The Role of Central Bank Independence in a World of Capital Mobility

Abstract

Historical developments during recent economic history have demonstrated a remarkably parallel development of international capital mobility (ICM) and central bank independence (CBI), making both fundamental factors of today’s monetary system. Neoliberal economic models depict the anti-inflationary credibility associated with CBI as the outcome of strict market rules, insulating policy from political control. The structural power of mobile capital subsequently forced governments to adopt it as policy. However, the theoretical assumptions underlying these arguments misrepresent current realities and obscure the fact that credibility is a social phenomenon. Looking at CBI as a social institution shows that it facilitates a consensus between current political and market interests. For financial market actors, CBI functions as a guide for their intersubjective expectations and ensures the continuity of the current economic order with the financial markets at its centre. Governments consciously support the embedding of society within these markets, while shielding themselves from the reputational costs of adverse market outcomes. Within this consensus, substantial indirect state control over policy decisions remains. Consequently, CBI’s central importance does not lie in anti-inflationary credibility derived from the removal of political control, but in its institutional role as a link between political and market interests in contemporary financial governance.

Introduction

Looking at the international monetary system, Mervin King, the current governor of the Bank of England, remarked that “capital mobility has changed the playing field” (1999:25). For the central bank, this change put a clear priority on “price stability, and the role of central bank independence in achieving it” (ibid). International capital mobility (ICM) and central bank independence (CBI) acquired their fundamental positions in the current monetary system as a result of major developments in recent economic history. The essay begins by highlighting the positive correlation between both phenomena throughout this history. The current peak in ICM, following a long period of market liberalization after the end of the Bretton Woods era (Cerny 1994:320-1), was thus accompanied in many industrial countries by statute changes promoting increasing CBI. Central banks further embraced price stability as primary goal, supporting the perceived anti-inflationary credibility of monetary policies.

Common economic theories, illustrated in section two, approach the connection between ICM and CBI from two perspectives. Firstly, CBI’s credibility is attributed to the removal of political control from central bank policy. The subordination of political discretion thus prevents the pursuit of self-interested short-term goals and allows rational market actors to anticipate monetary developments. Secondly, causal arguments in line with the ‘capital mobility hypothesis’ (Andrews 1994) portray the widespread adoption of CBI as the result of the structural power of mobile capital. According to these theories, CBI’s importance lies in the separation of political influence from the markets, allowing it to substitute gold as a new monetary anchor and accommodating the market’s deflationary bias (Thomas 2001:111).

However, as section three points out, the theoretical assumptions underlying these arguments are questionable. Imperfections in ICM remain, which are themselves essential to understand mobile capital owners’ interest in CBI. Furthermore, in contrast to common perceptions the anti-inflationary record of independent central banks is highly ambiguous. As economic models thus fail to adequately represent current realities, I argue that it is necessary to acknowledge CBI’s social foundations to understand its importance.

Looking at CBI as a social institution in the final section reveals that it facilitates a compromise between political and market interests, which Baker calls the “open market sound money consensus” (2006:67). The shared belief in credibility allows market actors to fix their expectations to central bank commitments. At the same time, CBI is a building-block in the institutional arrangement that ensures the ongoing priority of financial interests. Governments themselves consciously promote the embedding of society in the financial markets. Furthermore, CBI enables policy makers to avoid the reputational costs resulting from adverse market outcomes, while maintaining substantial indirect control over monetary policies. Accordingly, CBI’s central importance in today’s world of highly mobile capital does not lie in anti-inflationary credibility derived from the removal of political control, but in enabling a state-market consensus in contemporary financial governance.

Historic developments

A look at the strikingly parallel developments of ICM and CBI in recent economic history suggests the existence of an intimate connection between these phenomena. After a brief theoretical overview, this section therefore illustrates the distinct historical phases and highlights the industrialized world’s transition towards the current setup of highly mobile capital and increasingly independent central banks.

ICM is most suitably described as the capacity or potential of capital to move within and across jurisdictional boundaries without significant frictions (Andrews 2001:126). According to Andrews, its main sources are technological advances, financial innovation and the liberalization of capital markets (1994:198). Capital mobility is also one element of the ‘unholy trinity’ (Cohen 1993:2). This model, based on works of Mundell (1963) and Fleming (1962), essentially claims that only two out of the following three options can be obtained simultaneously: exchange rate stability, capital mobility and domestic monetary policy autonomy. The ‘unholy trinity’ thus emphasizes the link between ICM and monetary policy, as well as the related choice of monetary institutions (Clark 2003:36). Central banks, as the most important national monetary institutions, generally follow one or more of the following main goals: price stability, stimulation of real income growth, reduction of unemployment and safeguarding of an appropriate exchange rate (Eyler 2010:111-5). The way in which these goals are pursued has been dominated by the ‘rules-versus-discretion debate’ (Giovannini 1993:109-10), expressing different preferences for either political discretion or rule-based decisions and independent central banks. Like ICM, the level of CBI has been fluctuating with the political and economic circumstances of the time.

