Decision Costs and Democracy: Trade-offs in Institutional Design by Robert A. Bohrer

Author:Robert A. Bohrer [Bohrer, Robert A.]
Language: eng
Format: epub
Tags: Political Science, Political Ideologies, Democracy
ISBN: 9780754616047
Google: 8jKDAAAAMAAJ
Publisher: Ashgate
Published: 2001-01-15T04:34:13+00:00

The Development and Effects of Central Banks

During this time of rapid change and an increasingly strong relationship between governments and markets, institutions did not remain static. Specifically, several central banks became powerful actors in the political economies of advanced industrial democracies. Such banks are generally responsible, through varying levels of independence, for maintaining the country’s financial integrity.

Originally, banks of government charter – the predecessors of modern central banks – were used for debt financing following wars. Such banks allowed governments to spread out tax burdens required by the high costs of wars over a long period of time (Broz 1996). This policy of ‘tax smoothing’ has long received support from economists for its ability to stabilize the economy over the long-term while avoiding the short-term shocks (and potential for political upheaval brought on by levying heavy taxes) caused by high war-related expenditures (Barro 1979 in Broz 1996, 7).

However, these banks of government charter only served for a limited time while the strain placed on the government’s fiscal credibility was relieved (Broz 1996). In contrast, modern central banks are essentially permanent institutions with much greater responsibilities. Modern central banks ‘have become key institutions in the process of economic policymaking. Typically, their responsibilities include serving as lender of last resort, as financial agent for the government, and, most important, as bankers’ bank in charge of monetary policy’ (Goodman 1992, 329).

Hence, modern central banks are no longer merely tools of the government; they now play an integral role in governing the economy. However, the degree of independence that central banks enjoy varies greatly by country (Cukierman 1992). The German Bundesbank and the American Federal Reserve are examples of central banks that are relatively free of political domination and can pursue autonomous policies whereas the central banks of New Zealand and Italy are relatively weak (Alesina and Summers 1993).1

Central bank independence is important for several reasons. First, strong ties to the financial community make central bankers generally more averse to inflation than politicians, who subordinate inflation to growth and unemployment (Goodman 1992, 329). Second, central bankers seek market and price stability to insure the credibility of the financial sector (Goodman 1992, 329; Alesina and Summers 1993, 152). In short, the long-term goals of central bankers will likely conflict with the short-term goals of politicians who seek favorable short-term economic outcomes to stay in office.

Alesina and Summers (1993, 153) identify two dimensions of central bank independence, political and economic. Following Grilli, Masciandaro, and Tabellini (1991) and Bade and Parkin (1982), they define political independence as the ability of the central bank to set its policy objectives, free from government influence. This dimension is measured by:

[W]hether or not its governor and the board are appointed by the government, the length of their appointments, whether government representatives sit on the board of the bank, whether government approval for monetary policy decisions is required and whether the price stability objective is explicitly and prominently part of the central bank statute (Alesina and Summers 1993, 153).

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