Stiglitz(2)

["Z.CUI" <zcui@xxxxxxx>]

The Independence of the Central Bank

     So far, I have argued that monetary policy matters, and that it has
improved the economy's economic
     performance, even though it is fallible. I have focused on the United
States - showing that the theoretical
     framework that seems to underlie its rhetoric is not based on empirical
evidence, and that its understanding of
     economic events over the past decade has been, at crucial points,
flawed, sometimes to the detriment of the
     economy. I could have provided similar stories for other central banks
or other times. But why should that
     surprise us. As Shakespeare has said, "To err is human." Why should we
expect anything less or more of central
     bankers than of other mortals.

     Our economic institutions should be designed to cope with human
fallibility.19 The United States Constitution
     created a system of checks and balances, partly because the Founding
Fathers were worried about the fallibility
     of any single individual, especially one who is in a position that
wields enormous power.

     There is an increasing tendency around the world to devolve
responsibility for managing monetary policy on an
     independent central bank. In many, if not most, countries the
deliberations of the central bank are secret, and
     many, if not most, decision making power is highly concentrated in the
Governor. I find this deeply troubling on
     several accounts

     The most fundamental is a matter of democratic philosophy. Monetary
policy is a key determinant of the
     economy's macro-economic performance. The elected government is
inevitably held accountable for that
     performance, as I noted in my introduction; yet, especially as fiscal
policy becomes constrained by budget
     stringency (and it will be even more constrained in Europe with the
agreements underlying the monetary
     unification, and would have become more constrained in the United
States had the balanced budget amendment
     passed), monetary policy is the main instrument for affecting
macro-economic performance. That this key
     determinant of what happens to society - this key collective action -
should be so removed from control of the
     democratically elected officials should at least raise questions.

     Moreover, transparency - openness - is now recognized as a central
aspect of democratic processes. There
     cannot be effective democratic governance without information. Yet
central banks continue to operate in secrecy.

     The concentration of power in the hands of a single individual raises
concerns about fallibility. To be sure, some
     central bankers may be prescient - though I can think of none today
that fall within that category. Some may even
     have values that are broadly reflective of society as a whole. But the
same might be said about dictatorships. A
     fundamental principle of democratic philosophy is that there should not
be a concentration of power in the hands
     of any single individual; and this is also a fundamental implication of
the fact of human fallibility.

     The ostensible reason for delegating responsibility to a group of
experts is that the decisions are viewed to
     involve largely technical matters in which politics should not intrude.
But the decisions made by the central bank
     are not just technical decisions; they involve trade-offs, judgments
about whether the risks of inflation are worth
     the benefits of lower unemployment. These trade-offs involve values. I
recall a recent meeting with a former
     central banker in which he expressed his view on the matter: he
emphasized the asymmetries of the risk. If
     inflation increases, there are real costs that have to be borne; if
unemployment increases, and it turns out that the
     economy is operating at an unemployment rate above the NAIRU, then the
costs are minimal and the "mistake"
     can be reversed. Given the evidence on the macro-economic costs of
inflation in the low inflation environment of
     the United States, let me translate what he was saying: if inflation
increases, real people - bond holders - are hurt,
     as nominal interest rates increase and prices of bonds fall;
unemployment, on the other hand, mainly hurts
     workers, particularly marginalized workers, since these are the first
to lose their jobs as unemployment increases.

     Typically, those who make the decisions are not representative of
society as a whole, and in some countries, they
     are chosen in ways which are hard to reconcile with democratic
values.20 In many countries, bankers are
     disproportionately represented; and even if they do not come from a
banking background, they quickly get
     captured by the banking community in which they are immersed. Few
countries ensure that workers and their
     interests are represented, even though the actions of the central bank
have a vital impact on them.

     To be sure, we want expertise in running the central bank, and it is
natural that we turn to bankers for that
     expertise. This is the kind of conflict that arises in many aspects of
economic regulation: expertise is concentrated
     in those who are in the business, and plays an important role in the
capture of the regulatory bodies by the
     industries that they are intended to regulate.21 But at least in this
particular case there are bodies of expertise
     outside the industry itself, most notably in academia (though this
remark may seem self-serving). This is especially
     true for questions like monetary policy that do not rely on privileged
information or detailed hands-on knowledge.
     Some countries, motivated by these concerns, have taken the bold step
of forbidding bankers to serve on the
     governing board of the central bank. Expertise can be hired. In many
other areas, we separate out expertise from
     governance.

