Palgrave Dictionary of Emerging Markets and Transition Economics

Jens Hölscher, Horst Tomann, Jens Hölscher, Horst Tomann

• Publisher: Palgrave Macmillan
• Year: 2015
• Print ISBN:
  9781137371379
• eBook ISBN:
  9781137371386
• Topic: Business
• Subtopic: International Business
• Index: Business

The period of transition from socialism to capitalism in parts of Europe and Asia over the past 25 years has attracted considerable interest in academia and beyond. From the Editors of Palgrave's iconic series 'Studies in Economic Transition' comes the Palgrave Dictionary of Emerging Markets and Transition Economics. This dictionary addresses the needs of students, lecturers and the interested general public to quickly find definitions and explanations of topics, institutions, personalities and processes in this historical phase of changing societies, which as such is not concluded. Today newly emerging market economies try to learn from the experiences of transition economies. Those who love The New Palgrave Dictionary of Economics will enjoy the format of this Dictionary, which uses an encyclopaedia-based approach, where articles not only define the terms but provide an overview of the evolution of the term or theory and also touch on the current debates.

Part I

Monetary Aspects

1

Central Bank Independence in Transition Economies

Jane Bogoev and Goran Petrevski

Abstract

Starting from the early 1980s, the legal status of central banks all over the world has changed substantially in the direction of getting greater independence. The move towards greater degrees of CBI has been especially prominent in the emerging economies, including transition economies from Central and Eastern Europe. In this chapter we assess political and economic arguments for establishing independent central banks. Furthermore, we analyse and critically evaluate different indices that attempt to quantify the extent of legal and actual CBI. In addition, we provide a comprehensive overview of the evolution of CBI in former transition economies from Central and Eastern Europe. Finally, we provide a critical assessment of the empirical literature on CBI-inflation relationship.

Keywords: Central Bank Independence, Transition Economies, Monetary Policy, Inflation

1 Introduction

During the last three decades, the legal status and the operational framework of central banks throughout the world have changed substantially. These changes were mainly in the direction of greater degrees of institutional and operational independence of central banks in the formulation and implementation of monetary policy. The trend towards increasing central bank independence (hereafter, CBI) could be seen as a result of several factors: first, the negative experience with the discretionary policies during the 1970s, which led to the so-called stagflation (combination of high inflation and low output growth); second, the advances in economic theory, suggesting that discretionary economic policy results in inferior macroeconomic performance due to the ‘time inconsistency’ and ‘inflationary bias’ problems; third, the accumulated empirical evidence showing that CBI is associated with lower average inflation as well as lower inflation variability; fourth, the breakdown of the Bretton Woods system of fixed exchange rates, which used to promote price stability after World War II. Consequently, all of these developments have led to a consensus that isolating central banks from political influence may be beneficial in achieving and maintaining low inflation.

The move towards greater degrees of CBI has been especially prominent in the emerging economies, including transition economies from Central and Eastern Europe. As a result, nowadays, central banks in emerging countries enjoy higher political and economic autonomy compared to the central banks in developed economies in the late 1980s, while price stability is commonly specified as the primary objective in central bank laws (Arnone et al., 2007).

In the early 1990s, former communist countries initiated a massive transformation process from centrally planned towards market-based economies. As part of the transition process, they embarked on comprehensive institutional reform, which also included changes in central bank legislation. At the same time, during the initial stage of the transition process, these economies suffered from very high inflation, but sooner or later, most of them managed to achieve single-digit inflation rates. Therefore, it is commonly argued that changes in the legal status of central banks have been one of the key factors contributing to the successful disinflation process in transition economies.

In this article, we assess various theoretical approaches to CBI, focusing on both political and economic arguments for establishing independent central banks. Furthermore, we analyse and critically evaluate different indices that attempt to quantify the extent of legal and actual CBI. In addition, we provide a comprehensive overview of the evolution of CBI in former transition economies from Central and Eastern Europe. Finally, given the alleged negative relationship between CBI and inflation as established in theoretical models, we review the accumulated empirical evidence in this field. In these regards, we provide a critical assessment of the early findings in empirical literature, which might have not taken a proper account of the endogenous nature of CBI.

