Banking on Reform: Political Parties and Central Bank Independence in the Industrial Democracies

Chapter 1. Political Parties and Central Bank Independence

CHAPTER I Political Parties and Central Bank Independence Central banks stand at the intersection of economics and politics. These bureaucratic institutions implement monetary policy by regulating the supply of money and credit to the economy. Both academic and popular accounts emphasize how a country's central bank significantly shapes its economic destiny (e.g., Beckner 1996; Deane and Pringle 1995; Greider 1987; Marsh 1992). In many countries, opinion polls and newspaper stories recognize central bankers as the most influential nonelected public officials. Although central banks perform a similar function across the industrial democracies, their institutional structures-their levels of independencediffer across systems. The structure of an independent central bank restricts the government's ex-ante and ex-post influence over monetary policy, often by limiting the number of cabinet appointees on a bank's governing board, by preventing the cabinet from vetoing the bank's policy decisions, and by prohibiting the cabinet from punishing central bankers through dismissal or budget cuts. A dependent central bank, on the other hand, places few limitations on the government's authority. In the 1970s and 1980s, only a few central banks were independent; the majority of industrial democracies had dependent central banks. In the 1990s, however, this distribution shifted significantly as many countries legislated more independence for their central banks. Most dramatically, European Union (EU) member states agreed to a single currency under the administration of an independent central bank. In this book, I explain these patterns of central bank independence. 2 Banking on Reform Central Bank Independence: The Reform Trend Throughout most of the post-World War II period, only a few industrial democracies, including Germany, Switzerland, and the United States, possessed independent central banks. The German Bundesbank, for example, is generally recognized as one of the most independent central banks in the world (Deutsche Bundesbank 1989; Goodman 1992; Kennedy 1991; Marsh 1992; Sturm 1989). The German federal government appoints only a minority of the Central Bank Council, the bank's main decision-making body. Further, the government cannot veto the bank's decisions, although it may delay for two weeks the implementation of a bank decision. In countries such as Britain, Italy, and France, on the other hand, the government retained full control over the central bank's policy actions. In Britain, for example, the government appointed the entire governing board and could veto the bank's policy decisions. The Treasury dictated the Bank of England's policies (Fay 1988). Nigel Lawson, a former chancellor of the Exchequer, described the relationship between the government and the bank in this way, "I make the decisions and the Bank carries them out" (The Economist, 10 February 1990). Many economists and policymakers argue that an independent central bank insulates monetary policy from political influences to produce more stable and predictable monetary policies and as a result, lower levels of inflation. Indeed, countries with an independent central bank generally had better inflation performance during the 1970s and 1980s than countries with a dependent central bank. Yet during this time, no country moved to make its central bank more independent. In the late 1980s and 1990s, however, a wave of central bank reform swept across the industrial democracies. Politicians in Italy and New Zealand made the earliest efforts to grant their central banks more independence. In Italy a 1981 administrative decree freed the Bank of Italy from its obligation to purchase unsold public debt, an act known as the "divorce" of the Bank of Italy (Epstein and Schor 1989; Goodman 1991, 1992; Tabellini 1987, 1988). After the divorce, the Bank of Italy was less willing to finance budget deficits, forcing the government to pay for its debt through higher taxes and lower spending. Throughout the 1980s and 1990s, Italian politicians granted the bank widened authority over monetary policy, including control over the discount rate in February 1992 (Padoa-Schioppa 1987). In New Zealand politicians reformed the central bank in 1989. Under the new law, the government determines the inflation objectives, and the central Political Parties and Central Bank Independence 3 bank governor is charged with implementing monetary policy to achieve that goal. Uniquely, the reform links the bank's policy performance with the central bank governor's tenure: the governor can be dismissed if the bank does not achieve the inflation target (Dalziel 1993; Walsh 1995b). Additionally, the governor must report to the Parliament regularly about the government's economic policy choices. Perhaps the most...