London School of Economics and Political Science

Distributional Politics and Central Bank
Independence: Monetary Reform in the
United Kingdom, Canada, Australia and
New Zealand

A Thesis Submitted byMichael R. King

92,000 words(102,750 with appendix and footnotes)

Thesis Submitted for the Degree of Doctor of Philosophy in International Relations
University o f London
September 2001

UMI Number: U615222

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i yeses
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7%o
Library
British Library of Politicaland Economic S cienceAbstract

Why do politicians change the legislation governing the central bank to give thisinstitution operational independence in the setting of monetary policy?

This thesis

examines the political debates over central bank independence in New Zealand, Canada,
Australia and New Zealand during the 1980s and 1990s. These cases were selected dueto the variation in their levels of central bank independence, while holding key
institutional variables constant. Four hypotheses are suggested by the political economy
literature to explain the timing of this legislative change: the need to signal
creditworthiness to international financial markets, in response to lobbying by domestic
interest groups opposed to inflation, in response to proposals from an epistemic
community of monetary experts or based on the self-interest of politicians concernedwith re-election. The case studies find that politicians delegate to the central bank when
this reform has the consensus support of an epistemic community o f monetary experts,
and a key politician is willing to champion the legislation through parliament. Thisepistemic community has increased influence during periods of economic uncertainty,
such as following a financial crisis. A key politician is motivated to support this reform
due to ideological or electoral reasons. This reform was facilitated by politicalinstitutions characterised by few checks and balances that concentrated power in thehands o f the executive and offered few obstacles to changing the central bank’s statute.
Central bank independence was rejected in the cases where the epistemic community
did not hold a consensus on the need for reform, and politicians saw only electoral risks
from changing the central bank’s statute. This study finds that politicians retain room tomanoeuvre despite the rise of financial globalisation.

Acknowledgements
This study was made possible due to financial support from the Social Sciences andHumanities Research Council of Canada (award # 752-2000-0104). Field research wasmade possible by a grant from the University of London Central Research Fund and thesponsorship of Robert Pringle, editor of Central Banking. Much of the data used in thiswork was made available through the Data Archive at the University of Essex. The
author has benefited greatly from the contributions of a number of individuals. I would
like to thank my supervisor, Dr. Andrew Walter, whose guidance and ideas havestimulated and informed by research. The following individuals were kind enough toread and comment on earlier drafts of my work: William Bernhard, Daphne Josselin,
Randy Germain, Anja Graupe, Charles Goodhart, John Maloney, Layna Mosley, Adam
Posen, Razeen Sally, Tim Sinclair and David Stasavage. In the course of my fieldresearch, I received particular help from Chuck Freedman at the Bank of Canada, Guy
Debelle at the RBA, Michael Reddell at the RBNZ, Andrew Bailey at the Bank ofEngland, and Arthur Grimes and Roderick Deane at Victoria University at Wellington.
Finally and most importantly, I would like to thank my wife, Yvonne, and my parents
for their continual support and encouragement through this project.

Table of Contents
Abstract..................................................................................................................................... i
Acknowledgements................................................................................................................. ii
Table of Contents...................................................................................................................iii
List of Tables...........................................................................................................................v
List of Figures....................................................................................................................... vii
Ch. 1 Distributional Politics and Central Bank Independence............................................1
1.1 Central Bank Independence in the 1990s....................................................................2
1.2 The Role o f Central Banks........................................................................................... 8
1.3 Inflation Control.......................................................................................................... 11
1.4 Different Perspectives on Central Bank Independence............................................15
1.5 Four Hypotheses Explaining Timing........................................................................ 20
1.6 Summary of Findings................................................................................................. 27
Ch. 2 Central Banking and the Power of Economic Ideas................................................29
2.1 History of Central Banking........................................................................................30
2.2 Crisis of International Monetary Frameworks......................................................... 36
2.3 Emergence of New Paradigm ....................................................................................39
2.4 Central Bank Models and Policy Emulation.............................................................57
2.5 Status of the Paradigm............................................................................................... 59
Ch. 3 Domestic and International Sources of Central Bank Independence..................... 61
3.1 Pressure from International Financial Markets........................................................ 62
3.2 Ideas of a Transnational Epistemic Community...................................................... 65
3.3 Lobbying by Groups Opposed to Inflation...............................................................72
3.4 Politicians Tying the Hands....................................................................................... 81
3.5 Impact of Political Institutions...................................................................................86
3.6 Summary o f Hypotheses............................................................................................ 89

Ch. 4 Monetary Reform in Four Industrial Countries: An Introduction...........................94
4.1 Overview o f Cases......................................................................................................95
4.2 Political and Economic Institutions.........................................................................101
4.3 Interest Groups by Country...................................................................................... 124
4.4 Observable Implications of Hypotheses................................................................. 135
Ch. 5 Reserve Bank of New Zealand: Financial Crisis as a Catalyst for Reform

139

5.1 Overview o f RBNZ Act 1989................................................................................. 140
5.2 Background to Central Bank Reform.................................................................

144

5.3 Design and Political Debate over RBNZ Act 1989.............................................. 156
5.4 Explaining Timing and Design................................................................................ 165
5.5 Putting it All Together..............................................................................................180
Ch. 6 Bank of Canada: The Pursuit of Price Stability......................................................184
6.1 How Independent is the Bank of Canada?.............................................................. 187
6.2 Distributional Conflict over 'Zero Inflation'........................................................... 191
6.3 Political Debates over Bank o f Canada Independence.......................................... 197
6.4 Explaining Policy Continuity...................................................................................208
6.5 Measuring Electoral Gains and Costs..................................................................... 219
Ch. 7 Reserve Bank of Australia: The Importance of Electoral Gains......................

223

7.1 Status of Reserve Bank of Australia....................................................................... 223
7.2 Challenging Economic Background....................................................................... 229
7.3 Political Debates over RBA Independence.............................................................234
7.4 Assessment of Hypotheses....................................................................................... 244
7.5 The Importance of Electoral Gains......................................................................... 258
Ch. 8 Bank of England: Partisan Politics vs. the Power of Ideas................................... 264
8.1 Overview o f Bank of England Act 1997................................................................. 265
8.2 Economic Background to Reforms......................................................................... 268

V

8.3 Political Debates over BoE Independence..............................................................273
8.4 Explaining Timing and Design............................................................................... 286
8.5 Electoral Gains Plus Signalling............................................................................... 301
Ch. 9 International and Domestic Sources of Economic Policy R eform ...................... 303
9.1 Summary of Findings............................................................................................... 305
9.2 Questioning Legal Measuresof Independence...................................................327

9.3 Contribution to International Political Economy................................................. 335
Appendix: Political Economy Studies of Central Bank Independence..........................344
Bibliography....................................................................................................................... 359

List of Tables
Table 1 Changes in Legislation of Central Banks, 1989-1999 (years of amendments)... 1
Table 2: Legal Indices of Central Bank Independence duringthe 1980s 1........................ 6
Table 3: Theoretical Costs of Inflation................................................................................12
Table 4: Political debates concerning central bank independence,1980-2000................ 25
Table 5: Central Banks founded prior to 1914...................................................................31
Table 6: Central Banks Nationalised following W.W.1..................................................... 32
Table 7: Evolution of Monetary Frameworks, 1973-1995................................................37
Table 8: Misery Index for Selected Countries 1..................................................................37
Table 9: Sacrifice ratios during disinflations, 1960-1991 .................................................43
Table 10: Composition of Indices measuring legislative independence........................ 47
Table 11: Rank-Correlation Coefficients of Indices of Central Bank Independence.... 49
Table 12: Central Bank Independence and Economic Performance, 1989 - 1995..........51
Table 13: Empirical Studies of Central Bank Independence, 1989 - 1995.................... 54
Table 14: Inflation and Unemployment in Selected Countries....................................... 59
Table 15: Factors influencing interest group effectiveness..............................................75
Table 16: Theories of Central Bank Independence.......................................................... 92

Table 17: OECD Economic Performance........................................................................... 96
Table 18: Central Bank Independence: Early 1980s......................................................... 99
Table 19: Government Finances........................................................................................ 101
Table 20: Political Institutions during 1980s.................................................................... 101
Table 21: Results of Australian Federal Elections to the House of Representatives.... 104
Table 22: Distribution of Seats in the Australian Senate................................................. 106
Table 23: Results of Canadian Federal Elections to the House of Commons............... 108
Table 24: Results of New Zealand Elections to the House of Representatives............. 109
Table 25: Results of British Elections to the House of Commons................................. 110
Table 26: Canadian Financial Sector Overview...............................................................113
Table 27: Overview of Monetary Policy Frameworks.................................................... 115
Table 28: Overview of Supervisory Arrangements..........................................................119
Table 29: Overview of Labour Market Institutions..........................................................121
Table 30: Summaryof Interest Group Effectiveness in Australia................................... 125
Table 31: Summary of Interest Group Effectiveness in Canada.................................. 127
Table 32: Summaryof Interest Group Effectiveness in New Zealand............................129
Table 33: Summary of Interest Group Effectiveness in UK..........................................132
Table 34: Summary of Explanatory and Institutional Variables, End o f 1980s............ 135
Table 35: Predicted Outcome for the Case Studies..........................................................139
Table 36: Comparison of RBNZ Independence............................................................... 144
Table 37: New Zealand Economic Underperformance, 1975-1985.............................. 145
Table 38: New Zealand Gross and Net Public Debt.........................................................146
Table 39: Chronology o f Economic Reforms, 1984 - 1989............................................152
Table 40: Interest Group Submissions to the Committee on RBNZ Independence

169

Table 41: New Zealand Exposure to International Financial M arkets...........................172
Table 42: Bank o f Canada Governors...............................................................................189

vii

Table 43: Government Documents on Bank of Canada Independence......................... 203
Table 44: Bank of Canada Stages in Pursuit of Transparency....................................... 208
Table 45: Domestic Holdings of Government of Canada Securities (%)...................... 211
Table 46: Federal Government Finances (C$ in billions)...............................................211
Table 47: Sovereign Ratings History for Canada............................................................ 214
Table 48: Standard & Poor's MMS Ranking of Central Banks...................................... 226
Table 49: Australian Gross Debt Levels (% of G D P).....................................................231
Table 50: Net Public Sector Debt..................................................................................... 251
Table 51: Comparison of Bank of England Legislation..................................................268
Table 52: UK Government Foreign Borrowing............................................................... 288
Table 53: International Comparisons of Home-Ownership.............................................298
Table 54: Assessing the hypotheses in the four case studies.......................................... 308
Table 55: Partisanship and Central Bank Reform........................................................... 324
Table 56: Inflation Performance of OECD Countries, 1970-1997................................. 328

List of Figures
Figure 1: Rankings of Central Bank Independence............................................................. 7
Figure 2: Inflation Record of Select Countries...................................................................38
Figure 3: Unemployment Levels of Select Countries........................................................ 38
Figure 4: Cost of Long Term Debt Relative to US............................................................ 64
Figure 5: New Zealand Inflation and Unemployment Record........................................146
Figure 6: New Zealand Budget Position........................................................................... 153
Figure 7: New Zealand Public Sector Debt...................................................................... 172
Figure 8: Canadian Inflation and Unemployment............................................................192
Figure 9: Canadian Public Sector D ebt............................................................................ 213
Figure 10: Australian Public Debt Levels........................................................................232
Figure 11: Australian Inflation and Unemployment Performance.................................233

viii

Figure 12: Australian Long Term Interest Rates Relative to US.................................... 252
Figure 13: UK Inflation and Employment Record.......................................................... 269
Figure 14: UK GDP Growth.............................................................................................. 270
Figure 15: Sterling vs. the Deutschemark......................................................................... 273
Figure 16: Spread between UK and German 10-Year Bonds......................................... 286

Ch. 1 Distributional Politics and Central Bank Independence
Why do politicians change the legislation governing the central bank to give thisinstitution operational independence in the setting of monetary policy? Over the 1990s,
more than thirty countries increased the legal independence of their central banks, as
opposed to only three such changes during the 1980s (Maxfield 1997, p.3).1 This trend
in central bank independence was witnessed in industrial countries such as France, New
Zealand and the United Kingdom as well as many developing countries, as seen in table
1. Independence refers to the power of the central bank to set the instruments ofmonetary policy without the involvement of politicians. In other words, central banks
have been given independence to take interest rate decisions (instrument independence),
but not independence to determine the ultimate objectives o f monetary policy (goalindependence) (Debelle and Fischer 1994).
Table 1 Changes in Legislation of Central Banks, 1989-1999 (years ofamendments)
Non-OECD
Argentina
Chile
Colombia
Ecuador
Egypt
Honduras
Indonesia
Pakistan
Peru
Philippines
South Africa
UgandaVenezuela
Total

1992
1989
1992
1992
1992
1995
1998
1994
1992
1993
1989
1993
1992
13

OECD & EMU members 1
Austria
1998
Belgium
1993/98
France1993/98
Finland1998
Germany
1993/94/98
Ireland1998
Italy
1992/93/97
Luxembourg
1998
Netherlands
1994/95/98
Portugal
1990/95-98
Spain
1994/97
Total
11

OECD Ex-EMU
Greece1997
Hungary
1991
Japan
1998
Korea
1998
Mexico1994
New Zealand
1989
Poland1991/97
Sweden1998
Turkey
1989
1997
UK
Total
10

1. The European Central Bank was formed in 1999.
Source: Cottarelli and Giannini (1997); Cukierman et al (1992); Maxfield (1997); national central banks.

Political control of monetary policy was the norm in the post-war period, with many
formerly independent central banks being nationalised. This institutional arrangement

2

was seen as consistent with democratic principles. As elected officials, politicians in
the Ministry of Finance or Treasury took interest rate decisions and were held
accountable in elections for their stewardship of the economy. Central bankers were
civil servants, who gave advice on policy, but this advice was not made public andcentral bankers were not directly accountable for the outcome. During the 1990s, thisdivision of responsibilities was changed dramatically. Independent central banks took
on a higher public profile and were delegated considerable discretionary power tocontrol inflation. Central bankers' judgement on monetary issues was not questioned
and the decision making process by which interest rate decisions were taken lacked
transparency. As a consequence, critics in opposition parties or the media havequestioned the democratic accountability of this independent central banks. Critics arealso opposed to having a single objective of price stability, as opposed to the pursuit ofmultiple objectives that include employment and output.
1.1 Central Bank Independence in the 1990s

The trend in central bank independence in the 1990s has been driven by three main
forces: the founding of the European Central Bank (“ECB”); the desire of Latin
American countries to secure the gains from the stabilisation programs of the 1980s;
and the move by other countries to build the institutional structure for a market
economy (Cukierman 1994a, p. 1446). Preparations for the introduction of the single
currency in Europe led to changes in the legislation of all eleven-member countries,
which were required by Article 108 of the Maastricht Treaty of 1992 to bring their
existing national legislation in line with the legislation for the ECB.2 Countries on the
periphery o f the Euro-zone were also active in reforming their central banks, such as

1 This figure does not take into account the independent central banks set up in Central and Eastern
Europe following the collapse of the USSR.
2The ECB, formed in 1999, is the central bank for the Euro-zone, whose members are Austria, Belgium,
France, Finland, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.

Greece which failed to qualify for the first round; Sweden and the UK, who opted outof the single currency; the Czech Republic, Hungary and Poland, who are among thetransition countries in the first wave to join the European Union; Turkey, which hasformally requested to join the EU; and several members o f European Free Trade Area
which have remained outside the monetary union for domestic political reasons, namely
Norway and Switzerland. Two other OECD members - Korea and Mexico - increased
the independence of their central banks as part of the conditionality of IMF bailouts
following financial crises in 1997 and 1994, respectively.3 Finally, Japan's government
gave increased independence to the Bank of Japan following a political scandal thattainted the Ministry of Finance, which subsequently lost many of its powers.

Why Do Politicians D elegate?

The decision by politicians to give up control of interest rates is puzzling, as monetary
policy is a powerful instrument for guiding the economy. Electoral studies have foundthat the public votes with their pocketbook and rewards politicians for positive
economic performance, while punishing incumbents for poor management of theeconomy (Hibbs 1977; Tufte 1978). By giving up control of monetary policy,
politicians have reduced the instruments at their disposal for managing the economy andput their fate in the hands of central banks. Politicians lose the ability to manipulateinterest rates in the run up to elections in order to increase their electoral popularity, astrategy that leads to political business cycles (Alesina 1989; Alesina and Roubini 1994;
Clark 1998; Nordhaus 1975). Even worse, delegation to an independent central bank
may lead to conflict between fiscal and monetary policies, which could cause negative
economic performance and damage the chances of re-election of incumbents. In otherwords, it is not obvious why short-sighted politicians in democracies would choose toundertake a reform that is designed to deliver predominantly long-term benefits.

4
W hen Do Politicians D elegate?

A second puzzle concerns the timing of this trend. The move towards central bankindependence was a feature of the 1990s but absent in the 1980s. The timing does notappear to be closely related to any of the major structural changes in the international
financial system over this period. The increase in this trend occurred long after thecollapse o f the Bretton Woods system of fixed exchange rates in the early 1970s, theelimination of capital controls during the late 1970s or the Third World debt crises ofthe early 1980s. Nor does the timing coincide with the rise of stagflation and the
response o f monetary targeting which took place during the late 1970s and early 1980s.
One possibility may be that the trend in central bank independence results fromfinancial interdependence or ‘globalisation’, which is forcing a convergence ofeconomic institutions on one neo-liberal model. Such a view is contested.

Viewed from a historical context, this trend may be an effort by policymakers to regain
the credibility achieved under previous monetary frameworks such as the Gold Standard
or Bretton Woods. These frameworks relied on an external anchor to guide monetary
policy, and were successful in delivering price stability. Credibility is a central concept
for the study of monetary policy. A policy is said to be credible when private actors
believe that policymakers will deliver on an announced policy. In other words,
businesses, workers and financial markets become convinced that a policy will reduce
inflation and adjust their expectations accordingly. Such behaviour becomes selffulfilling, by guiding the inflationary expectations of private actors downward. With noconsensus existing on the optimal external anchor, policymakers have sought to find adomestic anchor to provide monetary policy with credibility. Thus central bankindependence is one such solution capable of delivering anti-inflationary credibility to

3 Indonesia also increased independence in its central bank due to IMF conditionality.

monetary policy by 'tying the hands' of politicians. Other possible solutions are
establishing a currency board or joining a currency union.

This thesis does not suggest that central bank independence represent the ideal
normative arrangement for monetary policy. Instead it studies the process of legislativechange of the central bank in order to see how economic policy is influenced byinternational and domestic factors. A large literature in political economy stresses that
economic choices are the result of a two-level game between the international systemand domestic politics (Gourevitch 1978; Milner 1997; Putnam 1988). The legal statusof the central bank results from different coalitions of domestic and international actors
seeking to influence the policies adopted by politicians, which Milner terms“distributional politics” (Milner 1997, p.61). This interaction is conditioned by ideas
concerning economic policy and constrained by existing institutions (Goldfinch 2000;
Hall 1997). Institutions play a political role as they benefit some groups at the expenseo f others by distributing wealth to some groups while forcing the costs of adjustment onothers. Domestic and international actors in this distributional game seek to put in place
the institutions that will benefit them most. Monetary institutions are important in this
distributional game as the welfare impact of monetary policy is so widespread.

A lternatives to Delegation

A third puzzle relates to the countries that chose not to legislate greater operational
independence for their central banks. Within the OECD, politicians in seven out of 29
countries resisted pressure to changed the legislation governing their central banks:
Australia, Canada, Denmark, Iceland, Norway, Switzerland, and USA. While the US
Federal Reserve, the Swiss National Bank and the National Bank of Denmark are seenas among the most independent central banks, the others generally fall into the categoryo f central banks that are subject to political control (figure 2). For example, Eijffinger

6

and Schaling (1993) classify the Bank of Canada and the Reserve Bank of Australia as
among the most politically controlled central banks based on the involvement ofpoliticians in the determination of monetary policy. A large body of empirical researchon central bank independence would suggest that these countries stood to gain the mostfrom delegation. Instead, both these countries adopted alternative monetary frameworks
based on inflation targets in order to increase the anti-inflationary credibility of theirpolicymaking, which continues to involve politicians and targets a diverse set ofobjectives. This alternative strategy raises the question of whether politicians havealternatives to delegating to the central bank for making monetary policy credible.
Table 2: Legal Indices of Central Bank Independence during the 1980s 1
Country

Bade &
Parkin(1987)2

Grilliet al(1991)

Cukierman et al(1992)

Eijffinger
andSchaling(1993)

Avg.

Stand.
Dev.

Coef. ofvariation3

Germany

100

100

100

100

100.0

0.0

0

Switzerland

100

92

93

100

96.3

4.3

4

USA

75

92

70

60

74.2

13.6

18

Netherlands

50

77

61

80

66.9

14.1

21

Canada

50

85

65

20

55.0

27.3

50

Japan

75

46

26

60

51.8

20.8

40

France

50

54

35

40

44.7

8.8

20

UK

50

46

39

40

43.8

5.2

12

Australia

25

69

52

20

41.6

23.2

56

New Zealand(pre-1989)

n.a.

23

35

n.a.

29.0

n.a.

n.a.

1. Re-scaled as percentage of the highest score, which in all cases was Germany.
2. Scores shown include additions made by Alesina (1989).
3. Standard deviation divided by average score.

7

Figure 1: Rankings of Central Bank IndependenceG e rm a n y|

S w itz e r la n d)Netherlands

C anad a

jap a nP H H H U ^ H flH U H H H H H H U i^ H H H

F ranceIUK

A u stra lia

Italy

N ew Z ea la n d (p r e -8 9 ) p B B B B B H M B B B B
0

25

50

75

100

This study proceeds in six sections. The first section has provided an overview of thetrend in central bank independence. The second section discusses the role of central
banks, providing important background information on the instruments and conduct ofmonetary policy. The third section looks more closely at inflation and its sources,
contrasting an economic explanation with a political one. The fourth section reviews
how the disciplines of economics, political science and political economy look at thetrend in central bank independence in order to highlight the contribution made by apolitical economy approach. The fifth section outlines four hypotheses from political
economy for explaining the trend in central bank independence during the 1990s,
highlighting the role of international financial markets, ideas, interest groups andpoliticians. The sixth section summarises the findings from the study of four cases ofmonetary reform during the 1980s and 1990s in New Zealand, Canada, Australia andthe United Kingdom. These case studies were selected due to the variation in their8degree of change of legal central bank independence over the past two decades, while
holding key institutional and cultural variables constant.

1.2 The Role of Central Banks

Before continuing, it is important to be clear about the function and responsibilities ofcentral banks. Central banks have a direct impact on the economy leading to wideranging distributional effects both domestically and - in the case of the Fed or the
Bundesbank - internationally. Central banks first emerged during the 17th century, withthe founding of the Swedish Riksbank in 1668 and the Bank of England in 1694. The
modem central bank as currently conceived developed during the 19th century, which
saw the widespread founding of central banks across Europe, the emergence of theClassical Gold Standard and the adoption by central banks of a greater role in thefinancial system (Capie, Goodhart, and Schnadt 1994, p.5). Following the First World
War, central banks came to be considered an essential element of statehood along with
the national currency and flag, leading to the founding of many central banks.4Central banks are charged with the implementation of monetary policy, which together
with fiscal policy are the twin instruments of macroeconomic policy. Central banks may
set monetary policy independently or in consultation with politicians, generally the
Ministry of Finance (or Treasury). Monetary policy is defined as the setting of monetary
instruments to achieve some macroeconomic objective for the economy, usually definedin terms o f price stability, output or the exchange rate. The main instrument of monetary
policy is a short-term interest rate. Changes in this benchmark rate affect key economic
variables indirectly such as the term structure of interest rates, the foreign exchange

4 The interwar years saw a worldwide trend towards establishing central banks in the newly independent
countries and former British colonies, which increased the number of central banks from 22 at theoutbreak of W.W.I, to 41 in 1940 (and ultimately 173 in 2000) (Capie, Goodhart, and Schnadt 1994;

King 1999).

9value of the currency and the rate of inflation. 5 This ultimate target may be specified
in the central bank’s statute or may be left to the discretion of policymakers. Generally
the ultimate target is to protect the value of the currency, which has been interpreted
under a floating exchange rate regime to mean the pursuit of price stability. Central
banks find it difficult to pursue their ultimate target directly due to the lag in theoperation of monetary instruments, uncertainty about the accuracy of data on theeconomy, and disturbances caused by exogenous shocks. Central banks may therefore
target an intermediate variable that is chosen based on its relationship with the longterm objective, such as the money stock, short term interest rates, nominal GDP or theexchange rate.6 Progress towards the long-term objective may be checked periodicallyusing other ‘indicator’ or ‘information’ variables, such as the growth of commodity
prices or interest rate spreads, which are used to calibrate the setting of instruments.

Central banks perform a variety of other functions, such as managing the supply of
currency, managing the payments system, acting as the government’s fiscal agent,advising the government on the exchange rate or the public debt, supervising andregulating the domestic banking system, and stabilising the banking system by acting as
lender o f last resort (Economist 1999b; Swinburne et al. 1991, p.441).7 The central bank

5 The central bank conducts monetary policy by setting its instruments, such as open market operations,the reserve requirement and the discount rate. Indirect instruments are the use of capital controls, credit
controls, or moral suasion (Downes and Goodman 1985). The central bank controls the money supply
directly by adjusting the level of reserves which banks are required to hold against their liabilities (the“reserve requirement”), or by using the central bank’s balance sheet to purchase or sell government
securities in the open market (“open market operations”). Selling securities reduces the amount of money
in circulation while buying securities increases it. This activity also changes interest rates. The central
bank may ‘print money’ by buying new debt which is issued by the government, increasing the money
supply and thus monetising the deficit. Short term interest rates can be targeted directly using open
market operations, or indirectly by changing the rate at which the central bank lends overnight funds tothe domestic banking system (“the discount rate”) or the reserve requirement. Among the leading central
banks, the interest rate is the primary instrument.
6 Bryant et al summarises research on different policy regimes (Bryant et al. 1993, p.30-31).
7 The central bank may have responsibility for controlling the money supply, but not always
responsibility for issuing the currency. Some countries have a currency board for the later, and a central
bank for the former such as Argentina, Estonia and Lithuania (Balino et al. 1997, p.2). In the OECD, 19

10

may be required to finance the government in the form of securitized loans,purchased directly in the primary market or indirectly through open market operations,or unsecuritized loans in the form of cash advances. Legal limits to government lending
are considered important for preserving central bank independence, as government
fiscal policy can unduly constrain monetary policy by forcing the central bank to fundbudget deficits (Masciandaro et al. 1988; Sargent et al. 1981). The central bank may
also play an international role, cooperating with other central banks throughinternational organisations such as the International Monetary Fund (“IMF”) and the
Bank for International Settlements (“BIS”), and taking part in international forums suchas meetings o f the G7 or the G30. The publications and statistics created by national
central banks are the primary source of data for cross-national studies of monetary
policy and the financial system. In some cases, the central bank is also the compiler ofnational statistics.

The central bank’s success in fulfilling its various roles is seen as a function o f theclarity of its mandate, how it uses the instruments under its control, and the credibility it
holds with private actors. The central bank’s ability to manoeuvre depends on themonetary framework in operation, and the degree of independence from politicians who
might seek to control the central bank. In particular, the choice of exchange rate regime
has fundamental implications for the scope of monetary policy. With fixed (or pegged)
exchange rates, perfect asset substitutability and no exchange controls, a small country
has no autonomy in monetary policy and must accept the inflation rate of its larger
trading partners (Downes et al. 1991,p.47). Such was the case with non-US countries
under the Bretton Woods system or the Exchange Rate Mechanism (“ERM”) of theEuropean Union. Imperfect substitutability or exchange controls provides some

central banks were responsible for supervising the domestic banking system of which five shared the11autonomy in the short run but not in the long run, as the currency will become
overvalued, or undervalued, causing pressure through the balance of payments. With
flexible exchange rates, monetary policy can be used autonomously to target domestic
variables in the manner discussed above. Foreign exchange intervention may be'sterilised', in which case the central bank offsets the effect on the domestic money
supply, or unsterilised such that the money supply fluctuates.

1.3 Inflation Control

Inflation is defined as an increase in the price level of goods, services or assets. The rateof inflation can be measured using the consumer price index, the producer price index,
the GDP deflator or the asset prices of securities and real estate. During the 1960s,
policymakers believed in a trade-off between inflation and unemployment, where lower
unemployment could be achieved at the cost of higher inflation, graphically represented
by the Phillips curve. A decade later, two leading monetarists - Milton Friedman and
Edmund Phelps - argued in separate papers that the trade-off implied by the Phillips
curve did not exist and expansionary monetary policy would only create inflation(Economist 1991). Their view was given support by the rise of stagflation in the late1970s, which discredited the reigning Keynesian paradigm and led to rising support formonetarism. While external shocks such as the OPEC oil shock combined with faulty
economic analysis were partly to blame for the rise of inflation, the “interaction ofKeynesian economics with democratic politics...was the real problem” (Willett et al.
1988, p.3).

Econom ics of Inflation

The following is a purely economic discussion o f inflation. A more political view ofinflation is provided below. Monetarists believe inflation is purely a monetaryphenomenon that is due to excessive growth of the money supply (Friedman 1969a).

responsibility with another agency (Goodhart et al. 1993).

12

While monetary policy is a potent tool for stimulating the economy in the short run,due to the long and variable lags associated with fiscal policy, excessive stimulus only
raises prices in the long run (18-24 months) without affecting real variables such as
output or employment. Friedman therefore argued that monetary policy should be used
to prevent money from being a major source of economic disturbance, to provide astable background for the economy by reducing uncertainty and increasing business
confidence, and to offset major external shocks (Friedman 1969a,p.l06). There is little
general disagreement with this view, or with the view that high and sustained inflation(“hyperinflation”) is damaging to the economy. The real disagreement concerns thecosts arising from low to moderate inflation (inflation below 10 per cent), the costbenefit trade-off during a disinflation and the benefits from accommodating inflation in
the short run.8
Table 3: Theoretical Costs of Inflation
Anticipated Inflation

Unanticipated Inflation•

Tax on cash holdings•

Money illusion•

Shoe-leather costs to minimise cash
holdings•

Redistribution of wealth••

Menu costs from revising prices

Intergenerational redistribution from old to
young

•

Decline in value of nominal income streams•

Distortion in relative price signals•

Reduced value of nominal contracts•

Loss of credibility by monetary authorities•

Erosion of subsidies & fixed grants•

Increased risk premium demanded by savers•

Distortions due to non-indexed tax systems& nominal accounting•

Increased wage premium demanded byworkers•

Distortion of exchange rate affecting tradedsector•

Increased cost of capital for firms•

Illusion of a real increase in company profits•

Costs of deflationary policies, in terms oflost output, increased cost of capital &increased unemployment•

Misallocation of capital•

Risk of government intervention in economy•

Increased search & information costs•

Increased risk of bankruptcy

Source: Briault (1995), Fischer (1986,1994)

13

Inflation represents a redistribution of wealth from those on fixed incomes to those on
indexed incomes, from creditors to debtors, from savers to borrowers and from theprivate-sector to government when the government is a net debtor. The most obvious
distributional costs of anticipated inflation are the decline in the purchasing power ofcash holdings (referred to as the “inflation tax” or “seignorage”) and the menu costs
associated with changing prices. Anticipated inflation also creates distributional costs
when the tax system is unindexed, lowering the rate of capital accumulation,
misallocating capital among sectors and affecting the labour supply.9 In a modem
economy, inflation costs an estimated 2 to 5 per cent of GDP annually when inflation isrunning at 10 per cent (Fischer 1994c, p.276). This figure concerns the economic costs,
but not the distributional costs among groups within society. Inflation below 5 per centthat is anticipated is seen as having moderate costs, a controversial view which lacks
empirical support.

Inflation has more significant costs when it is not expected. Unanticipated inflation
creates greater uncertainty, causing a misallocation of resources as investors shift fromnominal assets into real assets, and investments are put off. For individuals,
unanticipated inflation has significant wealth effects, with a redistribution from nominal
creditors to nominal debtors and an intergenerational redistribution from the older
generation to the younger.10 Finally, high inflation in the past has led governments tointervene in the economy, by imposing wage and price controls, or credit controls. This
intervention produces distortions in the economy that are ultimately destabilising as
they lead to disintermediation and misallocation of funds.

8 Inflation may be accommodated to ease the crowding out effect caused by rising deficits, to adjust to
external shocks to the economy and to avoid raising interest rates.
9 While numerous, these tax distortions can be avoided by indexing the tax system (Fischer 1986).
10 The decline in value of government debt is a tax on the savings of the older generation, benefiting thenext generation that face a lower tax bill.

14
Political View of Inflation

Orthodox economics treats inflation as an endogenous variable, resulting from increases
in the money supply beyond the full employment level, or the result of rational
behaviour by wage setters faced with politicians who cheat on their promises.
Normatively, inflation above some level is viewed as a social bad as it distorts market
signals, leading to an inefficient allocation of resources. Political economists contest
this position, viewing the struggle over monetary policy as a political contest between
interest groups where there are identifiable winners and losers (Burdekin et al. 1996).11
Inflation leads to the redistribution of wealth within society, providing strong incentives
for different interest groups to organise. In other words, inflation creates rents thatprovide the incentives for similarly affected groups to organise and lobby.

Domestic actors compete for a greater portion of the income available in an economy
creating excess aggregate demand for income. This excess demand may then be
accommodated by monetary authorities through increased money supply, or by thegovernment through increased budget deficits. From a political standpoint, inflation is apolitically inefficient tool for redistributing income as monetary instruments are dull
and non-discriminatory and the costs of inflation are not hidden. “At a high level ofabstraction, monetary policy actions can be viewed as reflecting the compromises
reached by the political system between groups benefiting from the redistribution ofincome deriving from unanticipated inflation... and groups harmed by such income
redistribution...” (Hetzel 1990,p.l08). This ‘conflict inflation’ approach suggested by
the public choice literature views monetary policy as a mechanism for redistributing

11 Burdekin and Burkett are careful to stress that ‘conflict inflation’ does not propose an alternative modelof how inflation originates, instead it provides an alternative framework for viewing inflation thatcomplements existing economic theories. Viewing inflation as the outcome of conflict does not imply
endorsing a particular conception of that conflict, say as a class struggle between workers and firms.
However this view does emphasise that economic events do not occur in a “socio-economic vacuum”(Burdekin et al. 1996, p. 17).

15

income between different interest groups in society, where the winners are theinterest groups that organise and have the greatest political clout (Burdekin and Burkett
1996).

1.4 Different Perspectives on Central Bank IndependenceThis discussion has highlighted two views of inflation - an orthodox view that sees
inflation as a problem to be solved through optimal control theory, and a more politicalview that sees inflation as the result of a distributional conflict between groups insociety. In a similar fashion, different academic disciplines have focussed on different
aspects of the debate over central bank independence. This section briefly summarises
three views, one each from economics, political science and political economy. This
discussion is intended to highlight the contribution that a political economy study of this
topic can make to the already substantive literature on central bank independence.

Econom ic Rationale for Independence

For economists, the importance of the debate over central bank independence is afunction of its perceived effects on economic performance. Empirical studies sought toprovide statistical support for these theories by quantifying the degree of central bankindependence and examining the links with economic variables such as inflation,
output, employment and interest rates (Alesina 1989; Bade et al. 1978; Cukierman et al.
1992; Eijffmger et al. 1993b; Grilli et al. 1991). Chapter two discusses the economic
findings relating to central bank independence in greater detail, while a brief summaryof the theoretical and empirical work is provided below.

The main insight of the theoretical literature is that an independent central bank with anarrow mandate of price stability is seen as reducing inflationary expectations among
domestic actors. Neo-classical economists used game theoretic reasoning to demonstrate
the importance o f credibility for monetary policy, modelling it as a repeated game16

between rational, forward-looking actors (Persson et al. 1994a). Time inconsistency
arguments were combined with rational expectations to show that discretionary
monetary policy generated an inflationary bias among private actors (Barro et al. 1983).
Time inconsistency reflects the fact that a policy stance that is best today will become
undesirable to policymakers when that future arrives (Roll 1993, p. 13).12An

institutional mechanism was needed which made political promises to pursue pricestability credible to private actors (Cottarelli et al. 1997). Central bank independence
was one institutional solution to this problem. In other words, central bankindependence solved the time-inconsistency problem of policy and provided antiinflationary credibility in the eyes o f key groups.

From this starting point, the empirical work advanced in three stages. First, researchers
operationalised the concept o f central bank independence, by creating legal indicesbased on the coding of central bank statutes. Next, these indices were regressed on
different economic variables in the search for statistically significant relationships.
Finally, researchers outlined the implications of their findings for institutional design,and the trade-off between credibility and flexibility in the use of policy instruments. The
most significant finding was that independent central banks were associated with low
inflation. In addition, no studies found a firm link between central bank independence
and GDP growth or employment. This somewhat surprising finding led central bankindependence to be portrayed as a ‘free lunch’ (Grilli et al 1991). It provides benefits interms o f reducing inflation, but does not come with any associated costs in terms of lost
output or increased unemployment. The economics literature addressed the question of‘why’ give independence to the central bank, but has not asked ‘how’ the process

12 For example, politicians may promise today to control the money supply in some future period, in orderto anchor inflation expectations, but may wish to loosen money supply when that time arrives due to arecession (Roll 1993, p. 13).

17

happens or ‘when’ it occurs. These latter questions are political, and require an
analysis of the distributional consequences of policy.

Dem ocratic Accountability of M onetary Policy

For political scientists, delegation of interest rate policy to an independent central bankraises the issue o f democratic accountability. In a democracy, politicians are elected by
the public to manage the economy. Politicians are held accountable for theirperformance on a regular basis, either through the scrutiny of the press and the
opposition, or through elections. By contrast, central bankers are unelected and are notdirectly accountable to the public. In some cases, the central bank may have a privileged
status within the apparatus of government, operating apart from the broader
bureaucracy, staffing itself independently from the civil service and controlling its own
budget and salaries. While central bank officials must generally report on theirmonetary policy decisions to the legislature or the executive, this accountability is one
step removed from the public eye. The deliberations of central bankers are notoriously
secretive and the language they use to describe their decisions can be highly technicaland elitist, adding to the public perception of a democratic deficit. This apparent
autonomy from the political process and lack of transparency about decision-making
raises questions of accountability which are difficult to refute.

Distributional Politics and Inflation Control

International political economy (“IPE”) is concerned with answering the question, who
wins and who loses from a given policy or a regime (Frieden and Lake 1991; Keohane
1989; Strange 1993). Economic policy is political because it affects the distribution of
wealth among different groups in society and determines who pays the cost for public
goods provided by the state. IPE studies of central bank independence start from thepoint of view of 'conflict inflation1, discussed above. IPE seeks to identify which groups
benefit from price stability and which groups bear the cost of adjustment during an

18

inflation or disinflation. “[This] struggle brings to light connections between politics
and economics. It shows how the existing distribution of power among actors influences
their ability to obtain the economic policies they desire and thereby affects the
distribution of wealth.” (Milner 1988, p.3). An important consideration is how
interdependence with the international system affects this outcome.

Who benefits and who loses from an independent central bank? And what incentives
exist to cause different groups to lobby in favour or against this institutional reform?
These questions can be answered by viewing the debate over central bank independence
as a debate over inflation - its sources, its effects and institutional remedies forpreventing it. To answer the question ‘who benefits?' we first need to look at the
distributional effects o f inflation and the impact of policies adopted to control inflation.
(Chapter 4 o f this thesis provides a study of the distributional effects of central bankindependence and highlights those actors who have an incentive to support or oppose
this institutional reform). Second, we need to look at how these groups influence
policymakers. The success of any anti-inflationary strategy adopted by monetary
authorities hinges on accommodating or protecting key interest groups that are either
making or resisting claims on income. The status of the central bank therefore becomesa crucial institutional variable for structuring the outcome of the monetary policy gamein their favour, but one that can be changed when the power of different interest groupschanges.

Domestically, inflation control through central bank independence causes a higher loss
in output during disinflations, as measured by the sacrifice ratio. This loss results froman independent central bank raising interest rates and holding them at a high level for
longer than a more politically controlled central bank. The costs of such a tight19

monetary policy are unevenly distributed, and fall disproportionately on workers, thetraded sector and manufacturers. Workers lose because the fall in output leads to a risein unemployment, putting downward pressure on wages and potentially causing
structurally higher levels of unemployment. Exporters are hurt because the currency
appreciates, reducing the competitiveness of exports and making imports less attractive.
Manufacturers are hurt because they typically operate in cyclical industries that rely
heavily on debt or variable rate borrowings. A slowdown in the economy combinedwith a higher cost of debt leads to increased bankruptcies amid falling demand.
Internationally, inflation is also destabilising as it can be exported throughmacroeconomic policy choices, trade links or exchange rate regimes. Witness thedecline of the Bretton Woods system due to American exorbitant privilege or the policyof competitive devaluations during the interwar period (Simmons 1994; Walter 1991). It
is no surprise that inflation is never far from the heart of debates over monetary
frameworks.

A game-theoretic approach to this situation highlights the vital role played byinformation and institutions. Information affects the incentives facing different interest
groups as they seek to predict the strategies of other parties in the game and try to
structure the game in their favour (Burdekin and Burkett 1996, p.22). The outcome ofthe distributional conflict over central bank independence therefore may depend on theability of different actors to control this institutional setting. This observation led Posen
to argue that “there is no institutional ‘fix’ for the redistributive struggle over monetary
policy,” (Posen 1993, p.53). The central bank can be seen as an intervening variable
used by interest groups to structure monetary policy in their favour. A change in its
status should be linked to shifts in the power of different interest groups that seek tochange the institutions controlling economic policy in their favour.

20
1.5 Four Hypotheses Exp/aining Timing

The political economy literature offers four hypotheses for explaining when a central
bank is likely to be given independence. These explanations are summarised below andare developed in greater length in chapter 3.

The first hypothesis is that politicians use central bank independence as a signallingmechanism to facilitate balance of payments financing (Maxfield 1997). Capital-poor
governments with limited domestic sources of capital need to convince international
financial markets of their anti-inflationary credentials in order to attract foreign capitaland to reduce the interest-rate charged on their borrowing. The decision to delegate to
the central bank signals this commitment to foreign investors, increasing their
willingness to lend to these borrowers.

A second hypothesis is that politicians give independence to their central banks inresponse to the advice of an epistemic community of monetary experts. Histories ofmonetary institutions have shown how they are profoundly influenced by thedevelopment of academic theories about their proper role (Capie, Goodhart, andSchnadt 1994). In terms of the trend in central bank independence, greater uncertainty
due to the rise of stagflation, the end of fixed exchange rates and the rise of international
capital flows led to a breakdown in the existing monetary frameworks. Inspired by thetime inconsistency literature, academics developed the view that central bankindependence was a simple reform that could provide low inflation with no negativeside-effects on growth or employment. An epistemic community o f central bankers,
academics and economists convinced key politicians in a few states to adopt thisreform, which other states later emulated.

21

A third hypothesis argues that politicians adopt this reform in response to thelobbying of domestic interest groups opposed to inflation, led by the financial sector(Goodman 1991; Posen 1995b). A number of features put the financial sector in the best
position to influence politicians in this area. The financial sector, it is argued, has thetechnical knowledge of monetary policy required in order to understand this issue. It has
the organisational incentives required to lobby as price stability - while providing apublic good - provides exclusive benefits to banks due to the impact it has on theirbalance sheets. This group has access to policymakers in this area and has the resources
at its disposal to pay for these efforts. Other groups that are expected to oppose thisreform are the trade unions, exporters and manufacturers.

The fourth hypothesis looks at the electoral incentives facing politicians to 'tie theirhands' (Goodman 1991). In the past, politicians used their control of macroeconomic
policy to increase their popularity around elections, despite the negative consequences
for price stability, creating political (or partisan) business cycles (Alesina 1989;
Nordhaus 1975). However, this behaviour is anticipated by the electorate and is nolonger rewarded. Politicians may therefore be willing to ‘tie their hands’ and delegate
control of interest rates to an independent central bank when this strategy provides
electoral benefits. For example, right-wing politicians with an expected short time frame
in office may grant independence to the central bank in order to reduce the room tomanoeuvre o f their left-wing successors. Alternatively, a left-wing government may
give the central bank independence in order to reduce the interest-rate premium charged
on its borrowing, as financial market actors are suspicious of left-wing governments
partisan preferences and expect an inflationary policy (Goodhart 1997). A third
explanation is that politicians view central bank independence as a mechanism for22

increasing cabinet stability and durability, by removing intra-party conflicts overmonetary policy which are divisive and hard to monitor (Bernhard 1996).

These four explanations supporting central bank independence must be qualified by theinstitutional setting in which policy is made. Both political and economic institutions
affect the likely outcome. The political institutions that are hypothesised to affect theoutcome are the political regime type, the number of checks and balances in the politicalsystem, and the degree of party ffactionalisation. A number of authors associate
independence with federal political systems, where there is a greater tendency forpoliticians to delegate power (Banaian et al. 1983; Pollard 1993; Posen 1993). Other
authors have suggested federalism is a proxy for the number of political checks andbalances in the political system (Keefer et al. 1998). A larger number of veto players
whose approval is required to pass legislation, such as in a federal system or with abicameral legislature, affects the likelihood that the central bank will be given
independence (Moser 1999).

The state of development of the domestic financial system and the access to private
savings are important factors affecting both the need for foreign financing and theeffectiveness o f financial sector lobbying (Mas 1995; Posen 1995b). The existence ofdeep and liquid domestic capital markets may weaken the need to signal
creditworthiness to international investors, reducing the need for delegation (Maxfield1997). The central bank’s role in regulating the banking system and the nature of labour
market institutions are additional variables that are suggested to impact this trend inindependence (Bleaney 1996; Hall et al. 1998; Posen 1993).13

13 The financial sector may face a conflict of interest when the central bank is responsible for banking
supervision, which prevents the financial sector from lobbying for greater independence. When wage
bargaining is coordinated, trade unions may prefer an independent central bank because inflation is kept

23
Methodology and Choice of C ases

These hypotheses provide a rich and varied group of variables for explaining the timing
when politicians will reform the legislation governing the central bank. However, theyalso raise a number of questions, as they suggest a large variety of explanatory variables- some of which are predicted to have contradictory effects - such as the time frame ofpoliticians, partisanship, the existence of domestic capital markets, or the number ofchecks and balances in the political system. Given the methodological weaknesses
identified with the coding of central bank statutes, statistical studies employing thechange in the status of the central bank as the dependent variable reached inconclusive
results (Eijffmger et al. 1996).

Under these circumstances, an alternative methodology to a large-n statistical study is toemploy comparative research of a limited number of cases to study the variation in theoutcome (King et al. 1994; Peters 1998). To avoid omitted variable bias or anindeterminate research design, King et al (1994) recommend controlling the researchsituation by matching, that is choosing cases which are alike in as many ways as
possible except for variation in the dependent variable. They also recommend increasing
the number of observations, defined as one measure of one dependent variable on one
unit, by measuring observations 'across space' or 'across time'.

This thesis employs a qualitative, case study approach of the central banks in theAustralia, Canada, New Zealand and the UK. The period being studied is the 1980 to
2000, a timeframe that was chosen to take in the rapid rise in the trend in central bankindependence during the 1990s in contrast to the relative absence of such a trend during
the 1980s. The choice of cases was designed to hold key political and economic

in check - mitigating the need for either wage increases or wage restraint - and the economy is more

24

institutional variables constant. These four English-speaking countries share acommon history, a similar Anglo-Saxon culture and political institutions. All four are
parliamentary democracies with the British sovereign as Head of State. Their
parliaments are based on the Westminster model, where effective power resides with the
Cabinet headed by the Prime Minister. During the 1980s and early 1990s, all of thesecountries elected representatives to the lower house based on either plurality or majority
electoral rules.14

Ideationally, all four economies share similar higher-education systems, have the same
exposure to the media (televised and printed), and exhibit a similar level of involvementof think tanks in the public debate. Policymakers, academics and central bankers are
exposed to the same economic research spread through a transnational network centringaround the Bretton Woods institutions, the OECD, the Bank for International
Settlements and the World Economic Forum. Many academic and professional
economists working in these countries have pursued their graduate studies in either the
UK or the USA, where they would have been exposed to the debate between
Keynesians and Monetarists, as well as the Rational Expectations revolution and the
New Classical Economics. Finally, these relationships would be cemented throughinteraction at academic conferences, membership in affiliated educational associations,
exposure to the main journals of their disciplines and subscriptions to the international
financial magazines such as The Banker, The Economist and Euromoney.

Economically, all four are small or medium-sized, open economies which are membersof the OECD. They are highly integrated into the global economy, and with a domestic

stable.
14 New Zealand changed the voting rules used to elect its Lower House, replacing its pluralitarian 'firstpast-the-post' electoral rules with a mixed member proportional representation system from 1996.

25

financial system based on the capital-market. Over the 1990s, all four of thesecountries adopted inflation targets as the framework for monetary, policy. However,
only two of these countries reformed their legislation to give formal independence to thecentral bank, New Zealand in 1989 and the UK in 1997. Both Canada and Australia
debated such a reform, but abandoned the proposals in favour of their so-called‘politically controlled’ central banks.

Observations to test these hypotheses have been selected based on both variations
across space and time. One observation within each case study occurs each time thelegal status of the central bank is debated among politicians elected to the main
legislative chamber. The evidence of a sustained political debate must appear in the
published record of Parliamentary proceedings, either debates over bills to reform thecentral bank statute, government-appointed commissions which examine the central
bank statute, or initiatives taken by the members of the Cabinet.
Table 4: Political debates concerning central bank independence, 1980-2000
COUNTRY#POLITICAL DEBATES OVER CENTRAL BANK INDEPENDENCE

Australia

3

1986-1989,1991-1993, 1996

Canada2

1991-1992,1993-1994

New Zealand1

1988-1990

United Kingdom

3

1989-1990,1992-1994, 1997-1998

As part o f this study, the author contacted and interviewed 84 officials in the four
countries being studied. These individuals represented a mix of present and former
politicians, central bankers, Treasury or Ministry of Finance officials, representatives
from trade and business associations, and academics. These interviews were conducted
face to face, over the telephone, or through an extensive correspondence by e-mail. The
majority o f these individuals agreed to have their contribution cited, in which case their26

comments are attributed in the case studies. A full list o f individuals is available uponrequest.

Road Map of Study

Chapters 2 through 4 of this thesis provide the theoretical framework. Chapter 2 reviews
economic theories of central bank independence and summarises the empirical findings.
By the early 1990s, a new paradigm had emerged that viewed central bankindependence as the solution to the time inconsistency problem with policy. Central
bank independence was a ‘free lunch’ which brought anti-inflationary gains without
economic costs. This new paradigm provided the backdrop to political debates over thispolicy reform. Chapter 3 reviews the four hypotheses that explain the timing of thisreform. The logic of these explanations and the importance of the institutional context
are set out in greater detail. Chapter 4 sets the stage for the case studies, by providing
important background material on the relevant economic and political institutions foreach country case, as well as more specific detail on the interest groups that are
expected to have been active on this issue. This chapter concludes by outlining what
outcomes we should expect to find in the case studies based on the hypotheses inchapter 3 and the institutional and interest group variables outlined in chapter 4.

The second part o f the study consists of chapters 5 through 9. Chapter 5 reviews theReserve Bank of New Zealand, which was given independence in 1989 by the Labour
government at the end of a comprehensive economic reform programme begun in 1984.
Chapter 6 looks at the Bank of Canada, where politicians considered a proposal toreform the legislation governing the central bank but rejected it in favour of the statusquo. Chapter 7 examines the debates in Australia, where close ties between Labor
politicians and the central bank governor turned this debate into an election issue in1993. Chapter 8 considers the UK, where the incoming New Labour government gave

27

operational independence to the Bank of England within a week of its election in
1997, despite the Conservatives rejecting this reform repeatedly over 18 years. Chapter
10 concludes by considering the four hypotheses for explaining why politiciansdelegate. It also considers the international sources of domestic institutional change aswell as the partisan nature of international financial market.

1.6 Summary of Findings

The case studies found that politicians gave operational control over monetary policy tothe central bank when this reform was promoted by an epistemic community ofmonetary experts, and was supported by a key politician who championed thelegislation through parliament. Politicians had an incentive to tie their hands due toideological or electoral reasons. In the case of New Zealand, the Finance Minister who
introduced the legislation was convinced of the need to remove political interference inthe setting of interest rates, an activity that was seen as responsible for leading to thecountry’s dramatic economic underperformance over the previous two decades. In theUK, the Chancellor of the Exchequer used this reform to reduce the risk of a financial
crisis in the short term and to lay the ground work for New Labour to get re-elected in
the future. In both cases, central bank independence was used to signal thegovernment’s anti-inflationary credibility to a primarily domestic audience in the nonfinancial sector. This reform was facilitated by political institutions characterised by few
checks and balances that concentrated power in the hands of the executive and offered
few obstacles to changing the central bank’s statute. Central bank independence in thesetwo countries was not explained by domestic interest group lobbying. While interest
groups took part in the political debates over central bank reform, their effectiveness at
influencing politicians was mitigated by collective action problems.

28

Central bank independence did not occur in the cases where the epistemic community
did not hold a consensus over this reform. In Canada and Australia, monetary
authorities did not see the need to change the central bank’s statute as the central bankoperated with a high degree of de facto independence, as witnessed by its success inbringing down inflation. Narrowing the central bank’s mandate to the pursuit of pricestability was seen as inappropriate, as it reduced the government’s flexibility to adjust
monetary policy for external shocks or to pursue other objectives. In both cases,
domestic academics were divided on the issue. A vocal group of opponents pointed tothe benefits of having multiple objectives and expressed concern over the costs ofnarrowing the mandate. Supporters of the need to reform the monetary framework could
not reach a consensus on a preferred alternative, but instead presented politicians with a
confusing array o f frameworks. Politicians in these cases saw only electoral risks fromchanging the central bank’s statute. Central bank reform in Australia was opposed by
key constituents among the trade unions. In Canada the reform was politically divisiveand came at a bad time, when politicians were preoccupied with more pressing
constitutional issues. British politicians opposed to reform saw delegation to anindependence central bank as a politically damaging admission of failure that also
restricted their ability to influence the timing of interest rate changes for electoral
reasons. Finally, the bicameral and federal political institutions in Canada and Australia
presented obstacles to passing legislation and provided an incentive to stick with thestatus quo. As a result of the lack of epistemic consensus and the electoral risks,
politicians in these cases were unwilling to champion central bank independence.

29

Ch. 2 Central Banking and the Power of Economic Ideas

This chapter charts the rise of central banking and the accompanying emergence of atransnational epistemic community of monetary experts who have played anincreasingly influential role in advising politicians on the conduct of monetary policy.
This epistemic community consisted of professionally trained economists, most of themadherents to the tenets of monetarism or rational choice economics, who havedominated the debate over solutions to the control of inflation. It is hypothesised that
this epistemic community has influenced policy by redefining how politicians perceive
their interests, by controlling the agenda and by translating complex ideas into strategies
for managing increased international interdependence. In particular, economists’theoretical and empirical work on central banking during the late 1980s and early 1990s
led to a new paradigm that associated greater central bank independence with lower
inflation, without necessarily creating higher costs in terms of unemployment or
reduced growth. This apparent ‘free lunch’ was attractive to politicians from both theright and the left of the political spectrum, as it appeared to offer a solution to the highinflation experienced during the 1970s and 1980s. In addition, experts could point to the
low inflation records of the independent Bundesbank, Federal Reserve and Swiss
National Bank as institutional models that policymakers could emulate. This newparadigm, this chapter argues, was behind the trend towards central bank independence
in the 1990s.

The first section provides a brief history of the rise of central banks and explains why
central bank independence was not the norm prior to the 1990s. The second section
reviews the policy failures that led to the collapse of the existing paradigm of monetary
targeting during the 1980s, allowing the new paradigm of central bank independence to30emerge. The third section reviews the theoretical literature on central bankindependence, which took off in 1983 following publication of a paper that applied thetime inconsistency arguments to monetary policy. It also summarises the subsequentempirical work on central bank independence that uncovered a negative association
between central bank independence and inflation, with no apparent relationship with
GDP. The fourth section reviews the impact of the Bundesbank and the Federal Reserveon debates in the literature, with reference to how they acted as models to be emulated
by other states. The final section summarises the status of the paradigm during the
1990s, and argues that central bank independence was presented to politicians as arelatively simple solution to the problem of inflation with no associated costs.

2.1 History o f Centra/ Banking
Classical Gold S tandard and Interwar Reconstruction

A growing number of central banks were founded during the 1800s, during the era of
the classical gold standard, which operated from roughly 1873 to 1914.1 Under thismonetary framework, gold flows theoretically responded to changes in trade and capital
flows, generating automatic increases or decreases in the domestic money supply.
During this period of laissez-faire, de facto central bank independence was the norm andcentral banks operated with relative independence within the constraints of the system,
performing a technical function of maintaining the convertibility of currency for specie
and controlling the money supply (Capie et al 1994, p. 10). The gold standard is often
described as a rule-based framework with changes in the gold stock acting as a de facto
fixed money growth rule. In practice the success of gold standard owed much to thecooperation o f the leading central banks, which placed operation of the international

1 Britain had been de facto on gold since the early 1700s but the gold standard only became widelyadopted in the 1870s.

31

gold standard above other domestic concerns (Eichengreen 1992).2 The system’s
credibility led to stabilising private capital flows and meant the commitment to gold in
the core countries was not tested.
Table 5: Central Banks founded prior to 1914
Sweden1668

Norway1816

Russia1860

Serbia

1883

UK

1694

Denmark

1818

Spain

1874

Italy

1893

France1800

Indonesia

1828

Germany

1876

Switzerland 1905

Finland

1811

Nth. Antilles

1828

Bulgaria

1879

USA

Netherlands

1814

Portugal1846

Romania

1880

Austria

1816

Belgium

1850

Japan

1882

1913

Source: Capie et al (1994)

The classical gold standard was suspended at the onset of the First World War.4 During
this period central banks became subservient to their governments, with monetary
policy implemented according to the exigencies of wartime finance. An attempt wasmade to reconstruct the gold standard during the interwar period but failed, as thepolitical and economic conditions underpinning the pre-war gold standard had eroded(Eichengreen 1992). The operation of monetary policy became politicised with thecreation of left-wing political parties, and the new emphasis on creating employment(Simmons 1994). International cooperation foundered as politicians abandonedbalanced budgets and printed money to finance deficits, creating inflation. A monetarycontraction originating in the USA was transmitted internationally by the gold standard,creating a deflationary spiral in the international economy. The spectre o f currency
devaluations in the absence of international cooperation led to destabilising private

2 Central banks varied the discount rate in “order to avoid having to absorb gold flows directly onto theirreserves” (Capie 1994, p. 13). Monetary instruments were used to resist or attract inflows, in a pro-cyclicalfashion, contrary to the ‘rules of the game’.
3 Capital flows are not a new phenomenon in the post-war period, nor was there an absence of financial
crises in the last century. By some accounts, the degree of integration in finance and trade was greater
between 1900 to 1914. See: (Farkas 1998; Hirst et al. 1996)
4 In the UK, specie payments were suspended and a moratorium was declared on the repayment of bills of
exchange. Central banks around the world took similar steps.(Capie 1994, p. 16)

32

capital flows that caused the interwar gold standard to collapse (Eichengreen 1992,
Simmons 1994).

