The Political Economy of Monetary Policy
Summary and Keywords
The recent global economic crisis has renewed interest in the nature and history of monetary policy, the distributional effects of central bank policy, central bank governance, and the personalities at the helm of major central banks. In modern times, a country’s central bank formulates, or, to a minimum, implements, a country’s monetary policy, or the process of adjustment of a country’s money supply to achieve some combination of stable prices and sustainable economic growth. Monetary policy depends heavily on a country’s exchange rate system. Under fixed exchange rates, the country’s commitment to keep the level of the currency at a certain level dictates monetary policy to a great degree. As the gold standard was unraveling after World War I, many countries experienced high inflation or even hyperinflation. A similar situation faced monetary policy after the collapse of the Bretton Woods system of fixed exchange rates in the 1970s. By the 1980s, however, countries turned toward central bank independence as an institutional arrangement to control inflation. The current issues surrounding monetary policy have emerged from the historical increase in central bank independence and the 2007 economic and financial crisis. In particular, the opacity of central bank decisions, given their autonomy to pursue stable prices without political interference, has increased the demand for transparency and communication with the government, the public, and financial markets. Also, the 2007 crisis pushed central banks toward unconventional measures and macro-prudential regulation, and brought back into focus the monetary policy of the euro area.
The recent global economic crisis has renewed interest in the nature and history of monetary policy, the distributional effects of central bank policy, central bank governance, and the personalities at the helm of major central banks. At the height of the great economic and financial crisis of 2007, financial markets, academics, politicians, and regular citizens followed and debated the words and actions of Ben Bernanke (U.S. Federal Reserve), Jean Claude Trichet (European Central Bank), or Mervyn King (Bank of England). Several recent books have recently taken the drama of monetary policy to mainstream audiences, including Liaquat Ahamed’s Lords of Finance or Neil Irwin’s The Alchemists. There are also some excellent reviews of related topics such as the political economy of international monetary relations (Broz & Frieden, 2001), the existence and nature of cycles in macroeconomic policies and outcomes (Franzese, 2002), or the political economy of central bank independence (Fernandez-Albertos, 2015). The Fall 2002 issue of International Organization similarly addressed the evolution of monetary institutions in the post–Bretton Woods period by analyzing independent central banks and fixed exchange rates together. More recently, Goodfriend (2007) provided an excellent review of the intellectual convergence on a monetary policy focused on stable prices through a central bank that is credible for a low-inflation policy; Blanchard et al. (2010) analyzed the challenges brought to this consensus by the financial crisis; and Blinder et al. (2016) reviewed the innovations in monetary policy brought on by the financial crisis.
A country’s central bank formulates or, to a minimum, implements a country’s monetary policy or the process of adjustment of a country’s money supply to achieve some combination of stable prices and sustainable economic growth. To control the supply of money and credit in the economy, a central bank has several tools at its disposal, including traditional changes in the interest rate and in reserve requirements, open-market operations, and capital controls. Since the 2007 financial crisis, central banks across the globe have struggled with the unusual situation of low inflation and very low interest rates, which were set to combat recession and potential deflation, marking the start of so-called unconventional measures to increase the money supply, including quantitative easing, credit easing, and forward guidance.1
Modern central banks manage the supply of paper money, or, in other words, the quantity of money and the credit available in terms of pure fiat money, backed only by faith in the government’s solvency or money backed by precious metal or other currencies. Thus, the key to monetary policy and paper currency is the credibility of the government’s commitment to maintain the value of money (in terms of goods and services, a particular commodity, or other currencies). Historically, governments have been tempted to use inflation, and the issue of low credibility has plagued monetary policy. The articulation of the traditional monetary policy model goes back to Barro and Gordon’s seminal 1983 article. In this model, governments make announcements about inflation (statements about the future value of money); private actors (wage-setters; government debt holders) make decisions based on their inflationary expectations; and the government acts again and tries to cheat by introducing surprise inflation after private actors have made decisions about the quantity of money they will hold, the wages they will demand, or the amount of government debt they will purchase. This cheating is attractive because, if it comes as a surprise, it will increase output and employment. A rational public, however, anticipates the government’s moves and does not believe the initial inflation announcements. The result is higher inflation than optimally desired by the government without the benefit of increased employment and output.
Rational expectations and the incentives to cheat combine to create a time-inconsistency problem for governments: the optimal monetary policy (i.e., inflation rate) is not the same before and after private agents make their decisions. Governments facing the time-inconsistency problem in monetary policy find it difficult to make credible commitments regarding the value of inflation by themselves. In this context, Rogoff (1985), Giavazzi and Pagano (1988), Alesina and Grilli (1992), and Milesi-Ferretti (1995) show the advantages (low inflation) of the government tying its own hands in monetary policy by fixing the exchange rate or by allowing the central bank to be independent of the government. The two monetary institutions (fixed exchange rates and independent central banks) are thought to achieve the same goal of low inflation, though in different ways. Allowing the central bank to carry out monetary policy without political interference (central bank independence) should work because, generally, central bankers come from business, financial, or academic circles, tend to take a longer view of the policy process; and are, on average, more conservative about price stability than elected politicians or the median voter. By comparison, fixed exchange rates, work by tying domestic economic policy to the policies of a less inflation-prone country, thus “importing” the lower foreign inflation.2
Historical Review—Monetary Policy under the Gold Standard/Fixed Exchange Rates
Monetary policy depends heavily on a country’s exchange rate system. Historically, each government decides whether to allow the exchange rate—the price of a country’s money in the currency of another country—to float or be fixed to other currencies, gold, or other commodity based standards. Under fixed exchange rates, the country’s commitment to keep the level of the currency at a certain level dictates monetary policy to a great degree.
