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

Chapter 4. Central Bank Independence and the Politics of Monetary Policy: The German Bundesbank in the Policy Process

CHAPTER 4 Central Bank Independence and the Politics of Monetary Policy: The German Bundesbank in the Policy Process Monetary policy reflects the strategic interaction of cabinet ministers, legislators , and central bankers in the policy process-strategic interaction that is conditioned by the formal and legal structure of the central bank. With an independent central bank, the cabinet has few direct controls over the central bank. The bank's governing board typically includes individuals appointed by a variety of political actors. Additionally, the cabinet can sanction the central bank only with the cooperation of the legislature. These institutions give central bankers more room to maneuver in the policy process (McCubbins, Noll, and Weingast 1989). As long as the central bank has the support of actors in the legislature who can veto any potential punishment, it does not have to respond to the cabinet's policy demands. Moreover, the bank can even challenge the cabinet's policy choices. This allows other political actors-backbench legislators , coalition partners, upper house legislators, voters, and interest groups-to learn about monetary policy by the interaction between the cabinet and the central bank in the policy process. An independent central bank therefore provides a check on the cabinet's discretion. This function in turn provides an important incentive in the choice of central bank institutions. In situations where cabinet ministers, party politicians , and potential coalition partners have different incentives over monetary policy, an independent central bank can help prevent political conflicts that could hurt their ability to remain in office. 57 58 Banking on Reform In this chapter, I examine the process of strategic interaction between the cabinet, legislators, and an independent central bank more fully. I first discuss the behavior to expect in the policy process. Second, I explore cases of strategic interaction between German politicians and the Bundesbank. In the conclusion , I show that politicians and central bankers from a number of countries recognize that an independent central bank can make cabinets more accountable for their policy behavior. The Political Strategy of Independent Central Banks As noted in chapter 3, politicians can influence the behavior of an independent central bank through two mechanisms: appointments and threats to reduce the bank's independent status (Lohmann 1998a). With an independent central bank, however, the cabinet does not possess sole control over either mechanism . The appointments procedures of an independent central bank typically limit the number of central government appointees to the bank's governing board. Instead, other institutions possess the authority to determine parts of the bank's board. In Germany, for example, Land governments appoint individuals to the Bundesbank's governing council. In the United States, district bank presidents, selected by regional commercial banks and business interests, form a portion of the Federal Reserve's main governing board. Furthermore, the formal institutions of an independent central bank drastically curtail the cabinet's authority to sanction the bank unilaterally. Typically , the bank can be punished only by a legislative act, requiring cooperation between the cabinet and the legislature. Threats to the bank's institutional status therefore carry more weight when the cabinet and a legislative majority share similar policy demands. Because central bankers recognize that the cabinet and the legislature are more likely to cooperate to punish the bank under these conditions, it will be more responsive to political demands. If the cabinet and the legislature are divided, however, the threat to sanction the bank is less credible. These institutional arrangements make an independent central bank accountable to multiple principals. Instead of being responsible only to the cabinet , an independent central bank is also answerable to other political actors, usually the legislature. The existence of multiple principals allows the bank to increase its room for discretionary behavior vis-a-vis the cabinet. Because both the legislature and the cabinet must cooperate to sanction the central bank, central bankers can play one principal off the other, protecting their institutional status by pleasing either the cabinet or the legislature (Morris 2000). In Central Bank Independence and the Politics ofMonetary Policy 59 the U.S. context, for example, Havrilesky (1993) shows that the Federal Reserve responds to congressional threats by implementing the president's policy demands . As long as the president is satisfied with the Federal Reserve's policy behavior , any bill to change the bank's institutional status will be vetoed. The existence of multiple veto points in the legislative process can dilute even further the...