their central banks enhanced. In addition, several members of the European Monetary System and other countries in Eastern Europe have recently made or are considering significant changes to their central banks legislation for the same purpose.
However, it is recognized that the government has ultimate responsibility for general economic policy. Hence the central bank independence does not mean that the central bank is/or should be divorced completely from government, but that it should be “independent within government”. The argument for central bank independence include, (a) the need to separate the currency function of the central bank from the financing and borrowing functions of Government, (b) to insulate central bank monetary policy function from undue political pressure, (c) to improve monetary policy transparency and credibility and (d) reduce the inflation bias from dynamic inconsistency in monetary policy. It was noted that the acceptance of central bank independence by Government is a means by which such government can demonstrate its commitment to price stability and enhance the quality of monetary policy, and other macroeconomic policy formulation.
Regarding the measurement of central bank independence, it was observed that independent central banks generally have narrow and clearly defined policy objectives and freedom to formulate and implement monetary policy to achieve the stated objective(s). They are either precluded from financing government deficits or strict limits are imposed on their ability to do so. They have budgetary independence while terms of appointment of the boards and Chief Executives are fairly long and their dismissal difficult or precluded.
The comparative analysis of the central banks of eight industrialized countries undertaken in this paper revealed the existence of varying degrees of independence. However, various empirical studies have demonstrated that the countries with more independent central banks, on average, have smaller and less variable fiscal deficit, lower inflation rates and better macroeconomic performance.
Before including this paper with some lessons drawn from the theoretical, empirical and comparative analysis done above, two important caveats should be borne in mind:
First, the desired degree of independence and details of the legislation on the relationship between the central bank and the government would be influenced by a number of country-specific factors. Such factors include the country’s inflation history, the nature of existing checks and balances in the political system, the level of public awareness and debate of economic issues, the state of development of the financial markets etc.
Second, however solid the economic case for central bank independence might be; it is not likely to happen in reality unless political stability is achieved in each relevant society – the minimum condition being the establishment of a constitutional government based on the rule of law.
The lessons drawn are as follows:
The central bank should not be allowed goal independence because the setting of monetary policy goal(s) is a fundamental responsibility of the government.
The goal of central bank should be clearly defined to include the maintenance or achievement of price stability. Conflicting goals should be avoided e.g. price stability, may conflict with objectives of full employment, economic growth, balance of payment etc.
The central bank should be granted instrument independence i.e. the ability to design and implement monetary policy freely using all the instruments at its disposal to achieve the goal(s) or targets set for it.
The central bank should publicly announce its intermediate term policy goals e.g. the inflation goal for the next three years should be announced after consultation with appropriate arms of government, such as those responsible Finance, Planning and Economic Development. The changes in the terms of trade, interest rates, indirect taxes etc in judging whether the target has been met.
The central bank should be accountable, by being held responsible for meeting its announced goals. The Governor should be required to explain preferably to a selected group of well informed elected officials. The testimony should be accompanied by the publication of a report. This is similar to the Humphrey – Hawkins hearing at which the chairman of the Federal Reserve Board testifies twice a year before the U.S. Senate.
The function and responsibility of the Board of Directors and Executive Board should be clearly stated to show that monetary policy is their primary responsibility, financial and economic matters. Board members should be appointed for a lengthy term, say 8 – 10 years.
The central bank should not be required to finance government deficit and should not manage the public debt.
Functions of the central bank should be defined to include the promotion of a stable financial system through the traditional roles of lender of last resort, banking licensing, prudential supervision and regulation etc. even where some of these functions (e.g. supervision and regulations) are delegated to other agencies, the central should either have concurrent authority or considerable input.
The central bank should enjoy budgetary autonomy, and its annual budget should not be subject to government or ministerial approval.
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