2 The case for CBI

2.1 Economic arguments

As mentioned above, one of the main reasons behind the global trend towards greater CBI was the observed negative experience during the 1970s when governments’ retention of discretionary policies created incentives for pursuing expansionary monetary policy in order to improve macroeconomic performances. In economic theory, the extremely influential concepts of ‘time inconsistency’ and ‘inflationary bias’ associated with discretionary monetary policy have provided a strong case for delegation of monetary policy to an independent central banker.

Specifically, the seminal papers of Kydland and Prescott (1977) and Barro and Gordon (1983) provide the theoretical justification for CBI as an institutional tool for achieving price stability. They argue that once economic agents have already formed their expectations about the future course of monetary policy, governments have incentives to engage in expansionary monetary policy by creating monetary surprises. This behaviour of central banks is motivated by the desire to stimulate the output by exploiting the short-run trade-off between inflation and unemployment as implied by the Phillips curve. If the monetary surprise occurs as a one-time action, policy makers will succeed in lowering the unemployment below the ‘natural’ rate. However, in a repeated game, this behaviour would be easily foreseen by rational economic agents, who would, consequently, revise their expectations about the future path of inflation and output, including the higher perceived inflation in their price and wage setting decisions. As a result, although ex-ante envisaged as optimal, discretionary monetary policy appears to be ex-post suboptimal because in the long-run it will end up with persistent and higher inflation with the same level of unemployment.

Apart from the desire to increase output and employment above the ‘natural’ level, the ‘inflationary bias’ associated with discretionary economic policy could emerge from the existence of other policy objectives, too. For instance, governments may pursue expansionary monetary policy due to some fiscal considerations, such as the desire to collect additional budget revenues relying on the inflation tax or the intention to decrease the real value of the existing public debt. In addition, in the open economies, the ‘inflationary bias’ may stem from the desire to improve the balance on the current account by depreciating the real exchange rate (see Cukierman, 1992, and Agénor and Montiel, 1996).

The ‘time inconsistency’ literature has been very influential in establishing institutional arrangements that would prevent the undesirable outcomes of discretionary policies. One possible solution to the ‘inflationary bias’ and ‘time inconsistency’ problems is to delegate monetary policy to an independent central bank that will be committed to maintaining low inflation. This solution has been proposed by Rogoff (1985), who argues that the social welfare could be increased by appointing a ‘conservative’ central banker, who is more inflation averse compared to the society as a whole. Within this framework, the central banker is said to be ‘conservative’ in the sense of putting a greater weight on inflation than on output stabilization in the ‘social loss function’. Since the ‘conservative’ central banker is concerned with output and employment to a lesser extent, he or she acts aggressively in offsetting inflationary shocks, which in the long-run results in a lower average inflation.

An alternative approach, suggested by Walsh (1995), would be to delegate monetary policy to an independent central banker with price stability as a main goal accompanied by an incentive contract between the central banker and the government on the basis of punishments and rewards according to the fulfillment of the price stability goal. Under some conditions, this proposal removes the ‘inflationary bias’ completely as opposed to the ‘conservative’ central banker who only reduces it. In addition, the solution of Walsh (1995) is preferable in terms of the flexibility of monetary policy. However, this institutional arrangement, too, implies that central banks should be granted independence in the conduct of monetary policy.

Though very influential, the ‘time inconsistency’ literature could be criticized on several grounds. For instance, Romer (2006) argues that in order for discretionary economic policy to produce suboptimal inflation, it is necessary that the aggregate supply contains a very large forward-looking element. Yet, as shown by some empirical studies on the dynamics of US inflation, this assumption simply might be overestimated (Fuhrer, 1997).

In addition, the criticism of the concept of ‘time inconsistency’ is related to the historical context in which this theory was developed. During the 1970s, industrialized countries experienced unprecedented high and volatile inflation, which coincided with the two oil price shocks. Hence, it may be argued that adverse aggregate supply shocks might have actually been one of the main reasons for the surge in inflation. In addition, the ‘time inconsistency’ literature disregards the evolution of the knowledge about monetary policy and macroeconomics in general. Specifically, during the 1970s, it was quite common for policy makers to believe in the trade-off between inflation and unemployment as suggested by the Phillips curve. In contrast, modern central banks have fully accepted the knowledge that this trade-off is not permanent (Romer, 2006). This means that nowadays central banks are fully aware of the ‘time inconsistency’ problem and thus, they are capable to avoid the inflationary behaviour as experienced in the 1970s (McCallum, 1996 and Mishkin, 2000). Therefore, it seems that the relevance of the ‘time inconsistency’ theory should be judged within the historical context in which it emerged.