Fixed exchange rates have significant advantages, including lower risks and transaction costs for international trade and investment (Mundell, 1961; McKinnon, 1962; Kenen, 1969) and a greater credibility of monetary policy when faced with inflation expectations (Rogoff, 1985; Giavazzi & Pagano, 1988; Alesina & Grilli, 1992; Milesi-Ferretti, 1995). The major cost of fixed exchange comes, however, from the government’s restricted use of monetary policy to react to large negative shocks to the domestic economy. In particular, when international capital is mobile across borders, the “unholy trilemma” principle (Mundell, 1962) dictates that fixed exchange rates imply the loss of monetary policy autonomy.3 That is, monetary policy must be geared toward propping up the fixed exchange rate, regardless of what may be going on in the domestic economy.
While countries have had fixed their exchange rates at other times, there are two periods of globally fixed exchange rates—the gold standard and the Bretton Woods periods. Before World War I, the monetary system was based on the gold standard, in place during the late 19th and early 20th centuries; the purpose of the central banks’ monetary policy was to defend the fixed exchange rate, and central banks faced little pressure from the government to deviate from the task. Inflation—the key concern of modern monetary policy—was not an issue under the gold standard. In this period, inflation was de facto determined by the supply and demand of gold (McKinnon, 1993), and because the demand for gold was growing faster than the supply of gold, this led to a general deflation in prices rather than price increases and inflation (Hibbs, 1987). The commitment to gold was extremely costly in terms of policy-induced recessions, major deflationary periods, and nonresponsiveness to downturns in the business cycle (Hibbs, 1987). Yet, during this period, the gold standard faced little opposition from politicians. This is largely because governments themselves faced negligible pressure from workers, the constituency that bore the brunt of the costs of the gold standard (Eichengreen, 1992; Simmons, 1994).
The end of World War I marks the beginning of gold’s steady loss of primacy in the monetary policy of central banks. In the 1920s, governments started to face fierce opposition to the gold standard and the commitment of monetary policy to exchange rate stability. The rise of left-wing parties and unions, as well as the enfranchisement of the working class, meant that domestic economic conditions loomed large in domestic elections and economic policy decisions (Eichengreen, 2008; Simmons, 1994; Ahamed, 2009). In the aftermath of World War I, most countries desired to return to the gold convertibility abandoned during the conflagration. However, given the use of inflation to finance the war, most countries faced great difficulties in restoring their currency’s convertibility. Regardless of whether countries returned to gold at the prewar parity or at a devalued conversion rate to gold, convertibility implied deflation, which proved extremely costly in terms of unemployment. Thus, in most cases, countries returned to gold many years after the end of the war; they remained on gold for only a few years; and government instability, organized labor protests, and large rifts between the political left and right marked these years. Gradually, countries lost their appetite for the limits imposed on monetary policy by the fixed exchange rate, and those countries that more quickly abandoned the constraints of the gold standard tended to emerge faster out of the Great Depression (Bernanke & James, 1991; Eichengreen, 1992; Simmons, 1996).
While the interwar experience with the gold standard was broadly inauspicious, countries still desired the stable international monetary system thought to be delivered by fixed exchange rates. Thus, for the first 25 years of the post–World War II period, exchange rates were tied to the U.S. dollar under the Bretton Woods system of fixed exchange rates, and inflation was not a major concern in most countries. Rather, countries were concerned about achieving domestic growth and employment, under conditions of free trade and restricted international capital flows, a combination of policies that scholars have labeled embedded liberalism (Ruggie, 1982). Accordingly, the Bretton Woods system encouraged international economic transactions, in particular international trade, but the focus on the free operation of markets was tempered by those countries wanting to achieve social goals distinct from economic efficiency. The collapse of the Bretton Woods system of fixed exchange rates in 1971 can easily be explained using the “unholy trilemma” framework: The system’s core country, the United States, was unwilling to sacrifice its autonomy in monetary policy and to rein in fiscal spending in the face of the increasingly internationally mobile capital. The result was a run on the dollar and an end of the dollar’s peg to gold (Eichengreen, 2008; McNamara, 1998). However, the end of the global system of fixed exchange rates set up at Bretton Woods, together with the price increases from the two oil shocks of the 1970s, led to high inflation in many countries, including the United States. Following the high inflationary 1970s, delegating monetary policy to an independent central bank and legal central bank independence became a key institutional mechanism aimed at restoring and maintaining price stability.