Bretton W oods

Following the wars, the laissez-faire paradigm of classical economics was overthrownas Keynesian ideas spread, introducing a new paradigm of activist macroeconomic
policy (Keynes 1936). Governments took control of the ‘commanding heights’ of theeconomy. In this atmosphere, the independence of central bank was questioned andmany existing central banks were nationalised. The newly emerging states created overthis period founded central banks that were politically dependent. Under the reigning
Keynesian paradigm, monetary policy was ‘twice damned’ as it was considered
impotent and it was tarred by association with the interwar period (Friedman 1969a,p.96). Therefore the instruments of monetary policy were not used (Cottarelli et al.
1997).
Table 6: Central Banks Nationalised following W.W.I
Year

Central Bank

1936

Danmarks Nationalbank
Reserve Bank of New Zealand

1938

Bank of Canada

1945

Banque de France

1946

Bank of England

1948

Nederlandsche Bank
Banque Nationale de Belgique

1949

Norges Bank
Reserve Bank of India

Source: Capie et al (1994)

Led by the US and the UK, international monetary cooperation was restored after the
war under the Bretton Woods regime (Walter 1991). Bretton Woods introduced a fiatmonetary standard backed by gold, with pegged but adjustable exchange rates. Unlike
the gold standard, this framework was discretionary and required the U.S. to maintain afixed price for gold while member states maintained a fixed exchange rate with the U.S.

33

dollar. Under pegged exchange rates, central banks had little autonomy despite theexistence of capital controls. Changes in interest rates generated offsetting capital flows
which had to be sterilised in order to maintain external exchange rate pegs. In addition,
domestic monetary instruments were initially limited, as credit and interest rate controls
adopted during the war were slow to be abandoned (Capie, Goodhart, and Schnadt
1994, p.25). Central banks were left with the largely technical task o f targeting theexchange rate. In this environment, the legal status of the central bank and was not apolitical issue. The Bretton Woods system worked well for two decades, providing pricestability with high economic growth rates for almost thirty years.

This view of the world lasted when monetary policy - which had lain dormant - became
expansionary in the 1960s as governments responded to slowing growth (Cottarelli andGiannini 1997, p.3). US abuse of the key currency created a credibility crisis, aspredicted by Triffin, as the number of dollars in circulation outstripped US gold
reserves(Eichengreen

1996, p. 116).

Fearing risinggoldlosses,the Nixon

administration closed the gold window in 1971 and broke the link with gold, signallingthe end of the exchange rate regime. The arrival of stagflation in the 1970s signalled thebreakdown of the ideological consensus underpinning the Keynesian paradigm(Cottarelli et al. 1997, p.4). The collapse of the Bretton Woods system of pegged
exchange rates witnessed the end of a system-wide monetary framework.5 In its place
there has emerged a patchwork of competing monetary frameworks, which vary basedon the degree of discretion they allow in monetary policy. The majority of industrial
countries opted for the status quo, adopting pegged exchange rates with the remainder
allowing their currencies to float. O f the pegged exchange rate regimes, eight European
countries launched ‘the Snake’ in 1972, while the others pegged to the US dollar, the34

Pound Sterling, or a basket of currencies. In this environment, central bankers'
specialised knowledge o f monetary policy and financial markets provided them withincreased responsibility and influence.

M onetarism

The ideological and operational breakdown of the Bretton Woods system opened theway for a monetarist counter-revolution. Monetarists, led by Milton Friedman,
capitalised on the inflationary surge to expose the weaknesses in Keynesian views ofmonetary policy and the Phillips curve. The rise of inflation turned out to be the“revival of belief in the potency of monetary policy” (Friedman 1969a, p.96). It
convinced practitioners and policymakers of Friedman’s claim that inflation was always
and everywhere a monetary phenomenon leading to the conclusion that monetary policy
should be directed towards the pursuit of price stability (Friedman 1969b). This
paradigm shift towards monetarism was supported by empirical studies demonstrating astable relationship between the velocity of money and long term rate of inflation (Capie,
Goodhart, and Schnadt 1994). With monetary policy reinvigorated, central banks began
focussing on ways to provide price stability through control of the money supply. As
monetary policy moved to become the centrepiece of macroeconomic policy, central
bankers moved to centre stage. Federal Reserve Chairman Volcker’s dramatic increasein U.S. interest rates in October 1979, which spurred the rise of interest rates
worldwide, pushed central bankers out of the limelight and into the centre o f a publicdebate (Economist 1999b, p.3).

5 The Smithsonian agreement, negotiated after the US closed the gold window in August 1971, collapsed
in February 1973, marking the official end of the Bretton Woods system (Eichengreen 1996).

35

By 1980, the fashion in monetary frameworks was monetary targeting, following theexample of Germany, which adopted monetary targets in 1974.6 Nine countries began
using monetary targets as operational guides for monetary policy, including the US,
Canada, Switzerland, and the UK (Cottarelli et al. 1997, p.26). Australia and France
adopted internal monetary targets in support of an external exchange rate peg. A host of
countries worldwide adopted a de facto monetary target by pegging their exchange rates
to a currency where this framework was in place, such as the members o f the Exchange
Rate Mechanism (“ERM”) launched in 1979. Despite arguments in favour o f floatingexchange rates, few countries were attracted to this framework due to the rising
volatility of foreign exchange markets and their tendency to overshoot their so-called
equilibrium levels.

Monetarism may have increased the importance of central bankers, but it did notpromote the trend in central bank independence. Friedman opposed central bankindependence on the basis that discretion in monetary policy making was invariably
inflationary. Friedman argued that the central bank could not control the price level, it
could only control the stock of money (Wood 1994, p.68). The effects of monetary
policy in the short run were highly unpredictable, and affected the economy with longand variable lags. Instead Friedman (1969) argued that the central bank and themonetary authorities should be tied down to clear, simple rules for monetary expansion(Capie et al 1994, p.83).7

6 Under monetary targeting, the central bank set its instruments to meet a short term target for a monetary
aggregate (Cottarelli et al. 1997, p.26).
7 Friedman's position owed much to the thinking of the Currency School and their analysis of thedeterminants of monetary disturbances in the 1820s and 1830s (Capie et al 1994, p.81; Goodhart 1995,
p.208).

36
2.2 Crisis of International Monetary Frameworks

The first stage in the development of a new macroeconomic paradigm is a process ofpolicy failure, accompanied by a crisis, which creates the space for a new conception of
economic policy (McNamara 1998, p.5). The stimulus for the rise of central bankindependence was the collapse of monetary targeting during the 1980s, accompanied by
the questioning of the monetarist orthodoxy underpinning targets. Ideologically, theview that expectations were forward-looking and rational, and that - once exploited systemic relationships in the economy would break down, led policy rules in general to
be discredited. This conclusion resolved the on-going economic debate between'discretion and rules' in favour of discretionary policy.

Operationally, structural changes in the international monetary system caused byfinancial deregulation, the removal of capital controls and the rapid rise o f international
capital flows led to the breakdown of the relationships underlying monetary targeting.
The Bundesbank and the Fed stopped placing as great importance on forecasts ofmonetary aggregates while many countries such as Canada and the UK abandoned
monetary targets altogether. These changes left monetary policy without an anchor, andleft the economics profession without any clear answers. Some countries adopted
floating exchange rates, while others sought some form of external anchor by pegging
to a basket of currencies. The uncertainty created by this change and the accompanying
ideological shifts set the stage for the trend towards central bank independence in the
1990s.

The failure o f monetary targeting is reflected in the failure of governments to control
inflation or to combat rising unemployment over the 1970s and 1980s, as shown in table
4. In addition, the sharp increase in interest rates at the start of the 1980s was followed
by a surprisingly painful slow-down and recession. While the industrial countries

37

exhibited relatively similar economic growth under the Bretton Woods era, they
showed considerable variation in performance after its collapse. This variation in
performance has been attributed to the different institutions in the respective countries,
with central bank independence playing an important role for most explanations.
Table 7: Evolution of Monetary Frameworks, 1973-1995
Exchange
Rate Peg
USA1
Japan

1970-1971

Germany 1

1972
1999-2000

France1970-1971
1979-2000

UK

1970-1971
1990-1992

CanadaAustralia2

1970-1983

New Zealand

1970-1978
1982-1984

Monetary
TargetFloating
Rate

1979-1984

1970-1978
1985-2000

Inflation
Target1972-2000
1975-1998

1970-1971
1973-1974
1972-1978

1980-1983

1972-1979
1984-1989

1993-2000

1977-1982

1970-76
1983-1990

1991-2000

1976-1984

1984-1992

1993-2000

1985-1989

1990-2000

1. The USA is treated as being a floater from 1968, when the convertibility of dollar balances had been
restricted to monetary authorities. Germany is treated as not having an exchange rate peg under the Snakeand the EMS as it was the numeraire for the system.
2. Australia had both an exchange rate peg and monetary targets from 1976-84.
Source: Cottarelli and Giannini (1997), Edey (1997), Macfarlane (1998).

Table 8: Misery Index for Selected Countries 1
Country

1950-72

1973-79

1980-89

1990-98

OECD Average

6.6

15.7

15.5

11.5

Australia

6.1

16.4

15.9

11.6

Canada

7.1

15.9

15.8

12.1

France

6.9

14.5

16.2

13.3

Germany

4.7

7.7

8.7

10.1

Italy

11.0

22.0

19.5

14.9

Japan

6.1

12.0

5.0

4.2

New Zealand

4.7

13.7

16.3

10.4

United Kingdom

6.6

19.4

17.2

12.4

USA

7.1

14.7

12.8

9.0

1. Misery index is the sum of the rate of inflation and the rate of unemployment, as developed by Okun.
Source: IMF International Financial Statistics

38

Figure 2: Inflation Record of Select Countries

16.0□ 195 0 -7 2
1 4 .0 +—■ 1 9 7 3 -7 9
□ 1 980-89

12.0

P ercen t

10.0

A u stra lia

C an ad a

F ra n ce

G erm a n y

U SA

Japan

OECD
A verageO
TQ

ure 3: Unemployment Levels of Select Countries
12.0□ 1 9 5 0 -7 2
1 9 7 3 -8 9
□ 1 9 8 0 -8 9Percen t

10.0

A u stra lia

C an ad a

F ra n ce

G e rm a n y

Japan

N ew
Z ea la n dOECDA v era g e

39

2.3 Emergence of New Paradigm

The trend towards central bank independence during the 1990s has been underpinned bya new theoretical paradigm supported a large body of empirical work. This paradigm
argues that the inflationary bias inherent in discretionary monetary policy can beovercome by putting in place an institutional framework that allows policymakers tocredibly commit not to resort to surprise inflation. An independent central bank was one
such institutional arrangement. This solution to the time inconsistency problem was
supported by research that purported to show a negative relationship between
independent central banks and inflation - a finding that has been used more than any
other argument to support and legitimise giving independence to central banks. This
link was established theoretically in the 1980s and then empirically in the first half ofthe 1990s by a number of scholars working under the paradigm o f neo-classicaleconomics. This paradigm was given greater visibility over this period due to the policy
debates surrounding European Monetary Union, on one hand, and the creation of newly
independent central banks in the former Soviet Union and Latin America, on the other.

Inflationary Bias, G am e Theory and Credibility

The economics literature on central banking took a dramatic turn in the mid-1980s with
the introduction o f game theory to the analysis of monetary policy. Earlier literature hadtreated policy as a one-time, utility maximising ‘game against nature’, where policy
makers optimised the setting of their instruments by solving a set of equations(Cottarelli et al. 1997).

This view was overthrown by the rational expectations

revolution which swept through the discipline in the 1970s. The new game theoretic
literature viewed policymaking as a repeated game between rational, forward looking
actors where policy is chosen to maximise some social welfare function, subject to welldefined constraints (Persson et al. 1994a, p.l). Whereas the traditional macroeconomics

40

approach - in its Keynesian, monetarist or Neo-classical variety - treated the money
supply as exogenous, this literature treated money supply as endogenous to the gamebetween fiscal and monetary authorities (Persson et al. 1993, p.54).8 Game theory
highlighted the importance of credibility for policymaking. Credibility is defined as “theconfidence invested by the public in the government’s commitment to a policy”(Eichengreen 1992, p.5).

The seminal article signalling this change of direction was Kydland and Prescott (1977)
which introduced the notion of time inconsistency of policy. Kydland and Prescottargued that discretionary policy results in excessive rates of inflation without any
reduction in unemployment, because rational economic agents anticipate and adjust for
future policy behaviour. Governments may adopt the best policy to meet circumstancesat the time, as suggested by optimal control theory, but past wage agreements havealready discounted its inflationary effects, making the policy sub-optimal when it istime to be implemented. In other words, policy is time inconsistent “when the best plancurrently made for some future period is no longer optimal when that period actually
starts.” (Eijffmger 1997, p.xii). Barro and Gordon (1983) applied the concept o f time
inconsistency to the conduct of monetary policy to show how rational expectations
make discretionary monetary policy ineffective for affecting real economic variables.
Policymakers are viewed as non-cooperative actors who have an incentive to cheat on
their commitments based on their loss function (Backus et al. 1985). In particular,
monetary authorities have an incentive to engineer surprise inflation in the short run,
expanding output beyond the natural rate of employment and reducing the real value ofthe public debt. Rational economic actors expect this systematic cheating behaviour,

8 Non-cooperative behaviour between actors can be modelled in two ways, as a Nash game where bothparties make their choices simultaneously, or a game where one party leads and the other responds(Pollard 1993, p.32).

41

view public policy announcements from the government with scepticism, and factor
inflation into their forward-looking expectations. Thus policy becomes ineffective forraising output and equilibrium in the economy occurs at a higher level of inflation. As aresult, discretionary policy creates an inflationary bias in the economy.

Credibility M echanism s

Kydland and Prescott (1977) and Barro and Gordon (1983) saw their demonstration of
the inflationary bias of discretionary monetary policy as “making the case for amonetary rule, along Friedman lines.” (Fischer 1994c, p.288) But rule-based solutions
suffered from a number of well-known disadvantages. First, they cured inflation byremoving flexibility that was desired to deal with output shocks. This lesson had beenlearnt under the Bretton Woods system and was reinforced by the oil shocks of the
1970s.

Second,rule-based

frameworks

wereconsideredinsufficient,

as theannouncement of a rule did not provide it with credibility. There remained incentives
for policymakers to cheat given the existence of a short run Phillips curve. Third, a
fixed money rule attained price stability at the cost of increased variability in output,
creating ‘deadweight’ costs for the economy (Lohmann 1992). Finally, the Lucas
critique and the failure of monetary targeting in the 1970s had shown how rational
expectations prevented policymakers from exploiting systematic relationships in theeconomy.

By the mid-1980s, a view emerged that what was really missing was an institutional
mechanism for convincing private agents that discretionary monetary policy would not
be exploited to achieve short-run gains (Cottarelli et al. 1997, p.5). The evolving debate
focused on how to overcome credibility problems through institutional mechanisms.
Research suggested three solutions for enhancing policy credibility: establishing a
reputation for price stability, which is tested at an early stage; devising a commitment

42

technology that removes the incentive to cheat; or increasing the transparency of thepolicy process (Cottarelli et al. 1997, p.6). These options are not mutually exclusive, but
may be combined with one another. Over the 1980s, these solutions could be seen in thetrend towards developing a reputation for conservativeness, the trend towards
delegating to an independent central bank, and the trend towards contracting with an
inflation-target to guide monetary policy. Reputation, delegation and contracting will be
addressed in turn.
Reputation
Reputation is a substitute for a commitment technology in a discretionary policy
environment. The logic of reputation is that policymakers will recognise that the future
costs of inconsistent policy outweigh the benefits, so they will adopt the ex post optimal
policy today which increases their credibility over time. (Persson et al. 1994a, p.8) One
way to build a reputation is to appoint a conservative central banker who has areputation within the financial community for defending price stability (Rogoff 1985).
A second way is to develop a reputation for toughness that is tested early and often. But
this appointment may not solve the credibility problem associated with cheating, aseven hard-nosed, zero-inflation bankers have an incentive to cheat in the last period of agame (Backus et al. 1985).

While building a reputation sounds good in theory, in practice it suffers from asignificant problem. Studies found that more independent central banks like theBundesbank have paid a higher cost for achieving price stability (in terms of lost
output) than more dependent banks (Debelle et al. 1994; Posen 1993). As seen in table
6, independent central banks have had a higher sacrifice ratio than more politicallycontrolled central banks - a finding suggested by Rogoff (1985) who argued that a focus
on inflation stabilisation comes at the cost of greater swings in output. Rather than

43

creating self-fulfilling expectations, building a reputation for credibility meantdemonstrating the will to fight inflation over and over again.
Table 9: Sacrifice ratios during disinflations, 1960-1991
Country

Quarterly Data

Annual Data

Average# Quarters

Average# Years

Germany

11.7%

51

10.1%

13

USA

9.6%

34

9.2%

8

Medium: Italy

7.0%

51

5.9%

13

Switzerland

6.3%

25

3.4%

8

Canada

6.0%

26

4.8%

7

Australia

4.0%

23

1.3%

9

Japan

3.7%

57

-0.9%

11

UK

3.1%

34

2.7%

10

France

3.0%

33

0.9%

11

High:

Low:

Source: Ball (1993)

Delegation
A second prescription for resolving the time inconsistency problem is delegation to anindependent central bank with a mandate of price stability. Game theory argues that
precommitment to a policy requires an external mechanism which ties the hands of theplayers in order to be credible. Alesina’s studies of partisan politics and politicalbusiness cycles led him to conclude that governments should adopt an institutional
mechanism, such as an independent central bank, to provide the optimal trade-off
between rules and discretion (Alesina 1989). Delegation is seen as a ‘commitment
technology* which increases the credibility of monetary policy by removing politicalcontrol (Lohmann 1992). Making the central bank independent is a means of achieving
credibility with wage-setters by pre-committing to an anti-inflationary policy (Neumann1991). Lohmann (1992) argued for the inclusion of an escape clause into the agreementwith an independent central banker, so that in extreme situations the policymaker canoverride the central banker, at some cost, to adapt policy to output shocks. She claimed

44

this arrangement - termed a partially independent conservative central banker - issuperior to other institutional arrangements, as it preserves flexibility while maintaining
credibility. The threat of overruling would make the central banker’s reaction function
non-linear during extreme circumstances, allowing the central bank to respond to output
shocks while retaining credibility during normal periods.

A number of criticisms of delegation stand out.9 First, delegation does not resolve theoperational debate on how best to implement monetary policy - it just shifts the problem
from one set of decision-makers to another (McCallum 1995). Second, delegation to thecentral bank in itself does not solve the credibility problem, as bureaucrats may cheat on
their commitments as easily as politicians. Third, there are limits to the degree of central
bank independence that is desirable. Debelle and Fischer (1994) found that society is
not better off if they have a completely independent central bank that is fixated on
inflation, as this mandate may result in a deflationary bias and increased output
variability. Instead, the central bank should be able to react to fluctuations in output aswell as inflation. Fourth, society may not want to give up democratic control of policy
to unelected bureaucrats who are unaccountable for their actions (Alesina 1989,p.62).
Contracts and Accountability
A central insight o f the delegation literature was the need to change the incentives
facing the central bank. The contracting approaching was designed for this purpose.
Walsh (1995) argued that designing a contract between the government and the central
bank, which tied transfer payments (such as funding or salaries) to achieving an
inflation target, was optimal for achieving the trade-off between flexibility and

9 Delegation to an independent authority is not feasible in countries with no rule of law, political regimesthat render delegation ineffective, or an underdeveloped financial sector. In this case, a lack of domestic
alternatives usually leads to adoption of an external constraint, such as IMF conditionality, to gain
credibility (Cottarelli et al. 1997, p. 16).

45

credibility.10 The central bank should have independence in the setting of monetary
instruments but the inflation target should be set by elected officials. In other words, acentral bank would have instrument independence but not goal independence (Debelle
et al. 1994). The contracting approach underpins the trend in inflation targeting, which
had been adopted by a growing number of states in the 1990s.

The contracting approach stresses accountability, which is a major normative issue inthe field, particularly in the debate over the European Central Bank. States where thefocus of the debate has been on accountability have adopted inflation targeting, such as
the UK, Canada, Finland and Sweden. Accountability mechanisms differ across states.
“The Fed is accountable to the Congress, and to public opinion. The Bank of England isaccountable to the Treasury. The Governor of the Reserve Bank of New Zealand isaccountable to the government for meeting his contract. The Bundesbank has very little
accountability.” (Debelle et al. 1994, p.217) Giving control over monetary policy tounelected and independent bureaucrats creates concern within democracies, where
public officials are held accountable through regular elections. To develop support for
its independence, central bankers need to make policymaking more transparent, need tomake regular, public reports on their decisions to elected officials, and need to educate
the public on their role and the benefits of low inflation. Inflation targeting has thus
been accompanied by an effort to increase the transparency of the monetary policy
process, by the publication of regular inflation reports or the issuance of press releases
around key events.

In summary, central bank independence is seen as only one of a number of solutions to
the time inconsistency problem. Developing a reputation for conservativeness or

10 Rogoff (1985) and Persson and Tabellini (1993) also discuss contracting.

46

adopting a contracting framework are alternative strategies for gaining antiinflationary credibility. These strategies are not mutually exclusive, but may be
combined, as seen in the case of New Zealand, which has an independent central bankwith a contract between the Governor and the government. Finally, theory suggests that
central bank independence may come with associated costs, such as greater output
variability.

Central Bank Independence and Economic Perform ance

The theoretical case in favour of central bank independence was reinforced by empiricalresearch that tested its relationship with economic variables. Over the decade from1985-1995, more than thirty economic papers regressed legal indices o f central bankindependence against economic variables ranging from inflation, economic growth,
unemployment, interest rates, budget deficits and debt levels. These statistical tests werepredominantly conducted for industrial countries, using legal measures o f central bankindependence developed by coding central bank statutes (Alesina 1989; Bade et al.
1978, 1988; Cukierman et al. 1992; Eijffmger et al. 1993a; Fair 1979; Grilli et al. 1991;
Masciandaro et al. 1988).11 The creators of these indices have focussed on factors
hypothesised to affect the central bank’s ability to operate independently, such as thegovernment’s role in appointments, the length of terms for the governor and senior staff,
the government’s involvement in determining monetary policy, the mandate of thecentral bank, its control over its main policy instruments, the central bank’s
responsibility to finance the government and the central bank’s role in supervising thebanking system. The creation of such an index is subjective, so researchers have

11 Attempts to codify the degree of independence of central banks have employed two approaches: alegislative approach and a behavioural approach. The legislative approach is by far the most common andrelies on a coding of the legal statutes of the central bank, without reference to working practice, thepersonalities staffing the bank or political influences.

47

focussed on different combination of variables and have therefore reached different
rankings for the majority of central banks.
Table 10: Composition of Indices measuring legislative independenceYear Published

1978

1988

1991

1992

1993

Bade and Masciandaro Grilli et al Cukierman Eijffinger
Parkin & Tabellini(GM T)1
et al
&
(BP)
(MT)
(CW N)
Schaling(ES)

Authors

Period studied

1972-86

1970-85

1950-89

1950-89

1972-91# o f countries in sample

12

5

18

72

23

# o f factors considered

4

16

15

16

3

Personnel appointments and terms

75%

44%

27%

20%

25%

Government role in mon. policy

25%

25%

20%

10%

75%

19%

33%

55%

7%

15%

W eighting:2

Lending to governm ent3
Explicit goal of price stability

13%

Control o f instruments

7%

Supervision o f banking system
Total
Statistical studies employing in d ex 4

7%

100%

13%

101%

100%

100%

7

1

8

7

1

1. GMT index is sum of political and economic indices.
2. Totals due not sum due to rounding.
3. CWN figure includes eight factors classified as limitations on lending, and one factor from policy
formulation (role in government’s budgetary process).
4. Studies through 1995, excluding original and subsequent studies by creators of index.
Source: Cukierman, Webb, and Neyapti (1992); Eijffinger and Schaling (1993); Grilli,Masciandaro andTabellini (1991); Masciandaro and Tabellini (1988)

Table 6 summarises details of five legal indices measuring central bank independence,noting the time frame and sample size considered, the number of factors which weretabulated, and the relative weighting given to each issue area. The table also shows thenumber o f empirical works known to this author that have used the respective index
when testing for the effect of independence on economic variables. Several points standout from this table. First, there is broad agreement that the two most important
categories are personnel issues and the government’s role in policy. The government’s
role in the appointment of key personnel, such as the Governor of the central bank, was

48

the most important factor considered for determining how the central bank will
behave. This emphasis suggests that the personalities involved may have a significant
influence on the behaviour of the institution. The government’s role in monetary policy
is a second significant factor.12 The government’s role is judged based on three factors.
First, does final responsibility for monetary policy reside with the central bank, thegovernment or is it shared? Second, is there a government official (with or without
voting power) on the board? Third, is there legislation in place to resolve conflicts in theevent that there is a disagreement between the central bank and the government? Whilemost central banks conduct policy in consultation with the political authorities,
legislative measures of independence generally do not consider actual practice but look
for a clear statement division of responsibilities in the legal statute.

A second observation concerns the change in focus of the most recent indices, whichstress the importance of the lending to government and the central bank’s mandate.
First, limits on lending address the monetarist concern that a dominant fiscal authority
can force the central bank to increase the money supply to accommodate budget deficits(Sargent et al. 1981). In theory, establishing legal limits protects the independence ofthe central bank under these circumstances, which otherwise may be forced by thegovernment’s fiscal decisions to expand the money supply, creating inflation (Leone
1991). Second, researchers have recognised that the central bank’s mandate affects its
ability to control inflation. An explicit mandate of price stability is preferred to a broad
and potentially contradictory set o f objectives. When the central bank has a single
objective, it does not have to make political decisions, only technical ones, which
reduces the pressure from interest groups and the government (Neumann 1991).

12 Eijffinger and Schaling (1993) consider this issue to be the crux of independence, and assign 75% of
the weight of their index to this category.

49

Weaknesses of Indices
The weaknesses concerning the construction of indices are well documented, notably by
their creators. Perhaps the most obvious (and least stated) is that there is no agreed
definition of independence among these authors. The authors measuring independence
have defined the concept differently, with some focussing on goal independence whileothers stress instrument independence.13 This lack of clarity has led to disagreement on
how to classify many central banks, affecting empirical results, as seen in the low
correlation coefficients among indices in table 7.
Table 11: Rank-Correlation Coefficients of Indices of Central Bank Independence

BP (Alesina)
GMT
ES

BP

GMT

ES

CWN

1

0.58 (0.69)

0.71 (0.78)

0.38 (0.44)

10.36 (0.48)

0.52 (0.63)

1

0.20 (0.35)

CWN
1
Note: Kendall rank-correlation coefficients are used, with Spearman rank-correlation coefficients inparentheses.
Source: Eijffinger and Haan (1996)

Second, legal indices have proven difficult to construct because the laws establishingcentral banks are incomplete and do not specify explicitly the limits o f authority. This
leaves room for different interpretations of legal statute. Coding legal independence,
therefore, is a subjective process. Third, legal measures may not reflect a central bank’s
de facto level of independence. The actual practice of central banking deviates from thelaw, shown most dramatically by the actual term of central bank governors (Cukierman
et al 1992; Woolley 1985, p.321). Likewise, legal limits on lending can be easily
circumvented by using open market operations to provide deficit financing indirectly
via the private sector. Fourth, legal independence does not guarantee that central banks
will be free of informal or formal government pressure. A number o f papers have

13This distinction was introduced by Grilli et al (1991) and reinforced by Debelle and Fischer (1994).

50

demonstrated through comparative case study work that even the most independent
central banks, such as the Bundesbank and the Federal Reserve, respond to signalling or
threats from politicians.14 Finally, several authors have questioned the statisticalrobustness of these indices by highlighting multicollinearity between the variables,
omitted variable bias or selection bias in the choice of cases (Banaian et al. 1998; Forder
et al. 1998; Mas 1995; Posen 1993; Temple 1998). Taken together, these weaknesses
suggest that any empirical study of the relationship between central bank independence
and economic variables should be treated with caution.
Central bank independence as a Free Lunch
Despite these shortcomings, the studies employing these indices claimed to haveestablished a number of statistically significant relationships that cast central bankindependence in a positive light. Table 8 presents an overview o f the results of thesetests.

14 For the Bundesbank, see Lohmann (1998). For the Federal Reserve, see Havrilesky (1993), Hetzel(1990), Willett and Keen (1990) and Woolley (1984).

51

Table 12: Central Bank Independence and Economic Performance, 1989 -1995
Dependent Variable

Significant
Relationship

No
Relationship

M ixed Results /D ependent1

Total

#of
studies

% of
total

#of
studies

% of
total

# of
studies

% of
total

# of
studies

Inflation

12

57

3

14

6

29

21

Inflation Variability

5

45

3

27

3

27

11

GDP Growth

8

80

2

20

10

GDP Variability

9

100

9

1

17

6

4

100

4
5

Sacrifice Ratio

5

83

Unemployment
Interest Rates

2

40

3

60

Interest Rate Variability

2

40

2

40

Budget Deficits, Debt,
Credit to Government

3

30

7

70

1

20

5
10

1. Results were dependent on the choice of index used to measure central bank independence.

The majority of studies (12 out of 21 studies) claim to have found a negative statistical
relationship between legal measures of central bank independence and the level ofinflation in industrial economies.15 No study has found a statistical relationship between
central bank independence and economic growth, or its variability, despite almost adozen attempts. Nor did any studies find a significant relationship between central bankindependence and unemployment. The lack of relationship between central bankindependence and these key economic variables led Grilli et al (1991) to comment that
central bank independence was a like having a ‘free lunch’, as “there are benefits but noapparent costs in terms of macroeconomic performance” (Grilli, Masciandaro, andTabellini 1991, p.375).

If any single article can be credited with establishing central bank independence as the
new paradigm, it must be Alesina and Summers (1993). The authors produced a seriesof easy-to-understand scatter plots - especially one displaying a clear negative

15 In developing countries, there is no relation between inflation and legal measures of independence, but
turnover of the governor of the central bank is positively related to inflation (Cukierman et al. 1992).

52

relationship between inflation and central bank independence - which forcefully
delivered the message supporting central bank independence. This article is referencedor the scatter plot is reproduced, wherever an argument has been made in a politicalcontext in support of central bank independence, often with little or no supporting
discussion.16 While the original studies of central bank independence may havecarefully qualified the negative relationship with inflation, this result was presented
more starkly to policy makers. The picture was intended to speak for itself. The
message it delivered was "Countries with independent central banks have low inflation",
without experiencing higher unemployment or slower GDP growth. The fact that thisparadigm was being questioned by the mid-1990s received little attention amongsupporters of central bank independence, consistent with Kuhn's (1962) description ofparadigms.

The claim that central bank independence was a free lunch was a powerful message forpoliticians. It provided them with a rationale for supporting this institutional change bysignalling the positive benefits that would accrue from delegating control of monetary
policy to an independent central bank. This message was ‘good news’ to policymakers
who had only received bad news about their role in economic management over theprevious decade. Politicians had been told that the apparent Phillips curve trade-off
between inflation and unemployment was illusory. Activist monetary policy could notaffect real variables and would only lead to inflation in the long run. Nor could
monetary policy be used to boost an incumbent’s popularity prior to an election, the socalled political business cycle. Rational voters would learn to expect higher inflationand interest rates following an election, and would discount such an overtly political

16 The chart was reproduced in the reports of Select Committees in Canada and the UK (Canada 1992;
Committee 1993a), and in a private report advocating BoE independence (Roll 1993). Early results of this

53

move in their decision making. Control of monetary policy was therefore not useful.
Instead, politicians could hope to improve economic performance by delegating
monetary policy to the central bank. This conclusion rapidly became the dominantparadigm, and was widely quoted by the financial press. This finding was presented asorthodoxy to receptive politicians and influenced the policy debates surrounding theMaastricht Treaty.17

paper were carried in Fortune magazine, 19 June 1989, and included in the NZ Business Roundtablesubmission on the RBNZ bill (Wilkinson 1989).
17 Forder argues that this association was misrepresented as causation in reports prepared for theEuropean Commission that supported the case for an independent ECB (Forder 1998a, 1998b).

Table 13: Empirical Studies of Central Bank Independence, 1989 - 1995
DEPENDENTVARIABLE

CORRELATED TO CBIDEPENDENT ON INDEXNO CORRELATIONINFLATION

Alesina (1989); De Haan and Sturm(1992); Alesina and Summers (1993);
Cukierman (1993); Havrilesky andGranato (1993); De Haan and Eijffinger

Bade and Parkin (1978); Grilli et al

Posen (1993); Cargill (1995); Mas (1995);
Eijffinger and Van Keulen (1995);
Campillo (1997); Chang (1998); Forder(1998); Hayo (1998)(1994)', De Haan and Siermann (1994);
Fratianni and Huang (1994); Al Marhubi(1991); Cukierman et al (1992); Eijffinger
and Schaling (1993); Debelle and Fischer(1994); Eijffinger et al (1994); Temple(1998); Banaian et al (1999)

and W illett (1995); Cukierman and Webb
(1995); De Gregario (1995); De Haan
(1995)INFLATION
VARIABILITY

GDP GROW TH

De Haan and Sturm (1992); Alesina andSummers (1993); Fratianni and Haung(1994); Cukierman and Webb (1995); De
Haan (1995)

Eijffinger and Schaling (1993); De Haan

Bade and Parkin (1978); Cukierman et al

and Eijffinger (1994); Eijffinger et al(1994)(1992); Eijffinger and Van Keulen (1995)

De Long and Summers (1992);
Cukierman and Webb (1995)

Grilli et al (1991); De Haan and Sturm(1992); Alesina and Summers (1993);
Cukierman et al (1993); Eijffinger and
Schaling (1993); De Haan and Eijffinger(1994); Eijffinger et al (1994); Fratianni
and Haung (1994)
GDP VARIABILITY

Grilli et al (1991); De Haan and Sturm(1992); Alesina and Summers (1993);
Cukierman et al (1993); Eijffinger and
Schaling (1993); Posen (1993); De Haan

and Eijffinger (1994) ; Eijffinger et al(1994); Fratianni and Haung (1994)

55

DEPENDENTVARIABLE

CORRELATED TO CBISACRIFICE RATIO

Posen (1993); Debelle and Fischer (1994);
Gaertner (1995); Fischer (1994); Walsh

DEPENDENT ON INDEXNO CORRELATIONDe Haan et al (1993)(1995)UNEMPLOYMENTINTEREST RATES

Alesina (1989); Grilli et al (1991); De
Haan and V an’t Hag (1995); Alesina andSummers (1993)
Cukierman et al. (1993); Eijffinger et al

Alesina and Summers (1993); Cukierman(1993); Cukierman and Webb (1995)(1994)
INTEREST RATEVARIABILITY

Alesina and Summers (1993); Cukierman
et al. (1993)

BUDGET DEFICITS,
SIZE OF PUBLIC
DEBT, LENDING TO
GOVT.

Parkin (1987); Masciandaro and Tabellini

Cukierman and Webb (1995)(1988); Leone (1991)

Note: Studies in italics were not checked by the author.
Source: Author’s calculations, De Gregario (1995), Eijffinger and De Haan (1996).

Cukierman et al. (1992); Eijffinger et al(1994)
Alesina (1989); Grilli et al (1991);
Cukierman et al (1992); De Haan andSturm (1992); Posen (1993); De Haan andV an’t Hag (1995); Pollard (1993)

56

Questioning the Paradigm
As with any paradigm, it is only a matter of time before the anomalies build up and theorthodoxy is questioned. This process occurred with central bank independence fromthe mid-1990s. Works by Posen (1993), Cargill (1995), Temple (1998) and Forder(1998) highlighted the inability of researchers to nail down any significant economic
relationship related to central bank independence.

Output, output variability,

unemployment, interest rates, interest rate variability, budget deficits, and the size ofgovernment debt had all shown mixed or no relationship with central bankindependence, despite considerable theoretical work predicting a relationship. One
statistical relationship that did find empirical support was the positive relationshipbetween central bank independence and output losses during disinflation (Ball 1993;
Baltensperger et al. 2000; Debelle 1996; Debelle et al. 1994; Posen 1993). Independent
central banks had higher sacrifice ratios, which measures the cost of reducing inflation
one point through an aggregate demand contraction (Ball 1993JP.7).1 The implication
was that countries with independent central banks did pay a higher cost for low
inflation, in terms of lost output and higher unemployment.

Early criticisms questioning the link with inflation were, however, discounted by theacademic community and ignored by the financial press. It was only towards the late
1990s that these claims began to be heard. At some point, the theoretical underpinningsof time inconsistency and the need to make a credible commitment was bound to bequestioned. Central bank practitioners and informed policymakers had always been
sceptical of the rationale behind time inconsistency and these empirical findings. For

1 Debelle and Fischer concluded that “no credibility bonus exists in the labour markets for more
independent central banks: they have to prove their toughness repeatedly, by being tough.” (Debelle etal. 1994,p.205).
2 For example, Eijffinger and De Haan (1996) dismiss Cargill’s finding as unconvincing on the basis that
his methodology is faulty.

57

example, Goodhart observes that the empirical relationship between central bankindependence and inflation is quite weak and is “pretty feeble stuff on which to base apolicy campaign” (Goodhart 1994b, p. 112). Former French Prime Minister Raymond
Barre states: “I was not inspired by the view that there was a causal link between[central bank] independence and low inflation; by itself, the [central bank] cannot assurestability because inflation results from many factors” (Posen 1993, p.55). Former RBA
Governor Fraser commented argued that the suggestion that low inflation is the result ofcentral bank independence was over simplistic, citing the anti-inflationary sentiment of
the German people and the performance of the politically-controlled Bank of Japan(Fraser 1989).3

With the economic rationale for central bank independence being questioned by themid-1990s, the monetary economics literature turned to research on inflation targets,
which are the new fashion in monetary policy. There has also been a greater focus on
normative issues such as accountability and transparency.
2.4 Central Bank Models and Policy Emulation

Politicians faced with a problem they cannot solve will look to the experience of othercountries for successful policies they can emulate (McNamara 1998). In the case ofcentral bank independence, politicians with poor inflation records looked to the exampleof the Bundesbank, and to a lesser extent the Federal Reserve. These two central banks
weathered the storms from the 1970s better than their counterparts. The Bundesbank
was able to keep inflation during the late 1970s at less than half the rate of the OECD
countries, but without any cost in terms of increased unemployment. The Federal

3 These views concerning Germany and Japan were widespread among critics of central bankindependence.

58

Reserve fared almost as well, although unemployment was higher than the OECDaverage.

Both the Bundesbank and the Fed had an increased public profile during the 1980s.
Following the oil shocks and the arrival of stagflation, central bankers like Volcker andTietmayer took the centre stage. The adoption of monetarism by the two leading central
banks was mirrored by other central banks around the globe during the early 1980s,
with monetary targeting spreading to other countries through a transnational epistemic
network of central banks and monetarist economists. Despite the collapse of monetary
targets in the mid-1980s, the Bundesbank and the Fed still managed to maintain low
rates of inflation. At this point, academics speculated that the success of these twocentral banks owed much to their degree of independence from politicians. Studies
concluded that the "more independent central banks have indeed been associated withless inflationary policies", pointing to the Bundesbank, the Federal Reserve and the
Swiss National Bank as the main examples of this phenomena (Banaian et al. 1983,
p.I).4 This message, supported by the empirical work on central bank independence,
reinforced the view that the Bundesbank and the Fed were model central banks thatpoliticians in other countries could emulate if they wished to improve their antiinflationary performance.

4 Studies have questioned the independence of both the Bundesbank (Lohmann 1998) and the Federal
Reserve (Hetzel 1990; Havrilesky 1993; Willett and Keen 1990; Woolley 1984).

59

Table 14: Inflation and Unemployment in Selected Countries
Inflation

Unemployment

Country

1950-72

1973-79

1980-89

1950-72

1973-89

1980-89

Germany

2.1

4.9

2.9

2.6

2.7

5.8

USA

2.4

8.2

5.5

4.7

6.5

7.3

Canada

2.6

9.0

6.5

4.5

6.9

9.3

Japan

4.4

10.1

2.5

1.7

1.8

2.5

France

5.0

10.2

7.3

1.9

4.3

8.9

Australia

4.5

11.7

8.4

1.6

4.6

7.5

O ECD A verage

4.2

11.9

8.8

2.4

3.7

6.8

New Zealand

4.6

13.0

11.8

0.1

0.7

4.6

United Kingdom

4.0

14.7

7.4

2.5

4.8

9.8

11.1

7.5

6.7

8.4

3.5
15.4
Italy
Source: IMF International Financial Statistics

2.5 Status of the Paradigm

By the early 1990s, central bank independence was widely seen as one institutional
solution for the time consistency problem of monetary policy. By delegating to a central
bank with a narrow mandate of price stability, politicians could hope to improve theirinflationary record without any negative effects on output and employment. This view
was supported by studies of economic performance in the post-Bretton Woods era, andembodied in the institutional frameworks governing the Bundesbank and the Federal
Reserve. For politicians, this reform provided a relatively straightforward solution forcontrolling inflation that could be easily emulated, following the collapse of monetary
targeting in the late 1980s. The fact that this paradigm was beginning to be questioned
from the mid-1990s was not widely communicated in policy circles.

One problem with this view of events is that it has difficulty with explaining the actual
trend in central bank independence during the 1990s. While it is true that the trend incentral bank independence took off following the decline of monetary targeting, it does
not explain why politicians chose to delegate when they did. For example, the change inlegislation o f the Reserve Bank of New Zealand took place in 1989, before much of the

60

empirical work on central bank independence had been published. Likewise thereform of the Bank of England in 1997 came nearly a decade later, when the paradigm
was being widely criticised in academic journals. It is also puzzling that policymakers
in Australia and Canada, who had access to the same body of literature, chose not tochange the legislation governing their central banks despite the promised benefits ofsuch a reform. Explaining this pattern of decisions and non-decisions, and the impact ofideas in these reforms, is the subject of the next chapter.

61

Ch. 3 Domestic and International Sources of Central Bank
Independence

Despite the growing trend towards central bank independence throughout the 1990s,
there has been little work from economists explaining the timing of these legislativechanges. As Eijffinger states: “It is quite remarkable that the literature dealing with thisquestion is, so far, hardly developed” (Eijffinger 1997, p.xxi). However a large andgrowing body of research in political economy has focussed on the status of the central
bank.1 Most of these studies treat an independent central bank as an independent
variable and look at how it affects the formulation or implementation of foreign
economic policy. A few works specifically focus on when a central bank is likely to begiven independence. This literature suggests four independent variables for explaining
why politicians delegate, of which two are international and two are domestic. These
explanations are the subject of the next four sections.

The first and second explanations focus on the international sources of domestic policychange, consistent with Gourevitch’s ‘second-image reversed’ and the literature on twolevel games (Gourevitch 1978; Milner 1997; Putnam 1988). The first section looks at
the impact o f financial globalisation on this trend, arguing that politicians use central
bank independence to signal their anti-inflationary credibility to international financial
markets. The second section points to international convergence around a new paradigm
that was promoted by a transnational epistemic community. The third and fourth

1Recent works have used the status of the central bank to explain financial liberalisation (Helleiner 1994)
and foreign exchange policy (Bernhard et al. 1999; Franzese 1999a, 1999b; Henning 1994; Simmons
1994). A second category has looked at the constraints imposed by independence on politicians (Alesina
et al. 1995; Clark 1998; Elgie et al. 1998), unions (Al-Marhubi et al. 1995; Bleaney 1996; Garrett 1998a;
Hall et al. 1998; Iversen 1998) or corporatist arrangements (Havrilesky et al. 1993). A third category
explores the historical origins of specific central banks (Broz 1998; North et al. 1994; Woolley 1984). A

62

explanations are taken from the comparative political economy literature and focus
on the demand and the supply of independence from different domestic actors. The third
section argues that central bank independence results from the lobbying of domestic
interest groups opposed to inflation. The fourth section considers why politicians may
decide to 'tie their hands' out of electoral self-interest. The fifth section reviews theinstitutional variables that have been hypothesised to constrain the outcome. The final
section summarises the four hypotheses that will be tested in the case studies.

3.1 Pressure from International Financial Markets

A feature of the late 20th century has been the rise of international capital mobility andtrans-border capital flows, which is often described as financial globalisation. Some
theories portray the international financial system as a deterministic structure thatsystematically constrains state behaviour by rewarding some actions and punishing

fourth category analyses the impact of central bank independence on political instability or party
fractionalisation (Bernhard 1996; Cukierman 1994; Keefer and Stasavage 1998; Simmons 1994).

63

others (Andrews 1994, p.197).2 This constraint operates through the foreign exchange
markets and the investment decisions of institutional investors and multinational
enterprises who direct large flows of capital in response to changing economic
conditions.3 The implication of financial globalisation is to create a new audience international financial markets - that political leaders must satisfy (Keohane et al. 1996,
p.257).

Signalling CreditworthinessMaxfield (1997) provides an explanation for the trend in central bank independence
based on this power of international capital markets. She argues that politicians with aneed for balance of payments financing give independence to the central bank as amechanism for signalling their anti-inflationary creditworthiness to international capital
markets.4 This institutional reform increases the confidence of international investors
that politicians will not renege on their promise to pursue price stability. Signalling
becomes more important when politicians have a long time horizon and the need forbalance of payment financing is chronic. Insecure politicians with short time horizons
are more likely to stimulate the economy prior to elections, and will not wish to beconstrained by an independent central bank. With longer time horizons, politiciansrecognise the benefit of attracting investment from abroad and the need for policy
credibility in order to reduce the premium charged on their international borrowings.5

2 There is a large and growing body of international political economy literature that addresses theconstraints imposed on states by capital mobility. For the view that states have lost autonomy, see
Andrews 1994; Crotty 1989; Kurzer 1991, 1993; Notermans 1993; Scharpf 1991; Strange 1996. For thecontrasting view see Garrett 2000; Hay 2000; Helleiner 1994; Mosley 2000; Oatley 1999. For general
discussions of the implications of capital mobility see Andrews and Willett 1997; Cohen 1996;
Dombrowski 1998; Simmons 1998.
3 The Mundell-Fleming framework captures these trade-offs, where policymakers face a choice between
monetary or fiscal policy autonomy based on their exchange rate regime and their use of capital controls.
4 Posen (1993) reaches a similar conclusion, but argues that the signalling is directed at domestic financial
markets when the government relies on home markets to fund its budget deficits.
5 A higher rate penalises governments with large borrowing needs, although this cost has not prevented
OECD countries from accumulating large external debt burdens (Garrett 1998c).

64

Figure 4: Cost of Long Term Debt Relative to US
1000-O —Canada- O - Australia-A -N Z-•-U K
750

m

500

C

I

</>

%
(0
m

250

0

•250

o

r-^

04

h-

CO

O-

0r-0 <J> o

00

r
00

N
00

rt
00

^
00

ifl
00

ID
00

00

00
00

o

00

o

O)

a> 04O)

CO
<J>

^
0

in
to
0 )0 )O(J)Maxfield's signalling-hypothesis is premised on a long-run structural need for balanceof payments financing. In other words, the need for capital inflows is chronic. It is also
possible to envisage a case where there is an acute need for capital inflows, such as
occurs during a speculative attack on a fixed exchange rate peg. Simmons (1994)
studied the interwar period in order to understand why some countries devalued whileothers played by the rules of the game and defended their exchange rate pegs. She foundthat countries with an independent central bank during the period 1923 to 1931 hadgreater success in attracting capital inflows, as an independent central bank increased
investor confidence that the peg with gold would be maintained and not be sacrificed todomestic political concerns (Simmons 1994, p.75). The architects of the 1992
Maastricht Treaty reached a similar conclusion, and made central bank independence a
condition for joining the single currency. Even though the individual member states lose
their monetary autonomy under a currency union, an independent central bank reassuresinvestors that politicians in the member states will not renege on their commitments in
response to domestic pressure. Likewise the IMF made central bank independence a65

condition of its bailouts o f Mexico in 1994, and Korea and Indonesia in 1997-98. In
these cases, these countries had an acute need for capital inflows in order to pay-down
foreign liabilities. These cases appear to show that central bank independence has somesignalling value even in the presence of an external anchor.

Hypothesis I: Politicians will give independence to the central bank as a mechanism fo r
signalling their creditworthiness to international financial markets, when they have astructural need fo r balance o f payments finance or to support the credibility o f an
external anchor.

3.2 Ideas of a Transnational Epistemic Community

A number of authors note the association between the status of monetary institutions
and the reigning economic paradigm (Capie et al 1994; Elgie and Thompson 1998; Fair
1979; Goodhart 1995; Henderson 1986). The status of the central bank has similarly
been profoundly influenced by the development of academic theories about monetary
policy, as described in chapter 2. The difficulty comes from explaining under what
conditions academic ideas succeed in convincing politicians of the need to change thecentral bank’s legislation. Based on her own study, Maxfield (1997) concluded thatideas alone provide an unsatisfactory answer for explaining the trend in central bankindependence.

Pathw ays of Influence

Ideas are theorised to influence policy through a number of pathways, although theorists
disagree on the motives of actors and the direction of causation. Three pathways
suggested by political economy for explaining how ideas influence policy are: throughthe policy advocacy of an epistemic community; through the sponsorship of key
political actors; or through the emergence of a new paradigm governing policy. These
contrasting pathways share the view that ideas are important, although they disagree on

66

the pathway of influence or the impact of other variables such as interest groups or
institutions. Each pathway will be addressed in turn.
Epistemic Community
The first view has been put forward by the literature on epistemic communities.6 An
epistemic community is defined as “a knowledge-based group of experts and specialists
who share common beliefs about the cause-and-effect relationships in the world andsome political values concerning the ends to which policies should be addressed” (Haas
1990, p.xviii). This definition consists of three components - a high degree of expertise,a consensus on causation, and a shared political goal. The first part recognises that
control over knowledge and information is an important dimension of power (Lukes
1974). Information asymmetries have been shown to provide different actors withgreater levels of influence (Milner 1997). Under conditions of uncertainty, epistemic
communities play a key role “in articulating the cause-and-effect relationships ofcomplex problems, helping states identify their interests, framing the issues forcollective debate, proposing specific policies, and identifying salient points fornegotiation” (Haas 1997, p.2). This potential power is increased when policymakers are
faced with a complex problem that must be addressed quickly, such as in response to acrisis (Haas 1990, 1997).

The second and third parts of this definition reflect the barriers to collective action.
Olson (1971) argued that members of a group sharing a common interest must still
overcome problems of free riding and enforcement. The dynamics o f group behaviour
inhibit cooperation. Likewise, an epistemic community can only translate its'knowledge-based' power into effective influence when experts hold a shared set of

6 A number of scholars have used theories of epistemic communities to explain the direction of economic
policy (Goldfinch 2000; Helleiner 1994; McNamara 1998; Verdun 1999; Woolley 1989). The literatureon think tanks and their role in influencing policy fits within this view (Stone 2000).

67

causative beliefs and are able to agree on a policy prescription (Goldstein 1993;
Goldstein et al. 1993). The group must also hold shared policy preferences. Without anagreement on the solution to a problem or the goals of a policy reform, experts arelikely to work at cross-purposes. Their inability to agree will convince politicians tostick with the status quo, or will leave open the door for other policy entrepreneurs tochoose select ideas that support their preferred policy position.
Political Champion
A second view argues that ideas require political sponsors in order to survive throughthe policy process. Ideas must have political salience or political viability in order to be
championed through the political process (Hall 1989; McNamara 1998). Put differently,
ideas must satisfy the interests or worldview of key politicians who adopt them for theirown purposes (Gourevitch 1989; Jacobsen 1995). The extreme version of this view sees
ideas merely as hooks upon which politicians hang their policies. A more nuanced sees
ideas as tools that aid politicians in the building of new coalitions by redefining how
different groups perceive their interests, making new alliances possible (Goldstein et al.
1993). For example, ideas reduce the complexity of a situation and provide a focal
point, making action possible despite uncertainty. Institutions are important in thisregard, as they facilitate or hinder coalition building (Goldstein et al. 1993; Hall 1989;
Martin et al. 1998).
Paradigm Shift
A third view of ideas adopts a more psychological approach, rejecting the rationalist
assumptions of the mainstream international political economy theories of ideas. Woods(1995) argues that new ideas emerge to meet the circumstances, with the best ideas
being adopted as the reigning paradigm. This ‘discovery view’ is based on the work ofKuhn (1962). It sees ideas and interests as inseparable, being mutually constitutive.
Ideas serve as maps that fit political priorities or rationalise action already taken. This

68

view adopts a path dependence approach to the influence of ideas, with the
emergence of new ideas conditioned by the existing cultural or historical endowments(Johnson 1998). Many histories of central banking and monetary policy echo this view.
“The switch to Keynesian principles of ‘managed money’ after World War II, theadoption of floating exchange rates and then monetary targets in the 1970s, and now theenthusiasm for central bank independence, all have owed much of their force to thepower of academic ideas whose time has arrived.” (Capie, Goodhart, and Schnadt 1994,p.80).
How Ideas Influence Policy

While these pathways are suggestive, it has proven hard for many researchers tooperationalise ideas in the study of policy. McNamara (1998) has developed aframework for explaining how new ideas become incorporated into policy that takes
into account the role of epistemic communities, political sponsors and the existing
paradigm. Ideas influence policy based on a three-stage process of policy failure,paradigm innovation and policy emulation.7 First, a period of policy failure leads to thecollapse of the old paradigm and the search for new solutions. This policy failure may
be accompanied by a crisis, although the main feature is a period of greater uncertainty.
Second, a new paradigm emerges offering a clear policy solution that is advocated by
the epistemic community and implemented in a few states. Other states monitor the
results of these test cases to judge whether the policy is effective or not. Third, otherstates proceed to emulate this policy, embedding the new paradigm in their institutionalframework. McNamara qualifies this framework by highlighting that ideas will survive
into policy only if they are politically salient, as discussed above. In other words, a
politician or influential civil servant must champion ideas in order to ensure that they

7 A similar framework for explaining the development of monetary policy frameworks has beensuggested by Cottarelli and Giannini (1997).

69

are implemented. This framework will be developed below to explain the trend incentral bank independence during the 1990s.
Monetary Experts as an Epistemic Community
Monetary policy appears to fit the criteria that would empower an epistemic
community, a fact recognised by recent work in international political economy.8 The
study o f monetary policy is dominated by the monetarist paradigm. Members share thebelief that the source o f inflation is excess growth in the money supply; they alsobroadly share a policy prescription for addressing it by controlling monetary growth(Friedman 1969b). Monetary policy is a complex issue area, featuring a high level of
uncertainty. Both the transmission mechanism and the length of lags are uncertain.
Monetary policy is further complicated by international factors, such as the policy
stances of neighbouring states and the impact of the exchange rate on the domestic rateof inflation. For this reason, the monetary instruments act on the economy with a lack ofprecision and are described as 'blunt'.

The field o f central banking is dominated by a knowledge-based group of experts andspecialists. This epistemic community is made up of a transnational network of central
bankers, academic economists, economic advisers to politicians, ‘conservative’ thinktanks, and the financial press. Many of the leading contributors to the field are central
bankers, or scholars who were formerly central bankers or Treasury officials.9 Central
banks have played a central role in formulating a consensus by sponsoring research onmonetary policy and by educating policymakers and the public on how inflation affects

8 Recent studies have looked at monetarism and its impact in influencing policy (McNamara 1998,
Johnson 1998) similar to an earlier body of work that focussed on the power of Keynesian ideas (Hall1989, Ikenberry 1992).
9 Some examples are Guy Debelle of the Reserve Bank of Australia; Stanley Fischer of the IMF; Jacob
Frankel of the Central Bank of Israel; Charles Goodhart, formerly of the Bank of England; Tommaso
Padoa-Schioppa of the ECB; Adam Posen, formerly at the Federal Reserve of New York; and Lawrence
Summers, formerly of the US Treasury.

70

them. This education has been conducted through the speeches and testimony ofsenior central bankers, the organisation of specialist conferences, and the disseminationof research through in-house journals and publications. Many of the leading findings on
this debate have emerged from conferences of academics sponsored by central banks,
university institutes or think tanks.10 The research on this epistemic community has
been directed at educating the public on where its interests lie.
A New Paradigm for Inflation Control
McNamara's framework can be used to explain the trend in central bank independence.
The first stage is a period of policy failure that leads to the collapse of the old paradigm
and the search for new solutions. The 1970s were characterised by stagflation, and a fallin the growth o f output. Widespread financial deregulation during the 1970s and 1980s
led to structural changes in the international financial system and increased international
capital mobility. These changes undermined traditional economic relationships leading
to a breakdown in monetary targets during the 1980s. Exogenous shocks have also beentransmitted among interdependent economies, such as the 1979 Volcker shock or the
1989 German reunification. Faced with this greater uncertainty and declining economic
performance, politicians turned to the monetary epistemic community to provide themwith a road map for how to go forward. Monetary experts were asked to find a monetary
framework capable of delivering the same price stability witnessed under the classicalgold standard and the Bretton Woods system. Monetarist ideas provided a focal point
for such a solution, recommending that price stability be made the sole objective ofmonetary policy. However, initially there was no consensus on the institutionalframework in which to pursue this goal as different camps debated the virtues of 'rules
versus discretion'.

10 See: Capie et al. 1994; Cukierman 1994; Debelle and Fischer 1994; Eijffinger et al. 1994; Forder andSlater 1998; Laidler 1997; Masciandaro and Tabellini 1988; Persson and Tabellini 1993; RBA 1997;

71

Second, a new paradigm emerges offering a clear policy solution that is advocated by
the epistemic community and implemented in a few states. The crisis in monetary
targeting during the 1980s, together with a renewed attack on the monetarist paradigm
by the rational expectations school, allowed a new paradigm based on the legal status of
the central bank to emerge. The new paradigm focussed on delegation to an independent
central bank as a credible mechanism for solving the time inconsistency problem. Thisepistemic community shared a causal belief that monetary policy could not be used toinfluence real variables in the long run, nor could it be used for short-term electoral
gain. Instead, delegation to an independent central bank with a mandate of pricestability was a simple policy solution that could deliver low inflation without causing
lower output or higher unemployment. The paradigm portrayed central bankindependence as a ‘free lunch’ that brought economic gains without costs. This claim
was supported by selective empirical studies described in chapter 2. A vocal group ofmonetary experts and advisers convinced key politicians that this institutional change
was in their best interests.