Finally, the concept of ‘conservative’ central banker is not without weaknesses, too. For instance, as noted by Rogoff (1985), this approach may have some shortcomings especially in the presence of various adverse shocks because the ‘conservative’ central banker would be concerned mainly with inflation stabilization, while output stabilization would be of minor importance. Hence, at least from a theoretical point of view, independent central banks should result in higher output volatility, though Waller and Walsh (1996) show that this problem could be solved by prolonging the ‘conservative’ central banker’s term of office. In addition, the delegation of monetary policy to a ‘conservative’ central banker would not be credible if monetary and fiscal policy have different goals because the government would not be willing to give independence to a central bank that is too ‘conservative’ (Välilä, 1999). The same outcome emerges when the economy has been hit by large negative shocks (such as during the recent global crisis), when the arrangement of the ‘conservative’ central banker would not be credible. Similarly, Eijffinger and Schaling (1995) argue that the optimal level of ‘conservativeness’ of the central banker depends on various economic and social characteristics, such as: the ‘natural’ rate of unemployment, variability of productivity shocks and real exchange rate, the degree of openness, and society’s preferences.

2.2 Political economy arguments

From a theoretical point of view, the delegation of the monetary policy to an independent central banker could be well grounded on political business cycle models. Within this framework, the pressures for higher inflation arise outside the central bank as a result of the interactions between the voters and politicians during the electoral process, which lead to political monetary cycles. Specifically, societies may end up in higher inflation for several reasons: politicians want to stay in office as long as possible (‘Office motivated politicians’), thus pursuing expansionary monetary and fiscal policies aimed at increasing their rating; elected politicians (‘Partisan politicians’) may represent the interests of separate social groups with different preferences than those of the median voter; political parties may differ in their preferences, that is, they put different weights to output and inflation in their loss functions; political parties may differ in their distributive programmes and regulatory actions, which cause lesser or greater need for offsetting monetary policy (see Nordhaus, 1975, Hibbs, 1977 and 1987, Frey and Schneider, 1978, Havrilesky, 1987, Alesina, 1987 and 1988, and Alesina and Sachs, 1988).

However, the main criticism to early political business cycle models, such as Nordhaus (1975) and Hibbs (1977 and 1987), is related to their assumption of non-rational expectations by voters. Therefore, later versions of political business cycle models incorporate the rational expectations hypothesis with the implication that the major explanation as to why the voters may be deceived by politicians is the asymmetry of information. Specifically, despite the rational behaviour of voters, due to the asymmetry of information, they have difficulties in inferring the behaviour of the politicians in the future. In these regards, information on the past actions of politicians does not reveal their future policy decisions. In addition, some of these models assume that voters have short memory and quickly forget the past behaviour of politicians (Alesina and Stella, 2010).

As can be seen, both types of political business cycle models (‘Office motivated politicians’ and ‘Partisan politicians’) lead to the same conclusion as the ‘time inconsistency’ literature, namely, that policy makers tend to exploit the short-run trade-off between inflation and unemployment. Consequently, this strand of literature, too, suggests that the delegation of monetary policy to an independent central bank arises as a socially preferable solution.

Nonetheless, political economy arguments for CBI suffer from some conceptual flaws, too. For instance, even political business cycle models with rational expectations usually assume predetermined wage contracts, which are signed before the elections. Quite naturally, the question arises as why economic agents simply do not postpone the negotiation of wage contracts until after the elections (Rogoff, 1988, Shepsle, 1988). Another shortcoming related to the model with ‘partisan politicians’ is associated with the assumption of only two types of political parties. Hence, as Rogoff (1988) argues, if both parties deceive the voters after the elections, then there is a space for the emergence of a third political party, which may better represent the preferences of the ‘median voter’.

2.3 Is CBI necessary?

Leaving aside the academic debate on the theoretical concepts, the very idea of CBI is subject to criticism, too. For instance, Friedman (1962) offers several political and technical (economic) arguments against the absolute independence of centra...

Table of contents

• Cover
• Title
• Introduction
• Part I  Monetary Aspects
• Part II  Institution Building
• Part III  Economic Policy
• Part IV  Growth and Development
• Part V  Wellbeing
• NAME INDEX