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

Chapter 5. Federalism and Central Bank Independence

CHAPTER 5 Federalism and Central Bank Independence Political economists have long noted the association between federalism and central bank independence (e.g., Banaian, Laney, and Willett 1983; Lohmann 1998a; Posen 1995). Federal systems, in which political authority is divided between the central government and constituent units, tend to have independent central banks. Germany, Switzerland, and the United States-all federal systems -have independent central banks. Unitary countries, in which political power is centralized in the national government, were more likely to have dependent central banks during the 1970s and 1980s. Although the association between federalism and central bank independence appears to be strong, the mechanism linking the two institutions remains unclear. Why do we observe a correlation between federalism and independence? How does federalism affect the choice of central bank institutions? I contend that the association between federalism and central bank independence reflects the potential for intraparty conflicts over monetary policy. Federal systems increase the potential for intraparty conflict over monetary policy, giving politicians incentives to choose an independent central bank. In federal systems, party politicians are likely to face different monetary-policy pressures. Constituents will make a variety of economic policy demands, reflecting regional differences in economic activity. Additionally, the political institutions of federalism-powerful regional offices, bicameral legislatures, and so on-force party politicians to appeal to different sets of constituents and to run for office at different times. Because the possibility of intraparty conflict over monetary policy is high in federal systems, the political benefits of an independent central bank are higher as well. In this chapter, I provide empirical support for this argument. The first section identifies factors that condition the nature of the relationship between 73 74 Banking on Reform backbench legislators, coalition partners, and cabinet ministers in the area of monetary policy. The second section examines episodes of central bank choice and reform in Germany and Britain to illustrate how federalism shaped the potential for intraparty conflict and, in turn, the choice of central bank institutions . The third section tests the argument statistically against the crossnational variation of central bank independence in the 1970s and 1980s. Backbench Legislators, Coalition Partners, and Government Ministers The choice of central bank institutions reflects the potential for intraparty conflict over monetary policy. An independent central bank can prevent some of these potential conflicts by acting as a check on the cabinet's discretion over policy. An independent central bank not only insulates monetary policy from day-to-day political manipulation, but it can also publicize its policy conflicts with the government, providing backbench legislators and coalition partners with information about the cabinet's policy choices and the consequences of those choices. In systems where conflicts over monetary policy are likely, therefore , politicians will choose an independent central bank. In systems where conflict between backbenchers, coalition partners, and government ministers is less likely, politicians will opt for a dependent central bank. What factors contribute to the potential for conflict over monetary policy? First, party legislators and coalition partners will be more suspicious of the cabinet if cabinet ministers possess policy incentives that differ from their legislative supporters and coalition partners. In this situation, backbench legislators and coalition partners recognize that the government is likely to pursue policies that do not reflect their interests. Second, political conflict is likely where backbench legislators and coalition partners can credibly threaten to punish the government for its monetary-policy performance. The factors that shape the relationship between backbench legislators, coalition partners, and government ministers reflect the configuration ofelectoral, legislative , and government institutions, as well as the distribution of constituent preferences between and across political parties. In particular, many ofthe institutions of federalism increase the possibility of conflict over monetary policy. Incentive Divergence The divergence of monetary-policy incentives between legislators, parties, and ministers contributes to the potential for conflict. As policy incentives Federalism and Central Bank Independence 75 increasingly diverge, backbench legislators and coalition partners become less trustful that government ministers will pursue policies in their interests. Consequently, they will prefer an independent central bank. If legislators, coalition partners, and government ministers face similar policy incentives, however, conflict over monetary policy is less likely. Backbench legislators and coalition partners will trust the cabinet and consequently will see no need for an independent central bank to check the government's policy discretion . In the area of monetary policy, the distribution of constituent preferences and electoral institutions conditions the degree of incentive divergence...