The fixed exchange rates discussed thus far are generally not fixed forever. Rather, in many cases, governments adjust them frequently or abandon them entirely,4 with important consequences for monetary policy, including additional inflation, loss of monetary policy credibility, or rising foreign currency indebtedness (Ghosh et al., 2011; Bodea, 2014). Thus, an important literature studies exchange rate regimes, government choices, and financial markets’ reactions to exchange rate events, with reference to optimal considerations for nations to fix their exchange rates (Mundell, 1961; Mckinnon, 1962), credibility concerns (Rogoff, 1985), or real economy—trade and investment—considerations (Frieden, 2002) and national preferences (Frieden, 1991; Walter, 2008; Shih & Steinberg, 2012). The literature also includes various aspects of exchange rate choice: Simmons (1994) studies the reasons behind currency depreciation and countries’ abandonment of the interwar gold standard. Frieden (2002) investigates the volatility and currency depreciation for western European countries after the end of the Bretton Woods era. More broadly, Bernhard and Leblang (1999) study the relationship between democratic institutions and the choice of the exchange regime. Policymaker-operated devaluations and changes to fixed exchange rates are studied by Klein and Marion (1997), Von Hagen and Zhou (2007), and Bodea (2010a, 2010b, 2015), while Frankel and Rose (1996), Eichengreen et al. (1996), and Kaminski et al. (1998) look into large currency devaluations and speculative attacks against currencies.
The early literature (Rogoff, 1985; Giavazzi & Pagano, 1988; Alesina & Grilli, 1992; Milesi-Ferretti, 1995) seemed to suggest that fixed exchange rates and autonomous central banks work similarly (are substitutes) to enhance the credibility of monetary policy for inflation-prone governments. More recent work, however suggests that the choice of the exchange rate regime and the central bank’s degree of independence are correlated processes. Bernhard, Broz, and Clark (2002) note that this makes sense empirically because, after the collapse of the Bretton Woods system of fixed exchange rates, 26% of countries chose both an independent bank and fixed exchange rates, whereas the rest of the countries chose only one institution or none. More analytically, Simmons (1996) shows that, in the interwar period, the more independent central bankers were less likely to cooperate on the gold standard with other world central banks and to lower interest rates, promoting a self-defeating cycle of interest rate hikes and gold hoarding. Bearce (2008) shows that fiscally irresponsible governments facing autonomous central banks may have to adjust their exchange rate regimes, as evidenced by increased exchange rate volatility. More broadly, Bodea (2010b) presents a model that allows policymakers the simultaneous choice of monetary institutions (fixed exchange rates that can be devalued and autonomous central banks whose independence is imperfectly discernible) and shows that imperfectly credible institutions will overlap: When exchange rates are fixed but adjustable and central bank independence is not fully ascertainable, governments will choose to tie their hands with both monetary institutions.5 Also, Fatas et al. (2007) discuss the effects of monetary policy with de jure quantitative goals, when one of these quantitative goals is dictated by a fixed exchange rate.
Monetary Policy and Central Banks
Before the 20th century, a national monetary policy for currency and credit did not exist per se. The Bank of England and Sweden’s central bank were created as early as the 1600s. Yet the central banks of other major Western nations were only established after 1800 (Goodhart, Capie, & Schnadt, 1994).6 Moreover, at this time the countries’ so-called central banks did not necessarily enjoy a monopoly over the issuance of bank notes, which is a prerequisite for the conduct of modern monetary policy. Most of the very few central banks that existed in this period were created to fulfill a fiscal agent role and to act as bankers to the government. Historically, central banks were created to enhance the ability of leaders to borrow and lower costs of loans during times of war (Broz, 1998, 1999). Specifically, Broz (1998, p. 231) notes that “Britain’s superior financial, economic, and military performance after 1689 rested in large part on the establishment of the Bank of England.”
Indeed, before 1850, most central banks emerged in the context of wars, to allow governments to spread out the costs of war over time (Broz, 1998). Countries chartered central banks to be their fiscal agents, and, in turn, these privileged banks purchased government debt, lowering interest rates (Stasavage, 2003; Broz, 1998). The early central banks were likely helped in reducing interest rates by the presence of representative institutions or their monopoly status as fiscal agents, which increased the likelihood that the designated central bank would remain in charge of debt repayment to the bond holders. The credibility of the central bank could also be high because of the stability of a mutually beneficial relationship between the central bank and the government, through the exchange of rents for monopoly power.
In the latter half of the 19th century, central banks started to gain some of the functions that are currently associated with them: holding a monopoly on the issue of bank notes, maintaining the value of the currency, and reducing the risk of financial instability through the lender of last resort function (Goodhart, Capie, & Schnadt, 1994). The ability to respond to bank failures during financial crises, in particular, was a key concern when newer central banks were created, including the U.S. Federal Reserve (1913), the Bank of Canada (1934), or the Reserve Bank of New Zeeland (1934). Thus, modern central banking that is responsible for national monetary policy is largely a 20th-century phenomenon, in terms of both the number of central banks in existence (there were 17 central banks in 1900) and the functions they perform.7
Central Bank Independence and Inflation
Intuitively, modern central bank independence means keeping the government away from monetary policy decisions and allowing the central bank to focus on inflation control without interference or threats from the government. Some central banks can choose their own target for inflation8 consistent with their definition of what stable prices means, while others need to target a rate of (usually low) inflation chosen by the government9 or have no publicly announced specific number for inflation. The independent central banks will thus have a focus on inflation (they are conservative in the Rogoff, 1985 way10) and will change the stance of monetary policy based on economic conditions, with little regard to politicians’ popularity.