Third, other states proceed to emulate this policy and embed the new paradigm in their
institutional framework. Central bank independence was modelled on the success of theBundesbank, widely seen as the most successful central bank in history, as well as the
US Federal Reserve and Swiss National Bank. This relatively straightforward solution
was tested in New Zealand in 1989, which radically overhauled its institutionalframework for monetary policy. Other states monitored the results of the 'New Zealandexperiment' to see if inflation could be brought under control. The early success of the
independent RBNZ contributed to faith in this new paradigm, and led to its emulation in

Siklos 1994; Swinburne and Castello-Branco 1991; Wijnholds, Eijffinger, and Hoogduin 1994; and York72

other countries. It was extensively studied and described by the epistemic
community. Many countries sent delegations of politicians and civil servants to study
these models. By the early 1990s, central bank independence was accepted as the newparadigm for controlling inflation, as given testament by the statutes of the ECB. Thisinstitutional reform was also used as a template by the newly founded central banks inEastern Europe. Finally it was accepted as part of the 'Washington consensus' andbecame part of the conditionality for IMF bailout packages in Mexico in 1994 and Asia
in 1997.

Hypothesis II: Politicians give independence to their central banks in response toacademic ideas concerning monetary policy promoted by an epistemic community o fmonetary experts.

-

Corollary A: Uncertainty or an economic crisis increases the effective influenceof an epistemic community over policy.

-

Corollary B: The epistemic community is only effective when its experts hold ashared set of causative beliefs and policy preferences.

-

Corollary C: Ideas must satisfy the interests key politicians who champion themthrough the political process.

3.3 Lobbying by Groups Opposed to Inflation

Inflation is a political issue, with well-documented distributional consequences that
benefit some groups at the expense of others (Briault 1995; Fischer 1994b). Theory
suggests that interest groups that are disadvantaged by an institutional framework can
be expected to lobby for change to a more preferential arrangement (Frieden 1991b;
Gourevitch 1986). An independent central bank is seen as favouring actors that prefer

1990.

73

price stability above competing policy objectives, such as full employment or output
maximisation. Posen (1993, 1995) and Goodman (1991) have therefore developed
explanations of central bank independence arguing that this institutional change resultsfrom the lobbying of domestic interest groups opposed to inflation.

In general, theories of interest groups have proved unsatisfactory for explaining policy
reform. An oft-heard criticism is that studies of interest groups do not lead to a set ofobservable, testable hypotheses due to a lack of precision in the specification of interest
groups and their policy preferences, and an overemphasis on the impact of historical orcultural variables (Baumgartner et al. 1998; Frieden 1999; Milner 1997).11 In order toavoid this problem, this section begins by discussing the factors that determine wheninterest group lobbying is likely to be effective. Next it outlines those domestic interest
groups that should be concerned with the status of the central bank. Finally it outlines
the a priori preferences of these interest groups towards the independence of the central
bank, and predicts which coalitions of domestic actors are likely to be effective at
influencing policy on this issue.

D em and from Domestic Interest G roups

An interest group is an organisation that seeks to influence the formulation andimplementation of policy (Grant 2000b, p. 14).12 Political science and public choiceview politicians exchanging policy promises for the votes or campaign contributions
from key interest groups (Becker 1983). Political economy studies of interest groups
focus on how lobbying allows some interest groups to capture distributional benefits
from policy while pushing the costs of adjustment on other less-influential groups. As

11 Interests refer to a basic need that a rational actor is seeking to fulfil when choosing how to act.
Preferences refer to the specific policy choice that actors believe will maximise their interest in aparticular issue area (Milner 1997).
2 The term 'interest groups' is used instead of the term interest group in this discussion.

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with social sciences, determining the effectiveness of lobbying is difficult andplagued by methodological difficulties (Grant 2000, p. 192). This study adopts theapproach taken by Coleman (1996) in his study of interest group lobbying of financial
services regulation, and evaluates the conditions that allow political potential to beconverted into effective influence over policy.
Potential versus Effective Influence
In the modem capitalist economy, there is nothing automatic in economic power beingtransformed into political influence due to the shift from the esoteric politics of private
networks, informal arrangements and specialist knowledge to a more open, formalised
and partisan process, termed exoteric politics (Moran 1984b, p.5). Coleman (1996)
breaks down the study o f interest group lobbying into two parts: political potential andeffective influence. The first step is to examine the characteristics o f interest groups thatallow them to convert their considerable economic power into political potential.
Political potential can be measured using a range of variables which include the size anddensity of membership, the size and source of a group's budget, the professional
expertise of the staff, and the control of specialised information (Coleman 1988, p.58).
These variables allow an interest group to gain access and develop legitimacy with
policymakers by providing briefings, technical expertise and analysis to politicians wholack the resources or the time (Grant 2000b, p.78). These resources become even more
important in a complex issue area such as monetary policy.

The next step is to look for those characteristics that allow an economic interest groupto transform its political potential into effective influence over politicians. Three mainareas determine the effectiveness of an interest group: its acceptance as a ‘policy
insider’, its control of information, and the configuration of political institutions. Grant(2000) distinguishes between insider and outsider groups, where insider groups have

75

preferential access to policymakers. An interest group’s legitimacy in claiming to
speak for a segment of the population is based on the group’s density and coverage ofmembership. The control of information becomes an important variable for achieving
insider status and vital for determining the success of an interest group in influencing
politicians in their favour (Milner 1997).

An effective interest group must therefore be able to manage the complex informationin its issue area and provide technical expertise and analysis to politicians who lack theresources or the time (Grant 2000b, p.78). Sinclair terms this ‘epistemic authority’(Sinclair 2000). An association with full-time policy experts on its staff may beeffective at influencing policy. In the area of monetary policy, the interest group musthave the ability to understand this specialised and highly complex issue area, and musthave an incentive to make the investment of time and resources required for lobbying(Posen 1993; Broz 1998).
Table 15: Factors influencing interest group effectiveness
Political Potential

Effective Influence

Concentrated geographically or by sector

Perceived as ‘insider’ group with accessto policymakers

Shared set o f preferences
Represented by peak association
Autonomous from members
Ability to sanction members
Ability to understand issue area

Technical experts on staff
Control of specialised information
Rents from lobbying exceed the costs
Design o f political institutions

Source: Based on Coleman (1988, 1996), Grant (1993, 2000) and Milner (1997).

Policy P referen ces tow ards Central Bank Independence

Having identified the criteria that make interest group lobbying effective, the next stepis to determine which groups have an incentive to lobby for or against central bankindependence. Such an analysis begins from the view that inflation has distributional
consequences, creating identifiable winners and losers within society. Those interest
groups most harmed by inflation will seek protection by pressing for the independence

76of the central bank. The political economy literature on central bank independence
suggests three interest groups that should be active on this issue: the financial sector,
businesses, and organised labour. The preferences of each of these groups towards thecentral bank will be outlined, in order to predict the formation of coalitions in favour or
opposed to central bank independence.
Financial Sector
Existing interest group explanations of central bank independence have focussed on thefinancial services sector as the most effective interest group lobbying for central bankindependence (Goodman 1991; Posen 1993). This group has strong incentives tosupport central bank independence. First, this reform is argued to promote the interestsof the financial community by controlling inflation, which reduces the real value offinancial sector assets. Second, an independent central bank may be better able torespond when a bank is in trouble, by acting as the lender o f last resort and providing
liquidity. This type of intervention may be delayed or constrained if politicians get
involved.13 Third, the central bank and the banking sector exist in a relationship ofmutual dependency - central banks and private banks have incentives to protect eachother's interests and independence. Thus the financial sector has an incentive to lobby
for this institutional reform.

A number o f factors put the financial sector in the best position to effectively influencepoliticians on this issue. First, the financial sector has the necessary expertise tounderstand this complex issue area. Their control of information relevant to monetary
policy puts them in a powerful position relative to politicians. Second, the financial
sector has the resources required to lobby politicians and to monitor policy actions in

13 A dependent central bank may be able to get around or minimise interference from politicians bydelaying reporting the crisis to the Minister of Finance. Such was the case with the Johnson Matthey
rescue by the Bank of England (Lawson 1992).

77

order to ensure politicians deliver on their promises. Third, the financial sector is a
key sector of the economy, controlling the flow of credit to industry and employing asignificant segment of the work force. This control of credit has a direct impact on
economic performance and the ability of politicians to deliver on their electoralpromises. Fourth, the financial sector is able to overcome collective action problems
because it is made up o f a few, large firms, with a narrowly defined objective and agreater incentive to act than the median voter (Posen 1995b, p.256). For these reasons,the financial sector is well placed both to lobby for greater central bank independence
and to protect this independence should it be threatened following a change ingovernment.

Moran (1991) challenges the view that the financial sector may be able to lobby
effectively. In his study of the financial services revolution in the USA, the UK andJapan, he found that financial firms had difficulty in reaching a common policy
position, due to the inherent rivalries and competing concerns of individual firms. “Thestriking feature of the three cases examined...is that private interests could not
independently organise effective reforming coalitions. The interests of the firms were so
divided that change either ground to a halt, or happened with agonising slowness”(Moran 1991, p. 124). Both Moran (1991) and Porter (1993) found that this deadlock in
the area of financial regulation was only overcome by the intervention of state agencies.
This view questions the ability of the financial sector to form an effective coalition tolobby for central bank independence.

The structure o f banking supervision affects the financial sector’s incentive to lobby forcentral bank independence. Posen (1995) argues that a potential conflict of interest
exists when the central bank is responsible for regulating the banking sector. Banking

78

regulation generally imposes a cost on banks, reducing their profitability. A more
independent banking regulator is in a stronger position to resist indirect pressure by thebanks it is supervising, as politicians are not in a position to intercede on behalf of thebanks. When the central bank is the regulator, financial sector firms are expected to beless unified as they individually lobby the central bank on different regulatory issues.
Under these circumstances, the banking sector may have a preference to limit the central
bank’s supervisory powers. Financial sectors not regulated by the central bank should
offer stronger opposition to inflation and have a clearer interest in central bankindependence, as their interests are more closely aligned with the central bank.
Business
Business remains a core political constituency, due to the influence o f investment andemployment decisions on the economy (Coleman 1988; Gourevitch 1986; Kurzer 1993;
Lindblom 1977; Moran 1984a; Milner 1988; Mitchell 1997). Businesses are affected bymonetary policy, although their policy preferences will vary based on the degree ofleverage in their capital structure, the cyclical nature of their industry, and their
exposure to the traded-sector of the economy (Frieden 1991b). Economic stability with
low inflation creates a climate that is positive for long-term investment. By contrast,
boom-bust cycles with high inflationary periods leading to higher interest rates
discourage firms from investing. High inflation and inflationary expectations lead to apremium for uncertainty being built into nominal interest rates, raising the cost ofcapital and increasing the required rate of return on investments. Seen from this point ofview, business should be in favour of an independent central bank, which can provide
price stability, reduce the variability of interest rates and lower the risk premium
resulting from political interference in markets.

79

While business may have an incentive to lobby, their ability to convert politicalpotential into effective influence is questionable. Coleman (1988) and Moran (1984a)
argue that the fragmentation of business associations representing different sectors orindustries means businesses associations often have a difficult time seeing what
problems they have in common. Many cyclical industries are sensitive to the level ofinterest rates, such as construction, real estate and engineering. These industries benefit
from lower interest rates, and should prefer a dependent central bank where politicians
are in a position to suppress interest rate increases. When lobbying for lower interest
rates, these firms should stand a better chance of success convincing politicians thancentral bankers. Exporters will favour a competitive exchange rate relative to theirinternational competitors. High interest rates lead to an over-valued exchange rate in the
short run, hurting their competitiveness. An independent bank bent on pursuing pricestability is likely to hold interest rates higher for longer than their politically controlledcounterparts. Exporters should therefore support a dependent central bank.
Organised Labour
Trade unions and central banks have developed an uneasy, if not antagonistic,
relationship due to the role played by wage pressure in creating inflation and theperceived short-term Phillips curve trade-off between unemployment and inflation.
Given the choice between higher inflation and higher unemployment, trade unions will
generally prefer more jobs. From this perspective, it would appear that trade unions
would prefer a dependent central bank where politicians have control of the monetary
instruments, as trade unions can lobby politicians more effectively than they canunelected central bankers.

However research on the relationship between collective bargaining and central bankindependence casts some doubts on the preferences o f organised labour on this issue

80(Bleaney 1996; Hall et al. 1998; Iversen 1998). The anti-inflationary benefits ofcentral bank independence may not be realised in the absence o f coordinated wage
bargaining. When wage bargaining is coordinated, trade unions may prefer an
independent central bank because inflation is kept in check - mitigating the need for
either wage increases or wage restraint - and the economy is more stable. This research,however, has only emerged during the late 1990s. For this reason, it is unlikely to haveaffected the policy preferences of unions on this issue.

An additional consideration concerns the preferences of unions in the traded-sector.
Recent research has suggested that these unions are likely to hold the same preferences
as their employers towards the exchange rate (and by default the interest rate), as
opposed to the preferences of unions that are not exposed to international competition(Garrett 1995; Garrett 2000; Frieden 1996). The rationale is that economic conditions
that damage the profitability or viability of exporters hurts management as well as
workers. For this reason, unions in the export sector can be expected to have anadditional incentive to oppose central bank independence.

Hypothesis III: A central bank will be given independence in response to lobbying byinterest groups opposed to inflation.
-

Corollary A: The financial sector will be most effective when the central bank is
not responsible for banking regulation.

-

Corollary B: The greatest support for central bank independence is expected befound in a coalition of the financial sector and businesses in the non-tradedsector.

-Corollary C: The coalition opposing central bank independence will come frombusinesses in the export sector, manufacturers and unions.

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3.4 Politicians Tying the Hands

Comparative political economy has provided a number of explanations of central bankindependence focussing on the incentives facing politicians to supply this reform. The
political business cycle literature views politicians exploiting their control ofmacroeconomic policy to increase their popularity around elections, despite the negative
consequences for price stability (Hibbs 1977; Nordhaus 1975; Tufte 1978). The
corollary of this view is that politicians may delegate control o f monetary policy to anindependent central bank, when this strategy is perceived to provide electoral gains. A
number of variations of this ‘tying the hands’ argument can be found in the literature,
which differ in the importance they assign to partisanship. Partisan theories argue that
central bank reform is associated with a change of government from a right wing to aleft-wing party. Non-partisan theories focus on the desire of the executive to increase its
chances of re-election. These hypotheses will be discussed in greater detail below.

Partisan Views of Political Behaviour

This class of 'tying the hands' arguments is premised on the view that political parties on
the right and the left of the political spectrum pursue distinctive policies (Hibbs 1977).
Partisan economic cycles emerge because the constituents supporting left and right wing
political parties have different preferences towards growth, employment and inflation.
Rational voters support the parties that best represent their preferences. Left-wingparties have the support of trade unions and workers, and are expected to give priority topolicies designed to increase employment and redistribution. Right-wing parties
representing business and wealthy individuals are expected to be more concerned with
low inflation. Nordhaus (1975) found evidence of political business cycles prior toelections across a variety of industrial countries, while Alesina (1989) found systematicpartisan differences in output and employment following elections. Empirical work has

82

confirmed that central bank independence acts as a domestic constraint preventing
political business cycles (Clark 1998).
Coalition for Reform
Goodman (1991) has extended theories of partisan politics to predict which coalitions ofdomestic actors will support or oppose central bank independence. Goodman’s view
begins from the assumption that politicians concerned with re-election will deliverpolicies appealing to the largest group of voters. Non-financial actors such as labour,
manufacturing and agriculture hold the majority of votes and prefer employment andoutput growth to inflation control. These groups are opposed to any attempts toinstitutionalise monetary restriction through central bank independence (Goodman
1991, p.329). By nature central bankers are conservative and support price stability,
gaining them the support of the financial sector and other groups opposed to inflation.
Because the anti-inflation coalition usually holds only a minority of votes, it cannotchange the status of a politically dependent central bank alone so the status quo ispreserved. This situation changes during ‘hard times’ when exogenous shocks
originating in the international economy create an upswing in inflation, leading nonfinancial actors to change their preferences. Such a situation presents an opportunity fora new coalition to form among financial and non-financial groups that support giving
independence to the central bank.
Impact of Political Time Horizons
The willingness o f politicians to delegate to the central bank is conditioned on their
expected time horizon in office. “Political leaders who expect their party to be in office
for a long time and to maintain a solid majority will seek to protect, if not increase, theirroom for manoeuvre. Regardless of their economic objectives, they will be unlikely tofavour an increase in central bank independence” (Goodman 1991, p.334). Right-wing
politicians with an expected short time frame grant independence to the central bank in83

order to tie the hands of their left-wing successors (Alesina and Rosenthal 1994).14
Delegation reduces the policy options available to the incoming government andpreserves the existing line of policy.

A second partisan version of the ’tying the hands’ argument focuses on the relative gains
available to left-wing governments. Left-wing governments are known to prefer
employment to price stability, and are expected to be more interventionist, using budget
deficits to fund counter-cyclical policies and wealth redistribution. This reputation leads
financial markets to charge left-wing governments an interest-rate premium on theirborrowing relative to right-wing governments (Garrett 1998). Goodhart (1997) argues
that it may be rational for a left-wing government to give independence to the central
bank in order to reduce this interest-rate premium. This view suggests that left-wing
governments with a longer time horizon will tie their own hands upon taking office,rather than inheriting this change from a right-wing government.

Taken together, these two views argue that both a right wing and a left-wing
government have an incentive to 'tie their hands'. However the impact of the time
horizon and the timing is different, as the change will take place when a right-wing
government is about to leave office or when a left-wing government has just taken
office.

N on-Partisan Explanations

Bernhard (1996) provides a non-partisan explanation for why politicians may 'tie theirhands'. Politicians view central bank independence as a mechanism for increasing
cabinet stability and durability, by removing conflicts between the executive, backbench

14 Garrett and Lange (1996) argue that politicians will only be willing to change an institution if they havelong time horizons as institutional reform provides few short-term benefits and may instead be damaging

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legislators and coalition partners over monetary policy (Bernhard 1996). With acoalition or minority government, there is always the risk that conflicts over monetary
policy will threaten the stability of a government. Raising interest rates is unpopularwith politicians, making monetary policy a contentious political issue. Not only hasmonetary policy wide-ranging consequences for the electorate, it is also technicallycomplex, poorly understood with information asymmetries and lack of transparency.
These characteristics make it hard for partners in a government to verify that theexecutive is sticking to its promises - a political version of time inconsistency.15

If backbench legislators or partners in the ruling coalition can credibly threaten to bring
down the government, the executive has an incentive to delegate as a means ofremoving this potential source of instability. Central bank independence reduces intra­
party conflict, Bernhard argues, by providing credible verification that government
ministers have attempted to achieve certain policy outcome.16 Bernhard’s intra-party
conflict hypothesis presents a twist to the economics literature on delegation, as it views
central bank independence as a technology for resolving internal conflicts within thegovernment, as opposed to providing credibility externally to domestic actors.

Central bank independence may be used by politicians who wish to minimise economic
risks and maximise the chances of re-election. Elgie and Thompson (1998) analyse therelationship between politicians and central banks in France and the United Kingdom
over 300 years, using both quantitative and qualitative measures. They argue that therise of financial interdependence and the increased complexity o f monetary policy haveto a politician’s position with different sectors of the economy.
15 Broader changes in the international economy brought about by deregulation and financial
liberalisation further complicate these efforts at verification.
16 Using Milner’s terminology, an independent central bank is an ‘informed signaller’ who can endorse orveto a policy (Milner 1997).

85

made control of monetary policy a liability for politicians. The ‘core executive’ consisting of the executive branch of government, heads of state, ministers and civil
servants - will use central bank independence to deliver anti-inflationary benefits while
minimising the risks of poor economic performance for which they are blamed.
“Politicians hoped that if central banks were made responsible for judging monetary
policy with a statutory framework defined by the pursuit of price stability, then they
themselves could preside over the delivery of a set of particularly anti-inflationary
benefits without risking the economic and political pitfalls inherent in more ambitious
projects of political control over economic life” (Elgie et al. 1998, p. 144). Delegation to
an independent central bank is seen as a risk-reducing exercise that fits within the wider
neo-liberal paradigm that the government should not intervene in the economy. The
timing of the change is explained by the broader changes in the international economy
during the 1990s, which have changed the incentives facing the core executive.

Hypothesis IV: Politicians will 'tie their hands' by granting the central bankindependence, when they judge that the electoral gains from this institutional reform
exceed the electoral costs.
-

Corollary A: Right-wing politicians with a short time horizon will delegate to
the central bank in order to reduce the room to manoeuvre of an incoming leftwing government.

-

Corollary B: Left-wing politicians with a longer time horizon will delegate to thecentral bank in order to reduce the cost of financing government debt.

-

Corollary C: Politicians in a minority or coalition government will 'tie theirhands' by granting independence to the central bank in order to increase cabinet
stability and durability, but only if backbench legislators or partners in the rulingcoalition can credibly threaten to bring down the government.

86-

Corollary D: Politicians will delegate to maximise the chances of re-election.

3.5 Impact of Political Institutions

All the authors cited in this discussion have been careful to qualify their claims byreferring to the institutional setting in which policy is made. Institutions can be definedas “the formal and informal procedures, routines, norms and conventions embedded in
the organisational structure of the polity or political economy” (Hall et al. 1996,
p.938).17 Institutions both constrain and enable the influence of interest groups, by‘loading the dice’ in favour of some groups at the expense of others (Underhill 1994).
Institutions also affect the incentives and costs facing different groups, and regulate therules of the policymaking game (Keohane 1989; Krasner 1982). The effectiveness ofinterest groups at influencing policy is therefore dependent on the nature of existing
institutions in a given issue area.

A political economy taxonomy of institutions classifies them in two categories political institutions and economic institutions. Political institutions are the politicalregime type, the election formulae, the degree of fractionalisation of political parties andthe number of veto-players in the political system. Political institutions affect policy
directly through a system of checks and balances on the power of the executive, andindirectly through elections that render policymakers accountable to the electorate on aregular basis. Examples of economic institutions are the structure of the financial
system, the regulation o f the banking sector and the system o f collective wage
bargaining. Economic institutions alter behaviour by affecting the distribution of wealthamong economic interest groups. This study considers the role of political institutions

17 Institutions can be usefully broken down into three classes: conventions which are informal with
implicit rules, regimes which are formal with explicit rules and organisations which are ‘purposive
entities’ (Keohane 1989).

87

only, as the economic institutions in the four case studies outlined in chapter 4 were
found to be very similar while the political institutions had some significant differences.

The political regime type is hypothesised to influence the status of the central bank,with a number o f authors associating independence with federal political systems(Banaian et al. 1983; Pollard 1993; Posen 1993; Swinburne et al. 1991). Posen (1993)
argues that federal systems are the most decentralised, increasing the effectiveness oflobbying by increasing the avenues of influence available to interest groups and by
making it more difficult for the government to monitor policy implementation. Despite
its appeal, federalism is a poor predictor of central bank independence, with the trend
displaying no clear pattern based solely on political regime type. Federal states such as
Austria, Australia, and Canada have had relatively dependent central banks while
unitary states such as Denmark, Italy (post-1981) and New Zealand (post-1989) had
relatively independent central banks (Goodman 1991, p.331). These discrepancies haveled authors such as Posen to suggest that while a federal system of government may be
an enabling condition for central bank independence, it is not sufficient.

A number of authors have made the opposing argument, namely that federalism acts as
a constraint on the government's ability to pursue economic policy reform (Bollard
1993; Castles et al. 1996; Gold 1989; Nagel 1998). Rather than facilitating thedelegation of power, federalism creates more obstacles when passing legislation, as it
requires more logrolling and consensus building in order for the policy to survive. Suchis the case with federal politics in Canada and in Australia. Similarly, a bicameral
legislature is more obstructive than a unicameral legislature. For example, New
Zealand's unicameral parliament was seen as a permissive because it concentrated

executive power in the hands of few individuals, with no checks and balances built
into the system.

Moser's (1999) work on checks and balances has provided a theoretical basis for theapparent association between federalism and central bank independence. The
explanation has two parts. First, the existence of checks and balances in a politicalsystem renders central bank independence credible as a commitment technology.
Central banks are generally awarded independence by statute, rather than a change ofthe constitution, which should in theory make it easy to reverse at politically convenient
moments. Thus the credibility of the central bank as a commitment technology is notguaranteed beyond the term of the existing government. But almost no independent
central bank has lost its legal independence since the initial wave of nationalisations
following W.W.n, with the exception of the Bank of Canada.18 Moser argues that
central bank statutes are not over-ruled following a change of government when thenumber of veto players whose approval is required to pass legislation is large. Winningover these veto players introduces a cost and acts as a disincentive for politicians tochange existing legislation. Such is the case with a bicameral legislature or a federal
parliament. Moser argues that delegation to an independent central bank becomes
credible when there are at least two veto players in the legislative process and if they
disagree to some extent about monetary policy (Moser 1999,p.l589). 19 Moser tested
this hypothesis for OECD countries and found that the negative association between
legal central bank independence and inflation is stronger in countries with strong checks
and balances than in countries with no checks and balances.

18 The Bank of Canada formally lost its independence following the Coyne Affair and the Rasminsky
directive in 1967 (Rymes 1994).
19 Lohmann has used this argument to explain the conditions under which the Bundesbank will respond topressure from federal politicians, while Keefer and Stasavage have used checks and balances to explain
when a commitment not to inflate is credible. (Keefer et al. 1998; Lohmann 1998)

89

Posen (1993) provides a similar view, arguing that political fractionalisation should be
negatively associated with central bank independence. Fractionalisation, whichmeasures the number of political parties forming the government, reduces theeffectiveness of lobbying, as greater fractionalisation increases the amount of policy
compromises and logrolling needed to pass legislation. Efforts of lobbyists may get lostin this process. Less fractionalisation therefore increases the voice of interest groups
seeking to influence government. Higher fractionalisation increases the number o f vetoplayers who need to be ‘bought out’ in order to change the legislation. Therefore
fractionalisation may be viewed as a second proxy for the number of checks andbalances or ‘veto-gates’ in the political system.

Institutional Constraint I: Political systems with fewer number o f checks and balances
will fin d it easier to reform the legislation governing their central banks, while
countries with federal systems, bicameral legislatures or higher fractionalisation will be
more likely to stick with the status quo.

3.6 Summary of Hypotheses

The four hypotheses put forward to explain the trend in central bank independence
during the 1990s are summarised below. These hypotheses will be tested in the fourcase studies outlined in the next chapter.

Hypothesis I: Politicians will give independence to the central bank as a mechanism fo r
signalling their creditworthiness to international financial markets, when they have astructural need fo r balance o f payments finance or to support the credibility o f an
external anchor.

90

Hypothesis II: Politicians give independence to their central banks in response toacademic ideas concerning monetary policy promoted by an epistemic community o fmonetary experts.
-

Corollary A: Uncertainty or an economic crisis increases the effective influenceof an epistemic community over policy.
Corollary B: The epistemic community is only effective when its experts hold ashared set of causative beliefs and policy preferences.

-

Corollary C: Ideas must satisfy the interests key politicians who champion themthrough the political process.

Hypothesis III: A central bank will be given independence in response to lobbying byinterest groups opposed to inflation.
-

Corollary A: The financial sector will be most effective when the central bank is
not responsible for banking regulation.

-

Corollary B: The greatest support for central bank independence is expected befound in a coalition of the financial sector and businesses in the non-tradedsector.

-Corollary C: The coalition opposing central bank independence will come frombusinesses in the export sector, manufacturers and unions.

Hypothesis IV: Politicians will 'tie their hands' by granting the central bankindependence, when they judge that the electoral gains from this institutional reform
exceed the electoral costs.

91-

Corollary A: Right-wing politicians with a short time horizon will delegate to
the central bank in order to reduce the room to manoeuvre of an incoming leftwing government.

-

Corollary B: Left-wing politicians with a longer time horizon will delegate to thecentral bank in order to reduce the cost of financing government debt.

- Corollary C: Politicians in a minority or coalition government will 'tie theirhands' by granting independence to the central bank in order to increase cabinet
stability and durability, but only if backbench legislators or partners in the rulingcoalition can credibly threaten to bring down the government.
-

Corollary D: Politicians will delegate to maximise the chances o f re-election.

Institutional Constraint: Political systems with few er number o f checks and balances
will fin d it easier to reform the legislation governing their central banks, while
countries with federal systems, bicameral legislatures or higher fractionalisation will be
more likely to stick with the status quo.

These four hypotheses are arranged in table 2 to show the different emphasis given to
domestic or international factors, and the role played by different actors.

92

Table 16: Theories of Central Bank Independence
Focus

TheoryView o f CBIMain Actors

International

Signalcreditworthiness

Political response to need for balanceo f payments financing, or need tobolster credibility o f external anchor.

International
Investors

International

Power o f economic
Ideas

Politicians implement paradigm togain anti-inflationary credibility andachieve price stability.

Transnational
Epistemic
Community

Domestic

Lobbying by Interest
Groups opposed
inflation

Result o f lobbying by domestic
interest groups, led by financial
sector.

Financial sector,
business andunions.

Domestic

Tying the hands'

Partisan - politicians reduce room-tomanoeuvre o f incoming government,or reduce interest-rate premium on
debt.

Politicians

Non-partisan - solution to internal
conflict within ruling coalition ordesire to increase chances o f reelection.

These hypotheses provide a range of plausible explanations for explaining why
politicians choose to delegate. A cursory review, however, demonstrates that these
explanations are not incompatible, nor are they mutually exclusive. More generally, it
will be difficult to judge whether the central bank's legislation is changed in response topurely domestic factors, or purely international factors, as both may be present. For
example, politicians who are convinced that independence will provide anti-inflationary
benefits may also implement this reform in order to improve their chances of reelection. Or a newly elected, left-wing government with a need for balance of payments
financing may wish to signal their creditworthiness to international markets in addition
to improving their chances of re-election. Given the increase in international
interdependence during the 1980s and 1990s, it is likely to be the case that both
domestic and international factors are present.

This situation suggests two strategies. The first strategy, based on Popper's method of
falsification is to use a case study to reject a hypothesis rather than to support it. In this93

approach, the hypotheses are rejected one by one until the most likely explanation
remains. A related strategy is to use what Eckstein referred to as the 'crucial case study'(George 1979, p.53). A case study may be chosen which fits as closely as possible to theexisting theory but does not fit any of the competing hypotheses. If this case study fails
to satisfy the prediction of the hypothesis, the hypothesis may be rejected. As thediscussion of the cases will show, Canada and Australia both provide crucial casestudies of Posen's lobbying hypothesis. A second strategy is to look for combinations of
explanations between hypotheses that reoccur in the positive cases. For example, if two
countries with newly elected left-wing governments reform their central banks
following a currency crisis, then the hypotheses concerning left-wing governments andsignalling may be compatible. The discussion of the case studies will attempt to makethese connections, but any conclusions must be carefully qualified by the size of thesample and the potential for omitted variable bias.

94

Ch. 4 Monetary Reform in Four Industrial Countries: An
Introduction

This thesis will test the hypotheses outlined in chapter 3 by comparing the history offour central banks during the 1980s and 1990s - the Reserve Bank of the New Zealand("RBNZ"), the Bank of Canada ("BoC"), the Reserve Bank of Australia ("RBA") andthe Bank of England ("BoE"). These central banks were all classified as among the mostpolitically dependent during the 1980s, based on the different legal indices of central
bank independence discussed in chapter 2. New Zealand and the United Kingdom
subsequently legislated increased independence for their central banks, in 1989 and1997 respectively. Politicians in Canada and Australia rejected such reform proposals.
These cases therefore provide variation across the dependent variable, namely the legal
independence of the central bank, as recommended by King et al (1994).

The period being studied is 1980 to 2000, a timeframe chosen to include the rapid risein the number of independent central banks during the 1990s in contrast to the relative
absence o f such a trend during the 1980s. This period was characterised by high capital
mobility and rising levels o f international interdependence, both of which represented
significant structural changes in the international monetary system. Focussing theexamination on the last two decades does not, of course, discount the historical events
that may have shaped the path taken by politicians in each state. The research on thepath dependency of institutions suggests that decisions taken in the past are one of thestrongest forces for shaping future outcomes (Garrett et al. 1996; Goldstein et al. 1993;
North 1990; Zysman 1983). In particular, the institutional endowment in each country
must be carefully considered in order to draw the correct lessons from these casestudies.

95

King et al (1996) argue that a productive research design “should include a section or
chapter carefully explicating the assignment and selection processes” (King et al. 1994,
p. 199). This chapter satisfies this requirement. The first section outlines backgrounddetail on the individual cases, focussing on their level of central bank independence atthe start of the 1980s and their inflationary performance in the post-war period. The
second section outlines the key institutional variables for each case, focussing on thepolitical and economic institutions that were highlighted in chapter 3 as influencing thetrend in central bank independence. The third section briefly outlines the interest groups
representing the financial sector, business and unions in the four countries. The final
section draws together the various strands from the discussion of institutions andinterest groups to predict what should have been observed in each case. This prediction
is based on the hypotheses outlined in the previous chapter. Highlighting theseobservable implications of the theories being tested allows us to construct a qualitative,
empirical test of each hypothesis by comparing the predicted versus the actual outcome(King et al. 1994, p. 100).

4.1 Overview of Cases

Central bank independence is perceived to be an institutional mechanism designed tosolve the problem of inflation. The table below shows the economic performance of arange o f industrial countries over the 1970s and 1980s, along with the degree of legal
independence o f their central banks over this period. The countries are ranked based on
their success in controlling inflation during the 1970s. What stands out from this table isthe association between central bank independence and low inflation, as predicted bytheory. Germany, Switzerland and the USA had the best inflation records over thisperiod, although their records on GDP growth were below the OECD average. In
particular, unemployment rose sharply in Germany. Both Canada and Australia had

96

better than average success in controlling inflation, although GDP growth slowed
noticeably and unemployment rose in both countries. New Zealand and the UK wereamongst the worst performers in terms of inflation, with below average growth andrising unemployment.
Table 17: OECD Economic Performance
Independence
Year

Inflationo f central bank 1970-79 1980-89
i

GDP G row th2

Unemployment

1970-79 1980-89

1970-79 1980-89

Germany

100

4.9

2.9

2.7

2.1

2.3

6.0

Switzerland

96

4.9

3.3

1.2

2.1

0.6

1.8

USA

74

7.1

5.5

2.7

2.9

6.1

7.2

Canada

55

7.3

6.5

4.6

2.9

6.6

9.3

Sweden

44

8.6

7.9

2.0

1.9

1.7

2.1

France

45

8.9

7.3

3.2

2.2

3.8

9.0

Japan

52

9.0

2.5

4.5

4.2

1.7

2.5

Australia

42

9.8

8.4

3.2

2.9

3.8

7.5

OECD Average

n.a.

10.1

8.8

3.4

2.5

3.5

7.3

New Zealand

29

11.4

11.8

2.1

1.9

0.6

4.4

Italy

41

12.2

11.1

3.8

2.2

4.4

7.0

United Kingdom

44

12.5

7.4

1.9

2.6

4.4

9.9

Ireland

59

12.7

9.2

4.7

3.5

6.9

14.2

1. Average of Bade and Parkin (1987), Grilli et al (1991), Cukierman et al (1992), Eijffmger and Schaling(1993), re-scaled as a percentage of score awarded to Germany.
2. GDP growth at 1985 prices.
Source: IMF, OECD

Inflation Record

The inflation record of countries over these two decades, shown in table 1, appears topresent a simple explanation for which countries legislated more independent central
banks. Countries like New Zealand and the UK that had politically controlled central
banks and experienced a poor inflationary record post-Bretton Woods had an incentive
to reform their monetary institutions in order to emulate the inflationary record inGermany, Switzerland and the USA. In 1989, New Zealand adopted an independent
central bank, leading the trend during the 1990s. The UK was amongst the last to
introduce this reform in 1997, a difference of almost a decade. These countries' relative

97

success at managing inflation would appear to provide a simple explanation for thisdivergence. New Zealand’s economic performance was poor over both decades, with
inflation remaining stubbornly high during the 1980s providing a clear incentive to
adopt an independent central bank early. The UK had a poor inflationary record during
the 1970s, with below average GDP growth with rising unemployment. However, theUK's inflationary performance improved substantially during the 1980s, removing any
immediate incentive to delegate monetary policy to the central bank. Likewise Canada
and Australia had below average inflation among OECD countries during the 1980s,
which suggests that their monetary regimes were successful. Thus a country's inflation
record during the 1980s relative to the OECD average would appear to provide a simple
explanation for the need to legislate greater independence for the central bank.

There are several problems with this statement. First, empirical studies that attempted to
predict changes in the central bank's legislation did not find any statistically significant
relationships (Eijffinger and Haan 1996). Second, this simple predictor does not explain
why the UK reformed its central bank legislation in 1997, even though inflation had
been brought down to below 3 per cent during the early 1990s. Third, this argument
does not explain why both France and Japan - that had better than average inflation
records during the 1980s - both legislated greater independence to their central banks, in
1993 and 1998, respectively. If a country’s inflation record does not explain the need forthis reform, what accounts for the difference in timing among these countries? The
answer lies in politics.

Central Bank S tatutes

Table 2 shows details of the statutory framework governing the central bank in each ofthese countries, as it existed at the start of the 1980s, with the Bundesbank and theFederal Reserve included for comparison. It focuses on some of the main areas that

98

have been highlighted by the literature as resulting in political control over the central
bank. At first glance, there does not appear to be much difference between them. In allcases, the appointment of the senior officials was controlled by the executive with thegovernment controlling the majority of appointments to the main monetary policy
decision making body in the central bank, and the governor’s term matched or exceeded
the length of the electoral cycle. In the case of Australia and New Zealand, agovernment official sat as a voting member of the board, while in Canada and Germany
there was a government observer. Turning to the objectives of monetary policy, only
Germany had a narrowly defined goal of price stability, while Australia, Canada, New
Zealand and the USA had broad mandates that combined potentially conflicting
objectives for currency stability and full employment.

99

Table 18: Central Bank Independence: Early 1980s
Australia

CanadaNew
ZealandUK

Germany

USA

Electoral cycle (years)

3

5

3

5

4

4

Governor Term (years)

7

7

5

5

8

4

Appointed by

Executive

Board

Decision making body

Board

Board

Board

Governor

Board

FOMC

Voting members

9

14

5

18

17

12

Appointed by

Executive

Executive% Appointed by govt.

100

12 out o f 14

100

100

100

7 out of 12

Govt, officials on body1
(voting)1(ex officio)

1(voting)01(ex officio)0

None
statedCurrency
stability

Employment,
stable prices

Country

Executive Executive Executive

Executive Executive Executive

Statutory objective (s)MoneyCurrency
Stablesupply,stability,
prices,currency maximum
full
employment stability, output andoutput and employme, public
employment
welfarent, public
welfareWho takes the final
decision on monetary
policy?

Board in
Joint
Board in
Executive Board inwithconsultatio
consultation consultation between
n withwith
Board and advice ofwithcentralExecutive
Executive
Executive Executivebank

Executive

Executive 7,
memberbanks 5

Board

Does the government havethe right to instruct thecentral bank?

Yes

Yes

Yes

Yes

Executive
can deferdecisionfor up to 2
weeks

No

Are there legal provisions
in case o f conflicts
between the Board and thegovernment?

Yes

Yes

No

No

No

No

Can the government
borrow from the central
bank?

Yes

Yes

Yes

Yes

Yes

Yes

Does the central bankparticipate in the primarymarket for government
debt?

Yes

Yes

Yes

Yes

No

No

Is the central bankresponsible for banking
supervision?

Yes

No

Yes

Yes

Sharedwith otheragencies

Sharedwith otheragencies

Source: Grilli et al (1991), Capie et al (1994), and national legislation.

100

Differences begin to appear when focussing on the ultimate responsibility formonetary policy decisions. At one extreme in the UK, the Chancellor of the Exchequermade interest rate decisions whereas in the USA full responsibility rested with thecentral bank. In Australia, Canada and Germany the Board took interest rate decisions
in consultation with the executive, with the government holding the right to direct theBoard in case of disagreement in Australia and Canada, or to defer interest ratedecisions for two weeks in Germany. In New Zealand, the executive and the board
reached a joint decision on monetary policy. Finally, all countries had some facility forthe government to borrow from the central bank, with four out o f six central banks
participating in the primary market for government debt. Based on Sargent and Wallace(1981), this arrangement could result in the government forcing the central bank tomonetize its debts.

G overnm ent Finances

Turning to government finances, most of these countries had low levels of debt andmanageable deficits by the end of the 1980s (compared with the criteria specified forEuropean countries under the Maastricht Treaty). The exception was New Zealand
where the budget deficit exceeded 6 per cent of GNP and government debt was 75 percent of GDP. The trend in government debt in Canada was also upwards, with thebudget deficit increasing sharply over the 1980s. None of these countries appears tohave turned to the inflation tax to finance government spending, as seignorage levels
were low , being the highest in Australia during the 1980s.

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Table 19: Government FinancesCountry

Australia

CanadaN.Zealand

UK

GermanyUSA

Govt, net debt (% o f GDP)
1970
1980
1989

40.1
24.9
16.5

11.6
13.0
38.0

n.a
n.a
74.7

79.2
47.3
30.3

-8.1
14.3
21.9

27.8
18.8
29.2

Govt, budget (% o f GNP)1
1960-69
1970-79
1980-89

-1.8
-1.9
-2.0

-1.0
-2.7
-4.4

-3.0
-4.9
-6.1

-0.9
-3.7
-3.7

-0.5
-0.9
-1.6

-0.6
-2.1
-3.9

Seignorage (% of GNP)
1960-69
1970-79
1980-87

0.4
0.7
0.6

0.4
0.7
0.2

-0.1
0.7
0.2

0.4
0.8
0.1

0.6
1.0
0.3

0.3
0.5
0.4

Current account ( % o f GNP)
1960-69
1970-79
1980-89

-3.1
-1.8
-4.7

-2.3
-2.6
-2.2

n.a.
n.a.
-3.3

0.2
-0.2
-0 .3 2

n.a.
n.a.
n.a.

0.5
0.0
-1.7

1. Total budget surplus.
2. Only for years 1987-89.
Source: Grilli et al (1991), OECD Main Economic Indicators

4.2 Political and Economic Institutions
Political Institutions

Table 20: Political Institutions during 1980s
Country

Australia

CanadaNew Zealand 1

UK

Federal or unitary

FederalFederalUnitary

Unitary

Unicameral or Bicameral

Bicameral

Bicameral

Unicameral

Bicameral

M ain elected chamber

House o f
Representatives

House o f
Commons

House o f
Representatives

House o f
Commons

Electoral rules

Preferential fromsingle member
districts

Plurality fromsingle member
districts

Plurality fromsingle member
districts

Plurality fromsingle member
districts

Fractionalisation

Low

Low

Low

Low

Intermediate

Intermediate

Very Low

Low

High

High

High

High

Electoral Cycle (yrs)

3

5

3

5

Average duration ofparliament (yrs)

2.5

3

3

3.7

Average mandate (yrs)

12

8

6.7

8

Majority governments

100 % 2

67 %

90 %

94 %

% o f control by two p arties3

100 %

100 %

100 %

100 %

% o f control by left-w ing3

40 %

0 %

30 %

38 %

Checks and balances
Political stability

102
1. From 1996, New Zealand has introduced a new electoral system based on mixed member
proportional representation.
2. The Liberal-National coalition in Australia is treated as a majority government, due to its stability andconsistency.
3. Based on election results post-1945, with control designated based on the party of Prime Minister.

All these countries are parliamentary democracies based on the Westminster model thatrecognise the British monarch as the head of state.1 Effective executive power resides
with the Prime Minister, the leader of the majority party or coalition in the principal
elected chamber, and his cabinet of ministers. Australia, Canada and the UK havebicameral legislatures, while New Zealand has a unicameral legislature after abolishingits upper house in 1950. The elected or lower chamber is the main legislative body withsole authority to approve government spending and taxation.

All of these countries have been dominated by two principal political parties, a result of
their system of electoral rules. Canada, New Zealand and the UK use plurality voting insingle-member constituencies to allocate seats in the lower chamber, commonly known
as ‘first-past-the-post’. Plurality electoral rules strongly favour a two-party system andgenerally deliver parliamentary majorities (Hague et al 1998). By contrast, the lower
house in Australia is elected using preferential, majority voting, which tends to generate
a multi-party system that over-represents the largest parties, usually leading to single­
party majority governments or a stable coalition (Jackson et al. 1994, p.474). Amongthese cases, Australia is unique in having an elected upper house with seats allocatedbased on proportional representation, providing a larger number of veto players.

The Westminster model concentrates power in the hands o f the Prime Minister and the
Cabinet with few checks and balances. The government may fall if the ruling party

1 Executive power is nominally vested in the sovereign, who invites the leading party to form agovernment and dissolves the Lower House on the recommendation of Prime Minister, leading to anelection.

103

loses a vote of non-confidence in the lower chamber by simple majority. Neither theupper house nor the judiciary has a veto, except in Australia where the Senate can force
an election. Individual Backbenchers have little power under the Westminster system,other than the ability to threaten the executive by passing a vote of non-confidence inthe lower chamber, or by working on parliamentary committees (Grant 1993, p.l 13).2

Under the Westminster model, the policy making process is centred on departments andthe civil service. The main route for interest groups to influence policy is through the
Cabinet and the committee system at the formulation stage, or the civil service at theimplementation stage (Grant 2000b, p.62). Secondary forms o f lobbying involve
working through political parties, the Parliament (such as proposing a Private Member
Bill) or the courts (Grant 2000b, p. 149).
Australia
Australia combines a federal structure with the Westminster model of Parliament.
Australia has a bicameral legislature consisting of the House of Representatives and the
Senate. The House of Representatives is elected by preferential voting from single­
member districts with an election held at least once every three years.3 The Senate iselected by preferential voting with seats allocated based on proportional representation,with one-half of the members elected every three years to six-year terms. Voting inAustralia is compulsory. Australia has both a Treasury and a Department of Finance andAdministration, with the former responsible for the conduct o f fiscal and monetary
policy while the latter has responsibility for the preparation of the budget and theauditing of government spending.

2 Grant (1993) argues that ministers and civil servants get off relatively easily in these forums as
disagreement among committee members generally reduces their influence.
3 Under preferential voting, voters must rank all candidates in order of preference. Votes are transferred
based on voter’s preferences until one candidate is supported by the majority of voters.

104

Table 21: Results of Australian
Representatives

Federal Elections to the House of

Election

ResultRuling Party

Prime Minister

Duration

28 September 1946

Majority

ALP

Chifley

3 yrs, 2 mth

19 December 1949
28 April 1951
29 May 1954
10 December 1955
22 November 1958
9 December 1961
30 November 1963
26 November 1966
25 October 1969

Coalition

Liberal National Party

Menzies

22 yrs 10 mths

5 December 1972
18 M ay 1974

Majority

ALP

Whitlam

3 yrs

11 November 1975
10 December 1977
18 October 1980

Coalition

Liberal National Party

Fraser7 yrs, 4 mths

11 M arch 1983
I December 1984
II July 1987
24 M arch 1990
13 M arch 1993

Majority

ALP

Hawke

13 years

M enzies / Holt / Gorton
Gorton / McMahon

Liberal Coalition
11 M arch 1996
National Party
3 October 1998 present
Source: Australian Electoral Commission

Hawke / Keating
Howard5 years +In the post-war era, Australia has effectively had a two party system, with the Prime
Minister’s office rotating between a coalition of the Liberal Party and National(Country) Party, and the opposition Australian Labor Party (“ALP”).4 The LiberalNational coalition has dominated, holding the Prime Minister’s office 60 per cent of thetime. The ALP, whose roots are with the trade unions, has had greater success at thestate level holding office for significant periods in five out of the six states.5
Commonwealth governments have been stable, with the ruling party holding office foran average of three terms or almost 12 years. Both major parties have exhibited rigid

4 Other smaller parties that are represented in the House of Representatives following the 1998 election
are the Australian Democratic Party, the Green Party, and the One Nation Party.
5 The ALP has held office in New South Wales, Queensland, Western Australia, Tasmania and South
Australia (Delury 1983).

105

discipline over backbenchers in both the House and the Senate. Fractionalisation islimited and the two major parties are clearly differentiated between a conservative-rural
coalition and a social-democratic alternative.

Australia's federal structure does not provide a check on the power of the executive, as
the constitutional division of power favours the national government over the state
governments. The Commonwealth has such obviously ‘national’ powers such asmonetary policy, defence, foreign affairs, and immigration. In addition, theCommonwealth monopolises the collection of income taxes and reimburses the states
based on a revenue sharing agreement, allowing the Commonwealth to set terms andconditions for the use of these funds.

However, Australia's bicameral structure presents a credible check on the power of theexecutive, as the elected Senate has the ability to force an election through a double
dissolution. A double dissolution occurs when the Senate has twice failed to pass a bill
introduced and passed by the House of Representatives. In these circumstances thegovernment may advise the Governor-General to dissolve both Houses, so that thedisagreement between the Houses may be determined by the people at an election.
Double dissolutions have occurred six times during the history of the federal
Parliament—in 1914, 1951, 1974, 1975, 1983 and 1987. The Whitlam Labor
government was forced out of office after two consecutive double dissolutions in 1974
and 1975. Likewise, the incoming Hawke Labor government overcame two double
dissolutions in 1983 and 1987. During the period being studied, the Australian
Democrats controlled the key seats needed by both major political parties to control the
Senate, forcing both the ALP and the Liberal-National coalition to court the support of
the Democrats, as seen in table 6.

106

Table 22: Distribution of Seats in the Australian Senate
Year

Australian
Labor Party

Liberal National

Australian
Democrats

Other
Parties 1

1977

27

34

2

1

1980

26

32

5

1

1983

30

28

5

1

1984

34

32

7

2

1987

32

34

7

3

1990

32

36

8

2

1993

30

36

7

3

1996

29

37

7

3

1998

29

35

9

3

1. Other parties include: Democratic Labor Party, Australian Greens, Independent Party and One Nation
Party.

CanadaLike Australia, Canada combines a federal structure with the Westminster model ofparliament, with elections held at least once every five years. Legislation is the
responsibility of a bicameral parliament consisting of the elected House of Commonsand the appointed Senate. Canada has low fractionalisation and moderately highpolitical stability, with plurality electoral rules generally delivering parliamentary
majorities. Two non-ideological, centrist parties - the Liberal party and Progressive
Conservative Party - have dominated the Prime Minister’s office (Jackson et al. 1994).
The Liberals have won 12 out of 18 elections in the post-war period, holding office 72
per cent of the time. Canada’s political system has shown only moderate stability with 6
out o f 18 elections generating minority governments. The average parliament has lasted
only 3 years (instead o f the maximum 5 years). In addition, since 1980 two acting Prime
Ministers have been forced to resign as head of their parties while in office.6 The leftwing New Democratic Party (“NDP”) has suffered most under the plurality system, as

6 Prime Ministers Pierre Trudeau and Brian Mulroney resigned as party leaders while in office, leading to
the short lived mandates of John Turner (66 days) and Kim Campbell (122 days), respectively

107

its evenly spread support implies that the NDP receives fewer seats in parliament
than is justified by its 15-20 per cent share of the federal vote. By contrast small,regional parties with concentrated membership have benefited disproportionately, suchas the separatist Bloc Quebecois that formed the opposition following the 1997 election.

Canada’s federal structure acts as a check on the power of the executive, which shareslegislative power with the Senate and Provincial legislatures. While the constitution
gives the Senate considerable de jure power, in practice it plays only a nominal and•7•

constraining role on the executive. The power of the Provinces is greater, and parties
that are in opposition at the federal level frequently have control of the provincial
legislatures. The ten Provinces share fiscal power with the federal government in many
areas including taxation and spending. However, the federal government has exclusive
jurisdiction over currency and banking, trade and commerce and national security,
among other areas.

7 The House of Commons generally introduces legislation, but both Houses must approve all bills before
they become laws.

108

Table 23: Results of Canadian Federal Elections to the House of CommonsElection

ResultParty

Prime M inister

Duration

11 June 1945
27 June 1949
10 August 1953

Majority
Majority
Majority

LiberalMackenzie King

8 yrs 2 mth

10 June 1957
31 M arch 1958
18 June 1962

Minority
Majority
MinorityPC

Diefenbaker

9 yrs 8 mth

8 April 1963
8 November 1965
25 June 1968
30 October 1972
8 July 1974

Minority
Minority
Majority
Minority
Majority

LiberalPearson16 yrs 1 mth

22 May 1979

Minority

PC

Clark

18 February 1980

Majority

LiberalTrudeau / Turner

4 yrs 6 mth

4 September 1984
21 November 1988

Majority
MajorityPC

Mulroney
Mulroney / Campbell

9 yrs 1 mth

25 October 1993
2 June 1997
27 November 2000

Majority
Majority
Majority

LiberalChretien

7 yrs 7 mth

St. Laurent

Trudeau

PC = Progressive Conservatives
Source: Canadian House of Commons

New Zealand
New Zealand is a Westminster-style parliament with a single legislature, the House ofRepresentatives, elected from single-member constituencies using plurality ‘first-pastthe-post’ electoral rules. Elections are held every three years. This system delivered
majority governments in every year.8 This combination concentrates power in the handsof the Prime Minister and Cabinet to a greater extent than in any of the other cases,
earning the nickname o f a 'parliamentary dictatorship' (Nagel 1998). Until the 1996
electoral reforms, New Zealand had a two-party system with the conservative National
party competing with the left-wing Labour Party. The National Party dominated,winning 13 out of 19 elections and holding office for 70 per cent of the time in the post­
war period. The Labour Party has formed the government on four occasions. New
Zealand has experienced stable governments with low fractionalisation, with the109average mandate lasting for two parliaments. The only check and balance on thiselectoral system is a short electoral cycle.
Table 24: Results of New Zealand Elections to the House of Representatives
Election

ResultRuling Party

Prime Minister

27 November 1946

Majority

Labour Party

Fraser

3 yrs

30 November 1949
1 September 1951
13 November 1954

Majority
Majority
Majority

National Party

Holland

9 yrs

30 November 1957

Majority

Labour Party

Nash

3 yrs

26 November 1960
30 November 1963
26 November 1966
29 November 1969

Majority
Majority
Majority
Majority

National Party

Holyoake

12 yrs25 November 1972

Majority

Labour Party

Kirk

3 yrs

29 November 1975
25 November 1978
28 November 1981

Majority
Majority
Majority

National Party

Muldoon8 yrs 6 mths

14 July 1984
15 August 1987

Majority
Majority

Labour Party

Lange

6 yrs

27 October 1990
6 November 1993

Majority
Majority

National Party

Bolger

6 yrs

12 October 1996 1

Coalition

National Party /New ZealandFirst Party

Bolger(National)

3 yrs

27 November 1999

Coalition

Labour Party /The Alliance

Clark(Labour)n.a.

Duration

1. The 1996 election was the first held under mixed-member proportional representation.
Source: New Zealand Electoral Commission

United Kingdom
The United Kingdom has a bicameral legislature, consisting of the elected House ofCommons and the hereditary or appointed House of Lords. The House of Commons iselected at least once every five years. The House of Lords has the power to review, toamend or to delay legislation. Britain has a partisan, dual-party, political system with

8 Since 1996, New Zealand has used a mixed member electoral system based on proportional
representation. An appointed upper house, the Legislative Council, was abolished in 1950 (Delury 1983,
p.721).

110

low fractionalisation.9 The right-of-centre Conservatives and the left-of-centre
Labour Party have dominated Parliament, with the Conservatives winning eight out of
15 elections since 1945, holding office two-thirds of the time. Majority governments
have been the norm with a minority government formed only once in 1974 and lasting
less than a year. Political stability is high, with only two governments failing to serve
their full term in the post-war period (in 1950 and 1974, both under Labour). The mostrecent significant threat to the ruling party occurred in 1993 when the Major
government faced a backbench revolt over the government’s paving bill for theMaastricht Treaty.
Table 25: Results of British Elections to the House of CommonsElection

ResultRuling Party

Prime Minister

Duration

5 July 1945
23 Feb 1950

Majority
Majority

LabourAttlee6 yrs 3 mth

25 Oct 1951
26 May 1955
8 Oct 1959

Majority
Majority
Majority

Conservatives

Churchill
Eden /Macmillan
Macmillan / Douglas-Home

13 yrs15 Oct 1964
31 M ar 1966

Majority
Majority

LabourWilson5 yrs 8 mth

18 June 1970

Majority

Conservatives

Heath

3 yrs 8 mth

28 Feb 1974
10 Oct 1974

Minority
Majority

LabourWilsonW ilson / Callaghan

5 yrs 2 mth

3 May 1979
9 June 1983
11 June 1987
9 April 1992

Majority
Majority
Majority
Majority

Conservative

Thatcher

18 yrs

1 May 1997
6 July 2001

Majority
Majority

LabourThatcher / Major
Major
Blair

5 yrs+

Source: (Banks et al. 1995; N ackie et al. 1990)

Domestic Financial StructureThis section reviews the changes taking place in the financial system of these four cases
over the 1980s and 1990s. All of the cases introduced significant financial deregulation,
which altered the structure and the actors in their financial systems significantly.
However, this review shows that all four countries went through similar reforms, and

9 There are a number of smaller parties, of which the Liberal Democrats are the most significant.

I ll

ended up this period with largely similar economic institutions. For this reason,these economic institutions were not seen as explaining the outcome of the study, due tothe lack of variation across the cases.
Australia
The Australian financial system was radically reformed in the early 1980s as a result of
the Committee of Inquiry into the Australian Financial System (the “Campbell
Committee”) (RBA 1989b). The Campbell Committee's final report in November 1981
called for a sweeping deregulation of the financial system, arguing that a less-regulated,
more open and more competitive financial system was needed. Despite a change ofgovernment to the ALP in 1983, most of the committee's recommendations were
implemented following the endorsement of a second commission, the Review Group on
the Australian Financial System (“Martin Review Group”).

The recommendations of the Campbell Committee affected all aspects of the financial
system (RBA 1991). In external economic policy, it led to the adoption of a marketdetermined exchange rate with reduced official intervention and an end to exchange
controls (RBA 1989c). In domestic monetary policy, it led to the overhaul of thegovernment securities markets, allowing a secondary market for government securities
to develop (RBA 1989d)10. Direct controls on banks - such as interest rate ceilings,
quantitative controls on lending and reserve asset requirements - were removed
between 1984 and 1987, allowing open market operations to become the main
instrument of monetary policy (RBA 1989e). A limited number of foreign banks were
finally allowed to establish operations in Australia from 1985.

10 The Treasury moved from a ‘tap’ system to a competitive ‘tender’ system, where Treasury yields
reflected market demand. This change led to an increase in the range of securities on offer, including
index-linked Treasuries from 1985.

