Central Bank Independence: Benefits & Risks
A state’s central bank exerts a large sphere of influence within its domestic and international markets. It is therefore important to examine the degree of independence that central banks hold, alongside the associated benefits and risks. A fully independent central bank possesses three characteristics: complete freedom to decide which economic goals to pursue, how to use monetary policy for these goals, and complete insulation from other branches of government (Oatley 290). With central bank independence (CBI), states can establish commitment mechanisms and solve time-consistency problems to mitigate inflation – yet, such autonomy also poses growth and unemployment risks and compromises public interest within the economic sector. By examining the risks and benefits of CBI, we can further evaluate how this metric affects economic prosperity.
Figure 1 depicts a cross-national scatter plot representing the unemployment rate of 176 countries as the CBI weighted index increases from 0 to 1. The CBI index (x-axis) represents the weighted average of the four components deemed essential to determining a bank’s independence: the CEO appointment/dismissal weighted score, central bank monetary policy objective rating, parties involved in policy formation weighted score, and government lending terms weighted score. The unemployment rate (y-axis) represents the percentage of unemployed people in the labor force (aged 15 to 74).
The CBI index, the independent variable, offered a standard measure for evaluating central bank autonomy across nations. The unemployment rate, the dependent variable, acted as an indicator of each country’s economic health. The unemployment rate of a country provides further information about factors such as labor market conditions, economic growth and income distribution. It tracks the demand for goods and services in an economy – if firms experience less demand, they are reluctant to increase employment. In this sense, a higher unemployment rate correlates with recessionary periods.
These two variables combine to create the trend exemplified in Figure 1. The trend line in Figure 1 depicts a positive correlation between CBI and unemployment rates: as a country’s central bank becomes more independent, unemployment rates increase. The slope of the trend line is 6.442; this suggests that the unemployment rate increases by 6.442% per every one unit increase in CBI or by 0.6442% every 0.1 unit increase in CBI, and is statistically significant (p < 0.05) with a standard error of 2.497. The constant of 4.371 suggests that the unemployment rate is 4.371% when the CBI is 0 and is highly significant (p < 0.01). This shows CBI has a positive effect on unemployment compared to its absence.
According to Oatley, a central bank gaining independence should lead to lower inflation, higher economic growth, lesser variation in and lower unemployment over the long run (Oatley 291). The data presented in Figure 1, however, does not correspond to the theory presented by Oatley. As Figure 1 suggests, unemployment tends to increase as CBI increases. However, Oatley cautions that the theory may not hold true and presents evidence for the positive correlation between unemployment and CBI and negative correlation between economic growth and CBI (Oatley 294). That said, the theoretical pattern according to Oatley considers employment in the long-run, which Figure 1 does not provide enough evidence for, since it provides data from multiple countries but only for one year (2012). Therefore, while we might observe a correlation, it does not imply causation. A holistic analysis of CBI and unemployment is possible if we consider one country over a period of time.
Figure 3 depicts the unemployment rate for Turkey from 1982 to 2020. Turkey experienced recessionary and growth periods, mirroring the rises and falls in the unemployment rate. However, there is a significant increase in unemployment in the year 2000/2001. This change can be explained by the data in Figure 4, which examines Turkey’s CBI index over the same time period. Here, a liquidity crisis in the 2000s (Alper) led to a “law on the Turkish Central Bank [that]… reinforced instrument independence” (Guney). This development is correlated with a jump from approximately 6.52% in 2000 to 10.5% in 2002. Since then, the Turkish central bank remained highly independent, which correlates with higher overall unemployment compared to pre-independence levels. These conclusions correspond with Oatley’s predictions about the problems with applying the theory in the real-world.
An additional risk of CBI surrounds its undemocratic nature. “Monetary policy is perhaps the single most important [government policy]” (Oatley 297). By limiting government intervention, it grants independent institutions the ability to control public sector elements like income tax rates (Oatley 297). During the Swedish Riksbank Crisis in the 1990s, citizens had little power to lobby against the 500% overnight rate that the central bank implemented to save the krona (Riksbanken). When the Swedish government stepped in to present a crisis package, interest rates returned to lower levels (Riksbanken). This illustrates the occasional necessity of government regulation, a concept that diminishes within CBI.
There are, however, benefits that result from an independent central bank. A key benefit is that it solves the time-consistency problem. This arises when the best course of action at a given point differs from the best course of action in general (Oatley 288). In this case, a time-consistency problem arises when governments control monetary policy. Since governments usually have short-term policy preferences, they cannot make credible commitments to keeping inflation low. The lack of a credible commitment, affects the interaction between wage bargainers and the government, such that the government has to choose between two suboptimal monetary policy responses: higher inflation or higher unemployment (Oatley 289). With a credible commitment, both unemployment and inflation could be lower. Here, the role of an independent central bank comes into play. Shifting monetary policy control towards the central bank prevents short-term policy preferences from influencing decisions. Because the central bank makes a credible commitment to lower inflation, nominal wages are more likely to maintain the real wage and therefore keep inflation low.
Overall, it is important to track CBI with metrics indicative of economic health. In this case, an increase in CBI is correlated with heightened unemployment, referenced in Figure 1’s cross-national analysis and Figure 3’s single-country timeline. This notion, coupled with CBI’s undemocratic nature, illustrates its ultimate risks as a political strategy. On the other hand, CBI may make it easier for a central bank to commit to low inflation and see beyond short-term policy preferences. Countries can analyze these risks and benefits when determining the degree of CBI they wish to institute to create an effective banking strategy.
Works cited
Alper, C. Emre. “The Turkish Liquidity Crisis of 2000: What Went Wrong.” Russian & East European Finance and Trade, vol. 37, no. 6, 2001, pp. 58–80. JSTOR, http://www.jstor.org/stable/27749601. Accessed 9 Dec. 2023.
Baffes, John, et al. World Bank Open Data, 6 Dec. 2023, data.worldbank.org/.
Garriga, Ana Carolina. 2016. Central Bank Independence in the World: A New Dataset. International Interactions 42 (5):849-868 doi: 10.1080/03050629.2016.1188813
Guney, Pelin Oge. “Does the Central Bank Directly Respond to Output and Inflation Uncertainties in Turkey?” Science Direct, June 2016.
“International Labor Organization.” ILOSTAT, ilostat.ilo.org/. Accessed 8 Dec. 2023.
Oatley, Thomas. International Political Economy. 6th ed., Routledge, 2019.
Riksbanken, Sveriges. “Interest Rate 500% – the Krona Floats.” Interest Rate 500% – the Krona Floats, www.riksbank.se/en-gb/about-the-riksbank/history/historical-timeline/1900-1999/interest-rate-500–the-krona-floats/. Accessed 8 Dec. 2023.
“Standard Dataset.” Standard Dataset, University of Gothenburg, www.gu.se/en/quality-government/qog-data/data-downloads/standard-dataset. Accessed 8 Dec. 2023.