     Moreover, the separation between expertise and values is not as clear
as it is sometimes depicted. For instance, I
     was repeatedly struck by how those who, on the basis of their values,
worried more about inflation and less
     about unemployment, also more frequently saw inflation lurking around
the corner. As I noted earlier, we shared
     data with the Fed. We even shared models. We had the same data
describing what was happening to wages and
     prices. But we frequently made different inferences about what was
likely to happen in the future. We all knew
     that we had at best a cloudy crystal ball - but policy makers have to
do with what they have, and when we each
     looked into the clouds, we saw different things. But what was
interesting was that the inflation hawks focused on
     the most pessimistic interpretations of the data; while the inflation
doves on the most optimistic. As it turned out,
     in the last several years the latter were far closer to the truth than
the former, but the point is not to crow about
     superior insight, but to remind ourselves both about human fallibility
and the bias values imparts to what is
     ostensibly technical analysis.22

     Value judgments often assert themselves even in what should be purely
"positive" discussions of the tradeoff
     between inflation and unemployment. As I noted earlier, the Fed acted
as if there was a high cost of inflation -
     when there was little evidence to support that belief in the
low-inflation environment currently in the United
     States. While we explicitly recognized that there was considerable
uncertainty surrounding the value of the
     NAIRU, I was always struck by how often at least their rhetoric, and
sometimes their models, they suggested it
     was at the high end of that range. Again, while there was no evidence
of a precipice, and there was evidence that
     the costs of reversing inflation were not high, their rhetoric
suggested otherwise. While in commenting on fiscal
     policy, on the revision of the cost of living index used for social
security or taxes, they were willing to provide
     high estimates of the likely bias in the cost of living index, I never
once heard them note the implications for U.S.
     macro-policy - that the current rate of inflation was not 2.2 percent,
but closer to 0.7 percent (using midpoint of
     the bias estimate the Chairman of the Fed has frequently mentioned in
public) - hardly a threat to the stability of
     the economy.

     The fact that monetary policy involves trade-offs, that values affect
not only the choice's one makes, but even
     one's perceptions of magnitude of those trade-offs, has one clear
implication in a democratic society. The way
     those decisions are made should be representative of the values of
those that comprise society. At the very least,
     they should see as their objective the application of their expertise
to reflect broader societal values. The central
     bank should not be seen as a mechanism for the imposition of the values
of a subset of the population on the
     whole.

     While values systematically skewed what was supposed to be expert
judgment, there was scope for doing so
     because of the extra-ordinary difficulties encountered in the wise
conduct of monetary policy. Because of the
     lack of up-to-date data, there is uncertainty about the state of the
economy today, let alone about where the
     economy will be six months from now; and because of the lags in
monetary policy - the fact that it takes six
     months or longer for the full effects of monetary policy to be felt -
what one needs to know precisely is just that.
     The economy is always changing, and so historical data experiences may
be of only limited relevance.
     Fortunately, financial crises like the meltdown of the savings and loan
industry in the United States are relatively
     rare; the last banking crisis was more than a half century earlier. Not
only had none of the members of the Board
     of Governors lived through that experience, but there had been so many
changes in the economy in the
     intervening years that there were questions about its relevance. And
economists are a contentious lot: even the
     experts cannot agree on the appropriate model of the economy, with fads
and fashions changing with a frequency
     comparable to that of the business cycle. Just as monetarism, whose
theoretical foundations had always been less
     than sound, became the flavor of the day, the constancy, and even
predictability, of the velocity of money, the
     empirical regularity upon which it was based, disappeared. Worse still,
the advice of two leading American
     schools of macro-economics was hardly helpful to the conduct of
monetary policy - real business cycle theory
     and the new classicals said that central banks should essentially just
be shut down.