As the gold standard was unraveling after World War I, many countries experienced high inflation or even hyperinflation. A similar situation faced monetary policy after the collapse of the Bretton Woods system of fixed exchange rates. In the 1920s, the lesson was that countries with dependent central banks lacked credibility for low inflation and that there was a “need to insulate central banks from political pressures” (Eichengreen, 1992, p. 9). In the 1970s, countries did not immediately turn toward central bank independence and inflation control as a prerequisite for economic growth.11 Goodfriend (2007, p. 47) notes that “in the 1970s monetary policy was in disarray.” Only by the mid-1980s, as the economic literature focused on the use of an independent central bank to control inflation, policymakers followed: Thus, in the last 30 years, a great number of countries have reformed their central banks’ laws to give their central banks more autonomy from the government. Bodea and Hicks (2015a) update the central bank independence legal index first proposed by Cukierman et al. (2002): The index has values between 0 and 1, and a greater number show more independence. The average score for the central bank independence index was 0.36 in 1980 (47 countries) and 0.68 in 2008 (78 countries).12
For a time in the 1970s, a significant controversy arose between Keynesian and monetarist economists over whether independent central banks could become credible and thus be able to reduce and keep inflation low without significant costs in terms of employment (Goodfriend, 2007). The view that low inflation can be achieved through central bank independence and is key to real economic performance consolidated in the early 1990s. In its annual report, the 1990 Bank for International Settlements (BIS) stated that “the most satisfactory overall economic performance can be attained if monetary policy aims primarily at the achievement of price stability” (BIS, 1990, p. 177). Similarly, the International Monetary Fund (IMF), in its 1992 World Economic Outlook, noted the consensus that “medium-term objectives were best served by adhering to anti-inflationary monetary policies” (WEO, 1992, p. 16). The IMF continues to point to the importance of central bank autonomy and the danger of political pressures on central banks (WEO, 2013, ch. 3). Janet Yellen, the present chair of the U.S. Federal Reserve, has argued forcefully for central bank independence from short-term political interference. Responding to renewed legislative efforts to audit the U.S. Federal Reserve’s policy decisions, Yellen has stated not only that “the ability of the central bank to make the decisions about monetary policy that it regards as in the best longer run interests of the economy free of short run political interference is very important,” but also that “history shows, not only in the United States but around the world, that central bank independence promotes better economic performance.”13
To measure formally a central bank’s level of independence, the literature uses two main approaches. On the one hand, legal indicators of independence decide on a central bank’s degree of autonomy based on the legal statutes that govern the central bank. Prominent examples include Bade and Parkin (1978), Grilli et al. (1991), Cukierman et al. (1992), Alesina and Summers (1993), Eijffinger and Schaling (1993), and Siklos (2002). All legal indicators tend to capture similar theoretical ideas about how a bureaucracy such as the central bank can act autonomously from the government: For example, laws that specify that the central bank governor is appointed for longer mandates or by central bank personnel are considered to grant more independence than laws that provide for shorter appointments or give the power of appointment to the government. As another example, a greater focus on price stability and more restrictions on the ability of the government to ask the central bank to finance its fiscal deficit increase the autonomy of the central bank. Behavioral measures, on the other hand, focus on the day-to-day relationship between the central bank and the government to determine a bank’s level of independence. Behind the quest for behavioral measures (versus legal rules) is the idea that governments can easily disobey rules (Forder, 1998). Such measures can look at the actual behavior of inflation (Eijffinger et al., 1996) or monetary aggregates (Alpana & Honig, 2010) to infer the de facto degree of central bank independence. Other research has looked at the patterns of central bank governor turnover and has linked low independence to high turnover (Cukierman et al., 1992). With regard to behavioral measures of independence, a large literature investigates whether it is the central bank itself that matters for outcomes rather than the configuration of societal interests and attitudes behind the central bank (Posen, 1995; Hayo, 1998).
At times, even the most legally independent central banks will be forced to respond to politicians because politicians retain the most important bargaining chips—the power of re-appointment and the ability to change the status of the central bank. In order to preserve its statutory independence, a central bank occasionally will capitulate to the government (Woolley, 1984; Havrilesky, 1993; Lohmann, 1998), but at other times it will be able to ignore the government (Goodman, 1991). One can consider this the fundamental flow in thinking about central bank independence in terms of legal rules. Yet another approach, consistent with the focus on rules, is to obtain a better understanding of when the government is more likely to lean hard against the central bank (break the rules) in an attempt to politicize the institution. Lohmann (1992) provides a useful framework for identifying conditions when the central bank voluntarily backs down in front of the government. In her model, the central bank is independent, but, as a reflection of reality, the government retains the flexibility to override the bank at some cost.14 In this interaction, Lohmann shows that it is optimal for the central bank to accommodate the government’s demands in extreme situations (large shocks to output and employment) for fear of being overridden. Thus, in normal times, the central bank decides on monetary policy. In cases of large negative shocks to economic growth, however, the bank defers to the preference of politicians since the government’s utility loss from low growth is higher than the cost of overriding the central bank.