112

There are three broad categories of banks in Australia: privately owned Australianbanks, where shareholders own the bank; government-owned banks such as the StateBank of South Australia, and overseas-owned banks. For historical reasons, private,
domestic banks have dominated the financial industry, controlling almost half the total
assets in the financial system in 1990 (RBA 1991). Deregulation under the Campbell
Committee led to a consolidation in the financial sector, with the private banks
absorbing their finance companies and merchant banks that had been set up to getaround regulatory controls, and a number of building societies converting into banks.
CanadaCanada’s financial services industry has undergone enormous change in the 1990s,
evolving from four distinct pillars separated by legislation to a universal banking model
controlled by the top chartered banks.11 Financial reforms from the late 1980s onward
led to breakdown of these pillars. In 1987 commercial banks were allowed to acquire
securities dealers then in 1992 all financial institutions were allowed to acquire thecross-ownership in the other pillars, but only through stand-alone subsidiaries (Chant
1997, p.22). The 1992 legislation effectively led to a universal banking model, withinstitutions participating in banking, trust services, securities underwriting andinsurance. Consolidation reached its peak in 1998 when the four largest charted banks
announced merger plans that were subsequently disallowed by the Finance Minister due
to concerns over competition. However, the trend towards consolidation in the financial
services industry continues.

11 Prior to 1980, financial services were grouped under ‘Four Pillars' that were kept distinct by legislation.
For a discussion see Chant (1997).

113

Table 26: Canadian Financial Sector Overview
No. o f Companies
Sector1991

1997

Canadian Banks

8

11

Foreign Banks

56

TrustsAssets (C$ billions)1991

1997 percent o f

1997

Total Assets

553.7

1,132.4

57.0

44

58.2

91.9

4.6

78

34

155.1

55.1

2.8

Credit Unions

2,700

2,289

79.9

107.0

5;4

Life Insurance

155

132

200.5

251.4

12.6

Property Insurance

350

216

33.7

53.6

2.7

Securities Dealers

118

187

26.9

13.3

0.7

Mutual Funds

119

78

49.9

283.2

14.2

2,991
3,584
Total
Source: Standing Committee on Finance (1998)

1,157.9

1,987.9

100.0

New Zealand
Prior to 1984, the New Zealand financial services industry was divided into protected
but strictly controlled segments (Margaritis 1992, p.6). Banking was strictly licensed
providing a monopoly to four registered banks - one government-owned institution andthree foreign-owned banks (Margaritis 1992; Spencer et al. 1988). Domestic financial
markets were underdeveloped, with the government funding its debt by placing
securities at below market interest rates with various institutions. Low domestic interest
rates and an inability to invest overseas discouraged private savings while subsidisingdomestic investment.

Among the first reforms introduced by Labour government elected in 1984 was
financial sector deregulation (Deane 1985, p.6; Margaritis 1992, p.28; Spencer et al.
1988). Banking and foreign exchange was opened up to full competition. All controls
on prices, wages, credit, dividends, foreign exchange and out-bound overseas
investment were lifted and the New Zealand dollar was floated. Banks were freed fromany quantitative limits on their lending growth. Bank deposit- requirements and114

investment restrictions were abolished. These reforms led to a boom in the financial
services industry, with a major reorganisation of ownership and management.

From a segregated system of financial services in the early 1980s, the financial sector in
New Zealand has evolved towards a system of universal banking that is dominated byforeign institutions. By 1988, ten new banks had been registered while the restrictions
on trustee savings banks and building societies had been eased, allowing them tocompete for commercial banking business (Spencer et al. 1988, p.l 1). By 1996, thebanking sector had 19 registered banks but only one New Zealand-controlled bank, andthat a comparatively small one (Brady 1997). The majority of life insurance companies
are owned and controlled overseas. Securities underwriting services are mostly offeredby the registered banks, which also own two large finance companies and offer mutualfund products through bank branches.
United Kingdom
The UK financial services sector has developed from a segregated structure towards auniversal banking structure during the 1990s, driven by domestic and international
mergers. Banking is concentrated in the hands of less than a dozen clearing banks, withextensive branch networks, which sit atop a hierarchy of smaller banks, building
societies and other specialised financial entities. As an international financial centre,
foreign banks dominate London and outnumber their domestic counterparts five to one.
Britain’s traditional merchant banks have been swallowed over the 1990s by Americanand European investment banks. Britain’s deep capital markets reflect a well developed
sector o f institutional investors, featuring large pension funds, an extensive asset
management industry and the largest insurance market in the world.

115
M onetary Policy Fram ew orks

Table 27: Overview of Monetary Policy Frameworks

Australia 1

Exchange
Rate Peg

Monetary
TargetFloating
Exchange Rate

Inflation
Target1970-1983

1976-1984

1984-1992

1993-present

1977-1982

1970-1976
1983-1990

1991-present

1985-1989

1990-present

1972-1979
1984-1989

1993-present

CanadaNew Zealand

1970-1978
1982-1984UK

1970-1971
1990-1992

1980-1983

1. Australia had both an exchange rate peg and monetary targets from 1976-84.
Source: Cottarelli and Giannini (1997), Edey (1997), Macfarlane (1998).

Australia
Following the collapse of the Bretton Woods system of pegged exchange rates, theAustralian dollar ("A$") was pegged to the US dollar in December 1971 (RBA 1987;
Macfarlane 1998). This link was discontinued in 1974 in favour of a fixed peg against a
trade-weighted basket of currencies. In 1976 the fixed peg was replaced by a crawling
peg following a devaluation of the A$. Monetary policy was then without an anchor
from 1976 to 1983. In December 1983 the A$ was floated and exchange controls wereabolished as part of a wider deregulation of the financial system. Australian monetary
policy then evolved through three distinct frameworks (Lowe 1997; Macfarlane 1998).
First, a loose form of monetary targeting under an exchange rate peg was adopted fromFebruary 1976 until January 1985, based on ‘monetary projections’ contained in the
Treasurer’s annual budget. These monetary projections were discontinued in January
1985, as financial deregulation had undermined the usefulness o f monetary aggregates.
Monetary policy was again without an operating framework until 1993, when thecentral bank began informally pursuing price stability under an inflation targeting
regime (Grenville 1997, Stevens 1999). This regime was formally adopted from 1996,
following a joint announcement by the government and the central bank.

116

The RBA has sole responsibility for foreign exchange operations and owns
Australia’s foreign exchange reserves that form part of its balance sheet (Committee
1993b, p. 154).12 Under the floating exchange rate regime, the RBA views its objective
not as targeting a level for the exchange rate, but of maintaining a degree of order in themarket by dampening large fluctuations.
CanadaThe Canadian dollar has floated continuously since 1970. The removal of the Bretton
Woods peg, however, left monetary policy without an anchor until 1975.13 In that year,
the Bank of Canada adopted monetary targets under a program of ‘monetary
gradualism’, which were supplemented by wage and price controls introduced from1975-78. Monetary targets were formally abandoned in November 1982, leaving the
Bank of Canada without an intermediate guide to policy.14 Since the late-1980s, theBank o f Canada has focussed on price stability as the appropriate objective of monetary
policy. This objective was formalised in February 1991 with the introduction of
inflation targets, jointly announced by the central bank and the government (BoC
1991b).'5

The exchange rate has always played an important role in Canadian politics due to theeconomic importance of the traded sector and the high level of integration of Canada ininternational financial markets. The Bank of Canada views the exchange rate as an
operational target for policy and a complementary transmission mechanism to theinterest rate for signalling a shift in monetary conditions (Crow 1993c). This

12 The RBA engages in foreign exchange intervention with - as a practical matter - no prior consultation
with the Treasury, although the RBA keeps the government informed of major developments.
13 The Canadian dollar was floated from 1950 until the exchange rate was fixed in 1962, then floating
again from 1970 to the present (Crow 1993c).
14 For a comprehensive review of Canadian monetary policy in the post-war period, see (Courchene 1976,
1981; Howitt 1986; Laidler 1997; Laidler et al. 1993). A summary is available in Howitt (1993).
15 The initial target aimed at reducing CPI inflation to a range of 1 to 3 percent by the end of 1995.

117

relationship was formally recognised by the introduction of the monetary conditionsindex (“MCI”) as the operational intermediate target for monetary policy in 1995. The
use of the MCI has been downplayed since 2000 due to market misperceptions of its
importance for monetary policy.
New Zealand
New Zealand adopted a short-lived US dollar peg in 1973 that was replaced with a
trade-weighted peg later that year. From 1979 to 1982, a crawling band was introducedwith the rate o f crawl adjusted to reflect inflation differentials against New Zealand’s
trading partners. The peg was fixed in June 1982 and remained until the currency was
floated in March 1985, following the removal of exchange controls in December 1984.
Floating the currency was part of a broader package of reforms that liberalised thefinancial system and freed the monetary instruments.

Prior to 1984 monetary policy was based mainly on a framework o f regulatory controls.
Following financial deregulation, the Reserve Bank of New Zealand implemented astrategy of monetary base control aimed at achieving a rate of inflation comparable toits trading partners, by controlling the quantity of cash reserves in the banking system(Caesar 2000; Deane 1985; Margaritis 1992). This approach was supplemented by acheck-list of indicators - the exchange rate, the level and structure of interest rates,
inflation expectations, monetary aggregates and trends in the real economy (Deane
1985, p.20; Margaritis 1992, p. 15). The pursuit of price stability was made more
explicit in 1988 with the public endorsement of this goal by Minister of Finance
Douglas, which was then confirmed with the adoption o f an inflation target in 1989.16
Starting in September 1988, the RBNZ also began monitoring a monetary conditions

16 The initial inflation target of 0 to 2 per cent was agreed between the Labour government and theGovernor, with a path for disinflation extending until year-end 1992.

118

index (“MCI”). From June 1997, the relationship between interest rates andexchange rates in the formulation of monetary policy was clarified when the RBNZ
began publishing its operating target level for the MCI (Brash 1997).17 In March 1999,
the RBNZ adopted an official cash rate as its main policy instrument. However, the
MCI still plays an important role in the determination of monetary policy.
United Kingdom
The British pound has floated from 1972 to 1990, then again from 1992 onwards.
Following exit from the Bretton Woods system, Britain adopted a broad monetary target
as a domestic anchor in 1975. The following year, faced with a balance of payments
crisis, the Labour government went to the IMF for a stand-by loan of $3.9 billion, with
monetary targets formally included as part of that package. The Conservative
government suspended the use of the broad monetary target in 1985, then scrapped allmonetary targets altogether in 1987 (Atkinson, Baker, and Milward 1996, p.274).
Monetary policy was without an anchor until October 1990, when Britain joined the
Exchange Rate Mechanism of the European Monetary System (“the ERM”) at a fixedparity of DEM 2.95 to the pound. The UK was forced to exit the ERM in September
1992. The Conservative Chancellor sought to restore some monetary policy credibility
by adopting an inflation target in November 1992. This inflation target has been
continuously renewed, and was embedded in the Bank of England Act 1998.

17 The MCI is constructed as a 2:1 weighted average of the trade-weighted exchange rate and the 90-day
interest rate.

119Supervisory A rrangem ents

Table 28: Overview of Supervisory Arrangements
Country
Bank regulator

Australia

CanadaUK

New ZealandCentral bank(until 1998)

Office of theSupervisor of
Financial
Institutions

Central bank(until 1997)

Central bank(post-1984)

Source: Goodhart and Shoenmaker (1993), national authorities.

Australia
The RBA Act 1959 gave the central bank only general responsibility for banking
supervision, in so far as financial stability affected ‘the economic prosperity and welfareof the people of Australia’ (RBA 1991). Following deregulation, the RBA graduallybuilt up a specialised banking supervision function that was formalised in 1984 with theestablishment of a separate Supervision Unit. The following year foreign banks wereinvited to open operations in Australia for the first time. The RBA’s regulatory
responsibility was only formalised in 1989 when the Banking Act 1959 was amended togive the RBA explicit supervisory powers (RBA 1989a). Finally, in July 1998, banking
supervision was taken from the RBA and transferred to a new organisation, theAustralian Prudential Regulation Authority.18 At the same time, the RBA was given
extensive regulatory powers over the payments system to be exercised by a new
Payments System Board within the RBA.
CanadaIn 1987 the Inspector General of Banks merged with the regulators responsible for trust
companies and insurance to create the Office of the Supervisor of Financial Institutions(“OSFI”) (Chant 1997, p. 16). OSFI was given the powers to supervise and regulate all
federally regulated financial institutions, namely all banks, federally incorporated trust
and loan companies, insurance companies, co-operative credit associations and pension,8 This separation of monetary policy and supervision functions was considered by the Martin Review,
but then dismissed. The RBA was naturally opposed (Fraser 1991, p.2).

120plans. Prior to these reforms, chartered banks were subject to federal regulation,
while trusts and insurance companies were regulated either provincially or federally
depending on how they were incorporated.
New Zealand
Prior to 1984, New Zealand had only four registered banks that were supervised
informally by the central bank. Extensive controls on all aspects of the financial sector
had led to the emergence of a large number of non-financial institutions outside the
RBNZ’s supervision that dis-intermediated financial flows while escaping theregulatory net. The RBNZ Amendment Act 1986 tried to address this situation by making
the RBNZ responsible for both bank and non-bank financial institutions, although thecentral bank remained without statutory powers to ensure financial disclosure, to lay
down standards or to punish offenders. With the RBNZ Act 1989, RBNZ is responsible
for supervising only registered banks, while the use of the term ‘bank* has been
restricted (Dawe 1990, p.32). The RBNZ remains the lender-of-last-resort for thebanking system, with only registered banks qualifying for assistance. New Zealand has
no system o f deposit insurance, to discourage moral hazard by ensuring that depositors
invest their funds prudently.
United Kingdom
Prior to the 1980s, bank supervision had been conducted by the Bank of England on an
informal and non-statutory basis, which proved inadequate as seen in the secondarybanking crisis o f the early 1970s (Lawson 1992, p.407). The arrival of Big Bang in
October 1986 made the need to improve the regulatory framework more pressing, andresulted in the 1986 Financial Services Act (“FSA”) and the various agencies set up
under that Act (Lawson 1992, p.400). Following the collapse of Johnson Matthey
Bankers, the Conservative government introduced regulatory reforms in 1987 thatstrengthened the supervisory regime. This framework remained in place for the next

121

decade, despite the collapse of B C C I, the failure of Barings Bank and the Maxwell
pensions scandal. In 1997 a new Financial Services Authority (“FSA”) was created withresponsibility for the financial industry as a whole. As a result of this change, 450 Bankof England employees were seconded to the new FSA, but the Bank of England retained
responsibility for financial stability and continued to act as lender-of-last-resort - a
position it formalised in a Memorandum of Understanding with

the FSA and theTreasury agreed in Autumn 1997.

Labour Market Institutions

Table 29: Overview of Labour Market Institutions
Australia

CanadaUK

New Zealand

48
41
35

36
36
38

50
39
34

56
45
30

88
80
80

37
17
16

70
47
47

n.a.
67
31

Collective wage bargaining agreement

Yes

No

No

No

Public Sector Unions as per cent work force
1980
1990

17
14

11
11

15
12

n.a.
n.a.

1,173
730

441
270

128
50

834
298

Country
Trade union density (%)
1980
1990
1994

% workers covered by collective agreement
1980
1990
1994

Days lost to strikes
1980
1990
Source: OECD, Garrett and Way (1999)

Union membership in industrial countries has been significantly affected by changes inthe structure of developed economies, such as the shift in jobs from the public to theprivate sectors and from manufacturing to service industries. Industrialised countries
have experienced a decline in unionisation, with membership declining between 1985 to
1995 by 13 per cent in Australia, by 22 per cent in New Zealand and by 12 per cent in
the UK.

122

Australia
Labour market institutions and negotiated wage restraint with trade unions have playeda significant role in Australia’s political economy over the past two decades. In 1990,
Australia had some of the most encompassing unions among industrial countries, withcollective wage bargaining covering 80 per cent of union agreements (Garrett et al.
1999, p.423). Australia also had powerful public sector unions. However these figuresconceal a decline in the strength of organised labour, with union membership droppingfrom a peak of 42 per cent in the mid-1980s to 28 per cent of the workforce by 1998.19
Public sector union membership also fell to 53 per cent. Voluntary wage restraint wasan important element of Australia’s economic policy for more than a decade under thePrices and Incomes Accord (“the Accord”), which was in place from 1983 to 1995. The
Liberal-National coalition elected in 1996 rejected any Accord with the trade union
movement, ending this period of voluntary wage restraint.
CanadaIn 1990, about a third of workers were unionised of which 35 per cent were public
sector employees, a decline from the levels of unionisation of previous years. Canada
has the least coordination of wage bargaining among 18 OECD countries and among theleast encompassing unions (Garrett et al. 1999; Hall et al. 1998).20 In 1975, thegovernment announced mandatory wage and price controls under the Anti-Inflation
Board, which restricted or rolled back union wage increases. Following the 1981-82
recession, public sector unions were targeted by legislation that reversed union's
collective bargaining rights and right to strike, and imposed wage controls under thegovernment’s “6 & 5” program in 1982-84. This pressure on organised labour has led toa significant decline in union membership and power in Canada (Phillips 1997).

123

New Zealand
Prior to the 1980s, New Zealand had a tradition of tripartism between the government,
unions and businesses (Scott 1996). In 1982 the National government legislated wage
and price freezes and passed legislation to reduce the power of unions. The wage freeze
was ended in 1984 following the election of the Labour government, which reinstatedcompulsory unionism while preserving centralised wage bargaining.21 While unions
were entitled to negotiate directly with individual employers, individual firms could notbargain directly with individual unions and were required to take part in national wage
negotiations held annually. The Labour Relations Act 1987 contested union coverage of
certain industries and introduced legislative changes designed to strengthen the
democracy and accountability o f unions, while removing unnecessary restrictions in thewage-setting process (Margaritis 1992; Scott 1996). The National government elected in1990 passed the Employment Contracts Act 1991, which ended compulsory unionism,
reducing unions to the status of incorporated societies and extending the practice ofenterprise bargaining (Castles et al. 1996, p. 17). The proportion of the workforce on
individual or collective enterprise-specific contracts increased dramatically and by
December 1995 only 17 per cent of the workforce was covered by union-negotiatedcollective contracts (Brash 1996b). As a result of these reforms, union membership fellby 22 per cent over the decade from 1985, faster than in any other industrial economy.
United Kingdom
Britain does not have a centralised system of wage bargaining. About one in threeworkers belong to a union, with union membership declining due to structural changes

19As of February 1999 there are approximately 8.7 million workers in the Australian workforce, of which
28 per cent belong to unions. Source: ACTU.
20 Similar results are reported by a number of other authors (Garrett 1998b; Garrett et al. 1999; Iversen1998).
21 Specifically, membership of a union having in excess of 1,000 members was compulsory for all
individuals working in an organisation where a compulsory union membership ballot had been successful(Spencer et al. 1988, p.33).

124

in the economy and the anti-labour policies introduced by Thatcher. Britain’s
decentralised wage bargaining led to a legacy of strikes and industrial conflict that
finally declined in the 1990s. There are few all-encompassing unions, although mergers
over the past decade have created some large unions. The peak association for organised
labour, the Trades Union Congress, has declined in importance and cannot control its
members who are increasingly diverse.

4.3 Interest Groups by Country

This section outlines a number of the associations representing the interest groups
identified in the last chapter as being most likely to hold a preference for or against
central bank independence. The list is not comprehensive, and the discussion isnecessarily cursory, due to the large number of associations in operation in each o f thesecountries. This list is intended to give a quick assessment of which associations are most
likely to prove effective in transforming their economic power into political influence.
This judgement is based on four criteria: their ‘insider’ status, the existence of a full­time staff with technical expertise in monetary policy, their control o f specialised
information, and identifiable rents from their activities that can be used to finance theircosts o f lobbying.

125
Australia
T able 30: Sum m ary o f Interest Group Effectiveness in A ustralia
Insider
statusFull-time
staff withtechnical
expertiseControl of
specialised
information

Identifiable
rents >
costs

Score

Australian Bankers
Association

3

Business Council ofAustralia

3

Australian Chambero f Commerce andIndustry

2Australian Council
o f Trade Unions

4

1. The ACTU has insider status with the Australian Labour Party but not the Liberal-National coalition.

The Australian Bankers Association ("ABA") is the national organisation representing
licensed banks in Australia. It is funded by its 27 member banks that include retailbanks, investment banks, and foreign banks. Financial deregulation and increased
competition post-1985 has reduced the profitability of the domestic banks, leading toindustry consolidation that has benefited the four largest players - ANZ, Westpac,
National Australia Bank and the Commonwealth Bank. The ABA has a full-time staff
that includes expertise in monetary policy. The ABA, together with its members,
produces industry research that is then made disseminated through the ABA.

Australian business was represented by a range of associations during the period being
studied, ranging from the all-encompassing associations such as the Business Council
on Australia to sectoral associations such as the Metal Trades Industry Association.
These business associations have been fragmented and divided during the 1980s and1990s, with their organisational disunity and conflicting preferences mitigating theirpolitical influence on the left-wing ALP government in power for much of this period(Bray et al. 1996, p.81; Singleton 1997). By the 1990s, several of these associations had
declined in importance, merged or disappeared. The Business Council of Australia

126(“BCA”), established in 1983, is an association of chief executive officers of over
100 leading Australian corporations. The Australian Chamber of Commerce andIndustry, formed in 1992, claims to be the peak business association, with a nation-wide
network exceeding 350,000 businesses. The Metal Trades Industry Association mergedwith the Australian Chamber of Manufactures to form the Australian Industry Group,
Australia’s largest industry association.

The Australian Council of Trade Unions ("ACTU"), formed in 1927, is the peakassociation for Australian unions, representing over 70% of union members or around
one in three Australian employees. The ACTU speaks on behalf of all workers
including those in manufacturing, finance, government and the service sector generally.
The ACTU employs a professional staff of 35 that include economists, researchers, andjournalists. The ACTU increased its authority during the 1980s thorough its role innegotiating the Accord, which can be viewed as a source of rents for its membership. It
also increased its scope and membership through mergers with two white-collar peakorganisations, the Australian Council of Salaried and Professional Associations in 1978
and the Council of Australian Government Employees Organisations in 1981 (Bray etal. 1996, p.71).

127
C anadaTable 31: Sum m ary o f Interest Group Effectiveness in C anada
Insider
statusFull-time
staff withexpertiseControl o f
specialised
information

Identifiable
rents >
costs

Score

Canadian Bankers
Association

V

4

Business Council on
National Issues

V

3

Canadian Federationo f Independent
Businesses

V

3

Canadian Labour
Congress2

3
Canadian Auto
V
Workers
1. Formed from the merger of the Canadian Exporters Association and the Canadian Manufacturers
Association.

The Canadian banking industry is represented by a single trade association with limited
membership, the Canadian Bankers Association (“CBA”). Established in 1891,
membership in the CBA is compulsory but is limited to chartered banks, generating amembership of 40 domestic and foreign institutions. It has a full-time, salaried staff andhas employed a permanent lobbyist in Ottawa since 1894 (Coleman 1988, p. 184). The
CBA has been successful in creating and controlling private rents for its members,
initially through monopoly control of the payments system and now through ownershipof a proprietary, national network of automated teller machines (Chant 1997, p. 18). The
CBA has a full-time staff with technical expertise in monetary policy, but relies on its
members to comment on macroeconomic policy.

Business does not speak with a single voice in Canada, due to sectoral and geographic
divisions among business associations (Coleman 1988). A number of associations withoverlapping memberships compete on the policy stage for the attention of politicians
and the public. The Business Council on National Issues (“BCNI”) views itself as ‘the128

senior voice of Canadian business on public policy issues’. Founded in 1976, theBCNI is composed of the chief executive officers of 150 leading Canadian corporations
representing every major sector of the Canadian economy including banking. The BCNI
has a full time staff of 10, including technical expertise in monetary policy. The
Canadian Federation of Independent Business (“CFIB”), founded in 1971, is the voice
for small business and speaks for 98,000 members. The CFIB’s ability to survey its
membership and report the expectations of small business supports its claim to ‘insider’
status in Ottawa, but this activity only began in the mid-1990s.

The Canadian Labour Congress (“CLC”) is the peak organisation for trade unions,representing provincial labour federations and 125 district labour councils, covering 2.3
million unionised workers. However with coverage of only 60% of unionised workers,
the CLC has one o f the lowest densities among its peers reducing the legitimacy o f its
claim to ‘insider’ status. The CLC’s claim to speak for organised labour is challenged
by the major unions themselves, such as the Canadian Union of Public Employees(“CUPE”) and the Canadian Auto Workers (“CAW”), both of which are active
members of the CLC. CUPE is Canada’s largest union representing 485,000 workers in
the public sector with headquarters in Ottawa and over 70 regional offices, employing astaff o f more than 700. The CAW is the largest private sector union in Canada,
representing 245,000 workers organised into 282 local unions from a wide range ofindustries.

99

Both union associations have a full-time staff with technical expertise on

monetary policy.

22 The CAW has been transformed through mergers with other unions into a broad-based, general
workers' union, doubling its membership since 1985.

129
New Zealand
Table 32: Sum m ary o f Interest Group Effectiveness in N ew ZealandInsider
statusFull-time
staff withtechnical
expertiseControl of
specialised
information

Identifiable
rents >
costs

Score

New Zealand Business
Roundtable

3

Federated Farmers

3

Manufacturers'
Federation

3

Employers' FederationV

New Zealand Council o f
Trade Unions 1
1. Formed from merger of the Federation of Labour and the Combined State Unions.

3
2

The financial sector in New Zealand was not coordinated in the 1980s, with associations
representing the different financial sectors, namely the New Zealand Bankers'
•

•

•

•

Association, the Finance Houses' Association , the Mortgage Lenders Association andthe Insurance Council of New Zealand (Gold 1989; Lawn 1994; Roper 1992). These
associations did make submissions to government committees, but pursued lobbying
activities to the New Zealand Business Roundtable, to which many of their members
belonged.

The New Zealand Business Roundtable ("NZBR"), formed in 1980, is an organisationof Chief Executives of major business firms, which represented around 40 of largest
business and financial interests in New Zealand by 1989. Around one-third of its
members were from the financial sector. The NZBR did not have a formal structure or
an office until 1986, when Roger Kerr left the Treasury to become NZBR Director(Goldfinch 2000). It has a full-time professional staff of 3. The NZBR's members meet

23 Subsequently renamed the Financial Services Association.

130

informally every two months to discuss public policy issues and form common
positions. The NZBR's focus on the general economy, rather than particular sectors orindustries, has allowed it to develop a broad consensus around issues based on a longerterm perspective. The NZBR is well-funded, and its staff have produced orcommissioned numerous research reports and briefings that have proven effective in
influencing policy in many areas, particularly microeconomic reform and labour market
reform (Goldfinch 2000). The NZBR does not seek publicity, preferring to act as a'quiet lobby'.

The main associations representing business over this period were the Federated
Farmers, the Manufacturers' Association and the Employers' Federation (Gold 1989,
p.275). The Federated Farmers, founded in 1946, had coverage during the late 1980s of
80 per cent of agriculture representing 60 per cent o f export revenues. Its 30,000
members were organised in three commodity sections. The Manufacturers' Association,founded in 1927, had 2,400 members organised into 70 trade groups. Its membershiprepresented 85 per cent of manufacturing output, 50 per cent of manufacturing
employment and 25 per cent of exports. Both of these organisations held annual
conferences to determine policy. The Employers' Federation, founded in 1902, consistedof four provincial employers' associations with a combined membership of 10,000,
representing two-thirds o f employers and 80 per cent o f private sector employment. Itsbiennial conference was not a policy-making forum. All three associations played an
active role in policy lobbying, meeting as a 'Top Tier' association (with three otherassociations) since the 1970s in order to coordinate their lobbying and sitting on thesteering council of the 1894 Economic Summit. However these groups had overlapping

131

memberships and were unable to speak with one voice due to its members' sectoralinterests.24

Organised labour was fragmented during the 1980s, without a clear peak organisation
representing workers (Bray et al. 1996, p.85). Unions were represented by three main
associations, the Federation of Labour, the Combined State Unions, and the PublicService Association. In 1987, the Federation of Labour merged with the Combined
State Unions to form the New Zealand Council of Trade Unions (“NZCTU”), which
acted as the peak association for labour with an Executive elected by its membership. It
had a membership o f over 500,000 representing 78 per cent of union members. Despite
its size, the NZCTU had difficulty speaking for labour as not all unions were members,
and it had little control over its 69 affiliated unions (Gold 1989). It also had weak links
with the Labour government, making it an ineffective voice for organised labour (Brayet al. 1996, p.68; Easton et al. 1996, p.35). For example, the NZCTU’s policy stance led
a number of blue-collar unions not to join, leading to the formation of a competing peakorganisation -the Trade Union Federation - undermining the unity and voice oforganised labour (Bray et al. 1996, p.79).

24 In June 2001, the Manufacturer's Association and the Employers' Federation merged to form Business
New Zealand, in order to strengthen the voice of business and act as a coordinating body for lobbying
activities.

132
United Kingdom
Table 33: Sum m ary o f Interest Group Effectiveness in U K
Insider
statusFull-time
staff withtechnical
expertiseControl of
specialised
information

Identifiable
rents >
costs

Score

British Bankers
Association

3

Confederation of
British Industry

3

Institute o f Directors

2

Trades Union
Congress

2

With the decline of 'esoteric politics' and the restructuring of the financial sector during
the 1970s, the City o f London has been forced to adopt the same tactics as otherpressure groups in the 1980s, lobbying politicians through trade associations (Grant
2000; Moran 1984b). The City has a large number of trade associations, most withsmall staffs and overlapping memberships. The largest is the British Bankers
Association, with income of almost £5 million, representing 95% o f the domesticbanking sector in London and acting as an umbrella organisation for a number of otherbanking associations. The BBA is funded by subscriptions from its 300 members. It hasa full time staff of over 60, with a Director whose responsibilities include monetary
policy. The BBA is active in monitoring and commenting on banking legislation, giving
submissions and expert testimony to policymakers. However, the BBA has a policy of
not commenting on macroeconomic policy, leaving this role to the Confederation of
British Industry, of which it is a member. It does produce a limited number of
specialised surveys, but no regular publications.

The promotion of the City’s interests has suffered due to the confusing and overlappinggroup o f bodies with no shared policy agenda (Clarke 1995, p.39). While there has been

133

some consolidation of banking associations in the early 1990s, there are still too
many associations representing different areas of the industry, such as payment clearing
bodies, investment banks, building societies, mortgage lenders and securities dealers.
There are an equally large number of bodies representing insurance and pensions. Thisoverlap of bodies does not allow any one to speak for the industry, and creates problemsof collective action and free riding.

The Confederation o f British Industry ("CBI") is the peak association for business, andthe largest trade association in the UK. The CBI's members come from every sector andinclude half of the FTSE Top 500 companies, as well as over 1,500 small and medium­sized businesses. CBI member corporations employ over four million workers. The
mission of the CBI is to influence government and party policy-making. It has a full­time staff of over 80 professionals that includes a Chief Economist and an Economic
Policy Unit. CBI staff meet with ministers, backbench MPs and civil servants. Its staff
produce briefings on the public policy issues, economic forecasts and surveys ofbusiness trends, and organise conferences and other networking opportunities formembers.25 The CBI also maintains a high media profile. Despite this view of its own
importance, Grant (1993) argues that the CBI is an ineffective voice for business, as it is
too monolithic and encompassing.

The Institute of Directors ('ToD"), established in 1903, is a private-member organisation
for business directors. Membership is not restricted, and spans the spectrum from large,
public companies to small, private firms. The main purpose for joining is to have theuse o f the IoD's meeting and entertaining facilities in London, as well as similar
facilities in the regions. Members receive a variety of benefits including information,

134

advice, training, conferences and publications to help them in their businesses. The
day-to-day running o f the Institute is managed by a small team, headed by the Director
General. There is no attempt made to survey the membership on policy positions, which
are determined unilaterally by a Policy Unit, headed by a trained economist. The IoD
prepares specialised surveys of its members on a variety of issues, such as pensions,business opinion, and taxation issues. It also prepares commentary on economic trends
and submissions for government committees.

The Trades Union Congress ("TUC"), founded in 1868, is the peak organisation
representing trade unions. It is made up of 74 unions with a combined membership ofnearly 7 million workers. The TUC is funded by annual subscriptions paid by theaffiliated unions, and had an income of £12.5 million in 1996. The TUC employs morethan 200 staff in seven departments, which include a Campaigns and Communications
department and an Economic and Social Affairs department. The TUC is committed tolobbying the government, political parties and employers based on common policy
positions negotiated with its affiliated unions. The TUC's staff carry out research on
employment-related issues, and run an extensive training and education programme forunion representatives. The TUC maintains close ties with international bodies, such as
the European Union and the International Labour Organisation. Despite these activities,
the TUC is seen by Grant (2000) to be an association in decline. Organised labour lost
political influence under Thatcher and has shrunk in size, being spumed first by theConservatives and then by New Labour.

25 Recent economic commentary has focussed on the budget issues, EMU, interest rate policy and public
spending and borrowing.

135
4.4 Observable Implications of Hypotheses

Table 19 summarises the variables identified in chapter 4 as being important for
explaining why politicians delegate. Rows 1 through 3 are proxies for the need to signal
financial creditworthiness to financial markets. Row 4 and 5 measures the degree of
uncertainty in the monetary framework, as evidenced by a lack of anchor for policy or acurrency crisis. Row 6 reproduces the index of lobbying effectiveness derived in section
III (with a scale of 0-4 where 4 is the most effective influence). The remaining rows of
the table reflect the institutional constraints, with political institutions highlighted inrows 7 through 9 and economic institutions in rows 10 through 13.
Table 34: Summary of Explanatory and Institutional Variables, End of 1980s
ProxyAustralia

CanadaNew ZealandUK

1

Government debt level,
1989 (% o f GDP)

Low
(16.5%)

Intermediate,but rising
(38%)

High
(75%)

Intermediate,but falling
(30%)

2

Budget deficit, 1980-89(% o f GDP)

Low(-2.0 %)

Intermediate toHigh (-4.4 %)High(-6.1 %)

Intermediate(-3.7%)

3

Current account, 1980-89(% o f GDP)

-4.7%

-2.2%

-3.3% 1

-1.7%

4

Currency crisis

1983

n.a.

1984

1992

5

Monetary framework

No anchor(float 84-93)

No anchor(float 82-91)

No anchor(float 85-89)

No anchor2(float 85-90)

6

Lobbying index:(i) financial sector(ii) business(iii) unions

3
2-3
4

4
3
2-3

3
3
2

3
2-3
2

Labor
(1983-96)

Conservatives(1984-93)

Labour(1983-90)

Conservatives(1979-97)

7

Party in power

8

Stability o f government

High

High

High

High

9

Political system withchecks and balances

Yes

Yes

No

No

10

Banking regulator

Central bank

OSFI

Central bank

Central bank

1. Only for years 1987-89. 2. Monetary targets were suspended in 1985.

The following predictions can be made from this table concerning the willingness ofpoliticians to give independence to the central bank. (The relevant hypothesis andcorollary are referenced in brackets, marked H and C, respectively).

136
Australia

The indicators for Australia are mixed. The following factors suggest that politicians
would delegate to the central bank. The Labor government should have an incentive to
adopt this reform, as they were faced with a currency crisis upon being elected (H.I) andthey had a strong electoral mandate suggesting a long-time horizon (H.IVB). The shortelectoral cycle suggested a strategy to minimise economic risks would be prudent(H.IVD). Delegation would also increase cabinet durability due to the ability of the
Senate to credibly bring down the government (H.IVC). The Senate had used two
double dissolutions to bring down the Labor government of Whitlam, making this threat
credible. The presence of a currency crisis and the lack of monetary anchor should havemade the ideas of an academic community more influential (H.IIA). The trade unions
were the strongest position to influence policy, as witnessed by their role in negotiating
the Accord, implying that opposition to this reform should have been strong. Businessgroups were likely to oppose this institutional reform but had low levels of lobbying
effectiveness (H.IIIC).

Several factors mitigated the need for central bank independence. Low debt levels,
moderate budget deficits and a sophisticated domestic financial market indicatedpoliticians faced no need to signal creditworthiness to international financial markets(H.I, H.IVB). The financial sector may have faced a conflict of interest against central
bank independence as the RBA was responsible for banking supervision (H.IILA).
Finally, the Australian federal system of parliament made legislative change moredifficult due to the checks and balances in the system (C.I).

C anadaThe Canadian case offers a crucial test of Posen's hypothesis, as it satisfies most of
Posen's criteria supporting financial sector lobbying in favour of central bank137

independence (H.IIA). The financial sector had unified preferences due to thepresence of universal banking and a central bank that was not responsible for banking
regulation (H.IILA). It was led by an association with the highest level of lobbying
effectiveness, as seen in row 6 of table 19. Rising government deficits and intermediate
government debt levels suggested that politicians were dependent on this sector for
financing. Groups opposed to this reform - manufacturers, exporters and unions notcovered by a collective wage agreement - showed weaker lobbying effectiveness(H.IIIC). A political system featuring high stability and low levels of fractionalisation
was a contributing factor (C.I). The lack of a monetary anchor suggests that theacademic ideas would also have some influence (H.IIA).

However, a number of factors suggest that politicians would stick to the status quo.
First, the federal political system and bicameral parliament lead to a high number ofchecks and balances in the passing of legislation (C.I). Canada's conservative politicians
have no incentive to 'tie their hands' due to the lack of a credible, left-wing alternative in
Canada, strong parliamentary majorities and high levels of political stability (H.IVA,
H.IVC).

Nor did these politicians see any strong incentive to signal their

creditworthiness to international financial markets (H.I).

New Zealand

The case of New Zealand is unique, as it satisfied all four hypotheses for explaining
why politicians should delegate to an independent central bank. The government had astrong need to signal its creditworthiness, due to high debt levels, high budget deficits
and a need for balance of payments financing (H.I). The currency crisis faced by anincoming Labour government reinforced the need to signal creditworthiness (H.I),
provided incentives for a left-wing government with a strong majority to 'tie its hands'(H.IVB) and created the uncertainty that would increase the influence of the epistemic

138

community (H.IIA). The new Finance Minister Douglas has signalled his
willingness to undertake radical reform through his 1980 book, suggesting that hewould champion ideas through the legislative process (H.IIC). New Zealand's
unicameral legislature offered few checks and balances to such a reform (C.I). In
addition, the incoming left-wing government faced a short electoral cycle of three years
that supported a strategy designed to minimise economic risks and maximise thechances of re-election (H.IVD). The financial sector displayed only intermediate levelsof lobbying effectiveness and faced a conflict of interest as the central bank was
responsible for banking supervision (H.IIIA). The unions were in a weak position to
influence politicians on this issue (H.IIIC).

United Kingdom

The UK, like Australia, presents a mixed picture. UK politicians had no strong incentive
to signal their creditworthiness to international capital markets, due to a falling debt
levels and an external account that was relatively balanced over the 1980s (H.I).
However, the lack of credibility of the exchange rate peg led to the ERM crisis in 1992,
suggesting that international financial markets were not convinced of the government's
commitment. This event, combined with the increased uncertainty o f a floatingexchange rate, should have increased the influence of supporters of this reform (H.II).
The financial sector in the City was in a strong position than the trade unions to
influence the Conservative government (H.IIIA, H.IIIC). Only the supervisory
framework presented an obstacle to these efforts (H.IIIA). However, Conservative
governments under Thatcher and Major had a strong mandate, a history o f stability, anda long time horizon with no credible threat from either backbenchers or the upper
chamber, suggesting few incentives to delegate (H.IVA). The few checks and balancesin the Westminster system support this view (C.I).

139
Summary of Predicted Outcomes

In summary, this review of explanatory variables suggests that only New Zealandpoliticians faced clear incentives to delegate to the central bank. On balance, Canada
and the UK should have pursued this institutional reform if Posen's financial sector
lobbying hypothesis is valid. The outcome of the Australian case cannot be easily
predicted, although effective opposition of the unions is likely to have influenced a leftwing government not to introduce this reform.
Table 35: Predicted Outcome for the Case Studies
Country

Prediction

Australia

Mixed, favouring status quo

CanadaMixed, favour central bank independence

New Zealand

Strongly in favour o f central bank independence

United Kingdom

Mixed, favouring central bank independence

Ch. 5 Reserve Bank of New Zealand: Financial Crisis as a
Catalyst for Reform

In 1989, a Labour government in New Zealand introduced legislation that overhauled
the framework for monetary policy by giving the Reserve Bank of New Zealand(“RBNZ”) operational independence in the setting of interest rates.1 As a result o f thislegislation, New Zealand went from having one of the most politically controlled central
banks to one of the most independent. The institutional design was revolutionary,
incorporating both a contract between the between the government and the RBNZ
Governor and a formal inflation target - both innovations that had not been seenelsewhere. The legislation was introduced following a successful disinflation, at a time

1 The RBNZ was founded in 1933 then nationalised in 1936 by the Labour government (Capie,
Goodhart, Fischer et al. 1994, p.203).

140

when New Zealand’s public finances were on the road to recovery from a positionof economic crisis during the early 1980s.

This situation suggests a number of puzzles for the study of central bank independence.
First, why was a Labour government with a strong majority willing to tie its hands bydelegating control of interest rates to the central bank? Second, how did New Zealandsettle on this institutional framework, which was not based on any existing central bankmodels and was ahead of the state of the economic paradigm, particularly the researchon central bank independence and inflation targeting? Finally, how do we explain thetiming of this reform, which was introduced after a financial crisis had passed andinflation had been brought down, at the end of the Labour government’s second term?

The chapter will proceed as follows. The first section reviews the features of the newlegislation, comparing the degree of independence of the RBNZ before and after 1989.
The second section places central bank reform in the context of the wider economic
reforms introduced by the Labour government under Finance Minister Roger Douglas.
The third section reviews the drafting of the act, and considers the influences on theinstitutional design. It then reviews the subsequent political debates after the plans toreform the RBNZ were made public in 1988. The fourth section analyses the 1989
reform from the point of view of the four hypotheses put forward by the literature. The
fifth section concludes by demonstrating how RBNZ independence was heavily
influenced by the literature on time inconsistency and was designed to 'tie the hands' ofpoliticians to prevent partisan interference with monetary policy.

5.1 Overview o f RBNZ Act 1989

The Reserve Bank o f New Zealand Act 1989 (“RBNZ Act 1989”) was introduced into
Parliament in May 1989 by the Labour government o f Prime Minister Lange, which had

141been re-elected for a second 3-year term in August 1987. The Act came into force inFebruary 1990, shortly before the opposition National Party was elected in October1990. The RBNZ Act 1989 radically reformed the institutional framework for the
conduct of monetary policy, introducing three main changes relating to objectives,
accountability, and transparency.

Objectives

The Act had two main objectives. First, it gave the RBNZ operational independence inthe setting of monetary policy with a single objective of price stability. Under the RBNZ
Act 1964, monetary policy had been decided by the government, on the advice of thecentral bank, and was “directed towards the maintenance and promotion of economic
and social welfare, having regard to the desirability of promoting the highest level ofproduction and trade and full employment, and of maintaining a stable internal pricelevel” (Lloyd 1992, p.208). These incompatible objectives left the door open for thepolitical manipulation of interest rates, and led to a stop-go policy resulting in highlevels of inflation and poor economic performance typical of a political business cycle(Nordhaus 1975, Wood 1994). The RBNZ Act 1989 gave the central bank a single
objective “of achieving and maintaining stability in the general level of prices”(RBNZ
1990b, section 8). Explicit policy targets for price stability were set out in a separate
Policy Targets Agreement (“PTA”) agreed between the Minister of Finance and the
RBNZ Governor. The first PTA signed in March 1990 set a target of achieving inflation
between 0 to 2 percent by December 1992, making New Zealand the first country tohave a formal inflation target (Lloyd 1992, p.211; Bemanke et al. 1999).3 Each PTA
must be published and tabled before Parliament, and specifies the assumptions

2 The objectives in the RBNZ Act had been changed four times in 1936, 1950, 1960 and 1973 (Wood1994).
3 While the current PTA specifies an inflation target, the RBNZ Act 1989 leaves open the possibility of
specifying other targets in future (Lloyd 1992, p.213).

142

underlying the policy targets as well as the shocks that may cause inflation todeviate in the short term (Dawe 1990, p.33).4 Notably, the new Act did not set specificlegal limits on the central bank’s ability to finance the government (Wood 1994, p.65).5

Second, the RBNZ Act 1989 gave the central bank stronger but narrower powers ofbanking supervision. The RBNZ’s responsibilities were reduced to only registeredbanks, and the use of the term ‘bank’ was restricted. The RBNZ remained the lender-oflast-resort for the banking system, but only registered banks could qualify forassistance. These change led many non-bank financial institutions to register as banks,
bringing them under the new supervisory regime.

Accountability

Section 11 o f the RBNZ Act 1989 holds the Governor responsible for achieving the
inflation targets set out in the PTA. The Minister of Finance appoints the Governor to a
5-year, renewable term on the recommendation of the RBNZ Board. The Governor canbe replaced for failure to deliver on the agreement, for unsatisfactory performance, orfor a failure to sign a new PTA within one month of a formal override of the pricestability objective (Lloyd 1992, p.215). This framework was designed to create personalaccountability, as the RBNZ Act 1964 had created a situation where no individual could
be called to account for the RBNZ’s performance (Dawe 1990, p.30). This arrangement,
however, does not relieve the Governor of the responsibility to consult with thegovernment over the conduct of policy as required under Section 10 of the Act (Lloyd
1992, p.210). Under Section 12, the government has the power to issue a directive to the
RBNZ by passing an Order in Council that must be tabled in Parliament. Such a

4 The price index used for the inflation target is designed to measure underlying inflation, and thus
excludes supply shocks, changes in energy and commodity prices, and indirect taxes (Bemanke et al.
1999, p.87).
5 While leaving open the possibility of debt monetization, such a restriction was believed unnecessary due
to the government’s commitment to fully fund its budget deficits.

143

directive may be valid for up to 12 months, and would override any PTA. The
directive ensures that ultimate accountability for monetary policy remains with elected
politicians. It also ensures any actions taken by politicians to interfere with the RBNZ
are made public.

As part o f the Act, the RBNZ Board lost its policy-making role and became thegovernment’s agent, responsible for monitoring the Governor and the conduct ofmonetary policy (Lloyd 1992, p.214).6 The Board therefore replaced the role of theTreasury Secretary, who formerly sat as an ex-officio member on the policy-making
Board under the old legislation. Finally, the RBNZ Act 1989 deprived the central bankof the automatic right to the seignorage. Instead the Governor is required to negotiate
five-year funding agreements with the Minister of Finance, which are frozen over thisperiod (Brash 1996b).

T ransparency

Under the old legislation, the government could direct the RBNZ to aim monetary
policy at different objectives, without the public’s knowledge (Dawe 1990, p.30). This
lack of transparency is seen as the main cause for the lack of credibility of the oldframework and the resulting high level of inflationary expectations. A principal concernof the RBNZ Act 1989 was to increase the transparency of monetary policy in order tomake it more credible with the public and the financial markets. The focus is therefore
on disclosure. The RBNZ is required to publish a semi-annual policy statement and anannual report, both of which are tabled in Parliament. The Governor is required to give
regular testimony to a Parliamentary Committee, the Finance and Expenditure
Committee. Other features designed to increase transparency are the stipulation of a

6 The new Board has between seven to ten directors: the Governor, either one or two Deputy Governors,
and between four to seven non-executive directors appointed by the government (Lloyd 1992, p.214).

144

single objective, the use of an inflation target, the requirement to publish the PTA
and the requirement to publish any government directive.
Table 36: Comparison of RBNZ Independence
RBNZ Act 1964

RBNZ Act 1989

5

5

Executive

Executive

Board

Governor

Voting members

51

Appointed by

Executive

Executive% Appointed by govt.

100 %

100 %

Govt, officials on body1 (voting)

None

Statutory objective (s)Stable prices, maximum
output and employment

Stability in the generallevel o f prices

Who takes the final decision on monetary
policy?

Joint between Board andExecutive

Governor

Does the government have the right to instruct
the central bank?

n.a. (Government
sets policy)

Yes, by Order-in-council
laid before Parliament.

Are there legal provisions in case o f conflicts
between the Board and the government?

n.a.

Yes

Can the government borrow from thecentral bank?

Yes

Yes

Does the central bank participate in the
primary market for government debt?

Yes

Yes

Yes, registered banks &‘specified entities’.

Yes, registered banks
only.

Governor Term (years)
Appointed by
Decision making body

Does the central bank have responsibility forthe supervision o f the financial system?

5.2 Background to Central Bank Reform
Econom ic U nderperform ance

The RBNZ Act 1989 represented the final step in a widespread program of economic
reforms introduced by the Labour government between 1984 and 1990. Central bankreform cannot be properly understood in isolation from this wider programme, which
has been labelled 'Rogemomics' after its chief protagonist, Finance Minister Roger
Douglas. The RBNZ Act 1989 and Rogemomics were a direct response to New
Zealand’s chronic economic underperformance over the post-war era, particularly
during the two decades to the mid-1980s (Bemanke et al. 1999; Douglas et al. 1987;
Lloyd 1992; Scott 1996). This economic underperformance was visible in the level of

145

inflation, GDP growth, the employment record, the government’s finances, and debt
levels. First, inflation averaged almost 12% per year over the 1970s and 1980s, as New
Zealand developed a seemingly entrenched tendency towards high inflation (Lloyd
1992, p.205). Second, New Zealand had one of the slowest rates of GDP growth in theOECD, with growth between 1976 and 1984 totalling only 1.15 per cent annually(Lloyd 1992, p.205; Scott 1996, p.7). New Zealand’s per capita GDP growth averaged
0.3 per cent per annum, compared with the OECD average of 2.0 per cent, so that New
Zealand's relative ranking based on GDP per capita declined from fifth in the world in
the 1950s to twentieth by the 1980s (Scott 1996, p.6; Spencer et al. 1988, p.7).
Table 37: New Zealand Economic Underperformance, 1975-1985
Year

New
Zealand

Australia

USA

Germany

Japan

97
81
82

99
95
95

137
134
134

96
100
98

93
89
96

0.4
3.3
4.3

4.8
6.0
8.2

8.3
7.0
7.1

3.6
2.9
7.1

1.9
2.0
2.6

GDP per head 1
1975
1980
1985
Unemployment (%)
1975
1980
1985
Inflation (%)
9.2
6.0
11.8
1975
14.9
15.0
8.0
13.5
5.5
1980
10.2
17.3
2.1
2.0
1985
3.5
15.5
6.7
1. Expressed in 1991 purchasing power parity equivalents, with the average OECD countries =100.
Source: Lloyd (1992)

Third, unemployment began to rise rapidly from negligible levels in the 1960s to 5 percent in the late 1970s, finally reaching 7 per cent by 1983 (Scott 1996, p.7). Fourth, thegovernment faced persistent balance of payments deficits and rising fiscal deficits,
arising from a stop-go policy that amplified the business cycle. The current accountdeficit averaged 4.8 per cent of GDP, compared with an OECD average of 0.3 per centfor the same period (Spencer et al. 1988, p.7). The budget deficit reached 9 per cent of
GDP in 1982. Fifth, government deficits were funded by an increase in both external

146

and internal debt. Gross public and private sector debt rose from 11 per cent o f GDP
in 1974 to 95 per cent in 1984 (Evans et al 1996).7 New Zealand’s credit rating wasdowngraded as international confidence in the economy eroded (Brash 1996b).

Figure 5: New Zealand Inflation and Unemployment Record
12.0
CPI
16.0

U n e m p lo y m e n t

10.0
14.0

12.0

8.0

10.0
6.0
8.0

6.0

4 .0

4 .0

2.0
2.0

0.0

0.0
O

T-

CM

CO

Tf

m

CO

O

O

<r-

CM

CO

co

o>

cm

co

Tf

m

co

co

Table 38: New Zealand Gross and Net Public Debt
NZSmlnForeign Gross
Debt as % GDP

Total Gross
Debt % GDP

Foreign Net
Debt as % GDP

Total Net Debt
as % GDP

1983

23%

56%

20%

27%

1984

21%

57%

19%

29%

1985

28%

63%

25%

36%

1986

28%

61%

26%

37%

1987

36%

71%

26%

43%

1988

26%

59%

19%

39%

1989

24%

57%

19%

43%

1990

28%

61%

22%

49%

Source: NZ Treasury, OECD

7 Failure of the Muldoon government’s large energy-related industrial projects added NZ$ 7 billion worthof debt alone, equal to 10 per cent of GDP (Scott 1996, p.6).

147

The National party elected under Prime Minister Muldoon in 1975, and re-elected in
1978, must bear the responsibility for most of these economic problems. After failing tonegotiate an incomes policy with New Zealand’s powerful trade unions, the National
government legislated a total freeze on prices and incomes in 1982 in an attempt to stop
inflation that reached 15 per cent that year (Scott 1996). Prime Minister Muldoon, who
also served as Finance Minister, responded with a program of massive government
intervention and control of the economy. Wages, prices, dividends, rents, interest rates
and foreign exchange transactions were all regulated. Direct govemment-ownership
industry increased, reaching 12 per cent of total economic activity, with the government
providing goods and services below cost pushing up the deficit. Extensive licenses,
tariffs and subsidies were used to protect domestic industries, and to protect key interest
groups such as farmers and manufacturers.

This protectionism, combined with monetary, fiscal and income policies to control
inflation, led to a misalignment of the exchange rate that undermined the tradable
sector. Capital markets were distorted by controls on the financial sector intended tochannel savings into the public sector. Financial institutions were forced to holdgovernment bonds at below-market interest rates and pension funds were restricted toholding government bonds. As former Treasurer Scott recalls: “New Zealand’s reform
program...began in 1984 from a situation in which government interventions andcontrols in the economy were more pervasive and rigid than in any other developed
economy. The regime o f controls was parallel in significant respects to the control
regions in Eastern Europe” (Scott 1996, p.5).

R ogem om ics

The introduction of economic reforms following the 1984 election of the New Zealand
Labour Party (“NZLP”) would not have been accomplished without the leadership of

148

Finance Minister Douglas, who is widely seen as driving the reform process fromhis power-base within the Labour Cabinet (Easton 1989; Jesson 1989; Scott 1996).
Douglas believed in the need for fast and comprehensive action, as opposed to gradualand piecemeal reform (Douglas 1993). He rejected the conventional view that reform
could succeed only if political support for it has been established beforehand, which hefelt merely compromised the quality of the reforms, thus adding to their eventual costand sowing the seeds of opposition (Brash 1996b). Instead reform should advance inquantum leaps, which do not give interest groups time to mobilise and drag the process
down. “Consensus among interest groups on quality decisions rarely, if ever, arises
before they are made and implemented. It develops after they are taken, as the decisionsdeliver satisfactory results to the public” (Douglas 1993, p.218). Rapid reform retained
the initiative in the hands of government and confounded the efforts of vested interests
to coalesce against further reform. The nature of political institutions in New Zealandand dynamics of the NZLP caucus made this type of reform process possible as theunitary legislature and first-past-the-post electoral rules offered few checks and balances(Bollard 1994; Goldfinch 2000; Nagel 1997; Schwartz 1994, p.546).

Rogemomics took shape prior to 1983 while the NZLP was in opposition. Douglas put
together an ‘Economic Policy Package’ with the assistance of Doug Andrew, theTreasury official seconded to the Opposition, and Geoff Swier, an economist in theQ

Opposition Research Unit (Douglas et al. 1987, p.30). The package reflected many of
the ideas that Douglas had elaborated in his 1980 Alternative Budget, which had been
published as the pamphlet There’s Got to Be a Better Way (Douglas et al. 1987, p. 16).
The reforms were free market-oriented and included a proposal to devalue the currency

8 Doug Andrew had worked in the Economics Department of Auckland University, before joining theTreasury and spending time at the World Bank (Jesson 1996, p.60). While seconded to the Opposition,

149

by 20%, followed by a tight monetary policy, tax reform and the dismantling oftrade protectionism. The paper “prescribed a firm monetary stance and the need tosignal that intention very clearly to the business and financial community, to minimise
any uncertainty about the economic climate a Labour government would create”(Douglas et al. 1987, p.33). At this point in time, institutional reform of the RBNZ was
not on the agenda.

This Economic Policy Package was submitted to the NZLP Policy Council in
November 1983. The package faced resistance from the left-wing within the party, as
well as the trade unions. Opposition leader David Lange assured these groups that a
Labour government had no such plans for radical reform (Jesson 1989, p.65). A watereddown version of the Economic Policy Package became the NZLP’s 1984 economic
manifesto. Douglas later concluded: “[For] anyone who had read that first document,
there were no surprises in the actions taken by the Labour government after its election.
The total programme had been spelled out in detail in advance...[Everyone] now knew
clearly what I intended to do if I became Minister of Finance” (Douglas et al. 1987,p.38).

Overview of Econom ic Reforms

In June 1984, Prime Minister Muldoon called a snap-election. During the month-longelection campaign, speculation mounted against the currency with the RBNZ selling as
much foreign exchange as it would normally have sold in one year (Deane 1985).9 New
Zealand has a history of runs on the currency prior to elections, but the situation wasmade worse in 1984 by the knowledge that Douglas was in favour of devaluation

Andrew had no contact with his Treasury colleagues. Source: Interview with Doug Andrew, 24 August
2001 .

9 Total spot sales of foreign exchange during the four-week election campaign reached NZ$1.39 billion,leaving liquid reserves at NZ$929 million - insufficient to cover the NZ$1.48 billion of forward exchange
rate commitments (Gustafson 2000, p.388)

150(Douglas et al. 1987, p.42; Gustafson 2000; Margaritis 1992, p.8). The RBNZ and
the Treasury had also been calling for devaluation since December 1982, which
Muldoon steadfastly refused (Gustafson 2000). The end of a two-year wage and pricefreeze in February 1984, combined with loose fiscal and monetary policies, added to the
speculative pressures. Speculators were offered a one-way bet against the currency, with
the inevitable outcome. The massive defeat of the National government triggered thecurrency crisis, forcing the RBNZ to suspend trading in foreign exchange for several
days.10The currency crisis forced the incoming Labour government to abandon many of its
election promises (Scott 1996, p.6). It also provided a window of opportunity for
Douglas to push forward with his preferred neo-liberal reforms. “The extremity o f thecurrency situation presented an opportunity which I doubt our political opponents
recognised... The foreign exchange crisis brought with it the chance to introducechange more quickly” (Douglas et al. 1987, p. 136). On the advice of the Treasury and
RBNZ, Douglas devalued the exchange rate by 20 per cent, removed all interest rate
controls and imposed a three-month wage and price freeze. These changes bought the
new government some breathing space from financial market pressures, but createdmomentum for the reform program (Deane 1985, p.3).

