Central bank independence, growth, investment, and real rates

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Central bank independence, growth, investment, and real rates
  Carnegie-Rochester Conference Series on Public Policy 39 1993) 95-140 North-Holland zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA Central bank independence, growth, investment, and real rates* zyxwvutsrqponmlkjihgfedcbaZYX Alex Cukiermant Tel-Aviv University, Tel-Aviv 69978, Israel Pant elis Kalaitzidakis zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGF Columbia University, New York, New York 10027 Lawrence H. Summers The World Bank, Washington, D.C. 20433 and Steven B. Webb The World Bank, Washington, D.C. 20433 Abstract This paper uses new measures of central bank independence (CBI) for a sample of up to seventy countries in order to investigate the effect of CBI on growth, private investment, productivity growth, and the variability (over time) of growth, controlling for other variables. The proxies for independence are an aggregate index of legal independence based on sixteen specific features of the central banks’ charters and the average turnover rate of central bank governors. The paper also addresses the issue of simultaneity between growth and inflation by using an index of political vulnerability of the central bank. This index is the fraction of political transitions which are followed, within a short period of time, by a replacement of the governor of the central bank. A main finding of the paper is that CBI h as a positive effect on growth in LDCs (less-developed countries) and no effect within industrial countries. The paper also presents evidence on the relation between CBI and the distri- bution of interest rates. *We are indebted to Matthew Canzoneri, William Easterly, Alan Gelb, and Allan Meltzer for useful comments and to participants at the Conference for a lively discussion. t Correspondence to: Alex Cukierman, Department of Economics, Tel-Aviv University, Ramat-Aviv, Tel-Aviv 69978, Israel. Elsevier Science Publishers B.V.  1. Introduction zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA It is generally believed that a high degree of central bank independence (CBI) reduces the inflationary bias of policy and enhances the credibility of stable monetary policies. To the extent that higher and less-stable inflation rates cause inefficient resource allocation and discourage investment, we would therefore expect more CBI to lead to higher growth on average. But, by reducing the scope for policies to maintain full employment and to encourage investment directly, more independence of the central bank (CB) may reduce the average performance of the economy and the long-run rate of growth.’ Thus it is ambiguous a priori which way central bank independence will affect real growth. Recent evidence supports the view that there is a clear-cut negative rela- tion between CBI and the level and variability of inflation (Grilli, Mascian- daro, and Tabellini (1991), C u lerman, Webb, and Neyapti (1992), Cukier- ’ man (1992, Chapter 20) and Alesina and Summers (1993). The evidence with respect to the relation between growth and CBI is not as clear. Grilli, et al. and Alesina and Summers find no relation between growth and CBI in industrial economies. Delong and Summers (1992), however, find, after controlling for initial GDP, a positive relation between growth and CBI in a sample of 15 industrialized economies. Obtaining wider and more solid evidence on the relationship between growth and CBI is interesting for several reasons. First, it may shed some light on whether reduced discretion is good or bad for growth. Second, it should make it possible to determine whether the negative effect of inflation on growth found in recent studies like Fischer (1991) is due to unstable macroeconomic policies or to a reverse causality in which negative real shocks, by reducing real output growth, push the price level up. Measuring CBI is not easy. Existing studies were therefore limited to industrial economies and to proxies of legal independence. Those proxies are poor indicators of actual independence in less-developed countries (LDCs). This paper utilizes new broadly-based and unified measures of CBI for a sample of about sixty countries. Those include aggregate indices of legal independence and the actual turnover of CB governors. Details appear in Cukierman, Webb, and Neyapti (1992) and in Chapter 19 of Cukierman (1992). Recent literature (Barro, 1991, is a representative example) has identified a number of variables like initial GDP and education that partially account for the cross-sectional variability in rates of growth during the last three decades. After controling for some of those variables and other time-related ‘Those who advocate such policies must believe that nominal contracts and/or infor- mational asymmetries produce sufficiently long-lasting effects of money on the economy. 96  variables, like changes in terms of trade, this paper investigates the effect of CBI on growth. Both cross-sectional and pooled cross-section time series (across decades) regressions are tried. The experiments reported here show no evidence of a relationship between growth and CBI within industrial countries but that growth is positively related to CBI in most LDCs. Differences in CBI also help account for differences in growth residuals between the two groups of countries. This evidence takes the form of a ceteris paribus significant negative relationship between growth and two measures of actual CB dependence. One measure is the frequency of turnover of CB governors and the other is the fraction of political transitions that is followed within a short period of time by a replacement of the CB governor. The first measure was found to be a good proxy for inflation in LDCs (Cukierman, Webb, and Neyapti (1992) and Chapter 20 of Cukierman (1992)). Th e second measure is a proxy for the political vulnerability of the CB. Both measures have a significant negative impact on growth within LDCs as well as in the entire sample of countries. These proxies for CB dependence are also used to shed more light on the issue of potential reverse causality in growth equations in which inflation is used as a proxy for unstable monetary policy as an explanatory variable. This is done by using turnover, or the index of CB (political) vulnerability, or both as instruments for inflation. Controlling for other determinants of growth, the impact of inflation on growth is still negative, but less signif- icant than in the ordinary least squares regressions. The paper also looks at the relation between private investment, productivity growth, and the intra-country variability of growth on one hand and CBI on the other. New evidence on interest rates and CBI is also presented. Both nominal and real rates are less variable the higher is CBI, and ex post real deposit rates are, in many cases, higher on average in countries with more independent central banks. To make the paper self-contained, Section 2 discusses the construction of the indices of CBI used in the rest of the paper. Section 3 develops a benchmark growth equation and uses it to investigate the effect of CBI on growth. The issue of potential simultaneity between growth, inflation, and Central Bank governors’ turnover is investigated empirically in Section 4. Evidence on private investment, productivity growth, and CBI is presented in Section 5. The relation between the intra-country variability of growth and of growth residuals on one hand and CBI on the other is taken up in Section 6. Section 7 presents new evidence on interest rates and CBI. The last section concludes. 