One important point of contention in understanding central bank independence is the treatment of the goal of central bank policy. Most of the literature agrees that a more independent central bank is governed by legislation that defines price stability or low inflation as the key goal of monetary policy—this is the Rogoff (1985) conservative central banker. Adolph (2013) presents the most comprehensive approach to measuring and exploring the effects of central bank conservatism and how it relates to central bank independence.15 Adolph argues that career incentives drive the behavior of central bankers, and he tests the effect of the employment and education history of central bank governors. For rich nations, Adolph finds that central bank conservatism is associated with lower inflation, with a sizable effect comparable to the effect of legal independence. Conservatism also has a conditional effect on inflation, depending on components of the traditional central bank independence index related specifically to appointment and dismissal, the split of authority over monetary policy, and resolution of conflict with the government. Interest rate responses to inflation and output shocks are also mediated by central bank conservatism, with different sizes of substantive effects conditional on central bank independence.
The evidence for an association between central bank independence and inflation is mixed, with a particularly weak relationship found in developing countries.16 The early work on the topic shows a strong negative relationship between inflation and central bank independence in developed countries (Grilli et al., 1991; Cukierman et al., 1992; Alesina & Summers, 1993). This relationship lacks robustness in some of the later work (de Haan & Kooi, 2000; Daufeldt & de Luna, 2008; Jacome & Vazquez, 2008). Crowe and Meade (2008), however, using data as recent as 2003, account for the country heterogeneity and potential endogeneity of central bank independence and find a robust negative relationship across developed and developing countries.
Because of the divergence of de facto central bank independence from legal provisions, the political economy literature suggests that political institutions significantly influence the extent to which a legally independent central bank will reduce inflation. Broz (2002) shows that, in political systems where decision making is transparent (i.e., democracies), independent central banks can contribute to low inflation. Keefer and Stasavage (2003), in contrast, focus solely on the narrower role of meaningful political opposition in enhancing the credibility of legally independent central banks. Their evidence shows that legal independence reduces inflation only in the presence of multiple constitutional checks and balances. In addition, Bodea and Hicks (2015a) show that central bank independence not only reduces inflation in democracies with political constraints and a free press due to a credibility effect, but also has a disciplinarian effect on rates of money growth. Also, Franzese (1999) shows that the effect of central bank independence on inflation depends on features of the political environment in which banks operate, including government partisanship and labor market organization. Similarly, other works show that strong institutional checks and balances (Moser, 1999; Hayo & Voigt, 2008) or the quality of political institutions (Hielscher & Markwardt, 2012) affect the ability of independent central banks to keep inflation low.
Central banks can adjust monetary policy and change interest rates in an effort to influence the behavior of economic agents. The reaction of these agents and therefore the transmission of monetary policy and a lower cost of anti-inflationary policies have also been shown to be a function of corporatist institutions, in particular unions and the rules governing wage bargaining. Thus, depending on labor market institutions, central bank independence and disinflation policy can be more or less socially and politically acceptable because these institutions affect the costs to society (in terms of unemployment) from pursuing low inflation. Unions and the central bank have been found to engage in a strategic interaction, and the nature of wage bargaining (coordinated/centralized) influences the effect of monetary policy and the level of unemployment (Iversen, 1998; Hall & Franzese, 1998; Cukierman & Lippi, 1999; Adolph, 2013).
Why Reform a Country’s Central Bank?
The time-inconsistency approach in monetary policy suggests that independent central banks or fixed exchange rates result from governments’ incentives to create surprise inflation and their attempt to tie their own hands. Yet, a more recent literature has proposed other explanations for delegating monetary policy to independent central banks. These explanations focus on the domestic political economy or, alternatively, on the international diffusion of what became known as the central banking model of Western nations that emphasized independence from political actors and a focus on price stability.
The mechanisms of domestic political economy invoked revolve around the relationships among key veto players, their preferences, and the overall transparency of the political system. For example, Bernhard (1998) argues that monetary policy is very technical and can have unexpected consequences and uneven effects throughout a country. Because of these effects and because laypersons tend to lack the expertise, coalition partners and back-bench legislators favor a monetary policy that is carried out by an independent central bank and prefer that this independent institution provides information about the conduct and effects of monetary policy. Along similar lines, Crowe (2008) suggests that countries with diverse political coalitions will have more independent central banks because taking monetary policy “off the table” through delegation allows easier agreement on other policy issues. Moser (1999) argues that monetary policy is only credible in countries with legislative checks and balances, and that therefore one should see more independent central banks in such countries. Similarly, federal systems and countries with multiple-party veto players should also have more autonomous central banks (Lohmann, 1998; Treisman, 2000; Hallerberg, 2002). Societal preferences have also been argued to be behind the independence of the central bank, more independence resulting from the presence of powerful coalitions in favor of price stability (Goodman, 1991; Boylan, 2001 for nondemocracies). Finally, Broz (2002) finds an inverse correlation between the transparency of the political system and the transparency of monetary policy commitment institutions. Thus, democracies, which are more transparent, will tend to have more independent central banks, given that central banks are more opaque institutions.