Following the election and the currency crisis, the New Zealand Treasury briefed theincoming Labour government on the many pressing problems that faced them, not least
chronic budget and balance of payment deficits and a large external debt. The Treasury- under the leadership of Graham Scott - had been preparing an economic reform
package for some time, and was able to present the new government with a151

comprehensive road-map, covering all areas of the economy. These proposals werein line with the recommendations reached by Douglas and his team in the Economic
Policy Package. Douglas made the 352 pages of briefings public, which saw their
publication under the title Economic Management 1984. The Treasury briefings weresignificant for influencing the direction taken, as they laid out a detailed strategy at atime when the new Labour government was coming to terms with the shock of thecurrency crisis (Douglas and Cullen 1987).

Following the election, the Labour government held a promised four-day Economic
Summit, modelled on the Australian summit of the previous year (Douglas et al. 1987,
p. 128). The summit was attended by 230 delegates and was run by a steering committeethat included key domestic interest groups - the Federation of Labour, the Combined
State Unions, the Manufacturers’ Association and the Federated Farmers. (Douglas etal. 1987, p.74). Finance Minister Douglas played little part in the summit, leaving thestage to Assistant Finance Minister Caygill, as the consensual approach o f the Summit
did not fit with Douglas’s belief in the pursuit of unilateral policies imposed without
consultation (Goldfinch 2000). Critics later argued that the Summit was an elaborate
attempt at window-dressing (Castles et al. 1996; Douglas et al. 1987, p.82; Easton1989).

Douglas revealed his own neo-liberal plans for reform in the November 1984 Budget.
The reforms outlined a liberalisation of the economy designed to promote greater
government efficiency with greater accountability. The cornerstone was the introductionof a comprehensive Goods and Services Tax (“GST”) of 10 per cent. The budget was
swiftly followed by reforms designed to lay the groundwork for floating the currency.

10 Prime Minister Muldoon’s lack of cooperation with the devaluation has led to the view that New

152

Douglas abolished restrictions on overseas borrowing, deregulated the financial
markets and removed controls on foreign exchange trading. Then in December 1984 heabolished all foreign exchange controls, which effectively made the float of the New
Zealand dollar in March 1985 a foregone conclusion. The main economic reforms
making up Rogemomics are summarised in table 3 below.11
Table 39: Chronology of Economic Reforms, 1984 - 1989
Year

Action

1984

Exchange rate devalued 20 per centRemoval o f controls on interest rates, overseas borrowing and investment
End o f export credit guarantees and other incentives
Abolition o f credit growth guidelines
End o f Wage and price freeze
Deregulation o f foreign exchange trading and removal o f foreign exchange controls

1985

Currency floated
Removal of lending restrictions, reserve ratio requirements, sector lending priorities
Liberalisation o f portfolio investment, foreign direct investment & profit repatriation
Deregulation o f financial services
Removal o f ownership restrictions on financial institutions
Corporate tax reform

1986

Liberalisation o f stock exchange
Introduction o f Goods and Services Tax
Reform o f core government departments under State Sector Act
Introduction o f user fees for government services
Reserve Bank Amendment Act allows unlimited increase in num ber o f banks

1987

Sale o f state-owned enterprises to repay public debt begins
Abolition o f 50 quasi-govemmental and non-governmental agencies
Removal o f tax concessions on savings

1988

Personal income tax reform
Redesign o f public sector accounts under Public Finance Act

1989

RBNZ independence with mandate o f price stability under RBNZ Act 1989
Adoption o f inflation target o f 0 to 2 per centPublic sector reform under Public Finance Act

Source: Scott (1996), Margaritis (1992), Evans et al (1996)

The financial reforms introduced over 1984-1985 paved the way for central bank reformby altering the domestic financial structure. Interest rate and lending controls wereabolished, freeing up the monetary instruments. The government committed to fully

Zealand experienced a constitutional crisis during this period (Evans et al 1996).
11 Comprehensive summaries of the reforms are available in Brash (1996), Evans et al (1996) and Scott(1996).

153

funding its budget through debt issues at market rates, ending the monetization of
deficits and increasing the supply o f government debt. Restrictions on domestic capital
markets were removed allowing these markets to develop. These changes enhanced the
RBNZ’s ability to engage in open market operations and made an autonomousmonetary policy possible.

Figure 6: New Zealand Budget Position
6 .0%

4.0%

2.0%

0.0%

-2 .0 %

^ . 0%
h03

00
00

CD
CO

o

CD

CM
CD

o>

CD

K

CD

00
CD

CD
CD

Financial reforms also had negative side-effects. Deregulation led to a speculative boomin the real estate and equity markets over 1985-1986, funded by international
investment flows and bank credit. The exchange rate appreciated sharply. Inflation roseand unemployment doubled, even as a bubble developed in the asset markets. From late1986, the RBNZ began to tighten monetary policy significantly with the express supportof Finance Minister Douglas. This tightening brought down inflation, albeit with further
increases in unemployment, and massive falls in real and financial asset values. The
global stock market collapse of October 1987 hit the New Zealand economy hard, andled to a significant number of corporate failures (Margaritis 1992, p. 12). This stock

154

market collapse came only weeks after the NZLP had been re-elected to a second 3year term in August 1987.12

As with the 1984 currency crisis, Douglas used the stock market crash to push forwardwith the second phase of economic reforms. While these reforms were influenced by theTreasury’s post-election briefings, Government Management 1987, the Labour
government did not deregulate the labour market despite the urging of the Treasury. The
NZLP's unwillingness to touch this area is explained by New Zealand's 3-year electoral
cycle and the need for the NZLP to carry these voters with them in order to be re­elected to a second term (Evans et al 1996; Nagel 1998). "Labour's commitment tocompulsory unionism and effort to cushion the blows that liberalisation inflicted on
workers and the poor were major reasons for 'botched' sequencing" (Nagel 1994, p.260).

The growing intrusion of the Treasury in social policy, and the realisation by Prime
Minister Lange of the social costs of Rogemomics, led to a confrontation between thePrime Minister and Finance Minister. In December 1987, Douglas’s proposed 23 percent flat rate o f income tax, which Lange publicly declared dead the following month(Castles et al. 1996, p. 16). Despite Lange’s objection, tax reform went forward with thesystem being flattened from three to two steps. The ensuing conflict led Lange todismiss both Douglas and his supporter Prebble from Cabinet at year-end 1988. Lange
was forced to resign in August 1989, after the Labour caucus re-elected Douglas toCabinet (Easton 1989, p. 183). The NZLP went into the 1990 election a divided party
that was adrift between its former left-wing support and its new-found centre-left
support. Not surprisingly, it was routed by the opposition National Party led by Prime

12 The Lange government played a two-level game to win electoral support for its unpopular economic
reforms, using its anti-nuclear policies combined with wage increases in health and education sector tokeep its traditional supporters loyal (Schwartz 1994, p.547).

155

Minister Bolger. Incoming Finance Minister Richardson not only continued thereforms undertaken by Douglas, but introduced fiscal policy and labour market reforms
designed to give monetary policy ‘some friends’ in the fight against inflation.

Intellectual Influences on R ogem om ics

Rogemomics is widely seen as incorporating the ideas of monetarism, neo-classicaltheory, institutional economics and public choice theory (Bollard 1988; Boston and Uhr
1996; Caesar 2000; Goldfinch 2000; Lattimore, Silverstone, and Bollard 1996; Lloyd
1992; Scott 1996).13 Many o f these views originated in the US,

although thecontributors to Bollard (1988) point to influences from the UK, Australia and Canada.14
The Treasury under Graham Scott is seen as a particularly important source of
influence, and one that was highly ideological and pro-market in its views (Jesson 1989,p.42). Publications by Treasury economists such as Cameron, Kerr and Wilkinson
channelled foreign academic theories to politicians, providing the incoming government
with a road-map of reform - best seen in the Treasury briefing papers prepared for theincoming governments in 1984 and 1987 (Easton 1988; Jesson 1989; Schwartz 1994,
p.546). The Treasury’s influence on economic debate was further increased by arequirement in the Cabinet Office Manual that all departmental submissions to the
Cabinet of an economic nature must have the Treasury’s signed endorsement or beaccompanied by a Treasury report (Easton 1989, p.72). This requirement provided theTreasury with an effective veto on economic advice from other areas of government.

13 Jesson (1989) provides a left-wing account of this capture by the Chicago school and the ‘libertarianright’ within the Treasury. Brash (1996) argues that the influence of Chicago School is somewhat
overstated.
14 The University of Canterbury was the home of a group of influential monetarist and Chicago-school
theorists, while a number of key Treasury officials either graduated from US universities or had spenttime at the World Bank (Jesson 1989, p.41).

156
5.3 Design and Political Debate over RBNZ Act 1989

In mid-1986, Finance Minister Douglas initiated the process leading to the RBNZ Act
when he invited RBNZ and Treasury officials "to explore options for reforming theinstitutional structure of monetary policy, with a view to reducing the scope for active
political involvement in monetary policy decision making (Reddell 1999, p.65). As
Governor Brash explains: "[There] was a perception that the previous National Party
Government led by Sir Robert Muldoon had manipulated monetary policy in a very
cynical way for the political benefit of that Government. So one of the requests made to
the Reserve Bank and the Treasury by the Finance Minister of the incoming Labour
Government was to find ways of ‘Muldoon-proofing monetary policy’, so that neveragain could government manipulate monetary policy for political gain."15 Douglas hadin mind the type of independence that existed at the Bundesbank or the Fed, which were
the policy models that New Zealand wished to emulate. By mid-1988, all the significant
institutional issues had been resolved and Douglas announced his intention to introduce
the legislation, which was announced in the 1988 budget.

A key concern of Douglas's economic team was to lift confidence in New Zealand's
economy and its currency by convincing the public that low inflation was going to be
the norm. As former Associate Finance Minister Prebble recalls: "New Zealand had
suffered double digit inflation under Sir Robert Muldoon's National government. MPs
like myself studied inflation. I became convinced that inflation was bad for the workers- wages were always to catch up with inflation and never did. Inflation transferredwealth, particularly to property holders.

Inflation undermined investment in

15 Governor Don Brash, RBNZ Governor, correspondence dated 30 July 2001.

157

employment industries. 16 One reason for the RBNZ Act 1989 was to change thismind set and to reduce inflationary expectations.

Finance Minister Douglas delegated this process to then Associate Finance MinisterPeter Neilson, who supervised RBNZ and Treasury officials in this process.17
Interestingly, the 'autonomy project1 was run on parallel, but distinct, tracks from thedevelopment of the inflation target.18 Neilson's main role was adjudicating between the
Treasury and the RBNZ, as each organisation came up with competing frameworks thatwere fundamentally incompatible. The RBNZ was very focused on a "independent
central banking" model while the Treasury focussed on an "accountable public sector
agency" model.19 The different academic influences and policy experiences o f the twoorganisations explain these contrasting approaches taken, as seen below. The framework
finally agreed represented a compromise between the two positions, combining theTreasury's principal-agent model with the RBNZ's independence with an inflation
target.
Design of Central Bank Reform

The actual drafting of the RBNZ bill was completed by the RBNZ itself, under a teamled by Assistant Governor Peter Nicholl along with two RBNZ officials, Steven Daweand Arthur Grimes. This team prepared all the policy documents, drafted the legislation,
and wrote the accompanying Cabinet papers and ministerial speeches. In the words ofDawe, they were responsible for "putting the economic theory/jargon into legal jargon".
This work took place at the same time as wider public sector reforms, which led to the

16 The Hon. Richard Prebble, former Associate Minister of Finance , correspondence dated 2 August
2001 .

17Neilson had been a professional economist in the Department of Labour before going into Parliament in
1981.
18 Reddell (1999) provides a comprehensive discussion of the development of the inflation target.
19 Material in this section is drawn from discussions with present and former RBNZ and Treasury
officials as well as their external advisers.

158

State Sector Act and Public Finance Act. Grimes admits that the RBNZ officials
were largely ignorant of the specifics of these other reforms but were aware of thegeneral thrust. The RBNZ team therefore recognised the need to establish a frameworkwith clear objectives, clear monitoring and clear accountability structures. But the
RBNZ team did not set out to consciously 'mimic' the other public finance reforms.
Instead the primary focus was on making the RBNZ independent, a view was shared by
Douglas.

A Treasury team, led by Howard Fancy of the macroeconomic policy area, held intense
debates with the RBNZ team throughout 1986 and 1987. A second key participant was
Paul Atkinson, an OECD official who was seconded as manager of the Treasury’s
macroeconomic policy over this period. Due to the Treasury's position as chief architectof on-going state sector reforms, Treasury officials were much more cognisant o f theneed to fit RBNZ reform into this wider context. Treasury officials were preoccupied
with the idea of trying to find an output-based measure by which they could assess
RBNZ performance to ensure accountability. The Treasury considered it inappropriatethat the RBNZ target inflation directly, as this target was an "outcome" not an "output"
for which the RBNZ could be directly accountable. The Treasury's focus on output
measures led to a flirtation with monetary base control, as well as a suggestion to divide
the RBNZ into two departments - an Issue department and a Banking department - sothat note issue could be used as an output target.

Intellectual Influences on the Design

Even today, RBNZ officials disagree on the primary influences on the institutional
design o f the RBNZ Act 1989. One view points to the influence of the economics
literature on time inconsistency while another view looks to the principal-agent
literature. The impact o f the former can be seen in the wish to have an independent159

central bank, as protection against inflation-prone politicians, whereas principalagent theory points to the contracting model wherein the Governor is held personallyresponsible for results. The time inconsistency view was introduced by Grimes, who
had returned to the RBNZ in 1987 having completed a PhD in monetary theory at the
London School of Economics.20 Grimes was deputy head of the Economics Department,
and worked on the details of the RBNZ Act 1989 over the next three years. In early
1987, Grimes drafted a seven-page memorandum summarising the key findings fromthe time inconsistency literature that was debated within the RBNZ. The memo outlined
the work of Kydland and Prescott (1979), Calvo (1979), Barro and Gordon (1983),
Backus and Driffill (1985) and Barro (1986) and provided some worked examples oftime inconsistent policies. The memo featured a long discussion of the importancedeveloping a reputation for credibility in a repeated game. Empirical support for time
inconsistency was evident in the failure of inflation expectations in New Zealand tocome down. In New Zealand, year-ahead inflation expectations were 14.1 per cent and10 per cent, respectively, in March 1987 and March 1988, while actual inflation in these
periods turned out to be 7.4 per cent and 4.1 per cent, respectively (Grimes 1996,
p.256).

Missing from Grimes's memo is any discussion of central bank independence as analternative to reputation. While the empirical work supporting central bankindependence was not widely developed in the economics literature at this point,
practitioners were very familiar with the concepts and studied the existing institutionalmodels. Governor Brash notes: "Prior to the drafting of the RBNZ legislation in 1989,
there was considerable work done by Reserve Bank staff on the various options for

20 At the LSE, Grimes was most influenced by Charles Goodhart, Mervyn King (now Deputy Governor of
the Bank of England), and David Webb. Source: Prof. Arthur Grimes, Victoria University of Wellington,correspondence dated 31 July 2001.

160

independence, and these staff had contact with a number of people both inside New
Zealand and abroad. As you will be aware, the model of central bank independence
which was typical at that time was the Bundesbank model, also exemplified by the
Swiss National Bank and the Federal Reserve, where the central bank has both
instrument independence and a substantial measure o f goal independence". These
central banks provided a number of features that were emulated in the design of the
RBNZ Act 1989.

Grimes recalls that the idea to have a legally independent RBNZ with a single objectiveof price stability came up in discussion with the RBNZ economics group, following aninternal seminar on time inconsistency. The officials present had been debating how it
was not credible for one institution to be responsible for two policy objectives, such as
inflation and employment. Instead the suggestion was made to have a single institution
with one policy instrument pursue a single objective. This solution led to theinstitutional design based on an inflation target, similar to the statutory single targets at
the independent Bundesbank and Swiss National Bank. What was novel about thissolution was to link accountability formally to a specific numerical inflation target.
When presented with this idea, Treasury officials objected to the inflation target as it
was not strictly an output. Discussions between the two organisations delayed thedrafting of the RBNZ bill by a year while the two groups fought out their differences.

Visiting academics and central bankers also influenced the RBNZ's thinking. However,external economic advisers did not play a role in determining the fundamental
institutional design. The RBNZ brought in one economic adviser to act as a 'sounding
board', Professor Charles Goodhart of the LSE. Goodhart was invited to New Zealand in1987 and asked to comment on the RBNZ's blueprint o f the policy framework, although

161

he was not involved in the specific drafting.21 Goodhart was asked to critique the
RBNZ's proposals internally before they were debated externally with the Treasury.22
The RBNZ arranged for Professor Goodhart to return in 1989 while the bill was before
parliament to act as an "expert witness" in the Committee hearings on the legislation. At
the Treasury, Atkinson arranged to bring in an external adviser, Professor Geoffrey
Wood of City University Business School, who provided advice on monetarist issues.

Domestically, the RBNZ team ran their proposals past Roderick Deane, a former RBNZ
Deputy Governor who left this position to become Head of the Public Service in 1986
(among other positions), and Professor Frank Holmes of Victoria University, who had
worked as the Head of the New Zealand Planning Council. Otherwise domestic
academics had no constructive influence on the RBNZ design. In fact, the RBNZ bill
was opposed by “nearly all New Zealand university academics, economists and politicalscientists alike” (Caesar 2000). Keynesian-oriented economists and political scientists
such as Dalziel, Easton, Kelsey and Whitwell were vocal critics of the RBNZ'smonetary policies over this period, and were opposed to the bill when it was debated
before parliament (Dalziel 1989; Easton 1989; Kelsey 1996; Whitwell 1990). Professor
Dalziel comments: "It was academic economists (including myself) who were loudest in
pointing out the dangers of independence... In official submissions to the hearings on
the Reserve Bank Bill, the Reserve Bank was very critical of academic economists forthis reason".23

21 Charles Goodhart had a longstanding relationship with the Bank, having been the guest public lecturer
at the RBNZ's 50th anniversary celebrations in 1984.
22 One idea that Goodhart originated, that was subsequently rejected as politically infeasible, was the
proposal of tying the Governor's salary to the inflation performance. Walsh (1995) later picked up thisidea.
23 Professor Paul Dalziel, University of Canterbury, correspondence dated 17 August 2001.

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Political Influences on the RBNZ Act 1989

Far from leaving all the detail to civil servants, politicians played a key role in three
aspects of the institutional design. Finance Minister Douglas provided the initial
impetus for RBNZ independence. While Douglas may not have read the time
inconsistency or principal-agent literature, these ideas were at the heart of his own
thinking. For his part, Associate Finance Minister Neilson played a very active role inshaping the final institutional design. Neilson was responsible for deciding that the
Policy Targets Agreement would be expressed in terms of an inflation objective, as
opposed to the Treasury's recommendation to use an 'output' measure and the RBNZ'spreference for no structure at all. And Neilson - together with Douglas - decided on the
single decision maker structure to ensure greater accountability, siding with theTreasury perspective that it was possible to 'sack' one person, but hard to sack a whole
Board. Finally the Treasury played a major role in determining the accountability
framework that was adopted. The Treasury was able to impose restrictive funding
provisions, whereby the Governor must negotiate the central bank's operating budget,albeit on a five-yearly basis, with the Minister of Finance.

Political D ebate over the Bill

The NZLP’s intention to give the RBNZ independence was first announced by Finance
Minister Douglas in the 1988 Budget Statement, with the legislation to enact this reform
being introduced into Parliament in May 1989 and becoming effective in February
1990. By December 1988 Douglas had left the Cabinet, leaving newly-appointed
Finance Minister Caygill to steer the legislation through the House.

The Act wascontroversial, particularly the adoption of an inflation target of 0 to 2 per cent whenunemployment was approaching double digits. In his introduction of the RBNZ bill(later the RBNZ Act 1989), Finance Minister Caygill set out the objectives for thesereforms:

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The Bill is significant. It implements a reform that was announced in the 1988
Budget. It will place the Reserve Bank on a more independent basis to improve thecredibility, consistency, and effectiveness of monetary policy. The Bill is an
important ingredient in the Government's battle to get inflation down and to keep it
down... The Bill places the bank on a more independent, but also more accountable,
legislative basis than at present, while recognising that it is the Government's rightto determine economic policy. Within that constitutional framework the Bill sets theprimary objective for the Reserve Bank's implementation of monetary policy as theachievement and maintenance of price stability. It also provides for the Governmentby Order in Council to substitute alternative economic objectives.24
After the first reading, the bill was sent to the House of Representatives Finance andExpenditure Committee (“the Committee”) for review. The Committee considered 25
submissions and 9 supplementary submissions, and heard 12 hours o f evidence from 19
witnesses.25 Officials from the Reserve Bank provided the Committee with 23 reportson the Bill which the Committee spent a week considering.

Submissions to the Committee revealed disagreement on two main issues: thenarrowing the RBNZ’s statutory objective to the pursuit of price stability, and the
reduction of the RBNZ’s supervisory role to cover only registered banks.26 The Reserve
Bank, the New Zealand Treasury, the Federated Farmers and the New Zealand Business
Roundtable firmly supported the concepts in the bill. A number of groups opposed
legislating a single objective of price stability: the New Zealand Council of Trade
Unions ("NZCTU"), the Manufacturers' Federation, the Public Service Association, theNational Council o f Women and a large group of New Zealand academics. The NZCTU

24 Hansards, 4 May 1989, “RBNZ Bill - Introduction”, Speaker: Hon. David Caygill.
25 Hansards, 12 December 1989, “Report of Committee”, Speaker: Mr. J.R. Sutton.
26 Hansards, 12 December 1989, “Report of Committee”, Speaker: Mr. J.R. Sutton.

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called the focus on price stability “a misguided and dangerous initiative” (Kelsey
1996, p. 163). Professor Dalziel highlighted the risk of hysteresis of unemployment
resulting from an anti-inflation policy, and argued for recognition of the need tocoordinate monetary and income policies in the bill (Kelsey 1996, p. 162). Opponents tothe bill argued to keep the status quo with the RBNZ pursuing multiple objectives
including employment and output growth. A number of witnesses also questioned thewisdom of limiting prudential supervision to registered banks.

In December 1989 the Committee returned the bill to Parliament substantiallyunchanged. Opposition Finance spokesperson Ruth Richardson (later Finance Minister)
convinced the National Party to support the Labour Government's legislation, despite
the continued opposition of Sir Robert Muldoon who called it a 'foolish piece oflegislation' (McLeay 1991, p.87). In December 1989, the RBNZ Act 1989 was passed by
Parliament with the support of government and opposition, without a single vote being
registered against it (Brash 1996b).

27

The degree of political consensus surrounding the RBNZ Act was evident during the
October 1990 election as none of the political parties made any mention of the RBNZ
Act 1989. The National Party won with a large majority, capturing 69% of the seats in
Parliament - the biggest electoral majority since 1935. As promised, bi-partisan support
for the RBNZ Act 1989 continued, although the Policy Target Agreement was
renegotiated with Governor Brash to extend the time horizon for achieving pricestability to December 1993. Finance Minister Richardson continued the reforms,
pushing through the Fiscal Responsibility Act 1994 that laid out the principles of soundgovernment finances. She also introduced long-awaited labour market reform. Both

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reforms were designed to support monetary policy by giving it ‘some friends’ in thefight against inflation.

Econom ic Perform ance Following RBNZ Act 1989

The reforms introduced by the RBNZ Act 1989 had greater economic success, but at thecost o f a disinflation and painful adjustment in early 1990s. Inflation fell faster thananyone expected, reaching 2.1 per cent by September 1991 then remained between 0
and 2 percent until June 1995. Inflationary expectations were also sharply reduced as
seen in long-term bond yields in New Zealand, which were consistently lower thancomparable rates in Australia and the UK. After peaking at 10.9 per cent in September
1991, unemployment fell to 6.2 percent in 1996. From 1993 the economy began torecover strongly with GDP rising by 5.6 percent in 1993 and 6.2 percent in 1994 - thefastest growth rates in the OECD during this two-year period (Brash 1996b). The fiscal
deficit, which reached nearly 7 percent of GDP in budget year 1983/84, was gradually
reduced so that by the 1989/90 budget it was down to just 1.3 percent o f GDP. Net
government debt fell from a peak o f 52 percent of GDP in 1992 to around 33 percent in
1996.

5.4 Explaining Timing and Design

This section looks at the New Zealand reforms from the point of view of the four
hypotheses outlined in chapter 3. These hypotheses are explained in the following order:
lobbying by domestic interest groups, pressure from international financial markets, theideas promoted by an epistemic community and politicians 'tying their hands' forelectoral gains.

27 Two National Party MPs did not attend the vote, Sir Robert Muldoon and one other National Party
opponent who was sick in hospital.

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Interest Group Lobbying

The facts of this case speak for themselves. Central bank independence did not result
from lobbying by domestic interest groups, either in favour or opposed to central bankindependence. While domestic interest groups had proved successful in lobbying the
Muldoon government, they lost all influence with the appointment of Finance Minister
Douglas.

O f the many accounts documenting interest group reactions to Labour's

economic reforms, only a few look at the RBNZ reform in any depth.28 Based on areview o f these works, it is possible to paint a broad picture of the lobbying activity
under the Labour government, in order to demonstrate the limited effectiveness ofinterest group activity during debates on the RBNZ Act 1989.

Douglas was ideologically opposed to what he saw as the rent-seeking activity ofinterest groups, and viewed them as part of the problem (Douglas and Cullen 1987).
Associate Finance Minister Prebble puts it bluntly: "Interest groups, so influential under
Sir Robert Muldoon, had little sway over the Lange government. I rarely met withthem... Their advice was self-serving. It was a waste o f time".
Douglas adopted a ‘crash through’ strategy to economic reform designed to shut interest
groups out of the process. Reform would advance in quantum leaps, not allowinginterest groups time to mobilise to slow the process down (Douglas 1993). Instead
economic policy reform was determined by a small policy community in the Cabinet,
the Treasury, and the Reserve Bank (Bollard 1993; Douglas et al. 1987; Easton 1989;
Goldfinch 2000; Goldfinch et al. 1993; Jesson 1989; Whitwell 1990).30 While interest

28 For general accounts of the economic reforms, see Bollard 1993, Bremer 1993, Castles, Gerritsen, andVowles 1996, Deeks 1992, Easton 1987, Gold 1989, Goldfinch 1998, Jesson 1989, Kelsey 1996, Mulgan
1993, Nagel 1998, Roper 1992, Roper 1993, Whitwell 1990. For discussion of the RBNZ reform, seeDalziel 1993, Evans et al. 1996, Goldfinch 2000, Lawn 1994.
29 The Hon. Richard Prebble, former Associate Minister of Finance , correspondence dated 2 August
2001 .

30 Douglas's key supporters in Cabinet were his Associated Finance Ministers, David Caygill and Richard
Prebble.

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groups in general were ineffective for influencing the economic reforms, the New
Zealand Business Roundtable ("NZBR") is seen as providing valuable support to thereforms, under Director Roger Kerr - one of the authors of Economic Management 1984
- who left the Treasury in 1986 to take up this post.

Apart from Douglas’s disposition against their efforts, interest group lobbying washampered by collective action problems. The associations representing business, thefinancial sector and trade unions suffered from fragmentation, overlapping memberships
and a lack of consensus on policy direction. Business was represented by the Federated
Farmers, the Manufacturers Federation and New Zealand Bankers' Association which
overlapped with the Employers' Federation, on one hand, and industry-wide
associations like the NZBR and the Chambers of Commerce on the other.31 The tradeunions were equally fragmented, represented by the Federation of Labour, theCombined State Unions and the Public Service Association among others (Bray et al.
1996, p.71). The situation improved in 1987 following the merger of the Federation ofLabour with the Combined State Unions to form the NZCTU, but this new association
could not control its affiliated unions.32 None of these groups was represented by a peakassociation capable of speaking with one voice, mitigating its influence in the policy
process.

In addition, the trade unions had no special access to the Labour government. Unions
had weak institutional links with the NZLP. Union affiliates controlled less than half thevotes at the NZLP annual conference, leaving policy formulation in the hands of the

31 Around one-third of the NZBR's members were from the financial sector.
32 A number of blue-collar unions refused to join, leading to the formation of a competing peakorganisation, the Trade Union Federation (Bray et al. 1996, p.79).

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Cabinet.33 The trade unions also had few personal links with the NZLP leadership,
making them an ineffective voice for organised labour (Bray et al. 1996, p.68; Easton etal. 1996, p.35). As a result unions were excluded from the process of policy formation
during the 1980s when Labour was in power (Castles et al. 1996, p. 11).

Business groups were divided over central bank independence. Export-oriented groups
led by the Manufacturers' Federation were opposed to RBNZ independence and anarrow mandate of price stability.34 Their submission to the Committee on the bill wasso critical, that the RBNZ took the unusual step of rebutting these views in a separate
submission to the Committee (Lawn 1994, p.49). By contrast, the Federated Farmers,
the New Zealand Business Roundtable and the financial sector associations endorsed
the proposed changes (NZBR 1989). The trade unions were predictably vocal critics ofcentral bank reform. The NZCTU argued in its submission that the shift to a narrowmandate of price stability was misguided and dangerous as greater independence would
favour a recessionary policy (Kelsey 1996, p. 163). The NZCTU, together with the
Public Service Association and the Service Workers Federation, painted an independent
RBNZ as ‘anti-democratic’. Based on the final outcome, it is clear that the voice oforganised labour was not influential in this debate.

33 In fact, the NZLP had unsuccessfully tried to disaffiliate unions following the 1981 electoral defeat(Bray et al. 1996, p.73).
34 These exporting branches later accused the RBNZ of causing an overvaluation of the New Zealanddollar in 1995, which contributed to the current account deficit (Caesar 2000)

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Table 40: Interest Group
Independence

Submissions to the Committee on RBNZ

In Favour

OpposedReserve Bank of New Zealand
New Zealand Treasury
Federated Farmers
New Zealand Business Roundtable
New Zealand Bankers Association
Financial Services Association
Mortgage Lenders Association

Manufacturers Federation
New Zealand Council of Trade Unions
Public Service Association
Service Workers Federation
National Council of Women

Source: Brash (1996), Kelsey (1996), Lawn (1994)

International Financial M arkets

RBNZ independence may be seen as a reform designed to signal the creditworthiness of
New Zealand to international financial markets. The related argument can be made that
New Zealand's left-wing politicians were pressured to introduce these reforms byinternational creditors who were suspicious of the NZLP's partisan biases. International
financial markets have the ability to sanction policy through two main avenues: pressure
on the exchange rate and the interest premium charged on foreign debt. An examinationo f these two channels suggests that the 1984 currency crisis was influential instimulating Finance Minister Douglas’s reform program, but it did not dictate thecontent o f reform or determine the timing of individual reforms. Likewise the cost andsize o f New Zealand foreign debt may have been a significant constraint on thegovernment’s room to manoeuvre, but it did not lead the government to introduce
central bank independence. This reform was designed to send a signal concerning the
NZLP's anti-inflationary credibility, but this signal was directed at a domestic audience
composed largely of actors in the real economy, not the financial one. These arguments
will be developed below.

The 1984 currency crisis is portrayed as a primary source of international pressure thatforced the Labour government to adopt neo-liberal reforms. This position is overstated.
First, it fails to recognise that the source of speculation on the exchange rate is believed

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to have been domestic, not international. New Zealand businesses, banks andcitizens appear to have been the major actors speculating against the currency prior to
the election (Brash 1996a). Floating the currency in 1985 was designed to reduce thissource of pressure, by eliminating the external anchor that served as a focus for
speculation (Deane 1985, p. 14). Second, it is inaccurate to say this policy was forced on
the Labour government. Douglas favoured reform as did the Treasury and the RBNZ.
He took steps to make the currency float inevitable by removing exchange controls,
which then created momentum behind a broader reform process.

The importance of the 1984 currency crisis was as a catalyst for reform. It forced the
public to recognise the need for reform and created an opportunity for a policy
entrepreneur like Douglas to pursue it (Bollard 1994; Goldfinch 2000). Under the
Muldoon government, domestic industries and interest groups had grown accustomed tobeing protected from competition. New Zealand's ’cradle to the grave' welfare system
had led to the same expectation among the public. These arrangement became
increasingly unsustainable during the 1970s and early 1980s, as witnessed by risingpublic debts and budget deficits. Douglas and other reformers within the Treasury andthe RBNZ recognised the need for reform, but this view was not shared within the
NZLP as seen by their reaction to his Economic Policy Package (Douglas and Cullen
1987; Goldfinch 2000, p.88). The currency crisis following the election, accompaniedby the so-called 'constitutional crisis' during the 10-day interregnum, changed the public
mood. It vividly demonstrated to the public and reluctant politicians that New Zealand'sinterventionism and 'cost-plus' economy were no longer viable. Douglas and his
Treasury advisers seized this window of opportunity to push forward with rapid andwidespread deregulation, first announced in the November 1984 budget four months

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after the election. This reform then created its own momentum as discussed in thesection on interest groups.

While the currency crisis was the catalyst for reform, it did not explain the content ofpolicy reform or the timing o f RBNZ independence (Bollard 1994; Goldfinch 2000).
Douglas had outlined his proposals in 1980 in his pamphlet There's Got To Be A Better
Way. Likewise the Treasury had put together 352-pages of post-election briefings
providing a comprehensive economic reform program. These proposals were combinedand determined the substance of Rogemomics. The content of reform was therefore put
together in the years leading up to the 1984 election, not in the weeks following thecurrency crisis. The crisis only gave Douglas the opportunity to pursue his reform
proposals. By the time the RBNZ bill was introduced in 1988, currency pressure was
not a concern as the New Zealand dollar was floating and had appreciated steadily from1985 to 1988.

The second potential channel for international financial market pressure was through
New Zealand's external debt, which was high and rising during the early 1980s, as seen
in table 6. This situation led the rating agencies to downgrade New Zealand’s foreign
currency rating repeatedly between 1983 and 1986. In 1984, New Zealand total
government debt was NZ$ 22 billion or 57% of GDP, of which almost 40% wasborrowed overseas. By 1987 total debt had risen to over 70% of GDP, due to thegovernment assuming the debts from Muldoon’s ‘Think Big’ energy project, of which
50% was borrowed overseas.

Following the 1984 devaluation, the spread on New

Zealand government debt relative to the US increased dramatically from 0.50 per cent toalmost 9.0 per cent by 1986. From this peak it halved to 4.25 percent in 1988. This
incremental cost represented a significant penalty on such a significant debt load.

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Table 41: New Zealand Exposure to International Financial Markets
Year

Exchange rate
per
USD

Total Debt,
Gross(NZ$ bln)

Foreign Debt,
Gross(NZ$ bln)

Total Debt
% of GDP

Foreign Debt Current Account% of GDP
Balance% of GDP

1975

0.8323

4.2

0.9

36%

8%

n.a.

1980

1.0267

10.3

3.6

45%

16%

n.a.

1984

1.7640

21.9

8.2

57%

21%

n.a.

1985

2.0234

45.0

12.4

63%

28%

n.a.

1986

1.9132

52.2

14.7

61%

28%

n.a.

1987

1.6946

59.7

21.7

71%

36%

-5.0%

1988

1.5264

65.9

17.0

59%

26%

-1.0%

1989

1.6722

69.9

16.5

57%

24%

-3.9%

1990

1.6762

72.8

20.6

61%

28%

-3.3%

Source: IMF, New Zealand Debt Management Office, and OECD.

Figure 7: New Zealand Public Sector Debt

80%
□ T otal G r o s s D eb t (% o f G D P)
70%
■ F o r eig n G r o s s D eb t (% o f GD P)
60%

50%

a

Q
2 40%
o

3*

30%

20 %

10%

0%

The size o f the external debt and its associated cost was a significant source of
weakness for the New Zealand government, and one that could not be ignored. Former
RBNZ Deputy Governor Deane recalls:
New Zealand politicians certainly needed to be responsive to international
financial markets at the time o f the 1984 currency crisis and the election, if forno other reason that our overseas borrowing was so huge, our external deficit

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probably the highest in the OECD region relative to GDP, and of course it
coincided with a huge fiscal deficit. In the weeks leading up to the July 1984
Election, we were faced not just with a huge borrowing programme but with anumber of international banks who were either unwilling to lend to us or
proposed to do so on terms which were patently unacceptable and non­commercial, thus giving us a powerful signal about the need to abandon
Muldoon's ‘borrow and hope’ policy.
The cost of foreign borrowing and the downgrades by the rating agencies signalled theneed for economic reform, but they did not dictate the content of economic policy.
International financial markets did, however, change the incentives facing politicians bycharging an interest rate penalty on government borrowing. However, provided New
Zealand politicians were willing to pay this penalty, they retained the ability to pursue
distinctive macroeconomic policies (Garrett 1998; Mosley 2000, Oatley 1999). The
Labour government did pay this penalty in the short run, and so introduced economic
reforms based on domestic political imperatives such as deregulating the financial
markets and traded sector but protecting the labour market from reform. Finance
Minister Douglas also took steps to reduce the external debt by selling state owned
enterprises, introducing a GST and reducing government deficits. By the end of the
1980s the budget was in surplus and total debt was brought down to around 60 per cento f GDP, where it remained until 1994.35 Likewise foreign debt was stabilised andremained constant in absolute terms, but declined as a share o f both GDP and total debt.

35 Following the introduction of the Fiscal Responsibility Act in 1994, the debt declined steadily reaching
38% of GDP in 1998.

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The RBNZ Act 1989 was not designed to signal the government's creditworthiness tointernational capital markets.36 Instead, central bank reform was directed at a domestic
audience and was designed to signal the government's anti-inflationary commitment toprimarily non-fmancial actors. Deane states:
I did not see [international financial markets] as a major pressure point withrespect to the decision to give the Reserve Bank independence in 1989, whicharose much more from the... need to not only reduce inflation but to ensure thatit remained at a sustainably low level in the belief that this would create moresatisfactory conditions to enhance our international competitiveness on the one
hand and our rate of economic growth on the other hand.
Governor Brash agrees, arguing that neither the RBNZ Act 1989 nor the Fiscal
Responsibility Act 1994 were enacted with foreign investors primarily in mind.
However, both pieces of legislation were hugely important for maintaining theconfidence of overseas investors in New Zealand (Brash 1996a).

Ideas of an Epistemic Community

This case study of the RBNZ supports the hypothesis that politicians give independence
to their central banks in response to academic ideas promoted by an epistemic
community o f monetary experts. During the late 1980s, a new paradigm came todominate monetary policy that prescribed delegating to an independent central bankwith a single mandate o f price stability. This paradigm was promoted in New Zealandby an epistemic community located in the RBNZ and the Treasury, and championed
through parliament by Douglas and his supporters. Each of these points will be
addressed in turn.

36 Former Associate Finance Minister Prebble points out that if international financial markets had been
hostile to an independent Reserve Bank, it might not have happened.

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First, the detail of the RBNZ Act 1989 reflected the state of the economic paradigm
circa 1988, particularly the work on time inconsistency and principal-agent problems.
The choice o f price stability as the sole goal of monetary policy reflected the monetarist
view that monetary policy could not affect real variables in the long run. It also reflected
the neo-classical view that delegation to an independent central bank would bolster thegovernment’s anti-inflationary credibility. The literature on principal-agent problems
led to the contracting arrangement agreed between the Governor and the government,
whereby the Governor is held personally responsible for outcomes. During the debate
over the RBNZ bill, Associate Finance Minister Neilson made reference to this new
ideological paradigm. “It appears from the discussion this afternoon that there isconsiderable consensus within this body about the way in which monetary policy, atleast in an institutional framework, should be carried out. I believe that that in partreflects the generation that makes up the composition of the House”. 37

Second, this paradigm was promoted in New Zealand by an epistemic community ofmonetary experts located in the RBNZ and the Treasury.38 Experts at the RBNZ cameup with the main features o f the institutional design and later drafted the legislation.
This design was then debated with the Treasury and a compromise was reached. This
domestic epistemic community actively sought the advice from international experts,
bringing in external advisers from the UK and the OECD, and speaking to officials at
the BIS and other central banks. What is striking about this case is the lack ofinvolvement of New Zealand academics, apart from Professor Holmes of Victoria
University. In fact, most New Zealand academics opposed the reform. The epistemic
community that supported RBNZ independence was therefore transnational in

37 Hansards, 12 December 1989, “Report of Committee”, Speaker: Hon. Peter Neilson.
38 The key officials involved were Dawe, Grimes, Nicholl and Brash at the RBNZ; Scott, Fancy andAtkinson at the Treasury; and former RBNZ Deputy Governor Deane.

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composition, but not all embracing. It was elitist, with its members sharing both anunderstanding of the problem and a prescription for fixing it. The influence of thisepistemic community increased following the 1984 currency crisis and the deregulationof the financial sector, both of which created a high level of uncertainty in the conductof monetary policy over this period.

Third, this policy reform suited the worldview of Finance Minister Douglas and hisdesire to ‘Muldoon-proof monetary policy (Brash 1996b). Political interference ininterest rates was seen as one of the principal causes of New Zealand’s economic
underperformance over the previous two decades. Douglas had made clear his desire to
fix this damage to the New Zealand economy and to see that it could not be repeated(Douglas 1980, Douglas and Cullen 1987). During the debate over the RBNZ bill,
Douglas outlined his view of this reform:
Under the National Government the Reserve Bank was given instructions by the
Minister of Finance [Sir Robert Muldoon] day by day, and that more thananything else was the reason that between 1975 and 1984 New Zealand had an
inflation rate of up to four times that of its trading partners. In the name of socalled fine-tuning the National Government continually interfered with theoperations of the bank between 1975 and 1984, and that interference destroyed
any chance o f achieving price stability. It became well known that monetary
policy would fluctuate with the electoral cycle; that every 3 years there would bea phoney boom that would give the appearance of prosperity, to persuade somepeople to vote for the National Party, irrespective of the costs that were laid on

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the community in the medium term. That is why New Zealand's position
deteriorated so disastrously during that tim e.39
Political business cycles had entrenched inflationary expectations, causing inflation toratchet higher each time as any tightening following an election was never enough toreturn the economy to its previous state, leading to cumulative inflation between 1974
and 1988 of 480 per cent (Brash 1998, p.221). Accordingly, Douglas asked the RBNZ
and the Treasury to look into a framework for this purpose. The RBNZ Act 1989 was theresult. Douglas and later Caygill championed the reform through the legislative process.

Tying the hands

The reasons given by Douglas for pursuing central bank independence are compatible
with the 'tying the hands' hypothesis. Echoing the comments by Douglas, Deputy Prime
Minister Palmer stated:
The vital origins of the Bill have to do with the behaviour of the Minister ofFinance in the National Government. That is the explanation for the Bill, and it
is a matter o f public record. We have only to look at the dispute in early 1984.
There was a public row between the Minister of Finance at the time and theReserve Bank over monetary policy advice that the bank had been giving to that
Minister in the previous 9 months... The advice of the Reserve Bank was
ignored, and the results for the New Zealand economy were disastrous... That isthe essence of the reforms in the Bill.40
The view that independence for the RBNZ would act as a constraint on a future
National Party government suffers from a major weakness. There was nothing to stop a
future National government from reversing the central bank’s independence. The

39 Hansards, 4 May 1989, “Reserve Bank of New Zealand Bill - Introduction”, Speaker: Hon. Roger
Douglas.
40 Hansards, 4 May 1989, “Reserve Bank of New Zealand Bill - Introduction”, Speaker: Rt. Hon.
Geoffrey Palmer.

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unitary political system in New Zealand concentrates power in the hands of theexecutive with no effective checks and balances. In fact the National Party had madesome political suggestions during the debate over the RBNZ Act to amend the RBNZ’s
statute. 41 While these comments were more for public consumption than meant inearnest, the risk of backtracking in the future remained.

Another possibility may be that Douglas saw a need to 'tie the hands' of his own party inorder to prevent Labour opponents of Rogemomics from subsequently undoing hisreforms. Economic reform had won the NZLP few converts, evidenced by rising
unemployment and stalled real GDP growth during its two terms. While voters gave theincumbents the benefit of the doubt during the 1987 election, Labour trailed consistently
in the polls following the stock market crash in October 1987 (McLeay 1991, p.20;
Vowles and Aimer 1993). Under these circumstances, “An increasing number ofministers, caucus and party members, motivated by a mixture of genuine concern andelectoral expediency, sought to slow, stop or even reverse the restructuring process. The
monetarist goal to eliminate inflation, which accepted the side-effects of high interestand high unemployment rates as inevitable, was at particular risk from politicalintervention" (Kelsey 1996, p. 159).

Cracks in the solidarity of the Labour caucus that had been hidden during its first term
began to show during this period.42 Prime Minister Lange had been willing to support
Douglas and his team during the first term, but he grew increasingly concerned with theimpact o f Douglas’s policies on Labour’s traditional supporters. These splits were
exposed in 1988 when Lange forced Douglas and Prebble to resign from Cabinet

41 Hansards, 12 December 1989, “Second Reading of RBNZ bill”, Speaker: Hon. J. Falloon.
42 Strict party discipline had been required in order to keep Cabinet united behind a set of policies thatwere not representative of the party (Boston et al. 1996, p.52; Castles et al. 1996; Jesson 1989).

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before stepping down himself in 1989. The return of Douglas to Cabinet led Jim
Anderton to desert Labour in 1989 to form the New Labour Party, that competed for the
allegiance of left-wing voters in the 1990 election. Douglas and his supporters may haverecognised the credible threat presented by the left-wing within the NZLP to undo his
reforms. It made political sense for Douglas to embed a commitment to fighting
inflation by delegating monetary policy to the RBNZ.

There is a major problem with these explanations for RBNZ independence. First, the'tying the hands' hypothesis as it exists in the literature is based on the assumption thatpoliticians are motivated by the desire to be re-elected. This premise informs both
political science and public choice theories of political behaviour. However, Douglas
and other members o f his faction resigned from the government after the RBNZ Act
1989 was safely through Parliament, and did not contest their seats in the 1990 election(McLeay 1991, p.6).43 They did not wish to be re-elected, removing the main incentive
for this hypothesis. Second, the partisan version of the 'tying the hands' hypothesis
predicts that left-wing governments will introduce these policy reforms upon taking
office, in order to reduce the cost of financing government debt. In the case of New
Zealand, the reform was introduced towards the end of their second term in office, whenelectoral polls indicated that they were clearly behind the opposition. Third, a left-wing
party may have an incentive to introduce this reform to reduce the interest rate penalty
on its borrowing. By the time the RBNZ bill was introduced, New Zealand's total andforeign debt had been reduced substantially, and interest rates were low. So the
incentives for delegation at this point were absent. Finally, the non-partisan version of'tying the hands' is premised on a desire to increase the stability of the Cabinet. Far fromleading to greater Cabinet unity, independence for the RBNZ promoted greater disunity,

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as it was opposed by the trade unions and the left-wing within the NZLP caucus. For
these reasons, it is possible to reject these hypotheses and to accept that Douglas
introduced this reform for ideological reasons.

5.5 Putting it All Together

The accepted view is that RBNZ independence was undertaken primarily for ideologicalreasons. Douglas and his supporters had been convinced by the academic argumentsthat political interference in monetary policy was damaging. Their own experiences
during the 1970s and the 1980s confirmed this view. Former Associate Finance Minister
Prebble puts it this way: "I was also persuaded that Sir Robert's reckless [monetary]creation was the cause of inflation. Prior to the 1984 election I was giving strong
monetarist speeches. It is just wrong that inflation is bad for growth or that soundmoney is not in the interests of those on low and fixed incomes. A prime cause of
inflation is printing money - that's not a left versus right argument - it is an economicfact".

The governmentof Prime Minister Muldoon and its legacy for New Zealand's

economic performance, appears to have shaped the thinking of politicians across thepolitical spectrum. As Goodhart puts it, the left and the right had no more meaning in
New Zealand after Muldoon.44 Studies of voting behaviour over this period confirm theview that traditional support for political parties based on partisanship did not apply
over this period, as the partisan differences between them became blurred (Nagel 1997;
Vowles and Aimer 1993). Traditional National Party supporters among business and thewealthy classes voted against Muldoon in the 1984 election due to his interventionist
policies. Traditional Labour party supporters abandoned the NZLP in the 1987 and 1990

43 In 1994, Douglas formed the Association of Consumers and Taxpayers (Castles et al. 1996, p. 14).
44 Professor Charles Goodhart, LSE, interview 29 August 2001.

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elections, as different groups voted based on their view of Rogemomics and its
impact on social policies.

In this context, the RBNZ Act was not designed to tie the hands of the left or the right.
It was designed to take politics out of monetary policy. As former Deputy Governor
Deane explains: "The paradox [of a left-wing party introducing central bankindependence] was not really a paradox in the context of that time, since the Labour
Government was anxious to pursue a remarkably clean mix of policies based on soundeconomic analysis, one of those windows of opportunity which countries typically getfor only a few years out of every 50 years". A private sector bank economist recalls,"Tying the hands of the National party was not the point. [The RBNZ Act 1989] wasdone for its own sake, as a piece of economic policy. It was simply believed on
ideological grounds to be the best thing to do".45

How do we explain the timing o f this reform, which was introduced in 1988 after afinancial crisis had passed and inflation had been brought down, at the end of theLabour government’s second term? Although the RBNZ bill was not made public until
this point, work had begun on the issue from mid-1986. The debates between the
Treasury and the RBNZ over the institutional design delayed the legislation, as bothsides agreed on a framework that was both independent but accountable. Introduction of
the RBNZ Act was also delayed because politicians were busy with other reforms that
had to take priority, particularly financial sector deregulation 46 Deane explains:
The timing [of the Reserve Bank Act reform] was really determined by thepracticalities of the huge amount of policy reform we were undertaking post the

45 Stephen Toplis, Bank of New Zealand, correspondence dated 6 August 2001.
46 The Hon. Richard Prebble, former Associate Minister of Finance , correspondence dated 2 August
2001 .

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1984 Election, and the issue was how could the major topics be prioritised
and how could the political risks around each of them be minimised. That meantin the financial sector that deregulation ...[was] given higher priority than thereform of the Reserve Bank Act which was regarded as quite a tricky topic
politically and for which considerable scene setting needed to be established by
way of the other reforms.47
Therefore the timing of the bill is not explained by the looming 1990 election, or by thetime frames of politicians. It was due to sequencing of economic reforms which wereneeded in order to make central bank independence viable (Evans et al 1996; Grimes
1996).

In summary, central bank independence resulted from the ideas of an epistemic
community being adopted by an ideological politician who championed them throughthe legislative process. This epistemic community was empowered by the economic
uncertainty that followed financial deregulation and the float of the currency. The
disastrous inflation record, the unsustainable state of New Zealand’s external debts andits decade-long record o f economic underperformance created a public consensus
around the need for reform, but did not dictate the content. This reform is not explainedby signalling creditworthiness to international financial markets or the lobbying ofdomestic interest groups. In fact, this reform was passed against the opposition ofdomestic academics and interest groups representing business and the trade unions.
New Zealand’s political institutions had an important effect on this outcome, as the lack

47 Roderick Deane, former RBNZ Deputy Governor and Head of the Public Service, correspondence
dated 24 August 2001.

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of checks and balances offered few obstacles making radical and unpopular reform
possible.

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Ch. 6 Bank of Canada: The Pursuit of Price Stability
The Bank o f Canada (“BoC”) was founded in 1934 as a privately-owned corporation,then nationalised in 1938, at which time the BoC’s share capital was transferred to the
Finance Minister (BoC 1978). As Canada’s central bank, the BoC has day-to-day
responsibility for the conduct of monetary policy, which the BoC has interpreted tomean the pursuit of price stability.1 The preamble states that the purpose of the BoC is
to regulate credit and currency in the best interests of the economic life of thenation, to control and protect the external value of the national monetary unit
and to mitigate by its influence fluctuations in the general level of production,
trade prices and employment, so far as may be possible with the scope ofmonetary action, and generally to promote the economic and financial welfare of
Canada.
The formal mandate of the BoC appears today an anachronism, providing as it does fora confusing and potentially incompatible array of objectives. This mandate reflected thestate of economic knowledge in the 1930s, but makes the operation o f monetary policyin the modem context less accountable due to the lack of clear objectives.
Operationally, the key policy instrument is a short-term interest rate - the Bank Rate which is set to target a range for inflation jointly agreed by the BoC and the federal
government.2

Despite being outdated, the legislation concerning the governance of the BoC - theBank o f Canada Act - has been changed only once, as a result of the Coyne Affair of

1 The other functions of the Bank of Canada are managing currency in circulation, acting as banker andadvisor to the federal government, and acting as lender of last resort for the banking system.
2 An inflation target was adopted in February 1991 then reaffirmed in 1993, 1997 and 2000.

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1961.3 James Coyne, the second Governor of the BoC, clashed with Conservative
Prime Minister John Diefenbaker over the BoC’s restrictive monetary policy thatconflicted with the expansionist fiscal policy of the government. Diefenbaker foundhimself in a difficult position, being criticised by Coyne in a series of public speeches
but not having the power to fire the Governor who served during ‘good behaviour’ andcould only be dismissed by Parliament, not the executive (Canada 1992, p.9). When
Coyne refused the Finance Minister’s request to resign, Diefenbaker trumped up
accusations concerning the Governor’s pension that questioned Coyne’s integrity.
Diefenbaker then pushed a bill through parliament declaring the Governor’s seat vacant,which went to the opposition controlled Senate for final approval. The Liberals in the
Senate made the most of this scandal, and negotiated a compromise with Coyne
whereby the Governor would have a platform to respond formally to Diefenbaker’s
charges in the Senate. The Senate would then reject the government’s bill in exchange
for Coyne’s resignation. Diefenbaker’s credibility was damaged by this affair, which
contributed to his defeat in the 1963 federal election.

The final chapter to the Coyne Affair was written by the incoming Liberal government
who reformed the Bank o f Canada Act in 1967 to allow a government override ofmonetary policy. In case of a disagreement, the Finance Minister was given theauthority to issue a directive to the BoC Governor, provided the directive was inwriting, in specific terms, applicable for a specified period and published forthwith.
Coyne’s successor as Governor, Louis Rasminsky, made it clear that if a directive were
issued by the Finance Minister, the Governor should resign as a directive would only benecessary if the Governor felt unable in good conscience to carry out the government’s

3 There are a number of interesting and sometimes contrasting accounts of this affair (Canada, 1992 ;Fleming, 1985 ; Howitt 1993; Rymes 1994; Smith 1995).

186

favoured policy.4 No directive has ever been issued, but the new power made clear
the government’s ultimate authority over monetary policy.

The case of the BoC raises four issues for the study of central bank independence. First,
given the trend in central bank independence over the 1990s, it is puzzling that the
BoC’s legal independence and mandate have not been changed since the 1960s. Unlike
most countries, Canada has had a floating exchange rate regime with capital mobility
for most of the post-war period, rendering monetary policy a powerful tool of economic
management. In fact, the government debated changes to the BoC’s legislation in 1991
as part of the debates over Canada’s constitution only to have the proposals dropped.
Why the BoC’s legislation came to be included in the government’s constitutional
reforms is a second puzzle. Nor did the issue of BoC independence go away. It
resurfaced during the 1993 election when the Opposition Liberals openly criticised
Governor Crow’s pursuit of price stability in the face of higher unemployment andsignificant disinflationary costs. Following the Liberal victory, the debate over Crow’s
reappointment became tied up with international financial market fears concerning theCanada’s debt as well as the political instability surrounding Quebec separation. Given
the high foreign ownership of Canadian debt, the government was portrayed as hostage
to international financial markets that supported Governor Crow. Assessing theinfluence o f international financial markets over the government’s decision is a third
issue that will be addressed in this chapter. Finally, this study of the BoC raises thequestion o f whether legal measures of central bank independence matter, or whether
there are alternatives to delegation for achieving anti-inflationary credibility.

4 While this recommendation is generally ascribed to Governor Rasminsky, the proposal was first madeby the BoC’s first Governor, Graham Towers, and reiterated by Governor Coyne in a letter to Finance
Minister Fleming in June 1961 (Canada 1992, p.9; Smith 1995, p.402).

187

The chapter proceeds as follows. The first section assesses the degree of
independence of the Bank of Canada, and provides important background information
on Canadian political and economic institutions. The second section sets the context byreviewing the conduct of monetary policy over this period and the public debates it
aroused over the appropriate framework and objectives for the central bank. The third
section reviews the distributional conflict caused by the governor Crow’s pursuit ofprice stability and reviews the political debates concerning the BoC and its
independence, focussing on the 1991 proposal to change the Bank o f Canada Act andthe 1994 reappointment of Governor Crow. The fourth section assesses the importanceof the outcome of these debates, from the point of view of the four hypotheses put
forward by the literature. The fifth section concludes.

6.1 How Independent is the Bank of Canada?

Academic economists cannot agree on the degree of independence of the Bank of
Canada (table 1). In the literature developing legal indices of central bankindependence, the ranking of the BoC shows the greatest variation among OECDcentral banks after Australia. Bade and Parkin (1988) rank the BoC as one of the morepolitically controlled central banks based on the government’s ultimate control overmonetary policy authority and BoC appointments, a view shared by Eijffinger and
Schaling (1993).5 “The balance between finance ministry and central bank found inFrance and Germany is lacking in Canada, with the finance ministry dominant”(Coleman 1996, p.77). By contrast Grilli et al (1991) argue that the BoC is one of themost independent central banks, in the company of the Bundesbank, the Swiss National

5 This paper was an updated version of a 1978 research report by the same authors (Bade et al. 1978).

188

Bank and the Federal Reserve.6 Cukierman et al (1992) see the BoC as relatively
independent, placing it 7th out of 25 countries.

In support of the view that the BoC is politically controlled, economists highlight the
government’s involvement in appointments and policymaking, and the multiple
objectives of monetary policy. The government appoints the Board of Directors (12 out
of 14 members) who then appoint the Governor and Senior Deputy Governor of the
BoC, subject to cabinet approval. The government has demonstrated its ability tocontrol the Governor’s office, as seen in table 2, by appointing the first Governor,
forcing the second to resign, failing to reappoint the fourth and finally naming a former
Deputy Finance Minister, David Dodge, as the sixth Governor in January 2001. The
Deputy Finance Minister sits as an ex officio member on the BoC Board of Directors
and Executive Committee. The Bank o f Canada Act requires regular consultation
between the Governor and the Finance Minister, which in practice occurs weekly.7
Since 1967, the government has the ability to issue a directive to the BoC in the event of
a disagreement over monetary policy. The BoC has multiple objectives, providing
flexibility in the interpretation of which objective to pursue and making it harder foroutsiders to detect political interference. The BoC is required to present an annual reportto the Finance Minister and the Governor is subject to questioning by the House ofCommons Standing Committee on Finance. The government may seek short-term
advances from the BoC, and can force the BoC to monetize its debts through the debt
management and foreign exchange operations run by the BoC (Laidler et al. 1993,p.44). Finally, the Finance Minister holds the entire share capital issued by the BoC

6 Grilli et al reach this assessment after considering 15 political and economic variables (Grilli et al.
1991).
7 In addition to formal avenues, Laidler (1997) outlines a number of informal links between the BoC andthe Department of Finance.