     The Federal Reserve does seek advice from a wide set of sources; and
even those from whom it does not seek
     advice offer up their opinions through a variety of media, from
scholarly journals to the popular press. There was
     a group of economists who did recognize the special nature of the 1991
downturn, whose research had focused
     on the role of financial markets in economic fluctuations, a group with
a long ancestry, going back at least to
     Fisher's theory of debt deflation.23 This group saw a need for far
stronger, and earlier, actions than those who
     continued to subscribe to other traditions. The theoretical foundations
had just recently been bolstered by
     research on the economics of information, which had provided insights
into the rationale and nature of the
     resulting capital market imperfections and their consequences for
macro-economic stability. The empirical
     foundations for their positions had been bolstered by evidence showing
the role of credit and equity rationing in
     investment and consumption behavior. It was ironic that one of the
leading contributors to the empirical literature
     actually served during this period as vice-chair of the Federal Reserve
Board, though his voice was not reflected
     in the policies pursued.

     Let me be clear: I think the Fed has done a good job managing monetary
policy over the last decade - perhaps
     not as good as it could have done, and perhaps worse than it is often
given credit for, but still a reasonably good
     job. In evaluating some of the exaggerated accounts which attempt to
endow a single institution with omnipotence
     and omniscience, we should remember several qualifications I have
discussed. Once account is taken of the
     increased ability of the economy to operate at lower levels of
unemployment without igniting rising inflation, the
     1990-91 recession was not the shallow downturn that is often portrayed,
but rather, the lost output was
     comparable to that of the average of the post-war recessions. Also, the
strong recovery beginning in 1992 could
     have been said to have been in spite of the Fed, not because of the
Fed. Furthermore, neither the Administration
     nor the Fed should be given much of the credit for the changing
structure of the economy that allowed it to
     operate at such a low level of unemployment without a pickup of
inflation. But these are minor qualifications and
     pale in comparison to the monetarist policies of the early 1980s which
led to high real interest rates, contributing
     to the Latin American debt crisis, the lost decade of development, and
the financial debacles that plagued
     economies throughout the globe. The cumulative loss of world output
relative to its potential - and the cumulative
     human suffering - was enormous.

     As I said earlier, human fallibility is a fact of life, and even the
best designed institutions will make mistakes. The
     point of these remarks is not to say, "I told you so," or to engage in
what Americans call Monday morning
     quarterbacking. The point is that all too often the governance
structure of central banks makes these mistakes
     more likely, and more costly, than they need be. The most important
function of the central bank is to make
     judgments about macro-economic policy, questions which deserve a
nation's greatest talents; yet the Board
     typically does not have on its membership anyone who would rank in the
top tier of macro-economists. There is
     a vicious cycle: The concentration of power in one hand, in the
chairman, makes appointments to the Fed less
     attractive to first rate economists - those that have come have come
out of real devotion to public service - and
     the absence of first rate economists provides the basis of enhanced
concentration of power in the Chair. (To be
     fair, the current Chairman deserves high marks for his political skills
in steering the Committee, some of whose
     members are quite hawkish, to policies which were as reasonable as they
were.)

     The benefits of central bank independence

     Having said all of this, let me say there are good reasons for central
bank independence. The conventional
     argument in favor of central bank independence is that independent
central banks will not be tempted to try to
     enjoy the transitory benefits of lower unemployment at the expense of
the permanent cost of higher inflation.
     There is the worry - and some evidence - that without an independent
central bank, politicians may try to
     stimulate the economy before a recession, knowing that the price -
higher inflation - will not be apparent until
     after the election.24 Empirically, both the rate and the variance of
inflation are lower in countries with independent
     central banks.25

     To some degree, institutional changes may not be enough to buy low and
stable inflation. Germany does not only
     have a highly independent central bank, but it also has a culture that
is highly averse to inflation. This culture itself,
     and not the institutional arrangements, may in fact be sufficient to
keep inflation down. The Indian Central Bank,
     for instance, has relatively little legal independence from the
government but has consistently delivered low
     inflation in response to political pressure. In contrast, one
transition economy has witnessed the spectacle of a
     highly independent central banker pushing inflation higher and higher
while the government was, initially, unable to
     remove him.

     Interestingly enough, however, the variance of output and employment is
no lower in countries with independent
     central banks.26 And, as we have seen, among countries with low or
moderate rates of inflation, the level and
     rate of growth of productivity is no higher.

