The Political Economy of Independent Central Banks

Abstract

Central bank independence (CBI) has been understood to originate in domestic political commitments to tackle inflation and government profligacy. But recent studies demonstrate that international financial institutions (IFIs) and capital markets also play a role in influencing states to delegate their powers to independent monetary authorities, i.e. to central banks. Further, it is apparent that central banks have powers that extend beyond maintaining price stability and reining in government spending. But scholars have yet to develop a theoretical framework that satisfactorily explains the origins of CBI — still less reversions therefrom. Drawing on the theories of institutional design, we hypothesize that domestic and international creditors use CBI to resolve the problems of control and information that are inherent to sovereign lending. Specifically, we argue that CBI is used to split central banks off from sovereign states, and to establish shared liabilities between the governments (still sovereign but diminished in power) and their central banks. This separation — often buttressed by elaborate structures of international surveillance and control — creates incentives for the paired agents to monitor and discipline each other, thereby curtailing the political hazard of sovereign lending. We also hypothesize that reductions in the power of lenders precipitate corresponding reductions in CBI. Using an in-depth historical survey of the German central bank in the interwar period to test our argument, we reveal dramatic variation in CBI attributable to the capacity of lenders to split sovereigns.