97  2. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA easures of central bank independence CBI) - an overview zyxwvutsrqpon Central bank independence depends on many attributes which are not easily quantifiable. As a consequence, existing evidence on the relationship between growth and CBI relies only on legal independence and is restricted to the industrial countries (Grilli, Masciandaro, and Tabellini (1991) and Alesina and Summers (1993)). Th ere often are serious gaps though, between legal independence and actual independence. These gaps are particularly notable in LDCs. Additional indicators of CBI are therefore needed. For the most part the paper utilizes two proxies for CBI. The first is an aggregate index of legal independence based on sixteen characteristics of central bank charters. The second is the actual turnover of central bank governors. To deal with potential simultaneity problems, we also use an index of political vulnerability of the central bank. These indices are available for a sample of up to seventy countries, including all the industrial countries and up to fifty LDCs. We do not claim that these proxies capture all the dimensions of CBI, but they are the most comprehensive systematic measures currently available and probably the only ones that provide information on actual as well as on legal independence. This is particularly important for LDCs, where actual and legal independence differ substantially. a. Legal independence2 Besides being an essential component of actual independence, legal indepen- dence is of independent interest for several reasons. First, it suggests the degree of independence that legislators meant to confer on the central bank (CB). Second, most existing attempts at the systematic characterization of CBI rely solely on legal aspects of independence. Availability of an index of legal independence is therefore needed to establish comparability with pre- vious studies. The specific features of legal independence, used to construct the aggre- gate index of legal independence, are constructed in the following manner: A code of independence is assigned to each central bank for each characteristic based on a limited number of narrow but relatively precise legal character- istics. Only the written information from the charters is used. Additional information on how the law is applied in practice is deliberately left out because it is reflected by separate indices. The coded legal characteristics of “variables” can be divided into four groups: (1) variables concerning the appointment, dismissal, and term of of- fice of the chief executive officer (CEO) of the bank (usually the governor); (2) variables concerning the resolution of conflicts between the executive branch zyxwvutsrq ‘This and the following subsection draw on Chapter 19 of Cukierman 1992). 98  and the CB and the degree of participation of the CB in the formulation of monetary policy and in the budgetary process; (3) final objectives of the CB as stated in its charter; and (4) legal restrictions on the ability of the public sector to borrow from the CB. Such restrictions take the form of various limitations on the volume, maturity, rates, and width of direct advances and of securitized lending from the CB to the public sector. In coding various central banks by the degree of independence within each group of characteristics, the following criteria are used: central banks in which the legal term of office of the CEO is longer and in which the executive branch has little legal authority in the appointment or dismissal of the governor are classified as more independent on the CEO dimension. By the same logic, central banks with wider authority to formulate monetary policy and to resist the executive branch in cases of conflict are classified as more independent on the policy formulation dimension. Central banks in which the only or main objective of policy (as specified in the charter) is price stability are classified as being more independent in this dimension than central banks with a number of objectives in addition to price stability. These banks are in turn classified as being more independent than banks with a large number of objectives or banks in whose charter price stability is not mentioned as an objective at all. This classification of the “objectives” variable is designed to capture the legal mandate of the bank to single-mindedly pursue the objective of price stability. (One of the few central banks in which such an unequivocal legal mandate exists is the Bundesbank.) It does not therefore reflect (as the previous two groups of variables) the general level of independence from government. It indicates, instead, the legal mandate of the CB to elevate the target of price stability above other objectives. In Rogoff’s (1985) terminology, it measures how strong is the “conservative bias” of the CB as embodied in the law. Similarly we classify banks in which the limitations on lending from the CB to the public sector are stricter as more independent to pursue the ob- jective of price stability. These limitations encompass a number of more detailed variables such as separate limitations on advances and securitized lending and restrictions on maturities and on interest rates. Generally, the stricter the limitation, the higher is the independence coding given to the bank on that dimension. The comparability of various types of limitations is complicated because different countries specify limitations in terms of differ- ent reference variables. A few countries specify limitations in absolue cash amounts, and others use a percentage of CB liabilities. The most prevalent type of limitation is formulated as a percentage of revenues, and in a minor- ity of cases as a percentage of government expenditures. The “bite” of these limitations obviously depends on the magnitudes of the reference variables. Other things the same, however, absolute cash limits are more binding than 99
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