New research published in the March 2003 Economic Journal provides overwhelming
evidence that central bank independence helps smooth out the cycle of boom and bust.
What’s more, the study by John Maloney, Andrew Pickering and Kaddour Hadri reveals that
central banks that can set their own monetary objectives – which, as yet, the Bank of England
can't do – are especially good at giving business a stable economic environment. They
conclude that the Bank should be given more independence and, in particular, the ability to
choose the inflation target.
Many economists have been sceptical about the advantages of an independent central bank
for smoothing the business cycle. But this research – the largest study yet of the issue, taking
in 20 countries over a period of 38 years – finds a clear 'political business cycle', in which the
economy is destabilised by the proximity of elections, and an equally clear mitigation of this
cycle when an independent central bank takes monetary policy away from politicians.
The political business cycle (where elections affect the economy) and the economic impact of
an independent central bank are both old tunes in economics. But it’s only quite recently that
there’s been much study of how the latter affects the former.
Why should elections affect output? The oldest theory is that politicians lay on a boom before
the election in the hope it will carry them back to power. This isn’t unknown, but the blatant
cases are a long way back, and econometric studies have found little evidence for this kind of
business cycle.
But according to another version of the business cycle, the ‘rational partisan theory’, the
economy is affected not by governments changing their policy as an election is coming up,
but the private sector changing its behaviour in view of the uncertain result.
Suppose your union is negotiating a wage deal to cover the next 12 months, but knows there
is going to be an election halfway through. Suppose one of the parties likes monetary growth
at 10% a year, while the other aims for 2%. Rational workers will hedge their bets and go for
an intermediate pay rise – say 6% as an example. Then if the more anti-inflationary of the
parties gets in, you will have 6% pay rises colliding with 2% monetary growth: a rise in
unemployment ensues. If the ‘10%’ party wins, then, by equal and opposite reasoning, it
starts its term with a boom.
Analysis of 20 countries over the period 1960-98 – Australia, Austria, Belgium, Canada,
Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, New
Zealand, Norway, Spain, Sweden, Switzerland, the UK and the United States – confirms this
theory.
But the size of the post-election boom or slump depends on how widely expected the election
result was. The more unexpected the winner, the more its monetary policy will collide with pay
claims drawn up on the assumption that the other party would probably win. Big political
upsets produce big economic upsets.
The evidence closely fits this theory too, but the researchers’ real interest is in what an
independent central bank does to all this. How to define independence? Here, the research
draws on a study by the Bank of Finland, which gives the 20 central banks scores, in terms of
four different types of independence, throughout the period.
The one kind of central bank independence that overwhelmingly mitigates the political
business cycle is ‘objective independence’, where the central bank chooses its own
objectives. ‘Personnel independence’, which covers, for example, the ability to appoint your
own board of governors, turns out to matter much less. This is no great surprise. Ability to
chose your own staff is little use if inflation objectives are still set by politicians.
On the basis of their study, the researchers conclude that the government should give more
independence to the Bank of England, and possibly let it choose an inflation target for itself.
ENDS
Notes for Editors: ‘Political Business Cycles and Central Bank Independence’ by John
Maloney, Andrew Pickering and Kaddour Hadri is published in the March 2003 issue of the
Economic Journal.
Maloney is at Exeter University; Pickering at Bristol University; and Hadri at Liverpool
University.
For Further Information: contact John Maloney on 01392-263202 (email:
j.maloney@exeter.ac.uk); or RES Media Consultant Romesh Vaitilingam on 0117-983-
9770 or 07768-661095 (email: romesh@compuserve.com).