189

whose annual profits are remitted to the government’s Consolidated Revenue Fund.8
On this basis, researchers conclude, “while the Bank of Canada does have substantial
policy latitude, in the final analysis it is responsible to the Cabinet” (Courchene 1976,
P* 12).
Table 42: Bank of Canada Governors
PeriodGovernor

Professional Background1934- 1954

Graham Towers

Formerly worked at Royal Bank of Canada. Represented
chartered banks on Macmillan Commission.

1955- 1961

James Coyne

Joined BoC’s Research Department in 1938, left thefollowing year and returned in 1944. Named Governor after
11 years.

1961 - 1973

Louis Rasminsky

Worked for League of Nations 1930 until joined BoC’s
Foreign Exchange Board in 1940. Named Governor after 21
years.

1973- 1987

Gerald Bouey

Joined BoC’s Research Department in 1948 fromuniversity. Named Governor after 25 years.

1987- 1994

John Crow

Worked from 1961 as IMF economist at the IMF until
joined BoC’s Research Department in 1973. Named
Governor after 14 years.

1994-2001

Gordon Thiessen

Joined BoC’s Research Department in 1963 fromuniversity. Named Governor after 31 years.

2001 - presentDavid Dodge

Academic and civil servant. Served as Deputy Finance
Minister 1992-1997, and sat on BoC Board. Appointed
Governor in 2001.

Proponents of independence argue that the BoC operates with a large measure of defacto independence, setting interest rates without government interference. The
government has never used its power to direct the BoC nor would it risk the public
controversy if it did. Thus the directive is seen as giving the BoC greater independence(Laidler 1991, p. 13). The government does not directly appoint the Governor or Senior
Deputy Governor, who are selected by the outside directors who themselves serve
overlapping three-year terms. The Governor and Senior Deputy Governor serve longterms - seven years - and hold office during ‘good behaviour’, not at the pleasure of thegovernment, making it difficult for the executive to fire them. The Deputy Finance

8 This section draws on BoC (1978), Canada (1992) and Crow (1993).

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Minister sits as an non-voting member on the BoC Board and Executive Committee,
which are not policy-making bodies of the BoC. The BoC does not require government
approval of public expenditures or the hiring of staff. Finally, the BoC is audited byexternal auditors appointed by the Cabinet, and not by the Auditor General who audits
other government agencies.

The BoC has largely remained neutral in debates about its legal relationship with
politicians. Governor Crow was at pains to avoid the term ‘independence’ in his
discussion of the BoC’s relationship with the government:
You may note that I have not used the popular term “independence” in settingout the issues relating to institutional arrangements. This is because I do not findthe concept of independence a terribly helpful starting point in discussing theseissues. If the notion of independence is not set carefully in context, it can leave
the impression that a central bank can, or should, operate without institutional
constraints. That, of course, cannot be the case. Simply put, in a democraticsociety a central bank has to be accountable in some way to the elected
representatives of the people - the government and/or parliament - for somereasonably clear responsibilities (Crow 1993b, p.27).
A government inquiry enquiry into the role and mandate of the BoC concluded that the
BoC is neither dependent nor independent (Canada 1992). “[In] our own typically
Canadian way, we have evolved a system in which the Bank of Canada is neither totally
independent nor is it totally under the control of the Department o f Finance. The BoC is,
if you like, independent if necessary, but not necessarily independent. This, in essence,is the genius o f the consultation-directive approach” (Canada 1992, p.ix).99 A similar arrangement existed for the Netherlands central bank, although the statute was reformed inorder to comply with the ECB legislation.

191
6.2 Distributional Confiict over 'Zero Inflation'

The Bank of Canada became the subject of political debate following two painful
disinflations that both ended in recession, the first in 1981-82 under Governor Bouey
and the second in 1990-91 under Governor Crow. In both cases, the BoC raised interest
rates to high levels in order to squeeze out inflationary pressures under monetary policy
frameworks considered to be at the vanguard of economic thought - monetary targeting
under Governor Bouey and inflation targeting under Governor Crow. An angry public
and press blamed the BoC for rising unemployment and a slow recovery, which led tocalls to rein in the Governor who was forced publicly to defend the BoC’s actions.
While the government refused to be drawn into the public debate under Governor
Bouey, the BoC’s actions under Governor Crow were seen as beyond its mandate andled to a confrontation between politicians and the Governor. This episode culminated in
the appointment of a new Governor in 1994. These issues will be discussed in greater
detail below.
Crow’s Pursuit of Price Stability

The public controversy surrounding Governor Crow began shortly after he was named
Governor in 1987. Under Governor Crow, the BoC began pursuing price stability more
directly, placing it above other objectives. Crow has joined the BoC’s Research
Department in 1973 from the IMF, where his work on Latin America had demonstrated
the damaging effects of inflation. Governor Crow described the costs of inflation as“pervasive and insidious” (BoC 1991b, p.9). He first made this policy focus clear in the1988 Hanson lecture (Crow 1988).10 In remarks on this topic, Crow is reported to havesaid that no level of inflation is credible and would lead to “a state of confidently held
expectations about the absence of inflation” (Laidler 1997, p.73). His critics interpreted

10 While the pursuit of price stability is closely identified with Governor Crow, it has been among the
BoC’s objectives since its foundation in 1934, and was a source of controversy under Governors Coyne
and Bouey. See Smith (1995) and Howitt (1986).

192

this comment to mean that the Governor would not be satisfied with any level but‘zero inflation’, a phrase that was picked up by the media and academics but was neverused by either Governor Crow or the BoC. Academics warned that the pursuit o f pricestability was “a radical, perhaps even dangerous, notion” (Laidler et al. 1993, p.91).

Figure 8: Canadian Inflation and Unemployment

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Despite Governor Crow’s speech, there were no concrete signs o f a decisive shift in the
BoC’s policy during the months that followed and the BoC itself gave no timetable foraction (Laidler et al. 1993, p.93).11 In fact, the Department o f Finance’s own mediumterm inflation projections continued to exceed the BoC’s projections for three years,
until the inflation target was jointly agreed in February 1991 (Johnson 1990).

Measuring the Costs of Disinflation

The focus on price stability soon embroiled the BoC in public controversy, centring on
the costs of disinflation. The debate concerned who was paying for this painful

11 It is unclear to what extent the contents o f this speech were discussed with the Department o f Finance,
although Laidler and Robson believe this must have been the case (Laidler et al. 1993, p. 123).

193

adjustment and who stood to benefit from price stability. To make the transition
from a high rate to a lower rate of inflation, the economy needed to undergo a period of
disinflation to reduce the excess demand for money. “Experience has shown that it takes
a massive recession to get inflation down even to 3 to 4 percent after several years indouble digits” (Howitt 1986, p.31). The costs of disinflation are captured by thesacrifice ratio, which measures the short-term trade-off between a reduction in inflationand lost output and employment. Canada’s sacrifice ratio is estimated to be 3-to-l - thatis, running the economy at three percentage points below output capacity would reduce
inflation by one percentage point (Laidler et al. 1993, p.22). This sacrifice ratio washigher during the 1990s than in previous disinflations (Ball 1993). This disinflationary
cost is borne disproportionately by different sectors of society.
Debtors will be hurt at the expense of creditors by the unexpected increase in thereal rate of return on debt, and homeowners will suffer at the expense of renters,
as the transition will result in a lower relative price of housing and a lower
relative cost of renting. The young will generally lose at the expense of the old
because of the increased real value of unindexed pension benefits. And, if thetransition is achieved very rapidly, the increased real debt may cause serious
problems of bankruptcy, or even financial collapse (Laidler et al. 1993, p.95).
Not mentioned is re-distribution through the tax system, which in Canada is not indexed
for inflation (York 1990, p.22). Regional-disparities are also evident as the provincial
economies are dependent on different industries, which leads to varying output gaps,
levels of unemployment and sensitivities to interest rates and the exchange rate. The
pursuit o f one monetary policy geared to the manufacturing provinces of Ontario andQuebec therefore pushes many costs of adjustment on the other regions in Canada. Thissituation aggravates the tensions between the Provinces and the federal government.

194

A second concern raised by opponents to ‘zero inflation’ was the possibility ofhysterisis of unemployment, where short-term job losses can become permanent (York1990, p.25).

12

This issue was particularly important in the context of the adoption of theCanada-US Free-Trade Agreement (“FTA”), which was anticipated to cause a structuralchange in Canadian labour markets creating temporary unemployment as workers
switched among industries.13 The risk was that the pursuit of price stability at this pointof structural change would leave many of these workers unemployed, leading to an antiUSA backlash within Canada and pressure for increased protectionism (York 1990,
p .148).

Battle Lines in ‘Zero Inflation’ D ebate

Strong views were expressed on both sides of a debate that lasted from 1989 until 1994.
This debate took place in the press, in academic conferences, in the Governor’s
speeches, and in parliament. On one side stood the monetary policy ‘elite’ that
supported the pursuit of price stability and Crow's reappointment. This coalition
consisted of BoC officials, the Conservative Finance Minister, academic economists,
conservative think tanks, the Business Council on National Issues (“BCNI”)14 and an
epistemic community o f financiers and foreign central bankers. Internally, Governor
Crow’s price stability policy had the support of the intellectual atmosphere within the
BoC, which used its research and its connection with central banks abroad to build
support for the pursuit of price stability. Externally, Canada's two major conservative
think tanks, the CD Howe Institute and the Frasier Institute, supported price stability.
The CD Howe Institute sponsored two major conferences on the debate, and published

12 For example, a worker who is temporarily out of work might become unemployable after some lengthof time due to the loss of job experience and relevant skills, leading to a permanently higher level of
unemployment
13 The FTA had been the focus of an intense political public debate in the late 1980s and the central issue
in the 1988 federal election (Lipsey 1990, p.56).
14 The BCNI is composed of the chief executive officers of 150 leading Canadian corporations
representing every major sector of the Canadian economy.

195

the proceedings as Zero Inflation - The Goal of Price Stability and Taking Aim: The
Debate on Zero Inflation (Lipsey 1990; York 1990). Both conferences were designed toprovide a platform for academic economists to endorse Governor Crow’s independence
and policy stance, offsetting the attacks by his critics (Lipsey 1990, p.v). Governor
Crow also had the support of an epistemic community. Internationally, The Economist
hailed Crow’s performance while Euromoney named commented favourably on the
BoC’s approach. The credit rating agencies and international investment banks alsocommented favourably. Finally, foreign central bankers demonstrated their high regard
for Governor Crow by appointing him chairman of the G-10 committee of central
bankers, the first non-European to hold this post.15

Critics of Crow’s price stability policy far outnumbered its supporters, and represented a
coalition o f monetary policy ‘outsiders’ led by the Canadian media, organised labour, a
few ‘heterodox’ economists, the opposition Liberal Party and the provincial Premiers.
Leading critic Professor Pierre Fortin used his Presidential Address to the Canadian
Economics Association to argue that the BoC’s price stability policy had caused thegreatest employment and output losses since the Great Depression, causing twice thejob losses of the 1982-86 recession (Fortin 1996). The left-of-centre Canadian Centre
for Policy Alternatives sponsored a conference of BoC critics, leading to the publication
Hard money, hard times: why zero inflation hurts Canadians (Fortin et al. 1998). The
contributors noted that the BoC’s price stability policy was not imitated from othercountries, and resulted in a ‘Made in Canada’ recession.
By raising interest rates and thereby engineering a 21 per cent increase in theexchange value o f the Canadian dollar, monetary policy precipitated a collapse
in aggregate demand. Excessively tight monetary policy worsened the severity

196of the recession from 1989 to 1992 and destroyed the debt stabilisation plansof Canadian governments. The debt-to-GDP ratio soared to new heights, and by
1995, Canadian governments perceived no alternative but to cut program
expenditures severely (Fortin et al. 1998, p. 164).
Federal and Provincial politicians were vocal in their opposition to Crow’s policies. At
the First Minister’s Conference in August 1988, the provincial Premiers objected to thehigh level of interest rates imposed by the BoC, pointing out that inflationary pressures
were lower and unemployment higher outside central Canada (Lipsey 1990, p.54; York
1990, p. 180). These economic disparities aggravated the regional divisions surrounding
Canada’s constitutional debates that were raging at the time. “[What] is the long-term
political cost for Canadian unity of starting an economic slowdown or a recession in allprovinces when the unemployment rate is 5 percent in one over-heated region and 9
percent in the rest of the country?” (York 1990, p. 148).

The timing of the BoC's pursuit of price stability was controversial for business. Highinterest rates pushed up the Canadian dollar at a time when many industries wererationalising and downsizing to take advantage of the Canada-US Free Trade
Agreement (“FTA”) signed in 1986 (Howitt 1993, p.494). Business had been strong
supporters of the FTA and had made massive investments only to see theircompetitiveness deteriorate relative to the US as the appreciating Canadian dollar undid
many of the benefits of the FTA. By 1989, Canadian industry was about 20 per cent lesscompetitive relative to its US counterparts than it was when the FTA was signed (York1990, p. 162).

15 “The Governor awaits his fate”, Financial Post Magazine, November 1993, p. 14-17.

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6.3 Political Debates over Bank of Canada Independence

The public controversy over the BoC’s price stability set the stage for the politicaldebate over BoC independence. “When a major national institution, such as the Bank of
Canada, makes a systematic series of decisions that, substantially decrease the economic
well-being of Canadian society, calls for radical change are to be expected” (Fortin et al.
1998, p. 176). The extent to which Governor Crow was personally identified with the
BoC’s pursuit of price stability and the suggestion that the Governor was unaccountablecalled into question the legitimacy of the BoC and raised concerns about the credibilityof monetary policy even among BoC supporters. As a direct result, both the ruling
Progressive Conservatives and the opposition Liberals introduced a set of proposals thatwould fundamentally change the independence of the BoC.

Setting the A genda

The debate over the BoC’s legislation began with the publication of a pamphlet byProfessor David Laidler, entitled How shall we govern the governor?, which effectively
set the agenda for the ruling Conservative government (Laidler 1991). Written in May
1991, this pamphlet was part of a series conceived by the CD Howe Institute tocontribute to the debate on renewing Canada’s constitution, following the failure of thegovernment’s Spicer Commission.16 Significantly, the pamphlet followed the joint
announcement o f the inflation targets in February 1991. Laidler recommended threeamendments to the Bank o f Canada Act: the mandate should be changed to one of pricestability, the Board of Directors should be restructured to decrease the power of theGovernor (along the lines of a Monetary Policy Committee), and the composition of theBoard should be changed to increase regional representation.
[A] systematic re-examination of the Bank’s role in Canada’s economic andpolitical life is overdue. The Bank’s current mandate is outdated and vague, and198

the Bank’s governance, reflecting its status as an exclusively federal
institution, ignores the interests of provincial governments in the conduct ofmonetary policies. Current arrangements confer on the Bank a high degree of
independence from day-to-day political pressure. That, as I shall argue, is very
desirable. They also ensure, however, that the power which such independence
confers is perceived to be concentrated in the hands of the Bank’s governor. The
desirability of this is less obvious... (Laidler 1991, p. 1).
The BoC mandate was vague and obsolete making it impossible for the BoC to be held
accountable, and should be replaced with a clear mandate of price stability along New
Zealand lines (Laidler 1991, p. 19). Laidler saw the joint adoption of the inflation targets
as a step in this direction, but one that did not go far enough to institutionalise thispolicy change. The Board should be strengthened and given a greater say in monetary
policy, in order to get away from ‘personal attacks on the governor’ that undermined thepolitical legitimacy of the BoC (Laidler 1991, p.2l). A stronger board with greater regional
representation would make it harder to level ill-informed and irresponsible charges ofregional insensitivity at the BoC (Laidler 1991, p.22). Laidler concluded that thestrengthened Board and a clear mandate of price stability would strengthen, not weaken,
the ability of the BoC to resist political pressure while ensuring greater accountability ofmonetary policy.

Laidler’s pamphlet caught the attention of the House of Commons Standing Committee
on Finance, a cross-party committee of backbenchers responsible for parliamentary
oversight of economic policy. The Finance Committee had its own concerns about the
BoC witnessed by periodic clashes between Finance Committee members and Governor

16 The Spicer commission report made no mention of the Bank of Canada, focussing instead on the deficit
and regional disparities (Canada 1991b).

199

Crow during his testimony over the BoC’s annual report.17 The Finance Committee
was concerned “that one of the most significant federal government institutions wasincreasingly being called into question” and formed a Subcommittee on the Bank of
Canada (“the Subcommittee”) in June 1991 to look into Laidler’s proposals (Canada
1992).18

C onservatives’ Reform Proposals

However before the Subcommittee got started, the Conservative government underPrime Minister Mulroney published its proposals for reform of Canada's constitution in
September 1991. Entitled Shaping Canada’s Future Together: Proposals, this document
featured twenty-seven proposals, with one specifically addressing the statute of the
BoC:
The Government of Canada proposes to amend the Bank o f Canada Act to makeit clear that the mandate of the Bank is to achieve and preserve price stability. To
ensure regional representation on the Board of Directors of the Bank of Canada,
the Government will solicit the views of provincial and territorial governments
and consult with them before making appointments to the Board. In addition ,the Government proposes to create regional consultative panels to advise the
Directors of the Bank on regional economic conditions. The Government will
also solicit the views of provincial and territorial governments with respect tothe membership of the regional panels. Moreover, the appointment of theGovernor of the Bank of Canada would be subject to Senate ratification (Canada
1991c).

17 In testimony over the BoC’s 1990 annual report, Liberal MP Herb Gray repeatedly challenged
Governor Crow’s discussion of the BoC’s policies. See: Minutes and Proceedings of die House ofCommons Standing Committee on Finance, 18 March 1991, p.158:12.
18 The Subcommittee consisted of five MPs, two from the ruling Progressive Conservatives, two Liberals
and one NDP.

200

A companion volume, Canadian federalism and economic union: partnership fo r
prosperity, elaborated on these proposals (Canada 1991a). The government’s
suggestions echoed Laidler’s, focussing on the BoC’s mandate and the composition of
the Board of Directors. The government acknowledged that considerable confusion
existed concerning the objectives of monetary policy, resulting in the perception thatmonetary policy was being designed for central Canada. “Clarifying the Bank’s
mandate and formalising and strengthening communications would help to eliminate
some of the misperceptions...And a clearer mandate would be consistent with theindependence of the implementation of monetary policy on an ongoing basis” (Canada
1992, p.38). A focus on price stability would mean the elimination of other objectives“that history has taught us a central bank cannot achieve or that can only be achieved
through price stability” (Canada 1992, p.39). Monetary policy would be made moretransparent by requiring the Governor to testify twice a year before Parliament and tomeet with the federal and provincial Ministers of Finance. The Board of Directors
would also be given a greater role, chairing new regional consultative panels andpublishing reports on regional conditions in the Board’s minutes.19

The Manley Report

In November 1991 the Subcommittee began hearings on three issues: the BoC’s
independence in setting monetary policy, the nature of its mandate and the way in which
it reached policy decisions (Laidler et al. 1993, p. 122). The Subcommittee heard
testimony from the Governor and BoC officials, as well an twenty-five witnesses“including experts on the central banks of Japan, U.S. and the UK, business andacademic economists, a former federal Finance Minister and a former provincial
Treasurer” (Canada 1992, p.xiv). Academic economists were the largest group to give

19 The report also recommended setting up an independent agency to monitor and evaluate themacroeconomic policies of the federal and provincial governments (Canada 1992, p.40).

201

testimony, representing over a third of the witnesses, including David Laidler, Pierre
Fortin, David Howitt and William Coleman. Next in line were witnesses from banking
and financial services who made up one-fifth of the witnesses with testimony from the
Canadian Bankers Association (“CBA”), Royal Bank of Canada, Toronto Dominion
Bank, the Trust Companies Association of Canada and the Confederation des caisses
populaires et d’economie Desjardins du Quebec.20

The Subcommittee’s report (“the Manley Report”), published in February 1992 came toa unanimous and surprising set of recommendations. The Manley Report recommended
leaving the BoC’s mandate unchanged. While a large majority of witnesses had
endorsed price stability as the appropriate goal of monetary policy, few were prepared
to incorporate such a narrow goal in legislation. A number of reasons were given. First,
a change o f mandate was unnecessary as the BoC was already pursuing a firm, anti­
inflation policy under the inflation-targeting framework. Second, effective central bankindependence - not the central bank’s mandate - was viewed as more significant fordelivering low inflation. Third, a narrow focus on price stability would encourage
adverse fiscal policies, as politicians would not feel responsible for price stability.
Fourth, other objectives had been the focus of monetary policy in the past, suggestingthat other targets than price stability might be desirable to pursue in the future, such as
exchange rate stability. Fifth, the timing of this proposal was wrong. The issue wasdivisive and including this reform in an already overloaded constitutional agenda would
only increase political friction. Finally, monetary policy has powerful short run effects
that should not be ignored, such as stabilising exogenous shocks to demand. Afterconsidering these positions, the Subcommittee decided that confining monetary policy

20 Foreign central bankers also waded into this debate, with Bundesbank President Schlesinger voicing
support for the proposal to give the BoC a mandate of price stability. “Bundesbank backs new mandate”,
The Globe and Mail, 18 January 1992, p.4.

202

to price stability would be a sharp departure from the past and would reduce policy
flexibility while ignoring the other objectives of public policy (Canada 1992, p.24). “Insum, a broad mandate is superior to a narrow one, and the present preferable to the one
proposed” (Canada 1992, p.xiv).

The second recommendation dealt with the independence of the BoC and endorsed thestatus quo. The BoC should continue to formulate monetary policy day-to-day, butultimate responsibility should remain with the government backed by the power to issue
a directive. Some witnesses argued for greater political control, arguing that theGovernor had too much power and that monetary policy lacked legitimacy. Other
witnesses argued for greater independence, pointing to studies linking independencewith low inflation and discussing the propensity for politicians to set policy for short­term political gain. Opinion was split on whether a directive could be used or not some witnesses argued it would “trigger serious, adverse consequences in Canadianfinancial and foreign exchange markets” while others believed the policy debate andpublicity surrounding it would “enable the market to pass appropriate judgement”(Canada 1992, p.28). A majority of witnesses felt the current arrangement between the
BoC and the Department of Finance was effective, leading the Manley Report toendorse the existing system o f dual responsibility. “In Canada we have struck a balance
between day-to-day independence of the Bank with ultimate responsibility resting withthe federal government. The more legitimate is the Bank of Canada’s policy making
process, the less likely is the government to interfere in its operations and the more realis this independence” (Canada 1992, p.xv).

The remaining recommendations addressed the accountability and governance of the
BoC. To increase accountability, the report recommended amending the Bank o f203Canada Act to require the BoC to report to Parliament twice a year, with theGovernor giving a hearing to explain the choice and direction of monetary policy. While
there was substantial consensus in favour of changing the governance of the BoC todiffuse the power of the Governor, the Subcommittee was not convinced of thesuperiority of any of a number of models, nor did it feel the concentration of power inthe hands of the Governor was excessive.21 To increase regional representation, theManley Report argued for legislating a regional balance on the Board of Directors.
Some Board and Executive Committee meetings should also be held in locations
outside central Canada in order to foster better public understanding o f the workings ofmonetary policy.
Table 43: Government Documents on Bank of C anada Independence
Year

Title

1933

Royal Commission on Banking and Finance (Macmillan Commission)

1964

Royal Commission on Banking and Finance (Porter Commission)

1978

Royal Commission on Financial Management and Accountability (Lambert Commission)

1991

Shaping Canada’s Future Together, Government of Canada
Canadian federalism and economic union: partnership fo r prosperity, Government of Canada.

1992

The Mandate and Governance o f the Bank o f Canada (Manley Report), House of Commons
Standing Committee on Finance, Subcommittee on the Bank of Canada.

C hanges following the Manley Report

Publication of the Manley Report attracted little attention in Canada, likely due to theconstitutional reforms being debated at the time that dominated the headlines (Laidler etal. 1993). More pressing was Quebec’s Belanger-Campeau Commission that had
recommended a second referendum on sovereignty-association be held in Quebec
before the end of 1992. Elsewhere the Mulroney government was putting the final
touches on the Charlottetown Accord of constitutional changes, approved by bothfederal and provincial leaders, which was strongly rejected in a national referendum in

21 On the issue of governance, the Subcommittee studied the operation of the Federal Reserve, theBundesbank, the Banque de France, die Bank of England and the preliminary plans for the ECB.

204

October 1992. Not surprisingly, reform of the Bank o f Canada Act was dropped
from an overloaded constitutional agenda as it was felt that the Act could be changed at
any time by a simple act of Parliament.

Despite this outcome, proposals to reform the BoC continued to be made throughout the
1990s by both opponents and supporters of the BoC. 22 There were proposals toincorporate the inflation targets into the Act, to modify the governance of the BoC andto change the terms of the Governor’s appointment. More radical proposals suggested
effectively delegating monetary policy to the Fed by entering a monetary union with theUSA; transforming the BoC into a full government department; or replacing the BoC
with a system of free banking (Laidler 1997, p.202).

Aftermath: Liberal Showdown with Crow

The opposition Liberal Party had its own ideas for the BoC. Crow’s term was due to be
renewed on 31 January 1994, less than three months after a federal election was set tobe held on 25 October 1993. In March 1993, Conservative Finance Minister
Mazankowski had floated the idea of reappointing Crow early before the election - anunprecedented move that was resisted by a BoC that wanted to remain non-partisan.
The main election issues were job creation and federal finances as unemployment wasover 11 per cent and the deficit was set to exceed C$40 billion for the first time. During
the election campaign, Opposition Liberal leader Jean Chretien directly challenged the
independence of the BoC, threatening not to reappoint Crow unless the BoC pursued aneasier monetary policy to put the 1.6 million unemployed Canadians back to work.23
Chretien’s populist threat reflected the public mood at the time. CLC President Bob

22 Fortin continued to argue that the management structure of the BoC be reorganised, and the mandate
should be re-worded to take explicit account of the costly trade-off between inflation and unemployment
at very low inflation rates (Fortin 1996, p781). Fortin and Osberg recommended replacing the Governor

205White called Crow the “architect of our current difficulties” and argued Crow
should not be reappointed as his policies had led to massive unemployment, a depressed
economy and rising deficits.24 White described the BoC’s price stability policy as “atroot a policy to maintain a very slack economy with unacceptably high levels of
unemployment almost indefinitely”.

On the whole, the participants in this debate were the same who had spoken out during
the 1991 debate over the BoC’s mandate. Vocal opponents of Crow’s reappointment
were Professor Fortin, the Canadian Centre for Policy Alternatives, the Canadian
Manufacturer’s Association, provincial Finance Ministers in Ontario and BC from
Canada’s left-wing New Democratic Party (“NDP”), and a newly founded protest groupcalled the Bank o f Canada for Canadians Coalition, composed principally of Reform
Party members.

Crow was supported by the financial press, academic economists such

as Laidler, the CD Howe and Frasier Institutes, the business community represented by
the BCNI and the Canadian Federation of Independent Businesses (“CFIB)”, financial
market actors and the international banking community.

Following the Liberal election victory, Prime Minister Chretien named Paul Martin another vocal critic of Crow - as Finance Minister. Martin had responsibility forappointing the next BoC Governor. In November 1993, Finance Minister Martin polled
his provincial counterparts on the subject of Governor Crow’s reappointment and found

22 Fortin continued to argue that the management structure of the BoC be reorganised, and the mandate
should be re-worded to take explicit account of the costly trade-off between inflation and unemployment
at very low inflation rates (Fortin 1996, p781). Fortin and Osberg recommended replacing the Governor
with a governing council (Fortin et al. 1998, p. 175).
23 “Liberal threat to sack bank chief may prove hollow after election”, The Financial Post, 23 July 1993.
24 Robert White “Crow the architect of current difficulties”, The Globe and Mail, 7 April 1993.
25 Jordan Grant, “Why John Crow should not be reappointed”; The Globe and Mail, 17 Dec 1993, p.A23;“Inflation fighter” Maclean’s, 13 Dec 1993, p.24.
26 “Crow’s critics come under fire”, The Globe and Mail, 4 Nov 1993, p.B3; “Crow’s future becomescloudy”, The Globe and Mail, 1 Dec 1993.

206

them mostly indifferent. In December, a special appointment committee of the
BoC’s Board o f Directors - controlled by the opposition Conservatives - recommended
that Crow be reappointed.

77

Finance Minister Martin rejected the Board’s suggestion.

For the Liberals, a major obstacle was Crow’s pursuit of price stability that conflictedwith the Liberal's campaign rhetoric to let inflation grow by 5 to 6 per cent in order tocreate more jobs. At the time of the reappointment, Canadian inflation was one of thelowest in the industrialised world at 1.9 per cent.28 Finally, on 22 December, Finance
Minister Martin announced that Crow would not be reappointed, but would be replaced
by Senior Deputy Governor Gordon Thiessen, a 30-year BoC veteran.29 The
appointment of a ‘Crow clone’ satisfied both the Liberal’s objectives - it assured
international financial markets that the BoC’s monetary policy would remain the same,and it symbolically met Chretien’s electoral promise to get tough with the BoC by
getting rid of the architect of 'zero inflation', Governor Crow.

At the time of theannouncement, Finance Minister Martin and Governor Thiessen jointly agreed to extend
the inflation target of 1 to 3 per cent to the end of 1998.30 Governor Thiessen had madethis endorsement a criteria for his accepting the job.

BoC C hang es under T hiessen

Governor Thiessen introduced a number of significant changes following his
appointment in answer to the BoC’s critics. First, Thiessen created a Governing Council
to decentralise the decision-making responsibility of the BoC and reduce theconcentration of power in the hands of the Governor. The six-member council, chairedby the Governor with the participation of the Senior Deputy Governor and four Deputy
Governors, would share collective responsibility for managing the bank. Second,

27 “Martin advised to reappoint Crow”, The Globe and Mail, 4 Dec 1993, p.B13
28 “The Indispensable Mr. Crow”, Western Report 20 December 1993, p.8
29 While press reports suggest that Crow asked not to be reappointed, this statement conflicts with reports
on his wishes several months prior to the announcement.
30 “Crow out, Thiessen in” The Globe and Mail, 23 December 1993, p.l.

207

Thiessen changed the appearance of the BoC’s Annual Report, to make it moreaccessible and understandable to the public (Bemanke et al. 1999, p. 127). Third,Thiessen launched a semi-annual report on monetary policy, the Monetary Policy
Report, which would provide more information on how decisions were reached andbring greater transparency and accountability to monetary policy. Fourth, Thiessen
launched a public awareness campaign to repair the damaged image of the BoC. Fifth,Thiessen acted to co-opt one of the BoC’s critics by inviting David Laidler to be thefirst academic-in-residence at the BoC. Sixth, Thiessen changed the language used todescribe the inflation targets, substituting the phrase ‘inflation reduction program’
introduced in 1991 with the phrase ‘inflation control program’ (Bemanke et al. 1999,
p. 127; Laidler 1997, p.2). Finally, Thiessen sought greater input from the provinces by
increasing the role of its regional offices.

In combination with these organisational changes, Governor Thiessen introduced anumber o f changes in the BoC’s operating framework designed to increase thetransparency and accountability of monetary policy. In mid-1994, the BoC began to set
a formal, unambiguous 50 basis point band for the overnight rate, later designating its
upper band as the Bank Rate.31 To remove confusion concerning the relationship ofinterest rates and exchange rates, the BoC developed a Monetary Conditions Index,
formalised from May 1995, to signal the direction of monetary policy. From January
1996 the BoC began issuing press releases to announce changes in this band that wereannounced at the same time each day. By educating the public and making policy moretransparent and accountable, Thiessen hoped to gain public approval while increasing
BoC credibility with financial markets (Bemanke et al. 1999, p. 128).

31 Because the message to the market from the BoC’s management of the overnight rate had been‘somewhat inarticulate’, the BoC had previously intervened in money markets to signal its intentions
more clearly (Grant 1997).

208
Table 44: Bank o f Canada Stages in Pursuit o f Transparency
Date

Event

December 1993

Inflation targeting regime extended through 1998

1994

Governing Council formed to share management responsibility for BoC.
Press release used to announce change in the band for the overnight rate.
New semi-annual Monetary Policy Report announced.

1994

Public adoption of Monetary Conditions Index as a guide to policy stanceJune 1994

Adoption o f a formal band for the overnight rate

May 1995

First issue o f new, semi-annual Monetary Policy Report
New appearance for BoC Annual Report
Monetary conditions index given higher profile in policy decisions.

November 1995

Bank o f Canada web site launched on the internet.

February 1996

Bank Rate tied to the top end o f the band for the overnight rate.

July 1996

Seek greater input from B oC’s regional offices

Source: Grant (1997)

6.4 Explaining Policy Continuity

Chapter 3 outlined four hypotheses for explaining the timing when politicians willreform a central bank's legislation. The Bank of Canada provides an interesting counterfactual test of these hypotheses, as the Bank o f Canada Act was not changed during the
1990s. Each of these hypotheses is discussed below.

Vocal But Ineffective Financial Lobbying

The discussion of domestic interest group preferences in chapter 3 and 4 argued that
Canada’s chartered banks would support greater BoC independence and a mandate ofprice stability. This reform should be opposed by organised labour and certain segmentsof the business community. However, an assessment of the effective political influenceof these groups in chapter 4 concluded that the financial sector would be mostinfluential in determining the outcome, due to the lack of political power of organised
labour and the collective action problems affecting the business community. The review
of political debates concerning BoC independence largely supports the predicted patternof preferences, but does not support Posen’s hypothesis concerning the effective
influence o f the banking sector.

209

Organised labour, represented by the Canadian Labour Congress and the CanadianAuto Workers, publicly opposed the reappointment of Governor Crow on the basis thathis price stability policy destroyed jobs and reduced the social wage. This opposition
was voiced through the media and publications by leftist think tanks, and may haveinfluenced the positions of the left-wing NDP Premiers in several provinces. Howeverorganised labour was not invited to give testimony to the Subcommittee, nor were its
views attributed in the Manley Report. Surprisingly, the federal NDP were also
relatively silent on this debate. These findings support the view that organised labour
had no political influence in this debate.

Big business stood on both sides of the debate over Governor Crow’s policies andreappointment. While exporters, manufacturers and small businesses were vocal in theiropposition to high interest rates and the BoC’s quest for price stability, the BCNI wasamong the most public supporters of Governor Crow. As predicted, those businesses
most exposed to the traded sector, who paid the short term costs of adjustment, were
opposed to greater BoC independence. The CEOs of Canada’s largest firms, who could
afford to take a longer term view, supported it. Small business represented by the CFIB
opposed the BoC’s high interest rate policy, but then supported Crow’s reappointment
suggesting no consistent position in these debates. The fragmentation of businessinterests and the lack o f a coherent voice undermined the political effectiveness ofbusiness on this debate, as seen in their lack o f representation in the Manley Report.

Canada’s chartered banks were active in this debate, with the Royal Bank of Canada,
Toronto-Dominion Bank and the CBA giving testimony in support of greater BoC
independence to the Subcommittee. They also voiced support for Governor Crow in thedebate over his reappointment. Both positions are consistent with Posen’s claim that thebanking sector will prefer price stability to job creation. However, in both cases

210

politicians did not endorse the preferred position o f the chartered banks, choosing
instead not to change the BoC’s mandate nor to reappoint Governor Crow. This resultclearly rejects Posen’s predictions, particularly as Canada meets all the criteria specified
by Posen for determining the effective of financial opposition to inflation. One
explanation may be that the chartered banks did not hold unitary preferences. Chief
Economist for Toronto-Dominion Bank, Douglas Peters, was one of Crow’s fiercest
critics.32

Another explanation for this outcome is that the power of the financial sector overpoliticians is overstated. Despite their ability to organise through the CBA and to embed
themselves in the policy network, the influence of the chartered banks may be restricted
to certain issue areas such as financial regulation. Certainly Finance Minister Martin’s
rejection of their merger proposals in 1998 was a stunning defeat for the charteredbanks, and demonstrated that the government is still able to make policy autonomously.
The government’s room to manoeuvre continued even as it became more dependent on
the chartered banks for financing the government debt, with direct and indirect
chartered bank holdings of Government of Canada securities growing from around 20
per cent in 1985 to over 40 per cent in 1995.

32 Given that Douglas successfully ran as a Liberal Party candidate in the 1993 election, his policy
preferences may reflect more the position of his party rather than the financial sector.

211

Table 45: Domestic Holdings of Government of Canada Securities (%)
Year
end

Chartered &other banks1Life Ins./
Pensions

Bank of
CanadaAll levels
of Govt

Individuals

Corps.

Total

1980

26

13

22

6

33

1

100

1985

21

18

9

6

43

4

100

1990

24

22

8

8

33

5

100

1995

42

26

7

8

13

4

100

1. Includes credit unions, trust companies, mortgage loan companies, investment dealers, mutual funds,
insurance companies, and other financial institutions.
Source: Statistics Canada, The National Balance Sheet Accounts.

Signalling International Financial Markets

Central bank independence is seen as a mechanism for signalling the anti-inflationary
credibility of governments that need attract foreign capital and that wish to reduce theinterest-rate charged on their foreign borrowing. Based on this hypothesis, thegovernment of Canada should have changed the mandate of the BoC to award it
independence with a mandate of price stability, based on the state of Canada’s finances
during the early 1990s, the downgrading of Canada’s sovereign debt by the major bondrating agencies, and the threats of international financial panic in the event Governor
Crow was not reappointed.
Table 46: Federal Government Finances (C$ in billions)FiscalYear
Starting

Operatingsurplus ordeficit (-)1

Publicdebt
charges

Budgetary
surplus ordeficit (-)

Borrowing
needs
(-)

Gross
publicdebt as %of GDP

Premium
to USinterest
rates (%)

Non
Resident
Holdings2

1970

0.9

1.9

-1.0

-1.0

n.a.

0.56

n.a.

1980

-3.9

10.7

-14.6

-9.9

n.a.

1.03

n.a.

1990

10.6

42.6

-32.0

-24.5

64%

2.30

25%

1991

6.8

41.2

-34.4

-31.8

68%

n.a.

28%

1992

-2.2

38.8

-41.0

-34.5

72%

n.a.

27%

1993

-4.0

38.0

-42.0

-29.9

75%

n.a.

26%

1994

4.6

42.0

-37.5

-25.8

76%

n.a.

26%

1995

18.3

46.9

-28.6

-17.2

77%

0.25

25%

1999

53.9

41.6

12.3

14.6

n.a.

0.75

n.a.

1. Budgetary revenues less program spending.
2. Shown as % of market, where market debt averaged 75% of total government debt over 1990s.
Source: Statistics Canada.

212

First, Canada’s public sector debt was high and rising during 1985 to 1995, asshown in table 6, increasing from 57 per cent of GDP to 77 per cent one of the worst
relative debt positions among the G-7 nations (Martin 1994). By 1995 the interest
charges alone were more than C$45 billion a year, creating large and unsustainablefiscal deficits. International investors held roughly 40 per cent or $280 billion of thetotal Canadian debt, and about 26 per cent or C$110 billion of Government of Canada
debt.33 However only about two per cent or $8.5 billion of the federal debt wasdenominated in foreign currencies. Given Canada’s poor financial situation, Finance
Minister Paul Martin announced plans in 1994 to cut the deficit to 3 per cent of GDP by
1996-97, as an interim target towards balancing the budget and reducing the public debt
(Martin 1994). By 1994 the operating budget was in surplus, but the high charges on the
public debt meant the overall budget was not in surplus until 1999.

Canada’s exposure to the international financial markets gave international creditors thepower to punish the Canadian government by demanding an interest rate premium ascompensation for rising levels of government debt and increased sovereign risk (Fortin
et al. 1998, p.43). Between 1992 and 1995, Canada’s sovereign and provincial ratings
were downgraded by both major bond rating agencies, with the foreign currency rating
falling from Aaa/AA+ to Aa2/AA+. The rating agencies cited the country's deterioratingbalance o f payments, the doubling of the national debt over the past decade, the risingprovincial debt load and Canada’s dependence on international investors.34 The
downgrades of the provincial governments forced them into fiscal austerity as theiraccess to foreign capital more expensive or more limited. In September 1995 Moody’s

33 Japanese institutions owned more than $50 billion or about 22 per cent of all foreign-owned Canadianbonds. See “The Fear Factor”, Maclean's, 12 October 1992, p. 14; “The Debt Beats” Maclean's, 29 March
1993, p.2.
34 The downgrade took place less than two weeks before the October referendum on the Charlottetown
Accord.

213

downgraded Canada’s local currency debt and its foreign currency shortly after
Finance Minister Paul Martin had tabled one o f the most austere budgets in Canadianhistory. These downgrades made dramatic headlines in the Canadian press, and led to
the view that the New York bond rating agencies were setting fiscal policy in Canada.35

Figure 9: Canadian Public Sector Debt
90.0%
□ G ross Public Debt (% of GDP)
80.0%

■ Foreign Currency Debt (% o f GDP)

70.0%

60.0%

50.0%

40.0%

30.0%

20 .0%

10 .0 %

0 .0 %
IO
00
CD

CO
OO

at

rCO
<7>

oo

00

o>

o>

OO
Ot

o

<7>
<T>

35 “The Debt Beats” Maclean's, 29 March 1993, p.2.

at
at

CM

<7>
o>

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at
at

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<7>

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Ot

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214
T able 47: Sovereign Ratings H istory for Canada

Date

Event

Foreign
RatingOct 1992

S&P downgrades Canada’s foreign currency rating from AAA to AA+.

Aaa/AA+

Nov 1992

Moody’s reviews Canada’s foreign currency rating for possible
downgrade.

Feb 1993

Moody’s confirms Canada’s foreign currency rating at Aaa after theend of the Charlottetown Accord constitutional crisis.

Jan 1994

Moody’s again confirms Canada’s foreign currency rating at Aaa.

June 1994

Moody’s downgrades Canada’s foreign currency rating from Aaa to
Aal.

Feb 1995

Moody’s reviews Canada’s local currency debt for possible
downgrade.

Mar 1995

S&P confirms Canada’s AAA rating on local currency debt butchanges the outlook on the foreign currency rating from stable tonegative.

June 1995

Moody’s downgrades Canada’s local currency rating to Aal andforeign currency rating to Aa2.

Feb 1997

S&P changes the outlook on Canada’s foreign currency rating tostable.

Aal/AA+

Aa2/AA+

International financial markets were seen as staunch defenders of BoC independence,
providing protection of the Governor against interference by politicians. Maclean’scolumnist Newman notes “[Attempts] by any politician, including the Prime Minister,
to interfere with Bank of Canada policies would almost automatically result in thegovernor’s resignation. That, in turn, would shake the confidence of world money
traders in our currency, triggering a major financial crisis”.36 Fortin admitted that any
attempt by the government to overrule the Governor would “immediately trigger afinancial and currency market crisis” (Fortin 1996, p776).

Supporters of Governor Crow’s reappointment couched their arguments in terms offinancial crisis. A Globe and Mail editorial suggested that Crow was a vital bulwark
against a dreaded loss o f confidence on the part of international investors. William

36 Peter Newman, “It’s time to bounce Crow out on his ear”, Maclean’s, 10 April 1993.

215

Robson of the CD Howe Institute suggested there would be a violent reaction in themarket if Crow were not reappointed, leading to a dramatic drop in the Canadiandollar.37 An economist at Salomon Brothers in New York predicted a severe backlash.38
The Financial Post noted that “the Canadian and international financial community
consider Governor Crow something of a demi-god”.39

Given the power ascribed to international financial markets, it comes as somewhat of asurprise to learn that none of the feared consequences occurred. Sovereign downgrades
were never treated as a serious threat by the federal government, due to its ability toforce the Bank of Canada to provide financing (Fortin et al. 1998, p.61).40 In the 1970s,
the Bank of Canada held more than 20 per cent of the federal debt, but by the 1990s thatlevel was less than 8 per cent suggesting the government had room to manoeuvre. Nor
did a rating downgrade from Aaa to Aa2 significantly raise the cost on federal
borrowing, with Canada paying from a quarter to half of one per cent over US
Treasuries on its borrowings. And while the Moody’s downgrade in June 1994 had
negative repercussions on the Canadian dollar and on Canadian equity markets, asimilar downgrade in June 1995 had little impact as the cost had been priced in and themarkets were impressed by Martin’s austere budget. Credit downgrades only proved to
be a serious concern for the smaller provinces. For example, debt-ridden Ontario wasable to raise funds easily in the Euromarkets in the 1990s, contrary to the claims ofdoomsayers. The Liberals’ failure to reappoint Governor Crow did not spark a crisis.
Quite the opposite, Thiessen’s appointment - synonymous with the extension of theinflation target - received a strong endorsement from the financial markets, with both

37 “The Indispensable Mr. Crow”, Western Report 20 December 1993, p. 8
38 “Inflation fighter” Maclean ’s, 13 December 1993, p.24.
39 “Liberal threat to sack bank chief may prove hollow after election”, The Financial Post, 23 July 1993.
40 Krehm's (1993) populist attack on the BoC written prior to the 1993 election reached the sameconclusion.

216

the Canadian dollar and Canadian bond prices rising following the announcement.41
These events demonstrate that international financial markets are not as constraining as
suggested.

On the basis of this evidence, it appears that the power of international financial markets
is overstated. The Canadian government rejected proposals for greater BoC
independence and a mandate of price stability at a time when it was most exposed tointernational investors. The fact that a financial crisis was averted, despite Canada’s
reliance on foreign capital and deteriorating finances, demonstrates that over methods
exist to signal anti-inflationary credibility than central bank independence. It may bethat centrist parties such as the Liberals and Progressive Conservatives do not pose an
inherent threat to financial markets. A left-wing NDP government, should it ever beelected, may be forced to legislate greater BoC independence similar to the case of the
UK’s New Labour.

Ideas Influence the A genda

How significant were the ideas o f an epistemic community o f economists, central
bankers and think tanks for determining the outcome? At first glance, it appears thatideas did matter for the case of the Bank of Canada. The ideas of economists like
Laidler created a focal point around the need for reform o f the BoC’s legislation, andpointed to a set o f potential policy options. Panels of monetary policy experts, convenedby the CD Howe Institute and invited to give testimony for the Manley Report, werecrucial for explaining this complex issue area. Academics also played a significant rolein moulding the preferences of policymakers and in creating coalitions of domestic andinternational actors with shared policy preferences. In short, this epistemic community

41 “Choice of Thiessen rallies dollar”, The Globe and Mail, 23 December 1993, p.Bl.

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set the agenda and provided a road map that politicians could use when considering
this complex issue area.

However it is easy to show that this epistemic community did not succeed indetermining the outcome due to a lack of consensus on both the need for this reform andthe form it should take. Academic and business economists took positions on both sidesof the debate, in favour o f greater independence and in opposition to it. Fortin, Rymes
and economists at the CLC built a successful coalition opposed to BoC independence,by highlighting the costs of disinflation, explaining which groups were paying the costs,
and pointing to the lack o f academic consensus on the supposed gains of price stability.
In addition, the range of alternatives presented by the experts in favour of changing the
BoC legislation was itself confusing and varied, creating enough uncertainty amongst
policymakers that they preferred the status quo to any change. And when the issues
were more concrete, politicians chose the policy that was most salient to their interests
in re-election.

While dismissing the effectiveness of the epistemic community on the issue of BoC
independence, it is important to highlight that the ideas of economists were significant
for determining the alternatives to central bank independence that were pursued by the
BoC and the federal government. On the surface, Canada did not follow the trend
advocated by the economic orthodoxy which was to delegate to an independent central
bank with a mandate o f price stability. This interpretation perhaps misrepresents thestate of the academic debate, as delegation was seen as only one of several solutions to
the time-inconsistency problem. Rogoff (1985) suggested that an alternative todelegation is to appoint a conservative central banker who has a reputation within thefinancial community for defending price stability (Rogoff 1985). The Canadian case

218

offers an example of this strategy in practice. Recognising that the Bank of Canada
would not be given greater independence, Rogoff s ideas may have provided a road map
to a viable solution. From the time he became Governor in 1987, Crow set aboutbuilding a reputation as a conservative central banker, revealing his preference for pricestability over job creation in his Hanson lecture in 1988. Crow then demonstrated his
toughness from 1988-1991, by pursuing a restrictive monetary policy to disinflate theCanadian economy (Debelle 1996). Governor Crow made a point of aiming for inflation
clearly below 2%, which the Bank’s critics took to mean ‘zero inflation’, insisting that
not even a low level of inflation was credible and leaving no room to question his
conservativeness. The cost of Crow’s toughness, critics argue, was the 1990-91
recession which was deeper and more painful than it needed to be, a reality confirmedby the loss in output in Canada during the disinflation as measured by the sacrifice ratio.
The adoption of an inflation target in 1991 signalled that the Bank had gained thegovernment’s support in the pursuit of price stability, removing any doubt in the mindsof private actors as judged by the subsequent fall in inflationary expectations.

This study of the Bank of Canada raises the question of whether legal measures ofcentral bank independence matter, or whether there are alternatives to delegation forachieving anti-inflationary credibility for monetary policy. Unlike the case with New
Labour and its 1997 reform of the Bank of England, Canadian politicians did not needto legislate greater operational independence to the central bank in order to gain policy
credibility (King 2001b). The ability to pursue reputation as a substitute for delegation
may be due to the fact that Canada has never had a left-wing government. It appears thata conservative government’s policies are viewed with less suspicion by international
financial markets and the public commitment to price stability embodied in an inflation
target may be enough to provide monetary policy with credibility. Canada’s

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Conservative government adopted an inflation target in 1991. Prior to this date, only
the Reserve Bank of New Zealand had an official inflation target, although both the
Bundesbank and the Swiss National Bank - the two most independent central banks inthe world - are seen as having an implicit inflation-targeting framework (Bemanke et al.
1999). The joint announcement of inflation targets in 1991 was intended to bolster thecredibility of the BoC’s anti-inflationary policy and the focus at this time was to build
public support in order to buttress the BoC’s commitment to price stability (Bemanke etal. 1999, p. 120).
6.5 Measuring Electoral Gains and Costs
Given the trend in central bank independence over the 1990s, why has the Bank o f
Canada Act not been updated to give the BoC greater independence with a narrowmandate of price stability? The answer is that this change did not provide politicianswith electoral gains and only suggested electoral costs. By 1992, Canada’s economy
was recovering and inflation had come down to below 2 percent. During this process,the BoC had been a useful scapegoat for the Conservatives who shared the belief that
inflation must be brought down. While Governor Crow is portrayed as crusading alone
for price stability, this policy was agreed and supported by the Conservative
government.42 It would have been discussed in the weekly meetings between the
Finance Minister and the Governor. At the height of the debate in January 1990, aMaclean's article confirmed that “Crow’s high-interest campaign has enjoyedunwavering political support from [Conservative] Finance Minister Michael Wilson” 43“In short, the Bank’s very autonomy from politicians made it an easy target for thosesame politicians, who could disown its policies whenever these were unpopular”(Laidler et al. 1993, p.48). In exchange for the Conservative government’s support of

42 “The Indispensable Mr. Crow”, Western Report 20 December 1993, p.8
43 “Policy under fire”, Maclean’s, 8 January 1990, p. 28-30.

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price stability, the BoC accommodated the Conservative government’s fiscal policy
including absorbing the inflationary shock from the introduction of the GST. In otherwords, despite the Governor Crow’s commitment to price stability, monetary policy
accommodated federal fiscal policy during this period even at the cost of higher short­term inflation. Given this accommodation and policy flexibility, the Conservatives had
no incentive to make the BoC more independent or to give it a narrower mandate.

The BoC’s legislation only came to be included in the government’s 1991 constitutional
proposals due to the public outcry over Governor Crow’s high interest rate policy andthe suggestion that monetary policy lacked political legitimacy. But when the
Subcommittee met, its members recognised that the timing for pursuing such a reform
was wrong due to the constitutional debates that were dividing the country. On thisbasis, the Conservative government dropped its proposals judging the electoral costs of
pursuing BoC independence as too high. Laidler argues the Manley Report rejectedreforming the Bank o f Canada Act because the Subcommittee recognised how
ephemeral received wisdom is among economists (Laidler 1997, p. 197). Canada had
been through exchange rate targeting under Bretton Woods, monetary targeting under
Bouey, and had only recently introduced inflation targeting earlier that year - aframework that was untested and unproven. Embedding a narrow mandate of pricestability that was not fully endorsed by other central banks or academic economists wasa political risk that was not worth taking.

The Conservative government’s defeat was ensured by their support of Crow’s pricestability campaign, their own fiscal austerity programs and the unpopular GST tax. In
the 1993 election, the Conservatives suffered the worst defeat in Canadian electoral
history, being reduced from the ruling party with 169 seats to only 2 seats. This

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electoral lesson was not lost on the opposition Liberals under Jean Chretien, whoattacked the BoC’s policy during the 1993 election campaign, threatening to get rid of
Crow if they were elected. When the Liberals were elected, their view of the electoral
costs of such a move changed, perhaps due to press speculation that international
financial markets would revolt if Governor Crow were not reappointed. However Prime
Minister Chretien weighed the costs of giving in to this market pressure versus thepolitical backlash if he reversed on his campaign promise. The Liberals saw Governor
Crow’s insistence on price stability as too politically costly, and it did not leave room
for the Liberals to deliver on their electoral pledge to create jobs, even at the cost of
higher inflation. For this reason, the Liberals faced down the threat from international
investors and replaced Crow, who would not accommodate the Liberal government’s
agenda.

Recognising that international financial markets were most concerned with low
inflation, Finance Minster Martin announced Governor Thiessen’s appointment while atthe same time extending the inflation target through 2001. The target range of 1-3 percent did not include zero, but it confirmed the commitment to price stability albeit at ahigher level of inflation. In recognition of financial market concerns about the
government debt and Quebec succession, Finance Minister Martin appointed Thiessen,a career central banker and ‘Crow clone’ who would continue Crow’s policies under agentler guise. In this manner, the Liberals had their preferred choice of policies. They
maintained flexibility, they symbolically asserted their control over the BoC and theyreassured international financial markets of their commitment to price stability.

This study of the BoC raises the question of whether legal measures central bankindependence matter, or whether there are alternatives to delegation for achieving anti-

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inflationary credibility. The government’s introduction of inflation targets in 1991
and Governor Crow’s campaign to develop a reputation as a conservative central banker
were alternatives to changing the legislation of the BoC. This combination of policies
gave credibility to the anti-inflationary pledges of the government, but at the cost ofhigh disinflationary costs as measured in a higher sacrifice ratio. Unlike the case with
the UK, the Liberals and Progressive Conservatives did not see the need to legislate
greater central bank independence, similar to their political counterparts in the UK.
Were an NDP government to be elected, however, it may be that the threat of a financial
crisis led by suspicious international investors might lead to a more institutionalisedcommitment to price stability, as was the case for New Labour in the UK.

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Ch. 7 Reserve Bank of Australia: The Importance of Electoral
Gains

The history of the Reserve Bank of Australia (“RBA”) has much in common with the
Bank of Canada. The statute governing the RBA has not been significantly altered since
the legislation was first passed in 1959, despite Australia’s central bank being seen bysome economists as among the more politically influenced central banks. Both Australia
and Canada have adopted inflation targeting frameworks during the 1990s following a
joint announcement between the government and the central bank. In addition to thesimilarities in monetary institutions, Australia and Canada have similar politicalinstitutions, as both are federal states with bicameral legislatures. The main area where
Australia and Canada differ is in politics, as the government in Australia was dominatedby a left-wing party - the Australian Labor Party (“ALP”) - that formed a majority
government from 1983 to 1996. It is these features that make the study of the Australiancase so interesting for testing hypotheses about central bank independence. Given thesimilarities between the two countries, we would expect to find the same outcome.

The chapter will proceed as follows. The first section assesses the degree of
independence of the central bank. The second section provides important backgrounddetail on the conduct of monetary policy in Australia and reviews the country’s
inflationary performance. The third section discusses the political debates involving thecentral bank. The fourth section provides an assessment of four hypotheses suggestedby the literature. The fifth concludes.

7.1 Status of Reserve Bank of Australia

In 1911, a left-wing Australian government established the Commonwealth Bank ofAustralia as a state-owned commercial and savings bank to compete with private

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commercial banks for the public’s business. In 1959, the Reserve Bank o f Australia
Act (“RBA Act 1959”) divided the Commonwealth Bank into two, creating the Reserve
Bank o f Australia to act as the country’s central bank, while the commercial and savingsbanking functions continued under the old entity. The RBA was given responsibility formonetary policy, as well as financial system stability, the safety and efficiency of thepayments system, and the monopoly on the issuance of Australian currency. Its main
counterpart is the Treasury, which has responsibility for economic policy advice andexchange rate issues.

The statutory objective of the new central bank were set out in section 10(2) of the RBA
Act 1959:
It is the duty of the Reserve Bank Board, within the limits of its powers, toensure that the monetary and banking policy of the Bank is directed to thegreatest advantage o f the people of Australia and that the powers of the Bank ...
are exercised in such a manner as, in the opinion of the Reserve Bank Board,
will best contribute to:(a) the stability o f the currency of Australia;(b) the maintenance of full employment in Australia; and(c) the economic prosperity and welfare of the people of Australia.
Like the Bank of Canada, the RBA’s mandate combines goals for employment, growthand price stability, allowing flexibility in the interpretation of these objectives. The
RBA acts as agent for the government in its domestic debt issues, and prior to 1986 was
the major holder and market maker in the secondary market for Treasury securities. The
RBA has sole responsibility for foreign exchange operations and owns Australia’s
foreign exchange reserves that form part of its balance sheet (Committee 1993b,

p.154).1 Under the original RBA Act 1959, the RBA did not have responsibility forsupervising banks, although it developed this responsibility informally over time andhad a statutory responsibility between 1989-1998 as discussed below. Finally, under
section 30 the net profits of the RBA are transferred to the Treasury.

Under section 8A (2), the Reserve Bank Board is responsible for the RBA’s monetaryand banking policy and for the Bank's policy on all other matters, except for payments
system policy. Monetary policy decisions are made by majority vote of the ninemember Board, with the RBA Governor acting as Chairman and holding the casting
vote. The Secretary to the Treasury also sits on the Board. The government appoints all
Board members - the Governor and Deputy Governor for seven-year terms and theother Board members for five-year terms. The Governor and the Deputy Governor holdoffice subject to good behaviour and may be reappointed.
M easuring the Independence of the RBA

Like the Bank o f Canada, neither experts nor market participants can agree on the
degree o f independence of the RBA. Bade and Parkin (1988) and Eijffinger and
Schaling (1993) view it as one of the more dependent central banks among industrial
countries, while Grilli et al (1991) view it as having relatively high independence.
Cukierman et al (1992) place it in the middle of twenty-eight countries, ranking it 12th.
The index used by Hall and Franzese (1998), which averages other indices, ranks
Australia last out o f 18 industrial countries making it the most dependent central bank intheir sample. Standard & Poor's MMS Guide to Central Banks provides rankings ofcentral bank independence from a financial market perspective, and places the RBA 15thout of 30 central banks, behind the central banks of Hungary, Slovakia and Colombia.