     The degree of independence of the central bank also has important
impacts on the relationship between key
     economic variables. An independent central bank, it is claimed, has
more credibility: markets are convinced that
     it will be more committed to fighting inflation. According to new
classical theories, this credibility should allow an
     independent central bank to deflate the economy relatively painlessly.
Unfortunately, the evidence suggests just
     the opposite: economies with independent central bank's have
substantially higher sacrifice ratios than other
     countries, even after controlling for a variety of factors.27 According
to Laurence Ball's (1994) estimates of
     sacrifice ratios, Germany and the United States both need to sacrifice
2 or 3 percentage points of output for each
     percentage point reduction in inflation. In contrast, France and Japan
both have sacrifice ratios on the order of 1
     percent. One explanation is that the existence of a highly independent
central bank changes the structure of the
     economy, including the degree of nominal rigidities, as participants
come to have more confidence in the stability
     of prices. Monetary policy in Germany and the United States is more
predictable than it is in France or Japan.
     Consequently Germans and Americans are less prepared for the abrupt
shift in policy that takes place during a
     disinflation. The higher sacrifice ratios have basically offset the
advantages of lower variability in inflation, leading
     to little change in output variability.

     Thus, the gains in economic performance in the dimensions where it
really counts - the ability of the economy to
     live up to, and expand, its productive potential, is little affected by
central bank independence. Indeed, the results
     that the variance of inflation has been reduced, but growth not
enhanced, suggest that it is output variability, not
     price variability, which should be the focus of concern of
macro-economic policy.

     Implications for the design of central banks

     What implications do these results have for the design of central banks
in a democratic society? How
     independent should they be? What should be their governance structure?

     We need to put this question in context: In a democratic society, we
often have a desire to depoliticize important
     decisions, especially in the sphere of economics, and to draw upon
expertise. An alcoholic may recognize his
     weaknesses, and turn over the key

     to the liquor cabinet to a friend, a form of pre-commitment. So too, we
often make collective choices to bind
     ourselves away from temptation. In the United States, we have created
independent regulatory agencies for
     securities regulation (the Securities and Exchange Commission), for
banking regulation (the Controller of the
     Currency), for energy regulation (the Federal Energy Regulatory
Commission), and for telecommunications (the
     Federal Communications Commission).

     This binding cannot, however, fully bind. One of the important, and
inherent, limitations on the government's
     power is that, while it can use its power to enforce private contracts,
it cannot enforce its own commitments. It
     can, however, raise the transactions costs to changes in policies. The
PAYGO rules adopted the 1990 Budget
     Enforcement Act, for instance, increase the cost of proposing a tax cut
by requiring it to be offset by equal or
     greater spending cuts. Changing the rule itself only requires a
majority vote, but there appears to be great political
     cost associated with changing these rules which reflect a collective
commitment to sound budgetary policy; and
     the rule itself makes it more costly to propose deficit-increasing
legislative changes.

     No central bank is fully independent. The legislation governing the Fed
can be changed or its governors
     dismissed (a process that itself is very difficult and costly).
Although these actions are undertaken rarely if ever,
     the existence of the threat forces the Fed to anticipate and to some
degree act according to the views of elected
     officials. The Chairman of the Fed must report to the Banking
Committees in both the Senate and the House. At
     various times, the powerful chairman of these committees have exercised
important influence on the Fed. The
     Fed, as a creation of government, is a political institution. Its most
successful governors have recognized this and
     struck a balance, anticipating the political response to their actions
and, to some degree, accommodating it. Paul
     Volcker, then Chairman of the Fed, testified before a Congressional
committee that "the Congress created us
     and the Congress can uncreate us."28 Arthur Burns, who served as
Chairman of the Fed somewhat earlier, is
     quoted as saying that the Fed was perpetually "probing the limits of
its freedom to undernourish...inflation."29

     The nature of this delicate balance is manifested in numerous examples.
The Fed, whose revenues essentially
     derive from the zero interest rate it pays on reserves, does not depend
on Congress for its annual appropriations.
     It remits to the government the excess of revenues over what it spends.
This might appear to give the Fed
     enormous discretion, yet the Fed realizes that its expenditures on very
much in the public eye - a dollar wasted is
     a dollar less for the public treasury - and its rules are close to
those of a purely public agency. Moreover, the
     salaries of Fed governors are linked to those of cabinet officers,
creating the anomaly where some staff are paid
     more than the governors themselves.