Three historical phases of fairly homogeneous development in CBI can be identified (Elgie and Thompson 1998:16-17), which match the phases of differing ICM. The developments begin with the gold standard era of the nineteenth and beginning twentieth century, which can be considered the closest approximation to a laissez-faire monetary system. It relied on the automaticity of Hume’s price-specie model ([1752] 1997:34-5), with gold serving as monetary anchor for most currencies. A general consensus surrendered monetary policy to the singular goal of maintaining stable exchange rates (Eichengreen 1998:30). While at the beginning of this epoch multiple banks had the right to issue legal tender, problems of coordination and free-riding led to the widespread creation of single central banks (Goodhart 1988:103-4). By the time of the International Financial Conference in Brussels in 1920, these were considered an essential element of statehood (De Kock 1974:9). Legislation, like Peel’s Bank act of 1844, mainly incorporated the dominant rule-based monetary ideology, and despite some measure of discretion central banks were largely independent (Fischer 1996:1158-9). At the same time, technological advances in transport, communication and financial products as well as the states’ relinquishment of monetary policy autonomy created an unprecedented degree of ICM (Bordo and Schwartz 1984:25).

However, ICM suffered a breakdown with the onset of World War I and remained largely restrained throughout the interwar years, despite attempts to return to the pre-war gold standard (Toniolo 2005:5). The next substantially differing phase was the Bretton Woods era following World War II, which was characterized by economic and monetary policy autonomy (Sinclair 2001:94). This autonomy was used to strengthen the welfare apparatus and maintain the social consensus of ‘embedded liberalism’ (Ruggie 1982:392). The increased role of the state extended to central banks (Goodhart 1995:212), which faced decreasing independence and tighter political control, as governments manipulated monetary policy instruments to support real income growth and employment (Elgie and Thompson 1998:17, De Kock 1974:316). In a ‘game against nature’ (Monticelli and Giannini 1997:1), government discretion was believed to be able to shape market outcomes better and more flexible than rule-based solutions (Fischer 1996:1169). While gold remained the monetary anchor via the gold-dollar-peg, and exchange rates were essentially kept fixed (although officially allowed to be readjusted in extreme circumstances), states now resorted to capital controls to shield their economies from adverse market impacts (Eichengreen 1998:93-6). In line with the ‘unholy trinity’ model, this meant that ICM was severely restricted. However, this setup was not to last. Technical progress and financial innovation, like the introduction of the Euromarkets, made controls increasingly ineffective, and major states supported the growing financial sector (Goodman and Pauly 1993:53, Andrews 1994:199).

ICM made another leap in 1971, when mounting pressures for the dollar to devalue led the Nixon administration finally to suspend convertibility and effectively end the Bretton Woods era (Eichengreen 1998:133). This also marked the end of gold-pegs, as the amendment to IMF Article of Agreement IV specifically precludes such an arrangement “to reduce the role of gold in the international monetary system” (IMF 2006:6). Governments initially welcomed the liberation from the constraining monetary anchor and high ICM to engage in deficit spending (Goodman 1992:2, Frieden 2007:364-72). However, this produced excessive inflation and increasing exchange rate volatility. This ‘inflation crisis’ provided an historical moment for neoliberal policy to emerge as orthodox thinking (Crouch 2009:388-9). Market deregulation as part of the ‘Washington consensus’ (Williamson 1993:1329) and technological advances led to the current peak in ICM. Beginning in the 1980s, the rise of ICM was accompanied by a number of states changing their central bank statutes in favour of enhanced CBI (Bernhard 1998:312). Policy autonomy has generally been given up to safeguard low inflation and stabilize the exchange rate (Bearce 2007:20-1). Rules, like the setting of explicit targets, were supposed to support anti-inflationary policies and guarantee price stability (Fischer 1996:1174). Governments thus officially removed central banks from direct control in order to increase their anti-inflationary credibility.

The credibility of CBI and the structural power of ICM

The role of increasingly independent central banks in a world of ICM attracted considerable scholarly interest. Most commentators argue along dominant neoliberal lines, portraying CBI as a way to overcome inherent political weaknesses and envisioning it as a new monetary anchor based on anti-inflationary credibility. Its widespread adoption, despite the loss of political control it represents, is attributed to the structural power of highly mobile capital.

The rise of neoliberal ideas altered the way in which economic incidents were subsequently interpreted. The ‘stagflation crisis’ of the early 1970s was portrayed as the result of discretionary monetary policy exploiting the sudden disappearance of constraints associated with former fixed exchange rates or metallic pegs (Clark 2003:37). The solution was seen in the return to a rule-based system (Fischer 1996:1170), which could overcome the ‘time-inconsistency problem’ between short term political interests and long-term economic inflation targets (Elgie and Thompson 1998:18). This idea is based on three general assumptions (Giovannini 1993:111).

Firstly, monetary authorities follow objectives that do not coincide with the natural economic equilibrium. Governments use monetary policy to pursue growth rather than inflation targets (Clark 2003:37), believing in the manipulation of the simple ‘Phillips curve’ (Phillips 1958). According to this model, an increase in the money supply can deliver an optimal trade-off between unemployment and inflation, as wages do not instantly adjust (Goodman 1992:14-5). Especially pre-election governments used either monetary or fiscal measures to create short-term economic effects (Clark 2003:50). However, neoliberal economists in the 1970s developed the ‘expectations-augmented Phillips curve’, which proposed a ‘natural’ level of unemployment. Any attempts to push the figure below this level would lead to adverse inflationary effects, as the public would react with demands for wage and price increases (Elgie and Thompson 1998:18).

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