1The RBA engages in foreign exchange intervention with - as a practical matter - no prior consultation
with the Treasury, although the RBA keeps the government informed of major developments.

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In summary, these legal indices place the RBA in the middle to the lower half of thespectrum, a ranking indicative of the lack of consensus.
Table 48: Standard & Poor's MMS Ranking of Central BanksCountry

Score

Country

Score

Country

Score

Canada91.67

Hungary

76.60

Hong Kong

56.60

Denmark

86.67

Slovakia

73.30

Indonesia

55.00

Japan (post-98)

86.00

UK (post-97)

65.00

Singapore

50.00

ECB

85.00

Colombia

63.33

Philippines

50.00

Czech Rep

83.30

Australia

63.33

Thailand

45.00

USA

81.60

Romania

61.67

Argentina

41.60

Switzerland

80.00

Russia

61.67

China

38.30

N.Zealand (post-89)

80.00

Mexico61.60

Taiwan31.60

Sweden80.00

Poland61.60

S.Korea

30.00

S.Africa

78.30

Norway60.00

Brazil

26.60

The argument that the RBA is politically dependent rests on a number of provisions in
the RBA Act 1959 which give the government direct and indirect power over the RBA.
First, under section 14(1) the Secretary to the Treasury is a voting member on the RBA
Board of Directors, which has the legislated responsibility for making interest ratedecisions. Like the majority of central banks, the government makes all appointments to
the Board, and the membership of the Board ensures that the government appointees
form the majority.2 While the voting of the Board is recorded, the minutes of thesemeetings are not published and are effectively unavailable to the public.3 Board
members are appointed for 7 year terms, significantly longer than Australia's 3-year
election cycle.

2 The Board has nine members: the RBA Governor (who is also Chairman), the Deputy Governor, theSecretary to the Treasury and six other members. Of the remaining six members, at least five must be
persons who are not officers of the RBA or of the Australian Public Service.
A request to publish the Board minutes is regularly raised by the House of Representatives SelectCommittee, chaired by David Hawker. See press comment on this issue for the period July-August 2000.

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Section 11(1) of the RBA Act 1959 requires the RBA Board to inform Governmentof the RBA’s monetary policy. Section 13 states "the Governor and the Secretary to the
Department o f the Treasury shall establish a close liaison with each other and shall keepeach other fully informed on all matters which jointly concern the Bank and theDepartment of the Treasury". In practice the Governor and Treasurer consult regularly
through weekly telephone calls and monthly meetings timed to coincide with RBA
Board meetings (Committee 1993b, p. 154). Before announcing a change in monetary
policy, the Governor advised the Treasurer of the decision taken by the Board. The
respective responsibilities for Australia's monetary policy were clarified in a jointstatement issued in 1996 by the Treasurer and the newly-appointed RBA Governor, aStatement on the Conduct o f Monetary Policy (“the 1996 Statement”). Until this time,
both the RBA and the Treasurer issued press releases announcing a change in monetary
policy, but this practice was ended as it led created the potential for confusion.4

Second, the Government has the right to issue a directive to the RBA in the event of adisagreement over monetary policy, under section 11 of the RBA Act 1959. This
directive is public and must be laid before Parliament within 15 sitting days.5 This
directive establishes the government’s ultimate control over monetary policy similar tothe case o f the Bank of Canada. A directive has never been issued and - again similar to
the Bank of Canada - this power is seen as a knife that cuts both ways, either increasingor decreasing central bank autonomy based on how it is interpreted.

4 The Treasurer will commonly hold a press conference to discuss the implications of rate changes for the
economy, but this arrangement is ad hoc.
5 If the Treasurer and the Board cannot reach agreement, a formal process exists allowing the Treasurer todetermine the policy to be adopted by the Bank. The process involves a number of parties, and ensures
such an action is made in a transparent fashion.

228

Third, government intervention in the Australian financial system prior to the 1980s
meant that the monetary instruments available to the RBA were limited.6 The financial
sector was heavily controlled through government restrictions on interest rates and bankloans, and the Australian dollar was pegged to the US dollar. Debt management
dominated monetary policy, as the Treasury would set the interest rates on securities
sold to the public, making up any shortfall in it deficit financing by placing Treasuries
with the RBA (RBA 1993). To further complicate matters, the government often soldsecurities to offset the monetary effects of foreign exchange movements. The RBA
needed the Treasurer’s permission to change its monetary instruments as thegovernment regulated both interest rates and the quantity of bank loans. The RBA
gained greater operational independence from government in the 1980s following
financial sector deregulation (Capie, Goodhart, and Schnadt 1994, p.224). From 1979
the government began auctioning Treasuries, and in 1985 it negotiated an overdraft
facility with the RBA. Finally in 1986, the Treasury recognised that it needed to financeits deficit entirely with auctioned securities, and in an exchange of letters the Treasurer
informed the RBA that the government would no longer place Treasury bills with theRBA.7 Only when these changes were in place could the RBA make effective use ofopen market operations as the main instrument of monetary policy without Treasury
interference. However these agreements remain informal, and technically thegovernment could force the RBA to monetize its debt. Such as situation would
inevitably lead to a public confrontation between politicians and the RBA, as it would
compromise the inflation target. On this basis of these legal and operational provisions,
the RBA is portrayed as having only a tenuous form of independence.

6 The RBA relied on moral suasion and more direct controls on the banks, as opposed to the more indirect
instruments used today.
7 The RBA continues to purchase government debt, but only to replace maturing issues or in the course ofopen market operations.

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7.2 Challenging Economic Background

Political debates concerning RBA independence emerged during the 1980s against the
backdrop of a challenging external environment. Australia, like New Zealand, faceddifficulties with government finances, the balance Of payments and the traded sector. In
1983, the incumbent Liberal-National coalition under Prime Minister Fraser was
defeated by an untested Australian Labor Party (“ALP”) led by Prime Minister Hawke
that took power after nearly a decade out of office. The new ALP government was facedwith two immediate problems - a larger-than-expected budget deficit of A$9.1 billion
and speculation against the currency in international markets. Prime Minister Hawke
and Treasurer Keating were forced to make an about-turn on their election promises,
dumping the government’s expansionary policy that had been paraded in the election
campaign, and devaluing the currency by 10 per cent (Carew 1992, p.90). Like theircounterparts in New Zealand, the ALP subsequently instituted a series of neo-liberal
reforms that went far beyond what the previous conservative government had thoughtpossible - reforms described as a hybrid of neo-liberalism and neo-corporatism (Castles
et al. 1996; Higgott 1991; Keating et al. 1989).

Treasurer Keating's mini-budget in May 1983 signalled the start of the ALP’s
conversion to 'economic rationalism'. The ALP began a radical deregulation of thefinancial sector along the lines proposed by the Campbell Inquiry into the AustralianFinancial System - reforms which the ALP had opposed in opposition and were seen by
the incumbent conservative government at the time as too radical (Carew 1992, p.97;
RBA 1989b). The highlight of the reforms was the decision taken in December 1983 tofloat the currency and to remove exchange controls - a decision forced on the ALP
government by speculation against the exchange rate peg. Prime Minister Hawke recalls
how the inflow of foreign capital into Australia in 1983 and early 1984 forced the ALP
government to introduce these reforms, despite opposition to this move by Treasury

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Secretary John Stone. “With hundreds of billions of dollars washing around theworld every day it was futile to believe that our little economy could say to the rest of
the world: ‘Listen and learn, this is going to be our exchange rate today, like it or lumpit’” (Hawke 1994, p.246). The extent of the ALP’s neo-liberal turn was highlighted in1984 when both Institutional Investor and Euromoney magazine named Treasurer
Keating as the Finance Minister of the Year (Carew 1992, p.122).

The main plank of the ALP's strategy was the 1982 Prices and Incomes Accord (“theAccord”), agreed with the peak organisation for the unions, the Australian Council ofTrade Unions (“ACTU”).8 Prime Minister Hawke had actually negotiated the terms of
the Accord when he served as ACTU President during the late 1970s, with then ALP
party leader Bill Hayden and Shadow Treasurer Ralph Willis. The details were thenfinalised in late 1982 (Carew 1992, p.78) The Accord was approved by the ACTU
membership at a special conference in February 1983 and adopted by the newly elected
government following a national economic summit in April 1983 (Carew 1992, p.77).9
The ACTU agreed to nominal wage restraint in exchange for a government promise of atax cut to benefit the unions, which was delivered as part of the August 1984 budget(Carew 1992, p. 83). The Accord covered public sector and private sector workers alikeand held base pay hikes below inflation during the 1980s. The Accord was renegotiatedeight times between 1983 and 1996, with later versions contained allowances forsecond-tier wage hikes based on productivity increases (Schwartz 1994; Stilwell 1993).
By promoting voluntary wage restraint under encompassing unions, the Accord allowed

8 Trade unions were willing to consider wage restraint under an ALP government due to the anti-union
rhetoric of the incumbent conservative Fraser government that had imposed wage indexation in response
to inflation (Bray et al. 1996, p.72).
9 The four-day summit was held in the House of Representatives and was attended by 33 delegates
representing government, industry and the trade unions.

231

real unit labour costs to fall along with unemployment, which declined from a post­
war peak of 10 per cent in 1983 to a low of 6.3 per cent in 1989.

The ALP government faced financial difficulties on all fronts. Domestically, a sharp
wage explosion in 1982 accompanied by a sharp depreciation of the Australian dollar
was followed by a severe recession in 1982-1983.10 The government then faced rising
current account deficits that reached 6 per cent of GDP in 1989. In May 1986, Treasurer
Keating suggested in a radio interview that Australia may become a ‘banana republic’
and warned of an impending financial crisis - a statement that captured headlines,
caused a sharp fall in the currency and opened a rift with Prime Minister Hawke (Carew
1992, p. 172; Castles et al. 1996, p. 15).

Internationally, rising current account deficits led to historically unprecedented foreign
debt levels that quadrupled between 1983 and 1989, reaching 45 per cent of GDP,
leading Moody’s to downgrade Australia’s foreign currency rating from Aaa to Aal(Higgott 1991).11 Foreign currency debt issued in international capital markets
represented 30 per cent of Australian government debt by June 1987 (Johnson 1997).

10

In July 1989, Treasurer Keating banned Treasury and RBA staff from speaking to
Moody’s officials when they conducted their review o f Australia’s rating, which did not
help Australia to avoid a second downgrade from Aal to Aa2 (Carew 1992, p.261).
Table 49: Australian Gross Debt Levels (% of GDP)

10 In the area of trade, Australia and New Zealand were caught up in a trade conflict between the US and
its main trade partners, Japan and the European Community, over agricultural subsidies (Higgott 1991).
11 More than three-quarters of foreign debt was issued by the private sector (Higgott 1991, p. 16).
12 This amount does not include foreign currency borrowing by private Australian companies, orgovernment-owned entities.

232

Date

PrivateSectorPublicSector 1

Total
Debt

Of which
Foreign Debt

1989

92.2

41.8

133.9

45.1

1990

94.4

38.3

132.6

49.1

38.8

133.6

50.9

1991

94.8

1992

93.3

42.0

135.4

51.9

1993

90.0

48.4

138.4

54.0

1994

88.4

50.1

138.5

54.1

1995

89.9

47.4

137.4

55.1

1996

94.1

44.5

138.7

54.4

1997

96.9

41.6

138.6

56.7

1998

100.7

38.7

139.4

60.0

1999

108.2

34.5

142.7

61.1

2000

114.1

28.9

143.0

64.8

2001

121.7

25.6

147.2

76.4

1. Debt issued by Commonwealth and states.
Source: Australian Bureau o f Statistics

Figure 10: Australian Public Debt Levels■ G r o s s P u b lic D eb t (*/• o f G D P)

1996

■ G r o s s F o r e ig n D e b t (% o f G D P )However, the measures introduced by the ALP succeeded in turning around thegovernment’s finances. In September 1987 Treasurer Keating was able to announce abalanced budget, the first in 17 years (Carew 1992, p.229). A budget surplus followed233

in August 1988 - the first surplus in 35 years - allowing the government to start
paying down the Commonwealth’s foreign debts (Carew 1992, p.245).13 Despite
success in controlling the government finances, headline inflation remained stubbornly
high, above 7 per cent at the end of the 1980s. Driven by financial deregulation and theunindexed tax system, speculation had pushed up asset prices in real estate and equity(Grenville 1997, p. 138). In response to these inflationary pressures, the RBA pushed up
short term interest rates by 7 per cent between April 1988 and July 1989 in order tosupport the currency and to cut off inflation, bursting the asset bubble, and contributing
to an unexpectedly severe recession in 1990-91.

Figure 11: Australian Inflation and Unemployment PerformanceU n e m p lo y m e n t %By November 1990, Treasurer Keating finally admitted that the Australian economy
was in recession (Carew 1992, p.284). The government’s finances deteriorated again,
running from a surplus o f 1.8 per cent o f GDP in 1989-1990 to a budget deficit o f 4.2
per cent o f GDP in 1992-1993 (Singleton 1997, p .118). Despite its negative effects on

13 In Australia, the budget moved from a deficit o f over 4 per cent o f GDP in 1983-84 to a surplus o f over
2 per cent in 1989-90 (Debelle 1996, p.65).

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the government's finances, the recession succeeded in bringing down inflation toaround 2 per cent by 1992, where it remained for the remainder of the 1990s. Official
interest rates declined by 5 per cent over 1991. The Australian currency depreciated by
20 per cent between 1988 and 1993. Currency depreciation further worsened Australia’s
foreign debt situation by pushing up its value in Australian dollars, although Australia's
net foreign liabilities remained unaffected due to an off-setting inflow of foreign equity
investment.

This brief review has highlighted the complicated interaction o f monetary policy andinternational economic policy for a small, open economy like Australia. The ALP and
the RBA were forced to take radical steps to bring the government finances andinflation under control. The ALP introduced nominal wage restraint in cooperation withthe trade unions under the Accord. It floated the currency and deregulated the financial
system. The ALP also introduced tax reform and pursued a tight fiscal policy throughspending cuts in combination with a disinflationary-monetary policy. These reforms,
together with a restrictive monetary policy, contributed to a recession that finallybrought down inflation, but these changes played havoc with Australia’s export sector
and foreign currency debts, and pushed up unemployment.

7.3 Political Debates over RBA IndependenceGreater RBA independence was publicly debated in Australia on a number of occasions
between 1989 and 1996. The issue gained prominence following the 1989 reforms inneighbouring New Zealand. An off-hand remark in February 1989 by ALP Treasurer
Keating to the effect that the RBA ‘did what he told it to do’ led to accusations from thepress and the opposition that the RBA was under the influence of the ALP government.
The debate heightened in 1989 with Treasurer Keating’s appointment of Treasury
Secretary Bemie Fraser as RBA Governor. This debate was politicised from 1991-1993

235

when the opposition Liberal-National coalition campaigned for greater RBA
independence and with a mandate of price stability. The debate ended in 1996 when the
newly elected Liberal-National government issued a joint statement with Governordesignate Macfarlane that endorsed the RBA's inflation target and reiterated thegovernment's support o f the RBA’s independence. Each of these political episodes will
be described in turn.

Appointment of G overnor F raser

The issue of RBA independence took on political significance following theappointment in 1989 of former Secretary of the Treasury Bemie Fraser as RBA
Governor, a move that was seen as reducing the independence of the RBA. Fraser was
known as a close confidant o f the ALP Treasurer (and later Prime Minister) Keating,
who had appointed Fraser as Secretary of the Treasury in 1984 (Debelle 1996; Fraser
1996; Macfarlane 1998).

Shadow Treasurer (and later Opposition Leader) John

Hewson alleged that the government had pressured the RBA to ease interest rates in the
run-up to the March 1990 election, which was won by the incumbent ALP (Macfarlane1998).14 In a press release on 15 May 1991, Hewson stated: “It is absolutely essentialthat the Reserve Bank be free of political interference so as to be able to implementmonetary policy in a sustainable, consistent, and transparent manner”. 15These
accusations of government interference were rejected publicly by RBA Governor Fraser
on numerous occasions. He denied them shortly after his appointment in 1989 andcontinued his denials with his last speech as governor in 1996 (Fraser 1989, 1991,
1996). “We can and do pursue our statutory responsibilities without political

14 The conservative opposition had levelled similar accusations RBA Governor Johnston between 1986
and 1989 (Fraser 1991, 1996). See also the letter to the Editor in the Australian Financial Review on 7
October 1988.
15 Hansards, 15 May 1991, "Question without Notice: Employment", p.3769.

236

interference. But we seek to do this in close consultation with the government - toexercise independence with consultation” (Fraser 1993, original emphasis).

Predictably, Governor Fraser downplayed the need to legislate greater independence for
the RBA or give it a narrower mandate of price stability. Governor Fraser’s voiced threeobjections to independence. First, increased central bank independence does notnecessarily lead to low inflation without the support of fiscal and wage policies. Second,
credibility cannot be legislated - it must be earned. And third, multiple monetary policy
objectives combined with policy flexibility are important in the Australian context given
the need to respond to domestic and international shocks (Fraser 1994b). The suggestionthat low inflation is the result of central bank independence, Fraser argued, was over
simplistic. In support of this view he cited the anti-inflationary sentiment of the German
people and the performance o f the politically controlled Bank of Japan (Fraser 1989).
Governor Fraser argued that the RBA has not been inhibited from raising interest rates
under the current framework, as had occurred over 1988-89. He concluded that “thequality of the Bank’s analysis and its capacity to persuade the Government...count for
more than enhanced legislative ‘independence’” (Fraser 1989).

Nor did Governor Fraser feel the RBA’s mandate should be narrowed to the pursuit ofprice stability, as the effects on the real economy could not be ignored. “As apractitioner, rather than a theoretician, I believe a central bank has to be concerned
about growth as well as inflation objectives.. .[There] is always a good deal to be said from the practitioner’s perspective - for retaining a wider margin of flexibility anddiscretion than is normally available with targets” (Fraser 1991, p.5). Focussing solely
on price stability by adopting an inflation target would lead to ‘unacceptable
recessionary costs’ and would unnecessarily constrain the RBA. On these points,

237

Governor Fraser had the full support of Deputy Governor Phillips, a known inflation
hawk and career central banker (Phillips 1992). Given that inflation had been brought
down to 3.5 per cent by 1991, the urgency of such a reform was not apparent.

Fightback! and Inflation Targeting

RBA independence became politicised when this proposal was included in the LiberalNational coalition’s Fightback! package, unveiled in November 1991. Fightback!
formed the basis of their 1993 electoral platform and was portrayed by critics as theAustralian equivalent o f the ‘economic rationalism’ introduced in New Zealand (Easton
et al. 1996, p.24). Fightback! featured a proposal to amend the RBA Act 1959 tolegislate greater central bank independence and a single objective of price stability.
Liberal MP Reith outlined the opposition’s proposals:
The changes to tackle inflation will have to be extensive. Firstly, the incoming
government will have an unshakeable commitment to beating inflation.
Secondly, we will set a clear target for eradicating inflation...of nought to 2 per
cent... Thirdly, we will secure real independence for the Reserve Bank byamending the Reserve Bank Act 1959. I have already prepared a first draft,which will be an exposure draft in due course, of the amendments on which wewill seek comment, and which we will eventually introduce. The legislation will
establish a new charter for the Reserve Bank with price stability, beating
inflation or taking on inflation as its principal objectives.16
The Liberal-National coalition proposal, as envisaged, would 'tie the hands' of thegovernment and eliminate any future political interference in the setting of interest rates.

The proposals contained in Fightback! owe much to Liberal leader Hewson’s
professional and academic background. Hewson completed a PhD in economics at John

238

Hopkins University and worked at the IMF, before returning to Australia to serve as
Visiting Economist at the RBA from 1974-76. This academic training and professional
work experience shaped his belief in ffee-markets and his opposition to politicalintervention in the economy (Abjorensen 1993, p.64). In 1976 Hewson became
Economic Advisor to the Liberal government and, together with Liberal MP John
Howard (later Prime Minister), wrote the terms of reference for the Campbell Inquiry
into the Australian Financial System (Abjorensen 1993, p.81). Hewson then took up his
post at the University of New South Wales, which he supplemented in 1985 by serving
as Chief Economist of the newly founded Macquarie Bank. Hewson successfully ran for
Parliament in 1987 for the Liberal Party, was named Shadow Minister for Finance in the
Howard opposition in 1988, being named Liberal party leader following the 1990
election defeat. The Fightback! package unveiled halfway through the parliamentaryterm in November 1991 was put together by Hewson, Peter Reith and John Howard.
Apart from legislative independence for the RBA with an inflation target, Fightback!
featured a proposed 15 per cent Goods and Services Tax (“GST”), a major cut in thesize of government, reduction in trade protection and wage-setting reforms (Barnett etal. 1997, p.579). It was accompanied by a set of industrial relations proposals under asecond document, Jobsback.

The ACTU was strongly opposed to Fightback/, viewing it as doctrinaire andinappropriate in the Australian context. As an ACTU representative recalls: "We did not
publish any 'research' defending the multiple goals of the RBA. Our 1983 'Accord' withthe then Labor government was premised on fighting unemployment and inflation
simultaneously and rejecting 'fight inflation first' monetarism. It has always been our
position that the Bank can and should pursue full employment and low inflation in

16 Hansards, 15 May 1991, "Price Stability: Discussion of Matter of Public Importance", p.3780.

239

maximising the welfare of the nation's people." A formal inflation target was
unnecessary, as the 1990 Accord included an agreement to achieve wage settlements at
a level consistent with Australian inflation remaining in line with that of our trading
partners. In practical terms, that meant keeping inflation in a 3% - 4% range.17

The ALP’s initial failure to adequately respond to the Liberal-National coalition’sFightback! economic package led the ALP caucus to depose Hawke as party leader andPrime Minister in favour of Keating in December 1991 (Barnett et al. 1997, p.583;
Carew 1992, p.299).18 Prime Minister Keating rejected greater independence for the
RBA on the grounds of parliamentary accountability during parliamentary debates in1991 and 1992. He argued that the current division of responsibilities between the
Treasury and the RBA and the multiple objectives for monetary policy was appropriate,
citing retiring Deputy Governor Phillips views in support.19 Keating went on to claimthat the RBA had independence, and that the opposition’s interpretation of the situation- and Keating’s comments about ‘his pocket’ - were false. Keating stated:
I have said in the Parliament on a number of occasions that governments andparliaments should be the supreme and accountable bodies to the public ofAustralia and that the right balance exists between the powers of the Reserve
Bank under its legislation and the prerogatives of the government. That is anappropriate balance between the prerogatives of the government and the rights
and entitlements of the Reserve Bank board. I have said that the existingarrangements work well, that the Reserve Bank Act is crafted well to encourage
the board and the government to agree, and that price stability and full

17 Grant Belchamber, Senior Research Officer of ACTU, correspondence dated 13 and 14 August 2001.
18 After unsuccessfully challenging Hawke as ALP leader in June 1991, Keating resigned the Treasury
portfolio and retired to the backbench.
9 Hansards, 26 March 1992, "Question without Notice: Reserve Bank of Australia", p. 1232.

240

employment are the dual objectives. They were well constructed when the
Act was written and they remain well constructed.20
The ALP argued that the proposals in Fightback! would lead to a rise in interest rates
and unemployment. ALP Treasurer Dawkins argued: “What [Hewson] knows is that, asa consequence of trying to target, amongst other things, inflation between zero and 2 percent and, as a result, put up interest rates and therefore make Australian industry andAustralian jobs the chopping block of the Opposition’s policy, unemployment must go
21

up”.

Prime Minister Keating responded to Fightback! by launching a jobs-based

package, One Nation, in February 1992. At the time, unemployment stood at 11.2 per
cent. One Nation included proposals aiming for higher inflation in the range of 3 to 4
per cent, in contrast to the 0 to 2 per cent proposal in Fightback!.

In the 1993 election, the ALP was re-elected with a sizeable majority. Political scientists
attribute the result to the failure o f Hewson’s Fightback! to offer any solution for therising unemployment. Instead their program looked set to make the situation worse(Singleton 1997, p. 114). Following this defeat, Hewson was replaced as opposition
party leader in May 1994 and the proposal to change the RBA’s legislation was
subsequently dropped by the Liberal Party.

Market P ressu re and the 1996 Joint S tatem ent

Developments in the bond markets appeared to cast doubt on the RBA’s commitment toprice stability. Despite having a significantly lower debt than either Canada or New
Zealand, the long term interest rate differential between Australia and the USA rose
during late 1993 and early 1994 to a level higher than Canada or New Zealand (Debelle

20Hansards, 9 September 1992, "Question without Notice: Reserve Bank of Australia", p.596.
21 Hansards, 24 March 1992," Question without Notice: Reserve Bank of Australia ", p.938.

2411996). Bemanke et al (1999) highlight financial market concerns with thegovernment's credibility:
While it became clear in early 1994 that the Australian economy was rebounding
strongly from the 1990-91 recession, the bond market downturn over the firsthalf of 1994 sent 10-year government yields from 6.4 per cent to 9.6 per cent.
That was twice the increase in long-term yields in the United States, and 1 percent more than in New Zealand, suggesting that the Reserve Bank’s
commitment to price stability was not fully credible among financial market
participants (p.222).
Debelle (1996) suggests that this premium may be due to Australia's "lower antiinflationary credibility" (p.71). Meanwhile the Australian dollar was being described in
the financial markets as the ‘peso o f Asia’.

Governor Fraser was on the defensive, making two major speeches on the topic ofcentral bank independence towards the end of the year (Fraser 1994a, 1994b). He
argued that a central bank with multiple objectives such as the RBA, the Fed or the
Bank o f Canada was not by definition ‘soft’ or ‘wimpish’ on inflation. Governor Fraser
repeated his view that “[Underlying] inflation of around 2 to 3 percent is a reasonable
goal for monetary policy”, describing such a rate as “not dramatically different from themore formal targets in the United Kingdom, Canada and New Zealand” (Fraser 1994a).
He concluded by noting that the RBA had gained significant instrument independence
in the 1980s through deregulation in the financial sector and the separation of debt
management from monetary policy. Fraser repeated these points more forcefully in thesecond speech in which he gave his strongest criticism of central bank independence todate (Fraser 1994b).

242

The issue of RBA independence re-emerged during the 1996 election. Prime
Minister Keating painted the opposition’s position in terms of a distributional conflictover inflation in a radio interview:
If this Government were to be defeated, the Accord goes, the sensible wage
outcomes go. So the only way you run the economy is then through higher
interest rates. A Liberal Government would turn straight to the Reserve Bank.
When they talk about Reserve Bank independence - you know this expression
they use - that's just code for higher interest rates. Every percentage point on the
inflation rate is one percentage point on interest rates, and they would run a lowgrowth, low-employment society. (Source: Hansards)
The opposition, led by Liberal MP Howard, refuted these claims, with Shadow
Treasurer Peter Costello announcing that a Liberal-National coalition, if elected, would
not seek to change the statute governing the RBA.

In March 1996, the centre-right coalition of the Liberal and National Parties was electedunder Prime Minister Howard, ousting the ALP that had been in power for thirteen
years. Bill Kelty, ACTU Secretary and a member of the RBA Board, resigned his
position in protest only to be replaced by a representative of the powerful mining
industry. Given that Governor Fraser’s term was set to expire, Prime Minister Howardnominated a new RBA Governor, Ian Macfarlane, who had served as Deputy Governor
under Fraser. Then in August 1996, the Liberal government issued a joint Statement on
the Conduct o f Monetary Policy with Governor-designate Macfarlane - a statement thatwas prepared without Fraser’s knowledge (Fraser 1996; Macfarlane 1996). “TheGovernment recognises the independence of the Bank and its responsibility formonetary policy matters and intends to respect the Bank’s independence as provided bystatute” (RBA 1996, p.l). However, the statement went on to cite the governments

243right under the Act to direct the RBA and the RBA Board’s requirement to informthe Government of the RBA’s policy. Treasurer Costello publicly endorsed the RBA's
inflation target o f 2 to 3 per cent over the business cycle.22 Governor Fraser’s reaction
was suitably sardonic: “[While] I see no particular need to be further emphasising the
inflation objective, that will, no doubt, be welcomed by many in the central banking
fraternity, the financial markets and at least some parts of the media” (Fraser 1996). The
inflation target was to be supported by arrangements to ensure transparency andaccountability, such as semi-annual statements on monetary policy and appearances by
the Governor before a Standing Committee of the House of Representatives. Finally, thegovernment ended the practice of making parallel announcements of monetary policychanges, reinforcing the RBA’s control of this instrument.

The 1996 joint-statement was intended to increase the anti-inflationary credibility ofmonetary policy by specifically addressing the concerns of international financial
markets concerning the RBA’s independence from politicians (Australia 1998, p.23). In
a press conference following the announcement, Treasurer Costello made this clear,stating:
The purpose o f this statement is not only for Australia but internationally. To
underline the independence of the Bank, the responsibilities that come with that,and the accountability that comes as a consequence. I want to make it entirely
clear, that the statement is designed to enhance the independence, thetransparency and the accountability of the Bank and indeed the Government.

22 By 1995, ALP Treasurer Willis was openly endorsing the RBA’s inflation target, but nowhere was thisendorsement formalised (Macfarlane 1998). It was also included in the June 1985 agreement between the
ALP government and the ACTU over the Accord Mark VIII.

245

statute governing the central bank in order to remove the threat of politicalinterference (Hendy et al. 1995). Opponents of central bank independence argue that thecurrent arrangements provide too much independence and undemocratic accountability
for the RBA (Eichbaum 1993; Gangopodhyay 1996). For the purposes of this thesis, thefailure to change the RBA’s legislation must be seen as an exception to the overall trend
in the 1990s towards legislating greater operational independence for the central bank,narrowly conceived. The RBA still has multiple goals for monetary policy, a Treasury
official sits on the Board, and the government has the ultimate power to issue a directive
to the central bank in case of a disagreement on monetary policy. Rather than giving the
RBA more independence, the 1996 Statement endorsed the RBA’s intermediate target
and its de facto independence in the setting o f monetary policy. Given thisinterpretation, which theories from the literature best explain the failure of politicians tochange the legislation of the RBA?

Domestic Interest Group Lobbying

Financial Sector
Posen’s hypothesis concerning effective opposition by the financial sector has not been
supported, despite the Australian case satisfying most of the criteria Posen argued
would render financial sector opposition effective: a federal political structure, a stabledual-party system with low fractionalisation, and a concentrated financial sector withshared preferences opposed to inflation. The development of the Australian financial
sector has concentrated economic power in the hands of four, oligarchic commercial
banks - ANZ, Westpac, National Australia Bank and the Commonwealth Bank - thatare represented by an encompassing trade association, the Australian Bankers
Association. The market position of these domestic banks was protected frominternational competition by a ban on foreign banks that was only lifted in 1986 when

23 Hansards, 14 August 1996, “Speech by the Hon. Peter Costello, MP. Commonwealth Treasurer”.

244

The statute governs the Bank's responsibilities. The Government does notpropose any change to the statute.
The joint statement obviated the need to reform the RBA Act 1959. Governor
Macfarlane gave his own view of events, saying “The Statement...at the time of myappointment was a means of clearing up any remaining ambiguity about the relationshipbetween the Government and the Reserve Bank” (Macfarlane 1996). He went on toacknowledge that “it is not possible to point to an exact date when the Reserve Bank
passed from being dependent to independent” but he sees it occurring as a result of theinstitutional changes taken by the government between 1983 and 1996 (Macfarlane1998).

That the incoming conservative government saw the need to publicly re-assert theindependence of the central bank suggests that the current arrangements lacked thetransparency that private actors desired. By endorsing the RBA's inflation target as theoperational guide for monetary policy, the government created a more transparent
framework by which to judge monetary policy decisions. This endorsement effectively
narrowed the RBA’s mandate to the pursuit of price stability. This change wasconsciously taken without amending the RBA Act 1959 and without narrowing thestatutory goals of the RBA. While the joint statement does not qualify as a legal or dejure change in the RBA’s institutional framework, it clearly reflected a de facto movetowards greater central bank independence.

7.4 Assessment of Hypotheses

The Australian case represents something of an unsatisfactory conclusion for research
into central bank independence, as it does not present a clear victory for either side ofthe debate. Some economists continue to argue that there remains a need to change the246

16 foreign banks were granted licenses. The banking market was also protectedfrom domestic competition by government controls on bank lending and interest rates,
and legal restrictions on the activities of different classes of institutions. These criteria
should have translated the commercial bank’s economic power into significant politicalinfluence.

This does not appear to be the case, judging from the evidence. Under the ALP,
Treasurer Keating overcame opposition within his party to allow the entry of foreignbanks, on the basis that refusing foreign entry would only benefit the domestic banks
who were the traditional enemies of the left (Hawke 1994, p.253). Foreign entry put
pressure on domestic banks' profits leading to bankruptcy of a number of smaller
institutions when the business cycle turned. Then in 1990, Treasurer Keating vetoed aproposed merger between the ANZ Bank and National Mutual Life in 1990, arguingthat it was contrary to the national interest (Carew 1992, p.271). Finally in 1990
Treasurer Keating announced an inquiry into competition in the Australian banking
sector, on the basis that the banks were earning excessive profits by failing to reduce
their interest rates in line with the official rate even as the economy began to stall(Carew 1992, p.279). Nor did the commercial banks fare better under the Liberal
government elected in 1996, as Treasurer Costello vetoed more proposed bank mergers.

The failure of Australian banks to realise their political influence may be explained bytheir failure to meet two of Posen’s criteria for effective influence. During the period
being studied, these banks did not operate as universal banks, due to the historical andlegal separation of financial services. However they did gain significant exposure toinvestment banking over the course of the 1980s, as deregulation allowed them tobecome more involved in investment banking. A second barrier identified by Posen was

247

the regulatory structure. The commercial banks may have faced a conflict of interestin supporting greater independence for the RBA, which had primary responsibility forbanking supervision up until 1998. Still researchers note that the closed network ofAustralian banking, with limited participation by foreign banks and an informal
regulatory structure prior to 1989, created a strong set of ties between the banks and the
RBA that only eroded over the 1990s. In this view, the regulatory structure should nothave prevented the banks from lobbying for greater central bank independence.
Business
Business had little political influence over the ALP government, although it fared better
under Prime Minister Hawke then it did under Prime Minster Keating. Prime Minister
Hawke developed a harmonious relationship with business without betraying theAustralian Labor tradition (Castles et al. 1996; Singleton 1997). He establishedindependent bodies such as the Economic Planning Advisory Council, the Industrial
Relations Commission and the Australian Manufacturing Council as public forums fordeveloping a consensus around the need for economic reform. By contrast, Treasurer
Keating had made his antagonism towards business clear, stating on the eve of the 1989
election that any business executives who backed the Liberal-National coalition would
be cut off from government. This vindictiveness may have resulted from the role playedby business associations in sinking Keating’s proposed consumption tax at a Tax
Summit held in July 1985.24

Prime Minister Keating preferred to deal with individuals rather than groups, and under
his term as Prime Minister he showed no interest in meeting with business
representatives or of formal tripartite bargaining arrangements. He froze out the248

influence of Economic Planning Advisory Council set up by Prime Minister Hawke
as the main forum for interest-group consultation on the economy, then remodelled it as
the Prime Minister’s Economic Round Table, staffed by experts rather than interestgroup representatives. True to his word, Keating refused to deal with the AustralianChamber of Commerce and Industry ("ACCI") following the 1993 election due to thisgroup's public endorsement of the Labor-National coalition’s Fightback! proposals.
When asked about the ACCI’s role in government policy, Prime Minister Keating
commented that the ACCI could put in all the submissions it liked, but they would go‘straight into the wastepaper basket’ (Singleton 1997, p. 144). Business groups like theBusiness Council of Australia, the Metal and Trades Industry Association and the ACCI
did retain contact with the ALP government, but only at the bureaucratic and ministerial
level and only on a non-partisan basis.
Organised labour
The failure to legislate greater central bank independence for the RBA may be
explained by opposition to such a move by the trade unions, acting through the ACTU.
Organised labour assumed considerable political influence following the election of the
ALP in 1984. The trade unions were in a position to control ALP policy as they held
significantly more than half the votes at ALP conferences where party policy is decided(Castles et al. 1996, p. 13). Senior ALP officials had close, personal links with theunions, especially with Prime Minister Hawke who had worked for the ACTU for morethan two decades. While at the ACTU, Hawke has sat on the RBA Board for a numberof years, later to be replaced by ACTU Secretary Bill Kelty. Kelty had a close personal
and working relationship with Prime Minister Keating, which developed during the

24 The summit was attended by 160 delegates with business associations representing a third of thedelegates, represented by the Business Council of Australia, the Confederation of Australian Industry, and
the ACCI (Carew 1992, p. 135).

249

early years o f the Accord that they renegotiated together a number of times to adapt
to changing external circumstances (Carew 1992).

Institutional ties between the ALP and the ACTU allowed the ALP to pursue ‘bilateralcorporatism’ with the trade unions, rendering the process of Australian policy reform
more consensual, slower, and less painful to organised labour (Castles et al. 1996, p.l 1).
The Accord is given much of the credit for Australia’s relatively costless disinflation
relative to Canada, New Zealand, and the UK (Debelle 1996). Wage restraint combinedwith fiscal austerity allowed the ALP government to reduce inflation and public debt
levels, without a large loss increase in unemployment. The preferences of the ACTU
towards economic policy, as embodied in the text of the 1983 Accord, were opposed tothe adoption of monetarist solutions and in favour of job creation. The Accord called forthe use of a combination of fiscal, monetary and exchange rate policies to achieve thesegoals, and supported increased government intervention in the economy as opposed tomeasures that pushed up interest rates. The 1989 and 1991 ACTU Congresses opposed
the government’s tight monetary policy. In place of high interest rates, the ACTU called
for a return to the regulation of money flows, and rejected the adoption of monetary
targets. An independent RBA with a single objective of price stability was clearly
opposed to this policy preference.

Following the 1996 defeat of the ALP, the ACTU was forced to make its opposition tocentral bank independence public, due to the loss of insider access to policymakers. The
1997 ACTU Congress condemned the use of inflation targets and the effect of thedisinflation on unemployment. “The social impact o f the Howard Government's ‘fightinflation first economic strategy’ is becoming more and more devastating for ordinary
Australian families. The Federal Government's abject failure to develop far sighted

250

economic and industrial policies is hastening the jettisoning of jobs and the closureof Australian industries”.

The ACTU repeated its earlier call for a progressive mix ofpolicy and government intervention in the economy to create jobs and reduce
unemployment below 5 per cent, but did not mention the Reserve Bank directly.

P ressu re from International Financial Markets

The evidence for the power of international financial markets to direct policy reform inAustralia is mixed. The neo-liberal reforms introduced by the Hawke government from1984 were in response to a currency crisis following the election of the ALP, which led
to a ten per cent devaluation in the currency. Inflows of capital forced the ALP to float
the currency and remove exchange controls, which opened the door to the subsequent
financial sector reforms. Seen from this point of view, international financial market
pressure was effective in stimulating institutional reform. However, this source ofinternational pressure did not extend to the design of the central bank and its
relationship with the government. The ALP did not face any international financial
market pressure when it appointed Treasury Secretary Fraser as RBA Governor in 1989.
Nor did the electorate’s rejection of the conservative coalition’s reform proposals in the1993 election - which included an independent RBA with a narrow inflation target lead to a financial crisis. Instead the ALP was able to convince international investors of
its policy credibility by negotiating wage restraint with the trade unions and introducing
financial sector reform based on the recommendations of the Campbell Committee.
These policy choices, combined with fiscal austerity leading to a budget surplus in 1988
and 1989, convinced international investors of the ALP’s anti-inflationary credentials.

25 See: “1997 ACTU Congress Resolutions”, available for download from the ACTU website
www.actu.asn.au.

251

Australia’s foreign currency debt was a source of concern, as seen by thedowngrades by Moody's Investor Services in 1986 and in 1989. However, at no time did
the Australian Commonwealth have significant debt levels by industrial country
standards, with net public debt to GDP peaking at 35 per cent in fiscal year 1994-95(table 3). By the time of the second downgrade, the ALP had already recognised therisk inherent in this exposure and had brought the government’s finances under control.
Budget deficits in the late 1980s were used to pay down Australia’s foreign debt and theCommonwealth has not issued debt offshore since 1987. Instead government deficits
have been funded entirely in the domestic financial markets, which are deep, liquid andefficient. By 1997, only 1 per cent of Australian government debt was funded abroad,however currency swaps had been used increasing the exposure to foreign currencies to
11 per cent (of which 97 per cent was US dollars). These steps mitigated this potential
source of international financial market pressure.
Table 50: Net Public Sector Debt
Budget% o f GDP

Budget% o f GDP

Budget% GDP

1987-8832.8

1991-92

30.2

1995-9631.2

1988-8927.2

1992-93

34.4

1996-97

28.4

1989-9024.9

1993-94

34.4

1997-98

23.1

1990-91

25.7

1994-95

34.7

1998-99

19.5

Source: Australian Bureau of Statistics

The success of this strategy is evident from the bond market’s reaction. As thecredibility o f Australia's fiscal and monetary policy frameworks has been establishedwith financial markets, long-term interest rates have fallen, both absolutely and relative
to other economies. The 1999-2000 Commonwealth Budget noted that the interest rate
differential between Australian and United States 10-year Treasury bonds averaged
around 70 basis points over the final three years o f the 1990s, compared with an averageo f around 350 basis points over the 1980s.

□ A u stra lia lo n g term in te r e s t rate
O P r em iu m to lo n g term U S in t e r e s t rate'

Figure 12: Australian Long Term Interest Rates Relative to US

By floating the currency the ALP removed a second potential source of international
financial market pressure. Whereas Treasury Secretary Stone predicted a sharp
appreciation of the Australian dollar, the currency depreciated after 1984 as speculators
unwound their bets (Hawke 1994). The operation o f monetary policy under a floating
regime has further reduced the impact o f foreign exchange flows on the government’s
economic policy. In contrast to Canada and New Zealand, Australia does not respond to
short-term fluctuations in the exchange rate, believing such changes reflect shifts in theterms o f trade, rather than changes in inflation expectations or business cycles

253(Bemanke et al. 1999, p.226). In addition, Australia’s foreign exchange reserves are
owned by the RBA that has sole responsibility for currency intervention, removing thispotential avenue for political pressure as politicians do not bear the responsibility forany external shocks. The RBA has made it clear that monetary policy is determinedbased on the needs of the domestic economy, and not in response to pressure frominternational financial markets (Australia 2000, p.l).

It is not entirely accurate to say that Australian politicians were not concerned about
international financial markets. The Australian government has clearly responded tointernational market pressure at certain points. A sharp fall in the Australian dollar inearly 1985 led Treasurer Keating to hastily renegotiate the Accord with the ACTU dubbed Accord Mark II - in order “to show domestic and overseas financial markets
that the government was taking a tough line on wages policy” (Carew 1992, p.84).
During the 1990-1991 recession, with government debt rising, the judgement ofdomestic financial markets became more influential.

The lack of monetary policy

credibility under the existing framework was reflected in the rise in inflation
expectations and the premium charged on government debt following the recovery
beginning in 1993 (Bemanke et al 1999; Debelle 1996). And the Liberal-National
coalition elected in 1996 was paying attention when it issued the 1996 Statement insupport of RBA independence upon assuming office. This joint statement, including theendorsement o f the inflation target, was intended to signal the government’s
commitment not to interfere in monetary policy - a signal that was explicitly directed at
an international audience. However, the Howard government stopped short of changing

26 In 1993, Governor Fraser noted how international financial markets respond to perceptions of large on­going budget deficits and borrowing requirements, which were unfounded, but these perceptions cancreate major instability as occurred with the Australian dollar over 1992 and 1993 (Fraser 1993).

254

the RBA’s legislation, as originally suggested in the Fightback! proposals, due toopposition from the electorate over this proposal.

In summary, Australia has not been hostage to pressure from international financial
markets despite its high level of openness, both in terms of trade and in terms of capital
mobility, and its significant exposure to foreign borrowing in the late 1980s. Australia
has avoided this pressure by putting in place institutional frameworks that mitigate theability of international financial markets to pressure policy, such as negotiating theAccord with the trade unions to reduce inflationary pressures or floating the currency
and delegating foreign exchange policy to the RBA. And when the ALP did experiencefinancial market pressure, the government took action to consciously reduce thispotential point of weakness.

Ideas of the Epistemic Community

How influential were the ideas o f the epistemic community of academics, central
bankers and business economists for explaining this outcome? Prior to the period being
studied, commentators describe Australian monetary policy as influenced bymonetarism with the Treasury adopting informal monetary targets during 1976-1985
independent of the RBA.27 When monetary targeting and the subsequent ‘checklist’(introduced briefly in 1985) both failed, the Treasury and RBA became suspicious of
the economic paradigm and did not introduce a formal framework for monetary policy
until 1996. This long interregnum is partly a result of the domestic epistemic
community failing to agree on a clear alternative, leading policymakers to stick with thestatus quo.

255

Over this period, academic critics described Australia as inflation-prone andattacked the RBA for a lack of independence, calling for a “radical reform of thelegislation to create some new type of central bank subject to some form of binding
monetary rule” (Macfarlane 1998). A large group of economists were in favour ofmonetary reform, publishing a wide range of mostly orthodox proposals between 19901995 (Cole 1990; Dowd 1990; Hanke, Porter, and Schuler 1992; Hartley and Porter
1991; Hendy and Evans 1995; Jonson 1990a; Jonson 1990b; Stone 1990; Stone 1992;
White 1990). These proposals were backed by think tanks and were published in the inhouse publications of the Australian Institute for Public Policy, the Centre for Economic
Policy Research, the Centre for Independent Studies, the Institute of Public Affairs andthe Tasman Institute.

This epistemic community was not successful in influencing the outcome of the debate
for several reasons. First, there was no consensus among monetary experts on the needfor reform. Australian economists like Eichbaum (1993) challenged support of thiseconomic paradigm by suggesting that the RBA was too independent (Eichbaum 1993;
Gangopodhyay 1996). Eichbaum argued that the RBA should retain its multiple
objectives, as this situation best reflected the policy preferences of the RBA Board,which consisted of representatives from trade unions, manufacturing, retailing, andfarming interests together with an academic economist.

Second, and more significantly, senior RBA officials were opposed to a change in thecentral bank’s mandate. Governor Fraser and Deputy Governor Phillips both opposed anarrow mandate, which they saw as inappropriately reducing the flexibility of monetary

27 The Liberal-National coalition government of PM Frazer was clearly influenced by monetarism,
leading to lower inflation and higher unemployment in the early 1980s than neighbouring New Zealand(Castles et al. 1996, p.9).

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policy (Fraser 1989, 1994b, 1996; Phillips 1992). A single goal of price stability
was not appropriate for the Australian context given the prevalence of money-demand
shocks and terms-of-trade shocks (driven by changes in commodity prices) that hit theeconomy.

28

Narrow targets were seen as constraining the discretion of policymakers in

an unfavourable way, particularly given the RBA’s broad mandate to consider
employment and output in addition to price stability. Given the historical andinstitutional context, the RBA supported a broad mandate and lobbied against a change
in the RBA Act. Opposition to central bank independence received greater credibility
from empirical work demonstrating that countries with independent central banks had
higher sacrifice ratios and paid a greater cost in terms of lost output during disinflations(Debelle 1996; Debelle et al. 1994).

While opposed to changing their statute, RBA officials were in favour of adopting aformal inflation target. To their dismay, this issue became politicised before theacademic community had a chance to form a consensus around the idea. With the
Liberal's promoting this idea in their Fightback! election manifesto, the RBA was
unwilling to endorse this framework publicly for fear of being drawn in to a politicised
debate. As Macfarlane recalls, “It was a great disappointment for the Bank that thisdebate was politicised before the economics profession had time to explore it fully in an
objective non-partisan way. But it would be unfair to criticise either of the two politicalprotagonists for this - there is nothing wrong with them being quicker off the mark thanthe economics profession” (Macfarlane 1998). When inflation targeting was formally
adopted in 1996, this framework was put in place when inflation in Australia had beenbrought down, mitigating the need to change the legislation of the RBA (Debelle 1996;
Debelle and Stevens 1995; Stevens 1999). “In some senses, it was this that ultimately

257

proved decisive in confirming that it was possible to return to a low inflation
environment without radical change to the Reserve Bank or its Act” (Macfarlane 1998).
Events therefore moved on and mitigated the need to formally embed inflation targetingin the RBA statute.

Third, proponents of reform in the domestic epistemic community did not reach aconsensus around the need for central bank independence. Nor could they agree on analternative monetary framework, proposing instead a confusing array of alternatives(Macfarlane 1998; White 1990). Their proposals ranged from legislating New Zealandstyle reforms, to adopting a currency board, to returning to monetary or exchange rate
targeting, to adopting a commodity standard or to getting rid of the central bankaltogether (Cole 1990; Dowd 1990; Hanke, Porter, and Schuler 1992; Hartley andPorter 1991; Hendy and Evans 1995; Jonson 1990a; Jonson 1990b; Stone 1990; Stone
1992; White 1990). By failing to agree on a new paradigm, academics failed to provide
politicians with a roadmap for reform. Given the uncertainty surrounding monetary
policy in Australia, it is not surprising that politicians would not endorse a reform that
did not even have a consensus among the so-called experts. So instead of changing thelegislation, both the ALP and the Liberal-National coalition (following election in 1996)
stayed with the status quo.

Fourth, this proposal did not find a political champion among ALP politicians and did
not agree with their worldviews. While reformers found a political champion for this
proposal in John Hewson, the failure of the Liberal-National leader to win the 1993
election effectively led to his exit from politics. With Hewson gone Liberal leader

28 These shocks also ruled out a return to monetary targeting and exchange rate targeting, as both would
lead to large business cycles and a variable monetary policy (Edey 1997).

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Howard dropped the proposal as too controversial prior to the election, and then did
not champion this reform post-1996.

7.5 The Importance of Electoral GainsThe answer to the question ‘why did Australian politicians not tie their hands bychanging the legislation governing the Reserve Bank of Australia?’ is simple. They did
not have to. No politically influential interest group was lobbying for greater
independence, while the most important lobby - organised labour - was opposed tosuch a reform. Nor was there meaningful pressure through international financial
markets for such a reform. Instead this outcome reflects calculations by politicians of
the electoral advantages to be gained from such a policy, where the costs were found tooutweigh the gains. The ALP did not pursue this reform for four reasons: it was against
the interests o f their core constituency, it reduced unnecessarily the government’s policy
flexibility, it was supported politically by the conservative opposition and theincumbents benefited politically under the current institutional arrangements. For theirpart, the opposition Liberal Party did not consider this reform after it was elected due tothe number of checks and balances in Australia's political system, which make changing
legislation difficult. Each point will be addressed in turn.

Opposition of ACTU

The ALP resisted tying-their-hands during their 13 years in office because this policy
did not match the policy preferences of their core constituency, the trade unions. The
trade unions preferred job creation and a loose monetary policy, as expressed at annual
ACTU congresses in 1989-1991 and in the various versions o f the Accord between
1983-1996, and opposed any monetarist policy designed to 'fight inflation first'. Insteadof delegating to an independent central bank, the ALP found alternative institutional
mechanisms for controlling inflation while preserving policy flexibility. They
negotiated wage restraint with the ACTU to reduce this source of pressure, leading to259

the adoption of a de facto inflation target following the 1990 version of the Accord.
And they floated the currency and deregulated the financial sector to reduce externalpressure on monetary policy and to create an increased pool of domestic savings to fundgovernment deficits. Highlighting the success of these strategies, Prime Minister
Keating stated "It galls [the Opposition] to think that a cooperative process can actually
reduce inflation".29 Keating continued:
The Opposition would not have put together the agreed incomes approach under
the accord. It would not have taken the risks we took with the floating of the
spot rate and the exchange rate and the removal of exchange controls, or theabsolutely revolutionary change to dividend imputation and the change tooccupational superannuation. These are path breaking. We have done this in a
way in which we have pulled the weaker people in society along with u s.30
Liberal Party MP Reith saw the ALP’s political opposition to the inflation target inthese terms:“The Government has never had a real commitment to attacking inflation; infact, it has abandoned targets for inflation. Why is that? If one wants to see what
the decisions of these guys are based on, one only has to look at the most recent
poll. The Government says that it is not attacking inflation because there is noconstituency to tackle inflation and it is not prepared to wear what it sees as theelectoral costs of it.31
These statements confirm the view that a policy must have political salience in order forpoliticians to adopt it and to champion it through the legislative process.

29 Hansards, 15 May 1991, "Price Stability: Discussion of Matter of Public Importance", p.3784.
30 Hansards, 15 May 1991, "Price Stability: Discussion of Matter of Public Importance", p.3784.
31 Hansards, 15 May 1991, "Price Stability: Discussion of Matter of Public Importance", p.3780.

260
R educed Policy Flexibility

Central bank independence with an inflation target was seen as politically costly. A
narrow mandate reduced government policy flexibility to respond to exogenous shocks,
which has been a concern for policymakers in Australia - a concern that was shared bysenior management of the RBA. A narrow goal of price stability was not appropriate
given the prevalence of money-demand shocks and terms-of-trade shocks that hit theAustralian economy. Nor did it suit the Australian historical context where employment
and output were seen as important goals for monetary policy that should not be ignoredin favour of price stability.

Political Manoeuvring

The ALP could not realistically consider proposals to adopt an inflation target or to givethe RBA greater legislation because these proposals were being advocated by the
opposition Liberal-National coalition. Hewson politicised these proposals with theintent of embarrassing Keating over his perceived political interference in interest ratechanges and RBA appointments. Following the release of Fightback! in November
1991, it would have been politically costly for the ALP to endorse these proposals
without admitting their guilt in politically interfering with monetary policy. In addition,such a move would have been seen as a dramatic policy reversal for the ALP thatbetrayed their core supporters among the trade unions. Instead, the ALP made political
capital out of the proposals contained in Fightback! during the 1993 election campaign,
successfully portraying the Liberal-National proposals as anti-democratic and opposed
to worker’s interests. Following their 1993 election defeat, the Liberal-National
coalition also viewed their proposal to change the RBA’s legislation as a politicalliability, which they publicly renounced prior to the 1996 election.

261
Benefits of S tatus Quo

Apart from the political costs of these reforms, the ALP saw important electoral gains
from the current framework. The institutional arrangement in place allowed the ALP toappoint an RBA Governor who shared the government’s preferences of full
employment, output stabilisation and price stability, and who would accommodate
government economic policy. Under an independent central bank as proposed by the
opposition, there was a risk the central bank might be led by a conservative central
banker who preferred price stability above all else, leading to a conflict with ALP
government policy. Treasurer Keating stated: “[This] fight-inflation-first policy amountto no more than a strategy to keep the economy comatose over a long period to grind
inflation out of the system...We target lower inflation and other policy targets
simultaneously” (Carew 1992, p.274). Both Governor Fraser and Governor Macfarlane
shared the ALP’s preferences for multiple objectives, and both governors understoodthat monetary policy acting alone could not deliver price stability without cooperationfrom the government over fiscal policy and cooperation from the unions on wage
restraint.

Impact of Bicameral Legislature

If the Liberal-National opposition had firmly believed in the paradigm concerning
central bank independence, why did they not change the RBA’s legislation upon being
elected in 1996? Again, the answer is that such a move generated political costs without
significant electoral gains, due to the checks and balances in Australia's political system.
In order to pass such legislation, the Liberal government would have needed toconvince their coalition partners in the National Party of this strategy, as well as theAustralian Democrats who held the balance of power in the Senate. The Australian
Senate has the power to credibly bring down the government, through a double
dissolution o f both chambers of parliament, as seen in the 1975 episode. Given the262political ideology of the Australian Democrats, it is safe to assume they would nothave supported a reduction of democratic accountability over monetary policy easily.
With so many veto gates in the political system, it becomes difficult for politicians tochange legislation unless conditions are supportive. In Australia, they clearly were notsupportive of central bank reform. For this reason, it was much simpler for the Howard
government to issue the 1996 Statement, and to adopt the RBA's inflation target. Afterthe election, inflation was low and the economy was growing mitigating the need forsuch a 'radical' reform.

And when Australian politicians did agree to an inflation target, it was less stringent
than the existing frameworks in New Zealand and the UK and more representative ofAustralia's situation and traditions (Bemanke et al. 1999). The target range for inflation
at 2 to 3 per cent was set higher than in other countries, but with the same effective mid­point as the inflation target in the UK. It had an open-ended time horizon with the target
expected to be met over the course of the business cycle, with no fixed dates forachieving the goal. Like Canada and New Zealand, the operational target for CPI
provided some room to manoeuvre for politicians in the interpretation of the level ofunderlying inflation. Unlike the UK or New Zealand, in Australia there is norequirement to explain a failure to hit the target band (Bemanke et al. 1999, p.225).
However, opposition politicians still are able to question the RBA Governor on thisissue during his semi-annual testimony before a parliamentary committee, increasing
the accountability o f this framework. In short, the Australian form of inflation target
was designed to minimise the conflict between the RBA and politicians, while
maintaining the greatest amount o f flexibility that politicians valued.

263

In summary, the RBA seems to have increased its independence over the course of
the 1990s without the need to change the central bank's statute, similar to the case in
Canada. This finding raises the question of whether legal indices of central bankindependence have any substantive meaning. By failing to account for de facto
independence (or classifying politically controlled central banks as independent),
economic studies underestimate the importance of reputation, transparency andaccountability mechanisms for increasing the anti-inflationary credibility of monetary
policy. The real test for Australia will come following the next change of government,
when the current arrangements will be tested under a more traditional left-wing party.32

32 Elections are scheduled for 2001. The opposition ALP has said it will preserve the inflation target of 23%, but this support would likely need to be put into a new joint statement with the RBA.

264

Ch. 8 Bank of England: Partisan Politics vs. the Power ofIdeas

On 6 May 1997, the incoming Labour government of Prime Minister Blair gave the
Bank of England ("BoE”) operational independence in the setting of interest rates. At
the same time it maintained the inflation target introduced by the outgoing Conservative
government that had resisted giving autonomy to the BoE for two decades.1 Chancellor
Gordon Brown announced reform of the BoE within a week of the election, withouteven waiting for the incoming Labour cabinet to meet, in order to establish New
1Labour’s anti-inflationary credibility quickly with financial markets. The decision toreform monetary policy had been taken months before the election and was signalled inLabour party manifestos beginning in 1993. The financial markets responded
enthusiastically to the news, sending the UK stock market to a new high, strengthening
the foreign exchange value of the currency and allowing the long term yield on UK
government bonds to decline. At a stroke, New Labour had shed its historical image as
the ‘party of devaluation’ and re-launched itself as the ‘party of economic stability’.