International conditions, in the form of competition among countries or emulation of peers also play a role in increased autonomy for the central bank. Maxfield (1997) prominently suggests that in the developing world, central bank independence signals creditworthiness to would-be investors. Using case studies from authoritarian countries and from countries transitioning back and forth to democracy, Maxfield finds evidence for the idea that central bank autonomy is more likely when countries have low capital account restrictions or balance of payment problems, and, as a consequence, compete for mobile capital in international markets. In her work, Maxfield seeks to explain changes to the informal (rather than legal) relations between the government and the central bank. Polillo and Guillén (2005) argue that cultural, political, and economic competition among states leads to the adoption of institutions prevalent in each country’s environment. Although resulting from a different causal logic, their hypothesis is similar to Maxfield’s prediction: Trade or investment dependency results in more independence for the central bank. Another implication is that trade ties put normative and competitive pressures on countries to mimic central bank reform in trade partners and competitors. On the one hand, Bodea and Hicks (2015b), combine the logic of competition for capital with the functionalist logic underlined by the delegation literature, find that central bank reform is driven both by competition and learning about when central bank can be credible, as well as by imitation of social peers from networks of intergovernmental organizations. McNamara (2002), on the other hand, suggests that social isomorphism and socialization are the leading causes for the adoption of central bank independence, with an emphasis on coercion from international organizations and pressure to conform to Western economic models. Moreover, Johnson (2016) argues that there is a global norm of central bank independence and that transnational actors (major central banks, the IMF, and the EU) contributed to central bank law reforms in postcommunist countries. The same transnational actors, she argues, contributed to the subsequent transformation of national central banks and de facto law implementation in this region of the world.
Monetary Policy and Political Cycles
A key question in the political economy literature is whether, depending on the independence of the central bank and the exchange rate regime, there are cycles in monetary policy. Monetary policy has both distributional and average effects on the fate of political constituencies. Therefore, (different) political actors could be and have been more or less inclined to “supply” different policy actions (e.g., low or high interest rates) and economic outcomes (e.g., inflation, employment) at some specific times rather than others (e.g., before or after elections) (Alesina et al., 1997; Hibbs, 1987; Clark & Arel-Bundock, 2013).
According to Lohmann (1998), politicians can influence monetary policy through appointing partisans (versus technocrats)17 and through exercising political pressure on already appointed central bankers (if central banks lack independence).18 In this setup, a number of outcomes are possible, ranging from pre-electoral and partisan cycles (if the central bank has zero independence, regardless of appointment patterns) and no cycles (if the central bank is independent and technocrats are appointed). Clark and Hallerberg (2000), however, condition the existence of cycles in monetary and fiscal policies on the overlap of monetary institutions—independent central banks and fixed exchange rates. They show that monetary policy pre-electoral cycles do not occur when the central bank is autonomous or the exchange rate is fixed. In addition, Bearce (2003) shows that in the Organisation for Economic Co-operation and Development (OECD) countries, left-wing parties are associated with more monetary policy autonomy (greater deviation of domestic interest rates from the prevailing world interest rate) and increased currency variability.19 Yet, Franzese (1999) shows that central bank independence tends to reduce the difference in inflation outcomes under left-wing and right-wing parties (i.e., it reduces partisan cycles).
A key premise of the literature on central bank independence is that the bank has more conservative preferences than politicians and the public at large (Rogoff, 1985). This assumption is needed to derive the result that delegation of monetary policy leads to lower inflation and that conservatism has generally not been linked to partisan support from the central bank. Rather, central bank independence is supposed to increase broad welfare by generating sustainable economic growth in the absence of inflation (Blinder, 1998). Yet, Cusack (2001) and Clark and Arel-Bundock (2013) argue that nominally independent central banks are politically biased in the way they conduct monetary policy (set interest rates). In this view, the non-neutrality of interest rates arises because the preferences of independent and conservative central banks are a natural fit for the agenda of right-wing governments, as evidenced by the central bankers’ backgrounds, financial markets’ constraint of the appointment process, and the professional socialization of bankers (Adolph, 2013). The fit between independent central bankers and the political right should be reflected in the coordination of fiscal and monetary policies (Cusack, 2001) or the monetary policy aimed at keeping the right in office (Clark & Arel-Bundock, 2013). Indeed, Cusack shows that, for 14 OECD countries during 1961–1994, the central bank served as a retaliatory monetary policy reaction only to left-wing government-induced deficits, as evidenced by higher discount rates when faced with fiscal deficits by the left. Using a larger sample of countries (78 countries, 1970–2007), Bodea and Higashijima (2017) show that central banks are politically savvy rather than having an optimal reaction to the economic business cycle: Autonomous central banks restrain fiscal deficits during nonelection years and under left-wing government tenures, not countercyclically during economic expansions. Also, for the United States, Clark and Arel-Bundock (2013) show that interest rates decline in election years when Republicans control the White House, supporting Republican presidents. Moreover, using congressional votes on “Audit the Fed” bills, Broz (2016) makes the case that the support base for the Federal Reserve in the U.S. Congress varies with the economic cycle: The Republicans support the Federal Reserve when inflation is high and volatile, whereas the Democrats support it when, following its dual mandate, the Federal Reserve places emphasis on reducing unemployment.
