The wave of central bank reform in the late 1980s and 1990s represents a remarkable change in how countries administer monetary policy. Among the industrial democracies, an independent central bank has become the norm rather than the exception. In most countries, elected officials no longer control interest rates or the money supply but entrust the management of these policy instruments to central bank bureaucrats. Although politicians still possess the ultimate responsibility for monetary policy, their means of influencing monetary policy are now less direct. Nowhere is this more evident than in the EU, where member-state politicians have given up national control over monetary policy in favor of an independent European Central Bank.
These reforms have occurred in the context of economic internationalization. With improved communication and transportation, economies have become more closely integrated over the past 40 years. The volume and pace of cross-border transactions have increased dramatically. While unprecedented levels of wealth in the industrial democracies have accompanied the internationalization of product and capital markets, increased economic openness has also brought pressure for economic change. Global overcapacity in manufactured goods, for example, has accelerated the process of deindustrialization.
Political economists have also noted a variety of domestic-policy changes and institutional reforms concomitant with economic internationalization, including central bank reform, European integration, and fiscal retrenchment. But the mechanism connecting increased economic openness to these political developments is not clear. Some argue that the need to attract scarce international capital drives reform. Other political economists suggest that the capital mobility allows markets to punish states for certain policies, forcing them to choose “market-friendly” policies. Still others suggest that economic competition between states pushes them to pursue institutional reform.
Instead of these mechanisms, I emphasize the role of political parties to link economic internationalization with domestic reform. Political parties supply central bank institutions. They will choose institutions that will help them win and retain office.
Economic internationalization changes the incentives of political parties over central bank institutions. First, economic openness alters constituent preferences over economic and monetary policy (Frieden 1991; Frieden and Rogowski 1996; Rogowski 1989). Second, increased internationalization makes it increasingly difficult to gauge the relationship between policy choices and their consequences, hurting the government’s ability to control the macro-economy and deliver promised outcomes.
These developments have eroded the social coalitions of the major parties in the industrial democracies (see, for example, Boix 1998; Ramseyer and Rosenbluth 1994; Rosenbluth 1996). These parties could once count on stable electoral support, but voters have become more instrumental, casting ballots on the basis of policy performance rather than cultural identity. Moreover, economic interests fall increasingly along sectoral lines rather than traditional class-based cleavages, with conflicts between exposed and insulated sectors, manufacturing and service sectors, rising and declining sectors, and the public and private sectors. The diversification of constituent demands has increased the possibility of intraparty conflicts over economic and monetary policy, hurting the ability of these parties to hold office.
Although this changed political environment makes it difficult to maintain their constituent base, it also presents opportunities for parties to court new sectors and new interests. In order to maintain their political viability, therefore, parties must decide which voters to pursue and then design policies to appeal to those constituents. Parties must determine how to balance the demands of their traditional support base with the electoral opportunities created by changes in the political environment. These strategic decisions are often difficult and contentious, pitting different interests against one another.
One way for parties to overcome these potential intraparty conflicts is to support institutional reform. Reform can provide representation to new interests, reassure constituents about the party’s intentions, or allow the party to shed responsibility for divisive issues. In turn, these reforms can help parties reassemble and maintain new social coalitions. Electoral reform, devolution, and delegation of policy authority to the EU represent a political response to the diversification of constituent demands and reduced policy effectiveness.
Central bank reform, I argue, is another one of these strategic reform experiments designed to help parties overcome intraparty conflicts. Because an independent central bank can challenge the cabinet’s policy choices, it enhances the cabinet’s accountability. Party politicians and constituents can rely on an independent central bank to monitor the cabinet’s policy behavior. Further, an independent central bank can also justify the cabinet’s policy choices in the face of unpopular economic outcomes, helping to prevent party politicians and constituents from withdrawing their support from the cabinet. The political credibility of an independent central bank can therefore help parties solidify their electoral base and keep the party in office, even where party legislators and constituents face different incentives over monetary policy.
That political credibility helps explain the association between central bank independence and federalism during much of the postwar period. In federal systems, parties typically need to appeal to constituents with a variety of monetary policy preferences, reflecting regional differences in economic activity. Further, the institutions of federalism tend to provide party politicians with different policy incentives. Parties in federal systems therefore relied on an independent central bank to help them manage these potential intraparty conflicts over policy.
With the diversification of constituent preferences and decline in policy effectiveness, parties in the late 1980s and 1990s sought to use the political credibility of an independent central bank to help them prevent intraparty conflicts and rebuild their constituent base. Political parties will remain committed to these independent central banks as long as the banks continue to help them appeal to constituents with diverse economic policy preferences.
Political parties will reduce the independence of a central bank if the bank loses a policy dispute with the cabinet or if the bank challenges a policy action that enjoys widespread support within the party. These scenarios are more likely where the party(ies) in government appeals to constituents with similar policy preferences or if party politicians have similar policy incentives. Central bankers, however, are strategic actors in the policy process. They are unlikely to risk their institutional status by challenging the cabinet under those circumstances. As a result, central banks are likely to retain their formal independence for quite some time—even if it means central bankers sacrifice some behavioral autonomy.
Many discussions of monetary reform close by noting the irony of central bank independence in democratic societies (e.g., Alesina 1989; Keech 1996). Independent central banks may improve inflation performance, but they are usually criticized as secretive undemocratic institutions, unaccountable to politicians and to the public.
This book has demonstrated the opposite in several respects. First, I have argued that the economic-policy success of countries with independent central banks depends as much on the bank’s political principals as it does on the bank’s institutional structure. An independent central bank does not “depoliticize” monetary policy. In countries with independent central banks, monetary policy remains a source of partisan conflict and tension. Both qualitative and quantitative empirical accounts indicate that politicians playa large role in determining monetary policy in these countries. An independent central bank therefore does not prevent politicians from influencing monetary policy.
Instead, an independent central bank changes the manner in which politicians affect monetary policy. In countries with a dependent central bank, central bankers are responsible to the cabinet only, allowing the cabinet to determine the course of monetary policy. With an independent bank, the bank’s principals include both the cabinet and the legislature. The bank’s multiple principals provide central bankers with the ability to influence policy debates by publicizing their policy disputes with the government. The strategic interaction between an independent central bank and the cabinet can therefore actually enhance the government’s accountability for monetary policy, allowing backbench legislators, coalition partners, and the public to have a better understanding of the cabinet’s behavior.
Furthermore, I have shown that the institutional status of the central bank actually reflects the interests of political parties. Parties will choose central bank institutions to help them win and retain office. In systems where intraparty conflicts threaten the party’s ability to hold office, politicians will choose an independent central bank. The bank’s political credibility can help them appeal to constituents with diverse preferences over economic policy and balance divergent policy incentives among party politicians. Where party politicians have similar policy incentives or the party’s position is secure, politicians will prefer a dependent central bank.
The wave of central bank reform in the late 1980s and 1990s reflects changes in party systems across the industrial democracies. With the economic developments of the past few decades, the major parties now face constituents with a wider variety of preferences over policy and the potential for intra party conflicts over economic and monetary policy. These changes have increased the political value of an independent central bank, prompting politicians in many countries to grant their central bank increased autonomy. Central bank institutions, therefore, are not undemocratic. Rather, they both reflect and enhance the democratic process.