Central Banks Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Since the establishment of the first central bank in Sweden in 1668, the number of central banks has increased to 178 (in 2008). The emergence of new sovereign states saw a corresponding increase in the number of central banks. Central banks have legitimate power to create national currency, an integral part of monetary sovereignty. These banks play pivotal roles in domestic and international economic management. In the past, they financed government war expenditures and economic development projects. Today, the central banks’ main responsibility is to keep the rate of consumer-price inflation low and stable to accomplish and maintain economic and financial stability.

The majority of central banks are state-owned. Thus, a central bank governor is essentially a government official. Politicians and governors may have different and conflicting policy preferences. In times of conflicting views between a governor and politicians, central bank independence (CBI) vis-à-vis political authority becomes significant. The key factor behind the move to increased independence has been the theoretical argument that an independent central bank restricts the avenues for political interference in monetary policy decision making. In doing so, monetary policy making can be insulated from electoral effects (i.e., political business cycles) and partisan politics (i.e., economic growth and employment oriented policies of leftist parties). Central bankers with legal autonomy from the executive and legislative branches of the government are assumed to have the ability to follow objectives that may conflict with these branches.

Not surprisingly, there has been a significant worldwide trend toward increased central bank independence, transparency, and accountability through legal reforms and actual practices. Introduction of legal reforms granting independence to central banks has been a universal temptation for the majority of sovereign states. Especially from 1990 onward, CBI has become a legal standard, and there has been an international trend toward legal independence. The governments in both developed and developing countries deliberately reformed the statutes of central banks to grant them more autonomy in order to achieve and sustain their primary objective: price stability.

A normative support for CBI revolves around the assumption that central bank governors, who place a greater weight on price stability, are more averse to inflation than politicians. However, the trends toward CBI are built on flawed neoliberal economic theory. It is assumed that inflation is caused by money supply growth, which is determined by the central bank. Conversely, in a world of global finance where financial capital moves freely, money supply increase and credit creation are not solely under the control of the central banks. Further, this view omits other inflationary pressures such as increases in primary goods and energy prices.

In regard to empirical evidence, early studies found that CBI and inflation are strongly negatively correlated in developed economies. These findings are questioned by subsequent studies that there is no correlation and causal link between CBI and inflation. Further, there has been no empirical evidence showing a negative correlation between CBI and inflation in developing economies. Nevertheless, in spite of the questions about the theoretical foundations and the mixed empirical evidence for the merits of CBI, the dominant practice of monetary governance is based on the maintenance of price stability where an independent central bank plays a pivotal role.

Transnational central banking culture is reflected in CBI reforms and promoted by ideational entrepreneurs that include organizations such as the International Monetary Fund (IMF), World Bank, and Bank for International Settlements as well as individuals such as governors who are the members of the translational epistemic community of central bankers. However, the critiques of CBI argue that the delegation of monetary policy to a central bank does not apoliticize monetary policy and has important distributional effects. It is argued that the CBI reflects the interests of international financial capital.

There is also a trend toward greater transparency in central banking. On the theoretical level, it is widely held that transparency in monetary policy can enhance the effectiveness and credibility of monetary policy. Monetary policy is considered effective when central banks influence investors’ medium-term expectations about the path of policy rates over time. In doing so, central banks have an impact on long-term bond yields and other securities. Such effectiveness can be achieved with the credibility of monetary policy if central banks’ actions match their public statements. On the empirical level, it is widely accepted that there is a cross-country positive correlation between transparency and inflation.

Finally, increased independence of central banks raises concerns about accountability. It is believed that independent central bankers should be accountable to elected politicians, who are accountable to the electorate. In doing so, central bank decisions regarding public goods such as price stability can be fully legitimate. More recently, renewed financial turmoil in global markets brought important questions about the role of central banks to strengthen the global financial system and their appropriate role as the lender of last resort. The financial upheaval of 2008 fostered the belief that central bankers would have to act more globally by introducing easier cross-border borrowing.

Bibliography:

Sang-Kun Bae and Ronald A. Ratti, “Conservative Central Banks and Nominal Growth, Exchange Rate and Inflation Targets,” Economica (v.75/299, 2008);
E. V. Borio, Gianni Toniolo, and Piet Clement, The Past and Future of Central Bank Cooperation (Cambridge University Press, 2008);
Sven-Olov Daunfeldt and Xavier de Luna, “Central Bank Independence and Price Stability: Evidence from OECD-Countries,” Oxford Economic Papers (v.60/3, 2008);
De Haan, S. C. W. Eijffinger, and S. Waller, The European Central Bank Credibility, Transparency, and Centralization (MIT Press, 2005);
C. W. Eijffinger and P. M. Geraats, “How Transparent Are Central Banks?” European Journal of Political Economy (v.22, 2006);
Helder Ferreira de Mendonça and José Simão Filho, “Macroeconomic Effects of Central Bank Transparency: The Case of Brazil,” Cato Journal (v.28/1, 2008);
Anne Dolganos Picker, International Economic Indicators and Central Banks (Wiley, 2007);
Lorenzo Smaghi, “Central Bank Independence in the EU: From Theory to Practice,” European Law Journal (v.14/4, July 2008);
Stiglitz, “Central Banking in a Democratic Society,” De Economist (v.146/2, 1998);
Watson, “The Institutional Paradoxes of Monetary Orthodoxy: Reflections on the Political Economy of Central Bank Independence,” Review of International Political Economy (v.9/1, 2002).

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