Current Issues in Monetary Policy
Transparency and Communication
Monetary policy is complex, with effects that occur with time lags and that are uneven across the economy (Bernhard, 1998). In this highly technical area, the last decades have brought central bank reforms aimed at increasing the independence of monetary policy from politicians. Central bank technocrats thus have become able to pursue their legal mandate—usually low inflation—without regard to incumbent politicians’ public approval or reelection prospects. Central bank independence seems to be accompanied, however, by a lack of real accountability, and independence increased the demand for transparency of operations as well as communication with the government, the public, and financial markets.
Traditionally, central banks thrive in secrecy as fiscal agents to the government or as competitors to commercial banks. However, this is increasingly at odds with democratic governance and central banks’ great degree of independence. Therefore, in the past decade, central banks have become more transparent (Eichengreen & Dincer, 2010). Transparent central banks have clear mandates for monetary policy, publish their macroeconomic forecasts, explain how they reach monetary policy decisions, and give a sense of the deliberation employed to make such decisions (Eijffinger & Geraats, 2006; Eichengreen & Dincer, 2010).
Given the contentious actions of central banks during the most recent financial crisis, increased transparency can demystify a bureaucracy that remains opaque even to experienced central bank watchers (Broz, 2002; Bodea, 2010b). Very importantly, transparency has the potential to clarify who is the principal of the central bank (the political right, large banks, the general public) and, in this sense, reduces the potential for undue influence from interest groups. To the extent that public opinion becomes more important to a technical policy area such as monetary policy,20 the transparency and legitimacy of the central bank and of monetary policy can only grow in relevance. More work on monetary policy will likely then focus on public opinion and legislative testimony analysis (Bearce & Tuxhorn, 2015; Broz, 2016; Schonhardt-Bailey, 2013). Other work will likely analyze the political consequences of central bank decisions and communication (as in Ehrmann & Fratzscher, 2007) and the way monetary policy relates to governments’ fiscal policy credibility and financial market confidence.
Monetary Policy in the Euro Area
After World War II, European countries pursued monetary integration despite low labor mobility and asymmetric reaction to shocks (Gros & Thygesen, 1998; McNamara, 1998; Martin, 2001; Frieden, 2001, 2002). In other words, a common monetary policy did not emerge mainly because European economies were similar enough or formed an optimal currency area. Rather, the Economic and Monetary Union and the euro, or its predecessor, the European Monetary System, were political choices that served as forefront issues for the broader European integration (McNamara, 1998; Jones et al., 2016). As political projects that came with limited integration in contingent but crucial areas such as fiscal policy or banking regulation, exchange rate cooperation and the single monetary policy have been subject to crises, notably the exchange rate crises and devaluations of the European Monetary System (Gros & Thygesen, 1998; McNamara, 1998; Bodea, 2015), as well as the euro area crisis that began in 2007.
To a great degree, interest in the monetary policy in a monetary union peaked before the introduction of the euro in 1999 but was reignited by the most recent financial crisis. The single monetary policy of the European Central Bank proved inadequate for both the slow-growth countries in Europe (Germany, France, Austria, and Finland) and the fast-growing periphery (Ireland, Spain, and Greece), and created large balance of payments imbalances. Several timely contributions (e.g., Copelovitch et al., 2016; Johnston, 2016) remind us of the need to understand the crisis in light of the political and economic tensions that had accumulated in the euro zone’s single monetary policy in the preceding 15 years. These contributions point to the importance of domestic institutions for outcomes under the single monetary policy in the euro area and the euro area crisis as a debt and balance of payments crisis. They also show the far-reaching effects of monetary union on unanticipated policies far removed from fiscal and monetary matters.
The Consensus and the Changing Role of Central Banks
As pointed out by many researchers (Goodfriend, 2007; McNamara, 2002; Johnson, 2016), monetary policy after 1980 converged around the idea of a politically independent central bank that pursued low inflation. On the horizon, there are other concerns and important challenges to the consensus (Blanchard et al., 2010): The developed countries and their central banks (U.S. Federal Reserve, Bank of Japan, the European Central Bank) fear deflation and monetary policy in a zero interest rate environment. This situation is quite the opposite to the experience before the financial crisis and is also very different from the concerns in developing countries, where inflation and monetary policy credibility remain important.
In addition, central banks may need to do more with respect to financial regulation and recognize that credit markets are segmented. However, bank regulation and low, stable inflation may be at odds with each other (Copelovitch & Singer, 2008), and intervention buying particularly risky assets may create distortions in certain markets as well as political arguments regarding the composition of the central bank balance sheet.21 Moreover, central banks may need to support or coerce governments into adopting responsible, countercyclical fiscal policy, such that governments will have the fiscal space to react to major crises. Bodea and Higashijima (2017) show, however, that independent central banks do not necessarily deter fiscal deficits in a countercyclical fashion, but rather exhibit political non-neutral behavior during election years and depending on government’s partisanship. Also, some central banks may need to start by actually promoting a somewhat higher, but still moderate, inflation to help governments reduce their fiscal debt burdens (Aizenman & Marion, 2011; Chinn & Frieden, 2011).