     A more important example is the result I discussed earlier - the
probability of a recession ending is increasing in
     the duration of the recession. Under standard assumptions about
rational expectations and serially independent
     stochastic processes, recessions should not die of old age. As the
recession goes on, the pressure on the Fed
     builds and their objective function changes to emphasize unemployment
more and inflation less.

     Power, however, works both ways. The Fed has an enormous influence over
short-term economic activity, and
     the threat of its exercise can provide an extra incentive for
politicians - especially the President - to implement
     policies that are favored by the Fed. To be sure, the Fed would not use
this threat in an extortionist manner. But
     the Administration could come to believe, for instance, that deficit
reduction or capital gains tax cuts would allow
     the economy to have lower interest rates.

     I think the United States has probably struck a good balance in the
institutional arrangements governing the Fed.
     We have gotten relatively predictable monetary policy, relatively low
inflation, and in the recent expansion the
     Fed has been flexible enough to tolerate the unemployment rate falling
below what others might have allowed.
     More broadly, the success of this balance is manifested in the two
results I showed earlier: expansions do not die
     of old age but recessions do.

     But while in practice we seem to have struck a balance regarding the
appropriate degree of independence, there
     are other aspects of governance in which questions may be raised.

     Is the concentration of power in the hands of one person compatible
with democratic values? Are there
     compelling arguments for the secret manner in which it operates that
offset the presumption in favor of openness
     and transparency in a democratic society? The Fed itself has moved
towards more openness in recent years.
     Should it go further?

     Public accountability is achieved in part not by having decisions made
directly by publicly elected officials, but by
     having them made by those appointed by elected officials. But in the
case of monetary policy, many of the
     decision makers are neither appointed nor even confirmed by elected
officials. Is this consistent with democratic
     values? Is this degree of removal from public accountability necessary
for achieving the degree of independence
     that would be warranted by improved economic performance?

     Have we marshaled the quality of expertise that the country could, and
should, obtain? Recall, the results given
     earlier on the efficacy of monetary policy only say that there is no
systematic component of fluctuations, for
     instance, no time dependence in economic downturns. It does not say
that we have reduced the variability in
     output to as low a level as we might.

     And most importantly, have we achieved the best balance between
stabilization and fighting inflation? Again, our
     earlier results say nothing about where the balance was struck, which
depends on the composition and beliefs of
     the Fed. Our earlier discussions suggests strongly that, as presently
constituted, there are important voices not
     being heard - voices I dare say that may represent a majority of
Americans. These voices ought to have some
     say on how the intertemporal trade-offs that are central to monetary
policy should be made. These voices could
     be represented, without compromising on the independence of the
monetary authority, and indeed, these voice
     could be represented at the same time that the quality of expertise in
the conduct of monetary policy is improved.

     There is an old saying that, "if its not broken, don't fix it." Many
people believe that our monetary institutions, if
     not perfect, have been doing a remarkably good job. There is a
collective amnesia at work: we forget the
     criticism our monetary institutions are repeatedly subjected to when
the economy goes into a downturn, or when
     it does not live up to its potential over protracted periods of time.
On the contrary, one might argue that the time
     to improve our institutions is when they are not in crisis, when we can
engage in thoughtful deliberations about
     what kind of society we are striving to create.

     But many other societies do not have the leisure of these thoughtful
deliberations. As political and economic
     arrangements change, as monetary unions get formed and dissolved, as
economic and political crises necessitate
     the design of new institutional arrangements, countries will have to
face these questions head on. They will have
     to ask, how much and what form of independence should the central bank
have? The answers will depend on the
     situation and history. Those who have had recent bouts with high
inflation are likely to be enticed into having
     central banks with a greater degree of independence, structured in ways
that signal a greater commitment to fight
     inflation. Those with a more favorable recent history will have harder
choices to make. They should not be misled
     by any myths of magical improvements in economic performance that this
latest nostrum of those looking for
     simple solutions to the complex economic problems have provided. They
should be concerned with the role
     democratic values should play in the making of macro-economic
decisions, which are, after all, among the most
     important of the collective decisions made by any society.
Zhiyuan Cui
617-253-2951(p)
617-258-6164(f)
http://web.mit.edu/polisci/www/faculty/Z.Cui.html