During the Great Moderation, central banks focused on price stability, and independence was seen as crucial to limit inflation bias. Since the Global Financial Crisis, emergency support measures for banks, and central banks’ increasing involvement in supervision, have called central bank independence into question. This column argues that the literature has overlooked the distributional effects of the tradeoff between monetary and financial stability. In a political economy framework, heterogeneity in voters’ portfolios can cause the degree of central bank independence to differ from the social optimum.
A successful transition to a European Banking Union requires robust and credible ‘Chinese walls’ between the ECB’s role as monetary authority and any responsibility in the Single Supervisory Mechanism or in the resolution rules. Otherwise, the ECB’s independence would be at risk, given that monetary policy would likely have larger distributional effects.
In 2014, the handover of supervisory authority over most of Europe’s banking system to the ECB, and the ongoing debate over the European resolution scheme, require a clear acknowledgement of the possible effects on the central bank’s design and stability. These effects seem to be have been overlooked so far, and not just in the European case.
Since 2008, one of the main effects of the Global Financial Crisis has been the massive state interventions in bank bailouts and the consequent deterioration of public finances in many countries (Panetta et al. 2009). The instability in the financial system contributed, at least partially, to the instability of public budgets. This had, among others, two important consequences concerning the role of central banks. First, their duties in supervising the financial system have been redefined (Reis 2013). Second, their role as independent monetary authorities has been questioned (Taylor 2013). Both of these consequences result from a changed perception of the tradeoff between monetary stability and financial stability.
The evolving role of central banks
The history of central banks is rich in modifications to their role and functions. In the last 30 years – before the Global Financial Crisis – the mandate of central banks has been progressively narrowed. In a large number of countries, the central bank’s mandate has been focused on the area of monetary policy, and on the goal of price stability in particular (Riechlin and Baldwin 2013). This narrowing of central banks’ mandate has been accompanied by modifications to their governance arrangements. The main pillar of central bank governance was identified as the degree of independence (Ejffinger and Masciandaro 2014). By the early 2000s, an increasing number of countries had adopted a well-defined form of central bank governance. With central banks becoming increasingly specialised in achieving their monetary policy goals, their traditional responsibilities in pursuing financial stability became progressively less important (Masciandaro and Quintyn 2009). But now the Crisis has posed new challenges to the modern central banking model. A significant number of reforms are taking place, which concern in particular central banks’ role in the structure of supervision (Cukierman 2013).
But what could be the effects on independence? The traditional answer to this question focuses on the fact that greater involvement of the central bank in supervision could trigger inflation risk via bailout monetisation. But this answer overlooks the financial distributive consequences of bailout monetisation and its consequences for both the optimal and the actual level of central bank independence. Indeed, even the monetary distributive effects have rarely been addressed (Posen 1995 provides an exception).
A political economy model of bailouts and central bank independence
The answer can be found in a political economy model of voting (Masciandaro and Passarelli 2014). In the model, banking bailouts and central bank independence are determined by majority voting, and both bank failures and inflation are socially costly. Two results emerge:
- There will be a socially optimal level of both bailouts and central bank independence.
- However, the optimal outcomes will rarely be adopted, if voters’ preferences over pursuing monetary and financial stability are heterogeneous.
The political distortions on central bank independence will depend on voters’ financial portfolios. Some voters, being essentially bank shareholders, are biased towards financial stability – they care a lot about the design of bailouts and their financing, but are relatively unconcerned by the inflation risk due to monetisation. Their optimal degree of central bank independence will be low. At the opposite end of the spectrum, voters who are essentially bondholders will be biased towards monetary stability, preferring a high level of central bank independence. The portfolio composition of the voters will determine how the actual degree of central bank independence will differ from the optimum.
The policy implications of the analysis are twofold:
- First, changing central banks’ involvement in supervision can affect central bank independence via both the inflationary and financial distributional effects of bank bailout financing.
Therefore, the greater the confusion and opaqueness between the ECB’s role as monetary authority and its involvement in banking supervision and resolution, the more its independence will be at risk. The design of the ECB as banking supervisor is addressing the issue, splitting the governing bodies of the two different policies. But at the moment features and details of both the Single Supervisory Mechanism and the resolution rules are in a state of flux, and consequently risks for the stability of the central bank regime are present and relevant.
- Second, as a consequence, central bank independence will depend on citizens’ portfolios – heterogeneity, volatility, and shocks in the distribution of income and wealth will trigger demands for reforms that alter the degree of central bank independence.
In other words, the more the central bank is involved in supervision, the more the stability of its independence will depend on how its choices affect the distribution of income and wealth through two channels – nominal and financial effects. This conclusion is particularly relevant when the main central banks in the advanced countries – the ECB, the Federal Reserve, and the Bank of England – are likely to become more involved in supervision.
•Cukierman, A (2013), “Monetary Policy and Institutions before, during and after the Global Financial Crisis”, Journal of Financial Stability 9(3), pp. 373–384.
•Masciandaro, D and S Ejffinger (eds) (2014), Modern Monetary Policy and Central Bank Governance, Cheltenham: Edward Elgar.
•Masciandaro, D and F Passarelli (2014), “Banking Bailouts and Distributive Monetary Policy: Voting on Central Bank Independence”, Paolo Baffi Centre Working Paper, Bocconi University.
•Masciandaro D and M Quintyn (2009), “Reforming Financial Supervision and the Role of the Central Banks: A Review of Global Trends, Causes and Effects (1998–2008)”, CEPR Policy Insight No. 30.
•Panetta F, T Faeh, G Grande, C Ho, M King, A Levy, F M Signoretti, M Taboga and A Zaghini (2009), “An Assessment of Financial Sector Rescue Programmes”, BIS Papers No. 48.
•Posen, A (1995), “Declarations are not Enough: Financial Sectors Sources of Central Bank Independence”, in B Bernanke and J Rotemberg (eds.), NBER Macroeconomics Annual, 1995, Cambridge MA: MIT Press.
•Reichlin L and Baldwin R (2013), Is Inflation Targeting Dead? Central Banking After the Crisis, London: CEPR.
•Taylor J B (2013), “The Effectiveness of Central Bank Independence Versus Policy Rules”, mimeo.
•Reis R (2013), “Central Bank Design”, NBER Working Paper No. 19187.