During the 2007 crisis, central banks innovated in terms of policy instruments, and many became responsible for macro-prudential measures (Blinder et al., 2016; Cerutti et al., 2017). Central banks in crisis countries have been more likely to resort to policy innovations, such as quantitative easing, forward guidance, or macro-prudential measures. The economics literature is still investigating the consequences of these policy innovations, and an important question is whether such changes will remain in the central bank’s tool kit (Blinder et al., 2016). At the same time, these policy innovations have faced significant domestic political challenges and another question is the degree to which broader mandates and more central bank responsibility will affect central bankers’ prized independence from politics.
The deregulation and globalization of finance helped propagate the 2007 financial crisis from its epicenter in the United States to countries across the globe. Globalized finance may also challenge the impossible trinity as a bedrock of international economics. The trinity states that autonomous monetary policy is not possible when there are no capital controls and a country has fixed exchange rates.
In a challenge to the trilemma, Helene Rey (2013, 2016) argues that the globalization of finance and the recent emergence of networks of global banks have transformed the Mundellian trilemma into a dilemma.22 Thus, when capital is mobile, even in the absence of fixed exchange rates, the credit conditions or monetary policy set in the world’s main financial centers restrict the monetary policy of the rest of the world. Rey demonstrates the existence of powerful global financial cycles (correlations of asset prices, gross flows, and leverage from across the globe), which she argues shows the response of capital to the monetary conditions of key countries like the United States, to the detriment of a response based on the macroeconomic conditions of a particular country. Countries may therefore experience massive capital inflows and credit growth in boom times and capital outflows in recessions (Rey, 2013, 2016). In many ways, Rey’s work has the potential to reignite the old debate about the effects of globalization on the state’s ability to govern the economy, suggesting that international capital may constrain states under an even wider set of conditions than thought before. Already, Aizenman et al. (forthcoming) suggest that domestic, country-specific institutional factors and macroeconomic policy frameworks continue to be important to countries’ sensitivity to shocks emanating from the world’s core economies (the United States, the euro area, Japan, and China).
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(1.) Quantitative easing increases the size of the central bank’s balance sheets through asset purchases. Credit easing implies a shift in the composition of a bank’s balance sheets toward riskier assets. Forward guidance is the central bank’s communication about the likely choices in monetary policy. Blinder et al. (2016) include macro-prudential measures (regulatory limits on leverage, stronger underwriting standards) as part of the policy innovations in central banking.
(2.) An important part of the literature conceptualizes the choice of the exchange rate system as dependent on societal interests rather than credibility concerns (Frieden, 1991, 2002; Walter, 2008; Shih & Steinberg, 2012).
(3.) The “unholy trilemma” implies that policy makers can only choose two out the following three policy choices: (1) freedom of capital to move across borders; (2) fixed exchange rates; and (3) autonomous monetary policy, or the ability to set domestic interest rates as a function of domestic economic conditions.
(5.) Broz (1999) links the creation of the U.S. Federal Reserve in 1913 to both the desire to avoid financial panics by having in place a lender of last resort and also to private interests that stood to gain from having the dollar emerge as a key currency (in the gold standard world) to settle international transactions.
(6.) For example, Banque de France was created in 1800, Germany’s central bank (the Bundesbank) in 1876, and the United States’ Federal Reserve in 1913 (following the dissolution of the Second Bank).
(7.) Most modern central banks are also responsible for the working of system of payments. In addition, some central banks supervise the banking system and have a say in the choice of the exchange rate regime.
(8.) For example, Chile, Czech Republic, Sweden, and Switzerland.
(9.) For example, the UK and Israel. Many central banks choose their inflation target jointly with the government, including Australia, New Zeeland, or Brazil.
(11.) Germany is an exception because it continued its strict control of the money supply to deal with the oil-shock price spikes.
(12.) Garriga (2016) codes more countries, including many more authoritarian regimes, new democracies, and common currency area countries or regional central banks and shows a central bank independence index of 0.39 in 1980 (104 countries), respectively, an index of 0.6 in 2012 (178 countries). Others update the central bank indexes for specific regions (Cukierman et al., 2002; Bodea, 2013; Jacome & Vazquez, 2008; Masciandaro & Romelli, 2015) or time periods (Polillo & Guillén, 2005; Eichengreen & Dincer, 2010).
(14.) Being overridden may mean losing one’s job or facing changes in the central bank law or the governance structure of the bank, and hostile appointments to the bank’s governing bodies. Costs entail the reaction of financial markets, political opposition, and the press.
(18.) Lohmann (1998) shows that in the period 1960–1989 when the legal independence of the Bundesbank remained the same, there are pre-electoral cycles in the rates of money growth (mediated by various domestic political factors), pointing to pressure from politicians for higher rates of money growth.
(21.) For example, how much Greek debt does the European Central Bank hold, versus other assets, or the haircut that the European Central Bank applies to collateral from Greek banks?