Like similar reforms in New Zealand, the paradox of this reform is that operational
independence was legislated by a Labour party whose roots lie with the trade union
movement, not a constituency likely to prefer price stability over job creation. At thesame time, BoE independence had been resisted by a Conservative Party whose politicalsupport comes largely from business, the financial sector and the wealthy middle classes
who arguably stand to benefit most from price stability. This case also appears tocontradict claims than an outgoing Conservative government would seek to tie the265

hands of its inflationary successors by changing the institutions of economic policy.
Instead a left-of-centre party tied its own hands upon entering office despite holding thestrongest parliamentary majority in the post-war period.

The chapter proceeds as follows. The first section reviews the changes made by the
New Labour government in 1997 when it gave operational independence to the Bank ofEngland. As a result of these reforms, the UK went from having one of the mostpolitically controlled central banks to one of the more independent. The second section
puts this reform in context, by reviewing the UK’s economic performance over the
1980s and 1990s. The third section reviews political debates on central bankindependence, which first surfaced in 1989 then re-emerged in 1992. The fourth section
examines the BoE reform from the point of view of the four hypotheses put forward by
the literature. This analysis shows that pressure from international financial markets andthe confidence of domestic businesses were key concerns for New Labour, for which
the academic ideas introduced by Brown’s economic adviser provided a politicallysalient solution. The fifth concludes with a discussion of the circumstances when
economic ideas are likely to be successful in motivating politicians to undertake central
bank reform, based on the need for clear electoral gains from delegation that exceed theelectoral costs o f giving up control over interest rates.

8.1 Overview o f Bank of England Act 1997

The BoE was given a mandate to maintain price stability - and subject to that - tosupport the Government’s economic policy, including its objectives for growth andemployment (BoE 1998, p.3). In this context, price stability meant pursuing an inflation
target set by the Chancellor that was not subject to approval by Parliament. The

1This operational independence came into effect 1 June 1998.

266

Conservative government had introduced an inflation target following UK exit fromthe Exchange Rate Mechanism in September 1992. Following the 1997 reform, thetarget was set originally at 2.5 percent for retail price inflation excluding mortgage
interest payments (“RPIX”). The BoE was therefore given instrument independence but
not goal independence. The Treasury withdrew its power to direct the BoE, enshrined in
the 1946 Bank Act following nationalisation, but maintained an escape clause allowing
the government to override the BoE in ‘extreme economic circumstances’ (BoE 1998,p.13).2 Greater responsibility for monetary policy came at the cost of sweeping reforms
to the BoE’s institutional structure and responsibilities.3 Interest rates would be set by anine-member monetary policy committee (“MPC”) consisting of five BoE officials andfour external members nominated by the Chancellor.4 The Court of Directors wasaltered to increase the representation of domestic interest groups. The BoE was strippedof its role in debt management with this responsibility reverting to the Treasury, similar
to the practice in other countries. And to the distress of the BoE’s staff and the joy of its
critics, responsibility for bank supervision was transferred to the newly createdFinancial Services Authority (“FSA”), which was given responsibility for supervising
the financial sector as a whole.5 These reforms were designed to de-politicise interest
rate decisions, to improve the credibility of monetary policy and to demonstrate New
Labour’s commitment to orthodox management of the economy.

2 See article 19 of Bank of England Act 1998. There is no definition of what constitutes extreme
economic circumstances.
3 The new Act places the BoE’s finances on a statutory footing by placing the cash deposit scheme on a
statutory basis and expanding this scheme to include building societies (BoE 1998, p.9).
4 The MPC is loosely modelled on the Federal Open Market Committee of the US Federal Reserve.
5 This arrangement abandoned various systems of self-regulation that had failed to prevent a series ofbanking collapses and scandals that had tarnished the BoE’s reputation (Keesing's 1998, May).

267

Brown took steps to increase the transparency of monetary policy while ensuring its
democratic accountability (BoE 1999, p.7).6 Transparency was provided by announcing
the inflation target, publishing the minutes of MPC meetings and continuing the
publication o f the BoE’s quarterly Inflation Report first begun in 1993.7 While theGovernor is not held directly accountable for missing the inflation target, he must
publish an open letter to the Chancellor if inflation strays by more than one percentage
point on either side of the target explaining this failure and steps being taken to correct
it. Accountability is further strengthened by revamping the management body o f the
BoE - the Court of Directors - and requiring a committee of its Non-Executive
Directors to report annually to Parliament on the BoE’s performance. This report card is
published as a separate section of the BoE’s Annual Report and will be debated in
Parliament. The Governor and other MPC members are required to give evidence before
the Treasury Select Committee of the House of Commons and to make appearances
before the House of Lords Committee on the MPC of the BoE.

6 Moran (1980) provides a history of the BoE’s relationship with parliament up to the 1970s. He
highlights how the lack of accountability and transparency in the conduct of the BoE’s operations led toparliamentary scrutiny by the Select Committee on Nationalised Industries.
The MPC minutes must be published within six weeks, but in practice the lag has been two weeks. The
minutes are attributed and record the voting record on interest rate changes.

268
Table 51: Com parison o f Bank o f England Legislation
BoE Act 1946

BoE Act 1997

Governor Term (years)

55

Appointed by

Chancellor

Chancellor

Decision making body

Governor

M onetary Policy Committee

18

9Members appointed by

Chancellor

Chancellor 5; BoE 4% Appointed by govt.

100%

5 out o f 9

Govt, officials on body00

Statutory objective (s)None statedPrice Stability

Who takes the final decision on monetary policy?

Chancellor

M onetary Policy Committee

Can the government direct the central bank?

Yes

Yes, through escape clause

Legal provisions in case o f conflict?

No

Yes

Limitations on holding government debt?

No

No

Central bank responsible for banking supervision?

Yes

No

Voting members

Source: HM Treasury, Bank of England

8.2 Economic Background to Reforms

In the post-Bretton Woods era, the British economy has been characterised by cycles ofboom and bust overlaid with bouts of high inflation. Inflation took off in 1973-1974
following the first oil shock, rising by 48 per cent over two years. The Conservative
government tried to stem inflation by introducing an incomes policy, while introducing
restrictions on interest-bearing deposits under a system known as the 'Corset'. These
policies precipitated an economic crisis, bursting a real estate bubble and leading to thebankruptcies among the ‘second tier’ banks (Moran 1984b). The Labour government
elected in late 1974 was forced by circumstances to adopt a monetarist policy ofmonetary targeting combined with cuts in government spending. These policies led to a
sharp rise in interest rates but succeeded in controlling inflation that peaked at 26.9 percent in August 1975.

269

Figure 13: U K Inflation and Employment Record
2 5 .0 0
RPIX
U n e m p lo y m e n t

20.00

1 5 .0 0

10.00

5 .0 0

0.00
00

<7>

00
CD

CT>

Labour and IMF Loan

Despite these efforts, the Labour government was faced with a sterling crisis in 1976,
forcing the government to seek an IMF stand-by loan o f $3.9 billion. As part o f the
package, more stringent monetary targets were adopted and restrictions on interestbearing deposits were re-imposed, although it was dis-intermediated through the ‘bill
leak’. The second oil shock o f 1978 led to a further sharp rise in interest rates causing
the currency to become overvalued. Then public sector unions rebelled against theLabour government’s incomes policy by going on strike, leading to the ‘winter o f
discontent’ in 1978-79. Given its failure to manage the economy and its inability to deal
with the unions, the Labour party was ousted in the 1979 election by the Conservatives
under Prime Minister Thatcher.

Thatcherism

Thatcher introduced a series o f ffee-market reforms, beginning with the abolishment o f
exchange controls in October 1979. Chancellor Howe introduced a Medium Term

270

Financial Strategy in 1980 based on targets for £M3 and a reduction o f the public
sector borrowing requirement through cuts to government investment. These moves did
not prevent the economy from falling into a recession from 1980-1982. The recession
brought inflation, which peaked at 22 per cent in May 1980, under control. Inflation
declined steadily falling below 4 per cent by 1983. Faced with a sharp appreciation in
the currency in 1980, Thatcher abolished the restrictions on interest-bearing deposits inJune, causing £M3 to far overshoot its range, reaching 20 per cent annualised growth by
February 1981. The redrafted medium term financial strategy in 1982 raised the targets
for £M3 and allowed interest rates to decline in time for the 1983 election. Thatcher was
re-elected and appointed Nigel Lawson as Chancellor.

8 .0%

6 . 0%

4.0%

2 . 0%

0 .0 %-2 . 0 %■4.0%

Figure 14: UK GDP GrowthChancellor Lawson pursued a new direction in economic policy, using macroeconomic
policy to target inflation while microeconomic policy targeted growth and employment.

271

In 1984, a sterling crisis forced Chancellor Lawson to push up interest rates. Then in1985 Lawson suspended the broad target based on £M3, replacing it with a narrowtarget for MO. These changes set the stage for a rapid rise in the money supply in 1986,
which combined with an expansionary fiscal policy and an accommodative monetary
policy, enabled Thatcher to be re-elected for a third term in 1987. The cost of thispolitical easing came back to haunt Lawson, as £M3 increased by 40 per cent per annum
feeding a boom in real estate and share prices. The deficit in the UK balance of
payments rose dramatically, hitting £20 billion in 1989 and putting pressure on thecurrency. Lawson raised interest rates causing the property bubble to burst andintroducing a new term into many homeowners lexicon, ‘negative equity’. In October
1989, Lawson resigned as Chancellor having been blamed for the real estate bubble andhaving lost the trust of Thatcher.

In and Out of the ERM

Chancellor Major’s review of economic policy undertaken when he became Chancellor
convinced him there was no domestic alternative in the battle against inflation to the useof high interest rates. But throughout late 1989 and 1990, Thatcher pressured againstinterest rate increases, despite rising inflation, in order to protect homeowners who were
suffering from negative equity following the collapse of the property market in 1989
(Seldon 1998, p. 106). This constituency pressured Conservative MPs to lower interest
rates. “[Backbenchers] repeatedly called for reductions in interest rates and continuallycounselled restraint on the Chancellor, even when economic circumstances may havesuggested that interest rates should be raised to account for changed economic
circumstances” (Atkinson et al. 1996, p. 15). Given domestic resistance to interest rateincreases, Major saw membership in the Exchange Rate Mechanism (“ERM”) as
providing an external anchor to monetary policy (Seldon 1998, p.l 11).

272

In 1990, Chancellor Major was given the task of introducing the hated poll tax as the
economy headed into a recession that lasted until 1992. In October 1990, Major wasable to convince Thatcher - weakened by the resignations in her Cabinet andincreasingly unpopular due to the poll tax - to join the ERM at a parity of DM 2.95.
Thatcher conceded the move at the expense of a simultaneous interest rate cut toappease mortgage holders. At the time, ERM entry had the support of the major
political parties and domestic coalitions, including the City, industry, the Confederationof British Industry, the TUC and most trade unions (Seldon 1998, p.321). Financial
markets were also supportive; the pound appreciated following entry despite the interest
rate cut. The following November, Thatcher was ousted in a leadership contest andreplaced by Major who named Norman Lamont as Chancellor. In 1991, the collapse of
BCCI badly embarrassed the government and the BoE, but did not prevent Major fromwinning the April 1992 election.

Then in September 1992, the UK was forced to exit the ERM following massive
speculation against the pound, which cost UK electorate dearly as they paid the costindirectly through higher taxes. In November 1992, Major narrowly survived achallenge to his leadership when Tory Eurosceptics voted against the government’s
Maastricht paving bill that passed by 319 to 316 votes. In the aftermath o f the ERM
crisis, Chancellor Lamont tried to rebuild the UK’s monetary policy credibility byadopting an inflation target and inviting the BoE to publish a quarterly Inflation Report.
In May 1993 Lamont resigned, bearing most of the blame for the ERM debacle, andwas replaced by Kenneth Clarke as Chancellor. In November of 1993, Chancellor
Clarke gave the BoE discretion in the timing of interest rate changes decided by the
Chancellor. Then from April 1994, Clarke agreed to allow the publication of the273

minutes of his monthly meeting with Governor George. At this point, UK inflation
had been brought down and was stable, although differences in opinion between the
Chancellor and the Governor created uncertainty in the markets keeping inflationary
expectations high.
Figure 15: Sterling vs. the Deutschemark
5.50

5.00

4.50

O 4.00Ui 3.50

3.00

2.50

2.00
CD

a>

r*

eo

a> o>

8.3 Political Debates over BoE Independence
T hatcher’s ‘M onetarism ’ and Law son’s Memo

Conservative Chancellor Lawson put independence for the BoE on the political agenda
in October 1989 when he revealed in his resignation speech that he had proposed a fully
worked out plan to Prime Minister Margaret Thatcher in an internal memo in 1988
(Lawson 1992, Annexe 4). Lawson viewed independence for the BoE as an alternative
mechanism for securing anti-inflationary credibility following the failure of domestic
monetary targetingand his strategy of shadowing the Deutschemark. Lawson’s

preferred strategy - to adopt the Exchange Rate Mechanism (“ERM”) as an externalanchor - was opposed by Thatcher who saw it as a threat to British sovereignty. Lawson

274

therefore worked out a plan with a high-level group of Treasury officials, being
careful to keep his plans secret from the BoE. Lawson proposal was to give the BoE
control over interest rate changes to pursue a mandate of price stability. The government
would keep control of the exchange rate and would take over responsibility for
financing the public sector. The independent BoE would be held accountable by
Parliament along the lines of the Federal Reserve. Lawson made his proposal public
hoping that such a move would “secure a groundswell of back-bench support” for theidea.1

Thatcher rejected the proposal, arguing that “it would be an admission of a failure ofresolve on our part” (Thatcher 1993, p.706). Independence could only be considered
once inflation was low and falling. Otherwise, she argued, the government would beseen to have failed in the fight against inflation that would be politically damaging.
Thatcher doubted independence would boost credibility and she had no confidence inthe senior staff at the BoE, who had undermined the credibility o f her monetary targets
by failing to alert the Treasury to the consequences of the ‘bill leak* when the
restrictions on interest-bearing deposits were abolished. Thatcher did not see the needto entrench counter-inflationary policy against subsequent Labour cabinets as, according
to Lawson, she was incapable of foreseeing a change of government.

Thatcher’s reasons for rejecting operational independence for the BoE were political.
Despite preaching the sermon of monetarism, Thatcher believed firmly in retaining the

1 Conservative MP Michael Heseltine included it in his campaign to succeed Thatcher as party leader in1990 - a move designed to gain the support of Howe and Lawson, not for any intrinsic appeal (Lamont
1999, p.26).
2 Thatcher described senior BoE officials as Keynesians who made no secret of their hostility to hermonetarist policies. The feeling was mutual. Governor Richardson is reported to have remarked: ‘She iscanine; I am feline’” (Lawson 1992, p.269).

275

ability to manipulate monetary policy for political ends. Interest rates werepoliticised under Thatcher, who fought against any increases in order to protect theinterests of mortgage holders. She admits in her autobiography that “I was always moresensitive to the political implications of interest rates rises - particularly their timing than was [Nigel Lawson]. Prime Ministers have to be. I was also acutely conscious ofwhat interest rate changes meant for those with mortgages” (Thatcher 1993, p.698)
Thatcher was pragmatic. She correctly saw that the defeat of inflation was the main
issue that concerned the electorate in 1979. Thatcher advocated ‘radical’ monetarist
policies and won the election on a platform designed to appeal to an electorate - thedefeat of inflation.3 The government’s policies would be of no avail “unless we achieve
our prime economic objective - the defeat of inflation. Inflation destroys nations andsocieties as surely as invading armies do. Inflation is the parent of unemployment. It is
the unseen robber of those who have saved. No policy that puts at risk the defeat of
inflation - however great its short-term attraction - can be right” (Harris 1997, p.l 12).
Thatcher had a clear understanding of the distributional conflict involved in the battle
against inflation, and her electoral policies were designed to tap into this demand.

Backbench Conservatives were supportive of Lawson’s proposal to give the BoE
independence, while Labour was predictably hostile. Labour party leader John Smith
stated that his party “would not be willing to accept any system of central banks thatwould be independent of political control, just as we strongly oppose an independent
status for the Bank of England” (Hansard 1989). Financial markets were not demanding
any reform of policy, trusting in Thatcher’s monetarism and placing confidence in her
widely respected Chancellor Lawson. Nor was the BoE lobbying for greater

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independence, being headed by a Thatcher appointee and more pre-occupied at thetime with changes in the supervision of banks, both domestically and internationally.4
Despite support in the financial press and moves in this direction in New Zealand andChile, the proposal was dropped by Thatcher and not raised by Lawson’s successor as
Chancellor, John Major.

The ERM Crisis and Lamont’s Proposals

The financial markets launched the second major political debate on BoE independence
in September 1992, when the UK was forced to exit the ERM under pressure from
speculators. The UK had joined the ERM in October 1990 in order to fight domestic
inflation and to anchor monetary policy. The story o f its exit showed how international
financial markets have the power to veto government policy when it is seen as lacking
credibility. In this case, the Conservative government was caught between the demand
to lower interest rates from mortgage holders, business and consumers and the need toraise interest rates in order to maintain the peg against the Deutschemark. While critics
argue that ‘Black Wednesday’ cost taxpayers as much as £20 billion, it did not lead toan immediate demand to give independence to the BoE. Instead it led to a series ofsmall institutional changes that had the unexpected consequence of leading to thisreform over time. More importantly, this second debate is at odds with Bernhard’s
hypothesis on the source of central bank independence.

3 In opposition, Thatcher had been converted to the monetarism of Friedman and the free market
philosophy of Hayek by Keith Joseph, with whom she set up the Centre for Policy Studies in 1975.
4 Governor Leigh-Pemberton, appointed by Thatcher, was heavily involved in the reform of banking
supervision including 1986 Financial Services Act, the 1987 Banking Act and 1988 Capital Adequacy
Accord.

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The UK was forced to exit the ERM in September 1992, following speculation
against the pound in the financial markets.5 Following this debacle, Lamont pushed
Major to give consideration to independence for the BoE on several occasions - in
September 1992 and again in November 1992 - in order to rebuild lost credibility withthe markets (Lamont 1999, p.322-325).6 Major refused, fearing it would “annoy theEurosceptics” whom saw independence as a part of the European debate (Kavanagh et
al. 1999, p.229; Lamont 1999, p.323).7 The Eurosceptics opposed central bankindependence, a requirement of the Maastricht Treaty for countries wishing to join
European Monetary Union in stage two. They voted against the government’s
Maastricht paving bill in November 1992 and against the final reading of the Maastricht
bill in May 1993.8 Having failed to defeat the Maastricht Treaty, the Eurosceptics tried
to unseat Major by challenging his leadership to the party (unsuccessfully) in the run-up
to the 1997 election.

Despite conflict within the ruling party, Major refused to consider independence for the
Bank of England, risking a vote of non-confidence rather than give control o f interest
rates to an ‘unaccountable’ body. Lamont therefore took steps to rebuild Britain’s antiinflationary policy on a domestic basis by introducing an inflation target, by requesting
the BoE publish a quarterly Inflation Report and by setting up an independent panel of

5 On 9 September 1992, the Finnish markka was devalued 15 per cent followed by Italian lira on 14
September that pushed to pound to its floor of DM 2.77. Wholesale speculation against the pound on
Wednesday 9 September led Chancellor Lamont to suspend UK membership of the ERM.
6 During the build-up to Black Wednesday, Chancellor Lamont discussed the possibility of leaving the
ERM with Treasury officials, suggesting it was worth thinking about BoE independence (Lamont 1999,
P-219).

Eurosceptics were Conservative backbenchers who opposed closer ties with Europe on the grounds thatit infringed on British sovereignty. They came to prominence during the debate over the 1991 Maastricht
Treaty, signed by the UK in 1991, and openly revolted against Major’s government following exit fromthe ERM.
8 On the first occasion, the bill passed by 319 votes to 316 (Seldon 1998, p.341). On the second
occasion Major formed a coalition with Labour to pass the bill against opposition from a record 46 ToryMPs (Seldon 1998, p.371).

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forecasters. These small steps laid the groundwork for future independence for the
BoE. Lamont observed: “Ironically, in so far as it precipitated Britain’s departure fromthe ERM, the Bundesbank helped put the Bank of England on the path to independence”(Lamont 1999, p.266).

Like his predecessor, Lamont used his resignation speech in June 1993 to condemn thepoliticisation of interest rates and to call for reform of the BoE. “Markets and businessmen are cynical. They know that, in a fixed exchange rate system, there are certain
things that Finance Ministers have to say. Credibility and confidence depend not onwords but on objective conditions... Nothing would be more effective in establishing
the Government's credibility than if [Major] would have the courage to establish an
independent central bank in this country. The time has come to make the Bank ofEngland independent.” (Hansard 1993a).

S teps Tow ards Independence

At the same time, the backbench Treasury Select Committee began an inquiry into The
Role o f the Bank o f England that revealed a similar concern with the judgement of thefinancial markets (Committee 1993a). The inquiry considered the case of an
independent BoE in light of the 1992 ERM crisis, the 1991 BCCI scandal and the trend
towards independence abroad. The Committee heard expert evidence over five months
and issued its report at the end of 1993. The report called for New Zealand-style reforms- the transfer of interest rate responsibility to the BoE, the continued use of an inflation
target, the creation o f a MPC (styled on the reformed Banque de France) and the279

inclusion of a government override - the same reforms put in place by Gordon
Brown.9 All but one (vocal) member of the Committee endorsed this recommendation.10

Coincident with tabling of the report, the Committee sponsored a Private Member’s Billin the House of Commons to implement these reforms with the parliamentary debate
taking place in January 1994. The debate revealed widespread agreement on thedesirability of price stability but no consensus on the institutional steps to achieve it.
Both the Government and the Opposition had concerns with democratic accountability
and transparency. Conservative backbenchers focussed on the impact on mortgage
holders with Eurosceptics suggesting the bill was a step towards European Monetary
Union. Labour MPs argued that financial interests were over-represented in the BoE’s
management at the expense of industry (Hansard 1993b, p.575). Opposition from
Committee member Diane Abbott particularly damaged her colleagues' case. Lacking
government support, the bill died.

Despite the failure of this backbench effort, it did result in several institutional changes
that would have wide-ranging, unintended consequences for this debate. While rejecting
greater autonomy for the BoE due to the lack of democratic accountability,
Conservative Chancellor Clarke agreed to publish the minutes of his meetings with
Governor George in order to increase the transparency of the process and improve thecredibility with financial markets (Committee 1994). Earlier that month the Chancellor
had announced that the BoE would have discretion in the timing of the announcementof the Chancellor’s changes in interest rate policy. These reforms, combined with the280earlier decision to adopt an inflation target and to publish the BoE’s Inflation
Report, were designed to satisfy critics who saw the process as politicised. Instead ofincreasing credibility, publication of the minutes revealed how the Chancellor wasaltering interest rates strategically in the run up to the 1997 election, undermining theConservative government’s credibility and providing an important political lesson to
Shadow Chancellor Brown.

The Roll Report

At the same time that the Treasury Select Committee was considering this issue, thefinancial sector was involved in a high profile effort to directly lobby politicians on theissue of independence for the BoE. In 1993, a group of City bankers convened under the
auspices of the Centre for Economic Policy Research and published a report titled
Independent and Accountable - A New Mandate fo r the Bank o f England (Roll 1993).
The President of S G Warburg, Lord Roll, chaired the panel that included representationfrom Barclays de Zoete Wedd, Lloyds Bank and Prudential Corporation, as well as anumber of influential (former) central bankers and high profile economists. The reportsummarised the theoretical case for independence and outlined a proposal for
maintaining accountability and democratic control based on the model of New Zealand.
The report, published at the same time as the Treasury Select Committee report,
concluded by calling for action ‘to strengthen both the independence of the Bank ofEngland and the accountability of macroeconomic policy’ (Roll 1993, p.65). Despite its
prominent authors and the growing consensus on its findings, Major’s Conservative
government ignored the group’s advice. New Labour officials recall reading the report

9 The Treasury Select Committee considered evidence from BoE staff, two former Chancellors,
representatives from industry and numerous academics. In addition the Committee surveyed 19 central
banks and visited the Bundesbank, the Federal Reserve, and the US Treasury.
10 Labour MP Diane Abbott opposed the report, viewing an independent central bank as essentiallyundemocratic (Committee 1993a, p.32).

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and being pleased that it agreed with their own position, but it was not influential intheir decision.11

In summary, international financial market actors led the second push for central bankindependence by challenging the government’s unsustainable policy mix of lower
interest rates for domestic reasons against higher rates for external reasons. The fall-outof the ERM exit saw a Conservative government lacking in credibility and divided
against itself, with Eurosceptics in open revolt against their Prime Minister. This
credible threat from backbenchers opposed to central bank independence was offset byanother group of backbenchers in favour of BoE independence on the basis that it would
provide greater credibility with financial markets. In the face o f these contrastingpressures, the Conservative government introduced some small institutional changes
that later had unexpected consequences for the independence debate. But Major held on
to interest rate policy for seven years from 1990-1997, refusing to tie his hands and giveup this politically useful tool for directing (and stimulating) the economy.

New Labour and New Economic Stability

By the 1990s, the Labour Party had come to be seen as the party of devaluation andinstability. Labour has held power for three periods in the post-war era, two of whichhave been marred by a financial crisis - the sterling crisis of 1947, the devaluation of1967 and the IMF crisis of 1976. Shadow Chancellor Gordon Brown had these facts
fresh in his mind as he developed New Labour’s economic policy manifesto for the
1997 election. “With memories o f forced Labour devaluations o f the 1970s still fresh,
Brown did not want the party of the 1990s to be thought o f as the party of devaluation”(Routledge, 1998 p. 168). New Labour needed to reassure business and the financial

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markets of its moderation once in office (Wickham-Jones 1997). In the words of one
o f Brown’s economic team:[Operational] independence removed one possible area o f conflict between Nos.
10 and 11... But of far greater significance than that was the importance of thepolitical signal the move sent to the City and the wider business community. It
portended in the clearest possible terms that New Labour was serious. In
essence, it was a political decision, supremely important and perfectly timed.
(Robinson 2000, p.45)12
As a successful MP with 14 years in opposition, Brown recognised the need to provide
policies that met the interests of his key constituents - in this case the financial markets
and business. He needed to convince them that New Labour would not follow the ‘soft
option’ of devaluation.13 For this reason, Brown had earlier supported British
membership in the rules-based ERM during the early 1990s, despite opposition within
his own party to this stance. Faced with speculation against the pound in late 1992,
Brown had refused to soften Labour’s opposition to ‘unilateral devaluation’ that meantthat Labour bore part of the blame for the subsequent events (Routledge, 1998 p. 154).
But Brown was adamant, and told the TUC conference before Black Wednesday that
“There is no policy for devaluation on the part of the Labour Party” (Routledge, 1998
p. 170). When the UK was finally forced out of the ERM, Brown did use it as anopportunity to paint the Conservatives as the party of devaluation (Routledge, 1998
p. 171). The message to be carried into the next election was that Conservatives could
not be trusted on the economy, whereas Labour could.

11 Interviews with Ed Balls, HM Treasury, and Geoff Mulgan, Prime Minister's Policy Unit.
12 Gordon Brown’s economic team in opposition was Ed Balls, Charlie Whelan, Sue Nye, Ed Miliband
and Geoffrey Robinson MP. Other ministerial members of the team were Alistair Darling MP, Helen
Liddell MP and Dawn Primarolo MP.
13 Weeks before the ERM crisis forced the UK to devalue the currency, Major stated in a speech that hewould not pursue 'the soft option, the devaluer’s option1(Seldon 1998).

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Brown formulated New Labour’s plans for the BoE when he was Shadow Chancellor,from 1992-1997. He first laid out his approach in the 1993 conference document
Labour’s economic approach, which pledged “It is now time to reform radically the
Bank of England and the conduct of monetary policy. The bank must be made moreaccountable and its decision-making bodies be made both more open and more
representative” (Labour 1993). This idea was more explicit in the 1995 conference
document A new economic future fo r Britain. “The Bank of England will need to be
restructured in order that it can carry out its functions in an open and accountablemanner...We are attracted by the option of establishing a new monetary policy
committee, overseen by a more representative court” (Labour 1995). Tony Blair echoedthese sentiments in his 1995 Mais lecture stating:
Our objective is clear. This is to reform the Bank of England so that it can carryout its increasingly important functions in an open and more accountablemanner. Gordon Brown spelt out a series of reforms last week. We will thenwatch the track record of the Bank before deciding what, if any, further steps
should be taken towards greater operational responsibility for the Bank ininterest rate policy (Blair 1995).

Prior to the 1997 election, New Labour set about winning the confidence of business by
undertaking one of the “biggest consultation exercise with business ever undertaken bya political party” (Labour 1997). The Shadow Cabinet spoke with thousands ofbusinessmen and women up and down the country in a consultation exercise that
resulted in New Labour’s 1997 Business Manifesto, the first of its kind by a Labour
party. The manifesto lists as the top priority “Stable prices with a target set to achieve
inflation of 2.5 percent or less” and speaks of reform of the relationship between the284Bank of England and the Treasury in order to deliver on this commitment (Labour1997). These documents clearly signpost the major institutional changes in monetaryand fiscal policy that were put in place following New Labour’s victory in the 1997
election.

Balls and Euro-m onetarism

The genesis of New Labour’s plan for the BoE did not come from consulting withinterest groups, but came from a pamphlet written in the aftermath of the ERM crisis by
a Labour party supporter, Ed Balls. In December 1992, Balls - a lead economics writerat the Financial Times - wrote a discussion paper for the Fabian Society titled EuroMonetarism: Why Britain was ensnared and how it should escape, which set out a ‘non­monetarist’ alternative for achieving macroeconomic stability and credibility in an open
economy (Balls 1992). At the time, no one in the Labour Party was advocating handing
over control of interest rate policy, as seen by John Smith’s reaction to Lawson’s
resignation speech (Pym et al. 1998, p.6). Balls was introduced to Brown in mid-1992
and became his economic adviser in 1994.14 Together Brown and Balls reworked thisFabian pamphlet and submitted it to an election strategy meeting in 1995.

Euro-

Monetarism effectively became New Labour’s economic policy manifesto for the 1997
election. It contained every major institutional change introduced by Brown: an
independent Bank of England with a mandate to pursue price stability backed by agovernment escape clause; devolution of bank supervision to a new agency; arestructured and more representative Court of Directors; and a medium term industrial
strategy emphasising fiscal responsibility and investment (Balls

1992, p. 17).

Foreshadowing Brown’s subsequent speeches, Balls calls for “a credible and predictable

14Balls was named Brown’s Chief Economic Adviser following the 1997 election.

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macroeconomic policy framework that can deliver economic stability combinedwith active government measures to promote growth and full employment” (Balls 1992,
p.3).

Balls builds his case for independence in three steps. First, ‘tying the hands’ would buy
New Labour anti-inflationary credibility with financial markets and allow it to breakwith Labour’s image as the party of devaluation. Previous Conservative governments
failed to put in place credible, institutional mechanisms to prevent politicalmanipulation of interest rates for short-term gain: “monetarist targets could not conceal
the gaping credibility gap between politicians’ short-term desire to stimulate theeconomy and the public interest in medium-term stability” (Balls 1992, p. 16). This
importance of financial markets was not lost on Tony Blair, who noted “We must
recognise that the UK is situated in the middle of an active global market forcapital...[Capital] flows...can swiftly move against policies which fail to win investor
confidence” (Blair 1995). Second, independence for the BoE would strengthen and not
weaken the hand of a Labour government that had little to gain and a great deal to lose
from trying to run monetary policy themselves (Balls 1992, p. 16). The benefits of
independence would be lower inflation and more time to focus on the fiscal and supplyside policies needed to build and sustain a recovery. Third, other left-of-centre
governments had recognised the new reality of integrated capital markets and had
pursued central bank independence, including the left of centre government in New
Zealand. Failure to take this step, Balls argues, would result in “debilitating market
doubts about the government’s anti-inflationary resolve” leading to the same boom-bust
cycles and financial crisis that were witnessed under the Conservatives (Balls 1992,
p. 18).

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With Blair in agreement, Brown made up his mind shortly before the election to
give the BoE full operational independence and asked Balls and Robinson to the draft aletter detailing these arrangements for the Governor (Robinson 2000, p.37). The newly
elected Prime Minister cleared this same document on the day following the election. A
team from the Treasury worked on the details o f the proposal over the weekend.
Chancellor Brown presented the proposal to Governor Eddie George in an informal
meeting on the Bank Holiday Monday 5 May. While the decision on the timing was the
Chancellor’s, the idea was pushed by Balls and was influenced by the successful
example of the US Federal Reserve.

Figure 16: Spread between UK and German 10-Year Bonds

2.0

8.4 Explaining Timing and Design
International Financial Markets

New Labour gave control over interest rates to an independent but accountable Bank ofEngland in order to gain credibility with the financial markets. This reform also

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provided a platform of economic stability that would encourage investment bybusiness. O f these two constituencies, the support of financial markets was mostpressing in the short term, because New Labour could not govern if it continued to be
seen as the party of devaluation and economic crisis. Operational independence for the
BoE gave New Labour the breathing space to prove itself and to deliver on its policy
promises that appealed to a broader centrist set of political interests in society while
distancing itself from the hard-left supporters of Old Labour. It also provided afoundation for economic stability in the medium to long term, which it was hoped
would lead businesses to undertake longer term investments and create jobs and growth.

With the approach o f the 1997 election, New Labour’s goal was clear. ‘[The] imperative
for the Blair Government was to establish credibility with the markets’ (Grant 2000a,
p. 16). Brown pledged to establish a stable macroeconomic framework and antiinflationary policy in order to provide a stable platform for investment and ‘retain theconfidence of the financial markets’ (Labour 1995, p. 13). Brown signalled thesepolicies to the financial markets through Gavyn Davies, chief economist at Goldman
Sachs and New Labour adviser, who outlined the entire strategy for the BoE in anarticle published in the Financial Times in the month before the election (Timewell1997). In this way, the announcement of the reform at the BoE was widely applaudedby the financial press and markets alike. Long term interest rates declined, the poundstrengthened and the FTSE equity index rose to new heights. According to The Banker,
giving independence to the Bank o f England established Gordon Brown’s anti-inflation
credentials and signalled that Labour could take the bold initiatives it had promised.15

15 "Blair's Britain", The Banker, June 1997, p.21-23.

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An independent BoE with a mandate for price stability and a symmetrical inflation
target reduces the threat from foreign exchange speculators who lack the target of a
fixed exchange rate peg. While New Labour wished to signal their credibility to this setof interests, they were not concerned with signalling creditworthiness to foreign
bondholders as Maxfield (1997) suggests. UK government debt is largely held bydomestic institutional investors, insulating government from the need to fund its
borrowing requirement abroad. The availability of inflation-linked instruments as analternative to nominal gilt investments further discounted the importance of pricestability to domestic bond investors.
Table 52: UK Government Foreign Borrowing
Year

Total debt held byprivate sector
as % GDP 1

Foreign debt
as % GDP

1980

52.2

6.8

1985

54.2

6.1

1990

36.0

5.6

1992

35.8

6.2

1994

47.9

9.3

1996

52.5

8.4

1. The private sector held between 75 to 80 per cent of total debt during this period.
Source: HM Treasury

Interest Group Lobbying

What of the argument that politicians give independence to the central bank in response
to lobbying from interest groups (Posen 1995b)? The evidence from the UK casesuggests that interest groups did not lobby the Government, the Opposition or theTreasury on this issue. Given the fragmented representation of the City’s interests andtheir preference for ‘quiet lobbying’, it is not surprising to learn that financial interests
did not take part in debates about BoE independence. Financial sector associations only
tend to lobby on those issues that are most relevant to their individual businesses, issues
that have a direct economic impact on their membership such as issues of taxation and289

regulation. They steer away from issues that are perceived as too political or notdirectly related to their interests. For example, the Director General of the British
Bankers Association (“BBA”), Tim Sweeney, claimed in a letter to this author not totake a position on monetary policy issues, leaving macroeconomic lobbying to the CBIof which it is a member. The National Association of Pension Funds that speaks for thelargest group of institutional investors in the UK also does not discuss monetary policy.
The International Primary Markets Association was active in lobbying on the detail of
the Financial Markets Act and the issue of the withholding tax on Eurobonds, but they
did not lobby the Treasury on independence for the BoE.16

For financial associations, lobbying policymakers on political issues is seen as
potentially damaging for their business and not worth the risk. When lobbying isundertaken, it is informal with a few senior representatives from member firms
expressing their views directly to the Treasury, rather than to politicians. The financial
associations do not issue reports on their views nor do they make their efforts public,
only expressing an opinion if they are called to testify by a parliamentary committee.
Otherwise they prefer the strategy of ‘quiet lobbying’ that is hard to detect and tosupport empirically (Coleman 1988, p.64). Nevertheless, key lobbies were able to signal
support for reform even if they did not push for this policy.

Nor did business and trade associations lobby politicians on the issue of BoE
independence. Both the Confederation of British Industry (“CBI”) and the Institute of
Directors had internal policies in favour of BoE independence following the ERM

16 Interview with Robert Gray, Vice-Chairman of HSBC and Chairman of International Primary Markets
Association, 16 June 2000.

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crisis, but neither association lobbied the government on this issue (CBI 1993;
Morgan 1993). Adair Turner, former Director General of the CBI, recalls:
When I took over in 1995 the CBI already had a formal policy in favor of Bank ofEngland independence, but it was not a topic on which we were strongly
lobbying. That reflected the fact that although there was a majority in favor of it[within the Economic Affairs Committee of the CBI], it was a somewhat technicalissue that did not interest the ordinary membership... It wasn’t something wherein our meetings with the Prime Minister we would ask ‘Why haven’t you
introduced central bank independence?’ 17
Leading business associations did not play an active part in this debate nor did theirmembership have a common preference. These conclusions suggest that the preferenceso f business were not a factor in the outcome.

Despite the lack of lobbying on BoE independence, it is still possible to argue that thepreferences of business influenced New Labour as they prepared their package of
economic policies prior to the 1997 election. Chancellor Brown knew his party needed
to win the support of business in order to delivering on their election promise ofachieving a higher rate o f investment (Labour 1995, p.22). Blair and Brown have madea concerted effort to consult with business, speaking with over 10,000 business people
through speeches to the CBI, the Annual Conference of the British Chamber ofCommerce, the Federation o f Small Businesses (Labour 1996). Given the wide ranging
nature o f this consultation, New Labour clearly had the preferences of business in mind
when they argued that BoE independence would deliver economic stability, lead tolower interest rates and avoid the cycle of boom-bust experienced under the291

Conservatives. However, not all New Labour’s economic policies were made withsolely business in mind as seen in the windfall tax on the privatised utilities, the moves
to strengthen the Monopolies and Mergers Commission and the decision to sign the
EU’s Social Chapter and pass legislation facilitating the ability o f unions to organise.
These policies clearly conflicted with the wishes of big business, suggesting that New
Labour imposed policies that would also benefit its traditional voters, not satisfy thepreferences of one interest group.

The approach taken by business associations on BoE independence was mirrored by theTrades Unions Congress (“TUC”), which also supported greater independence for the
BoE internally. However, during the public debate in the 1990s, the TUC resolutely sat
on the fence and refused to take a firm view on the issue either way for fear ofalienating parts of their membership. In the words of one TUC official:
We did not take a very firm view on it either way. We resolutely sat on thefence... We had other things on our agenda than worrying about Bank o f England
independence. It was a quite difficult period for us, on the industrial relations andlabour market fronts. So we were not being pushed to take a position.18
The TUC had other things on its agenda than worrying about Bank of England
independence. Externally the late 1980s and early 1990s were a difficult period on boththe industrial relations and labour market fronts. Internally, the TUC was preoccupied
with an internal reorganisation that sought to restore its role in influencing policy. And
in the run-up to the 1997 election, the TUC was focused on the issue of labour standards
such as the minimum wage, changes in the recognition laws of trade unions, the17 Interview with Adair Turner, Former Director-General of the Confederation of British Industry, 30
November 2000.
18 Interview with Ian Brinkley, Economist, Trades Union Congress, 24 November 2000.

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working time directive and the adoption of the Social Chapter of the EU.
Independence for the BoE was therefore not something that featured in trade union
debates. The trade unions were not influential in shaping New Labour’s policies, as
their traditional ties with the Labour party have been eroded. Given their diminishedinfluence on UK party politics, it is not surprising to leam that the trade unions did notlobby on the issue of central bank independence.

It is doubtful if the trade unions could have affected this outcome regardless of theirpreference towards the central bank. By 1997, New Labour had clearly abandoned many
traditional union concerns in order to move the party to the political centre. Marshnotes: “The decline in the number of a party’s core voters, due to social changes,
presents it with a dilemma. It has to choose whether to stick to the interests of its
traditional voters and face declining electoral support or to transform and attract votersfrom new social groups in order to maintain, or even increase, electoral support” (Marsh
1998, p.64). New Labour needed to transform itself in order to win the election. Part ofthis transformation involved freeing the party from the control o f the unions.

For his part, Ed Balls dismisses the suggestion that New Labour’s decision to give theBoE operational independence was the result of domestic interest group lobbying.19
Officials at the Treasury and the Bank of England cannot recall any private sector
lobbying on this issue. For example, Lord Bums, former Permanent Secretary of theTreasury during this period, recalls a certain amount of lobbying by the financial press
and through publication of the Roll report, but the Treasury received no serious

19 Interview with Ed Balls, Chief Senior Economic Adviser of HM Treasury, 8 January 2001.

293

representations from banks or their associations.20 Both the Treasury SelectCommittee and the independent Roll committee considered input from banks andindustry, but neither of these efforts was seen as impacting the political debate. Given
the lack of evidence to support the lobbying hypothesis - either in print or indiscussions with officials involved in this debate

it is possible to conclude that interest

group lobbying did not influence the Conservatives or New Labour on this. However it
is certainly true that indirect pressure through the financial markets, through theinvestment decision of businesses, and through the voting patterns of homeowners did
factor in the political judgements o f the likely benefits and costs of such a reform.

Impact of the Transnational Epistemic Community

The second hypothesis suggests that politicians give independence to their central banks
in response to academic ideas concerning monetary policy that are promoted by anepistemic community of monetary experts. The influence of this epistemic community
is increased by uncertainty or an economic crisis. These experts must form a consensus
on this paradigm and they must have a politician that can champion the legislation
through parliament on their behalf. The UK case clearly supports this hypothesis. New
Labour’s decision to adopt independence for the BoE was heavily influenced by theideas of economists, propagated by policy advisors and think tanks while the party was
in opposition. Ball’s pamphlet on Euro-Monetarism provided a coherent, worked-out
strategy that Brown could adopt as his own. Brown was convinced of these ideas
directly by his economic adviser, Ed Balls, with the assistance of monetary experts inacademia and practitioners at other central banks, notably the Fed, the Bundesbank andthe Banque de France. Each of these steps in the channel will be addressed in turn.

20 Interview with Lord Bums, former Permanent Secretary of HM Treasury, 24 January 2001.

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BoE independence emerged on the Labour Party’s agenda as a response to a historyof finance crises. Balls wrote Euro-Monetarism in the aftermath of the ERM crisis tosuggest a domestic alternative to an external anchor, or as he phrased it a ‘non­monetarist’ alternative for achieving macroeconomic credibility in an open economy.
British monetary policy was characterised by a high level of uncertainty in the early
1990s, with politicians searching for alternatives. Brown (and Prime Minister Blair)
wished to leam from the failure of income policies under previous Labour governments,
as well as the failure of monetary targeting and exchange rate targeting under theConservatives. These events were critical in guiding the debate during the 1990s
towards the solution of operational independence for the BoE.

As Chancellor Brown’s economic adviser from 1994, Balls played a catalytic role inintroducing Brown to the academic debate taking place among a transnational epistemic
community of economists and central bankers. Balls recalls the main influences:
There was a CEPR paper on central bank independence [the Roll report] which inpart we disagreed with but was quite important in terms of our arguments. I had
been at Harvard where Summers had written a paper with Alesina on central bankindependence and that gave the academic view of the debate. There was quite an
intensive academic debate about the European Central Bank and its statutes. I
certainly thought that [the architects of the ECB] were doing it the wrong way they were making the wrong choices for a newly independent central bank which
would have to establish its credibility. So we were quite negatively influenced by
the way that was done. There was a paper by Stan Fischer [and Guy Debelle]

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which looked at goal independence and instrument independence which wasaround at the time... Those would be the influences that we considered.

71*

Balls and Brown studied the institutional arrangements of other central banks - the Fed,
the Bundesbank, the Banque de France, the European Central Bank and the Reserve
Banks of New Zealand and Australia - in order to leam how to proceed from studying
other countries' experiences. They wished to emulate the institutional designs of themost successful central banks, while avoiding the pitfalls of individual models. The
BoE Act 1998 therefore represented a collage of best practices in central banking,combining the Fed’s decision making structure with the RBNZ’s inflation target andaccountability.

Balls and Brown met with a number of central bankers: Trichet at the Banque deFrance, Tietmayer at the Bundesbank, Brash from the Reserve Bank of New Zealand.
Perhaps the most influential meeting took place in February 1997 when Brown met with
Alan Greenspan of the Federal Reserve. Brown was stmck by how American interestrate changes were not politicised, and agreed with Greenspan’s sentiment that raisinginterest rates was an unpopular decision that was best handled by the central bank(Robinson 2000, p.36). Brown’s original plan was to have a new MPC to advise theChancellor on interest rate decisions. However, Brown and Balls decided that it was
better to move decisively at the very beginning of the Parliament rather than become
engaged in the old and unstable 'personality' relationship between the Chancellor and
the Governor. Balls convinced Brown that external pressures would inevitably push
Brown to give the BoE independence so it was better to make a virtue out of a necessity
and take the political credit for the inevitable.

21 Interview with Ed Balls, Chief Senior Economic Adviser, HM Treasury, 8 January 2001.

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While the importance of ideas for influencing policy is compelling in this analysis,
causation cannot be supported by this case study. There is a major problems with an‘ideas only’ explanation. Why did ideas favouring central bank independence
influenced New Labour, but not the Conservatives, as witnessed by the failure of theTreasury Select Committee’s Private Member Bill and the Roll Report? In both cases,
the Conservative Chancellor had championed this reform - first Lawson then Lamont yet the Prime Minister had opposed it. While the lack of empirical evidence supporting
central bank independence may explain Thatcher’s decision in 1988, it is anunsatisfactory explanation for Major’s refusal over 1992-1993 as the literature on this
topic was quite extensive at this point. Clearly ideas alone are important but insufficient
to convince the Conservative Party to adopt this reform The answer is that ideas weresecondary to the political imperative to get re-elected.

Tying the hands

Discussions with colleagues of Brown agree that the ‘Iron Chancellor’ did not blindly
follow the suggestions of his advisers on this - or any- issue. Brown is described as
someone who must be convinced of the arguments before making up his own mind andthen he takes the decision. For a politician with Brown’s experience, discussions of
economic gains are not enough - there also need to be clear electoral gains in order toconsider such a policy change.

BoE independence provided clear electoral gains for New Labour, but only electoral
costs for the Conservatives. New Labour would gain anti-inflationary credibility withfinancial markets, as well as providing more breathing room to concentrate on fiscal andsupply-side policies that were important for winning a second term. While critics argue297that an independent BoE provides a useful scapegoat for a Labour Chancellor, Ballsargues that Chancellor Brown always believe he would be held responsible for poor
economic performance regardless of the institutional framework. Nor did the marginal
gains from lower long term interest rates on the government’s debt factor highly, as
these savings are not easily identifiable by the electorate. For New Labour, the key was
to signal a new approach, to gain policy credibility and to open up room to manoeuvre.

New Labour needed to win credibility with business in order to be successful.
‘Delivering a higher rate of investment will be a key objective for a Labour
government’ (Labour 1995, p.22). Blair and Brown have made a concerted effort toconsult with business, speaking with over 10,000 business people through speeches to
the CBI, the Annual Conference o f the British Chamber of Commerce, the Federation of
Small Businesses (Labour 1996). But not all of New Labour’s economic policies weremade with solely business in mind. Many of the policies clearly conflict with the wishesof big business, such as reform of the regulation of the privatised industries, thewindfall tax on utilities, the strengthened Monopolies and Mergers Commission, thedecision to sign the EU’s Social Chapter, and new legislation facilitating the ability ofunions to organise. The concerns of business were important, but they were notparamount to New Labour.

By contrast, the Conservatives only saw electoral costs from BoE independence thatjustified their opposition to this reform despite the economic gains and stability it would
bring.

99

For Thatcher, such a move would be a politically damaging admission of failure

and it would remove the ability to set interest rates for electoral reasons. It would also

298remove the government’s ability to interfere with interest rates for political businesscycle reasons. British politicians are uniquely tempted among their industrial peers tomanipulate interest rates for political reasons, due to the structure of the homeownership in the UK (Hansard 1993a). Over two-thirds of the population own theirhomes, which are financed mainly by variable rate mortgages linked to short-term rates(Committee 1993a, p. 17). The extent of variable-rate debt in the UK means that interest
rate changes affect personal disposable incomes quickly and significantly (Miles 1994,p.41). Homeowners are an important part of the electorate in the UK and British
politicians recognise the tendency of the electorate to vote with their pocketbook.
Table 53: International Comparisons of Home-Ownership
UK

Australia

CanadaNZ

Germany

USA

Owner Occupiers

68

70

63

74

38

65

Social Rented

23

6

6

n.a.

15

2

Private Rented & Other

10

24

32

26

47

33

Total

100

100

100

100

100

100

Owner Occupiers with a Mortgage

63

38

52

53

n.a.

61

Mortgage Debt as % GDP

61

26

45

38

48

52

Variable Interest Rate Mortgages
as % Total

79

90

30

n.a.

5

26

Source: Evans et al (1998), Holmans (2000)

The Conservatives viewed homeowners as a key constituency of loyal supporters,
which Thatcher called ‘our people’. Thatcher resisted interest rate increases whenever it
was politically expedient, arguing that the needs of homeowners must never be

22 Ironically, within the first parliament the Conservative opposition came out in support of the newarrangements.

299

forgotten.

23“Other things being equal, on every ground a low interest rate economy

is far healthier than a high interest rate economy” (Thatcher 1993, p.698). Despite
telling the 1980 Conservative Party conference that “The Lady’s not for turning”,
Thatcher swiftly abandoned her monetarist principles in response to the sinking
popularity of her party. In the run-up to the 1983 election, the monetary targets werewatered down in favour of an expansionary discretionary policy designed to appeal toconsumers and mortgage holders. This switch reflected the imperative of the politicalbusiness cycle, not the defeat of inflation. Thatcher engineered a second fiscal
expansion prior to the 1987 election, resisting interest-rate increases in 1986 due to theirimpact on the homebuyers’ vote (Lawson 1992, p.85). Her resistance to interest rateincreases in the run-up to the 1987 election ironically led to the real estate crash of 1989
and produced negative equity in many homes (Lawson 1992, p.85). Reflecting on this
episode, Lawson concludes: “The picture [Thatcher] liked to present of herself as auniquely doughty fighter against inflation was, in this sense, largely mythical” (Lawson
1992, ch. 53). As testament to this claim, the Thatcher government failed to meet asingle one o f its monetary targets between 1979 and 1990.

Major was equally sensitive to the politics of interest rates and saw nothing wrong inaltering them for electoral purposes, such as the timing of a by-election. Chancellor
Lamont chided Major, claiming: ‘I do not believe that even the timing of interest ratechanges should ever be affected by political considerations. Interest rate changes should
never be used to offset some unfavourable political event. To do so undermines thecredibility of policy and the credibility of the Chancellor’ (Hansard 1993b). The
phenomenon of negative equity following the real estate crash of the late 1980s created

23 Thatcher had set out to create a home-owning democracy, passing legislation in 1980 allowing

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a core constituency who would resist interest rate increases at all costs (Whiteley
1990, p. 191). As the minutes of his meetings confirmed, Chancellor Clarke resisted
interest rate increases in order to retain the support of the 1.7 million homeowners, orroughly 3 million voters, who were suffering from negative equity (Budgen 1996).24
Apart from his interest rate concerns, Major saw a real threat to his electoral chancesfrom Eurosceptics should he move towards monetary union.

Despite their party’s history of boom and bust economics, and the debacle of the ERM
crisis, the Conservatives believed that financial investors and business would continue
to back their party due to the perceived radical threat from Labour and the trade unions.
This belief was behind their advertising campaign during the 1997 election “NewLabour, New Threat”. The Conservatives wished to continue using their control ofmonetary and fiscal policy tools to win the support of consumers and mortgage holders,promising lower interest rates in their election manifesto. Without any perceived need toreform monetary policy from the electorate, and no credible threat from backbenchers totheir durability as a government, the Conservatives did not have to respond to any
demands for operational independence for the BoE. Instead they introduced small, tokenchanges that had large, unexpected consequences such as adoption of an inflation target
in 1992 and agreeing to publish the minutes of the interest rate decisions in 1994.

Bernhard (1996) has argued that New Labour gave independence to the BoE in order toincrease the stability of their government. In this view, increased economic openness
created more potential for intra-party conflicts over UK monetary policy, as seen in theresidents in state-owned council housing to purchase their flats (Dale 2000a, p.397).
24 With the Conservatives suppressing interest rates in the run-up to the 1997 election, Labour Chancellor
Brown was forced to raise rates as his first action in office in order to meet the existing inflation target.

301

aftermath of exit from the ERM. This institutional change was not made in response
to fears that Labour party backbenchers might oppose Chancellor Brown’s economic
policies, threatening the durability of the New Labour government. The fundamental
problem with this hypothesis, as applied to the UK, is that it assumes that backbenchers
have the ability to credibly threaten to bring down the government. However, this threat
was clearly not credible due to the concentration of power under the Westminster
system and the lack o f checks and balances on the government. For this reason, Major
was able to face down numerous threats to his leadership from Eurosceptic
backbenchers. Likewise, Labour backbenchers were relatively powerless to threaten the
Blair government. The new intake of Labour ministers who took office in 1997
supported the modernising drive by Blair and Brown, as witnessed by their support forchanges in the Labour party’s constitution and institutional structure prior to theelection.
8.5 Electoral Gains Plus Signalling

In summary, the BoE was given independence in response to a set of academic ideasthat provided clear electoral gains to Chancellor Brown. The incentives for this reformcame from the Labour Parties history of financial crises that had blown previous Labour
governments off course in 1947, 1967 and 1976. BoE independence was designed tosignal the new governments ‘conservativeness’ to financial markets in the short term
while creating a platform of stability that would appeal to business in the medium term.
Only business investment could deliver long-term growth and employment that New
Labour would need in order to be electable in years to come. This plan was suggested
by a paper written by the Shadow Chancellor’s economic adviser, Ed Balls, thatprovided a road map to a politically salient solution. BoE independence matched
Brown’s desire to shed Labour’s reputation as the ‘party o f devaluation’ while acting as

302

a symbol of a new approach. Reform of the BoE was only part of Brown’s larger
plan of adopting tough fiscal rules, reforming the tax system and promoting a longer
term focus of government spending designed to signal New Labour’s prudence andtrustworthiness as managers of the economy. Independence for the BoE was not in
response to direct or indirect lobbying by trade associations, civil servants or BoE
employees, nor was not designed to avert a potential threat from Labour backbenchers
over economic policy.

303

Ch. 9 International and Domestic Sources of Economic
Policy Reform
During the 1990s central banks have become the focus of public interest and a source ofcontroversy in democracies. Over this period they have gone from operating in relative
obscurity to centre stage, with figures such 'as Federal Reserve Chairman Alan
Greenspan becoming as well known internationally as any head of state. This rise invisibility has reflected their growing importance given the rise in international capital
flows and the increased interdependence of states. Central bankers are the navigators of
the world economy (Economist 1999b). This rise has resulted in greater public criticism,not unlike the treatment given to international institutions like the IMF (Pauly 1997).
Greater power comes at the cost of greater accountability, a point that central banks
were perhaps slow to recognise during the 1980s. In recognition o f this fact central
banks during the 1990s focussed on increasing the transparency of monetary policy
decisions and educating the public on the benefits of price stability. This process has
been slow, as monetary policy remains an esoteric and complex area that few outsiders
understand (Moran 1984b). Even monetary experts cannot agree on the pathway by
which interest rate changes affect the economy. To be fair, it is only since the decline of
the Bretton Woods system in the 1970s and the general move to floating exchange rates
during the subsequent decades that monetary policy has become such a powerful
instrument for managing the economy. And structural changes in the world financial
system, such as the rise of international capital flows, the deregulation of financial
markets and the rise of stagflation have made the task of navigating more difficult.

Given the increasing importance o f monetary policy it is not surprising that the decisionby politicians to delegate control over interest rates to central banks should becontroversial. This formerly academic issue moved to the centre of political debates in304

Europe that followed the signing of the 1992 Maastricht Treaty, which required all
member countries who wished to join the single currency to legislate greater politicalindependence for their central banks. The changes in Europe took place at the same timeas the newly independent Soviet republics were setting up their own independent central
banks, most of them modelled on the most successful central bank of the past half
century - the Bundesbank. The Bundesbank itself became the source of heatedcontroversy both within and outside Germany at the time of reunification, when
Bundesbank President Pohl objected to the rate at which Chancellor Kohl agreed to
exchange East German marks for Deutschemarks. The Bundesbank then pursued a
restrictive monetary policy that threw much of Europe into recession, culminating in the
spectacular collapse of the Exchange Rate Mechanism in late 1992.1 Such episodes,
combined with increased media coverage of central bankers and their decisions, have
exposed central bankers to public criticism - a position that many no doubt finduncomfortable. It was only a matter of time, therefore, before critics began to question
the lack of democratic accountability of these bureaucrats who appeared to hold somuch power.

This study has examined these debates in four industrial countries, and offers an
explanation for the growth in the trend central bank independence that has been missing
from the economics literature. The case studies indicate that politicians were only
willing to delegate to central banks when a number of conditions were met. First, an
epistemic community of monetary experts had formed a consensus behind this newparadigm. Increased uncertainty arising from present or past financial crises made theideas o f this ‘policy elite’ more influential and weakened domestic opposition to thisreform. Second, this epistemic community succeeded in convincing a key politician to305champion this reform through the legislative process. This political champion was
motivated by the incentives provided by this reform. Either the reformer held an
ideological conviction that politicians should not be involved in setting interest rates, as
in New Zealand, or he was motivated by the electoral gains arising from this reform,
which improved the party’s chances of re-election. Third, the political institutions werepermissive by offering few checks and balances on an executive that wished to pushthrough this reform. The hypotheses based on domestic interest group lobbying and theneed to signal creditworthiness to international financial markets were rejected.
However, one motivation of central bank independence was found to be the desire tosignal the government’s anti-inflationary credibility to a domestic audience of nonfinancial actors, such as unions and businesses. The findings from the case studies are
summarised in the first section of this chapter.

The second section summarises the contributions made by this study to the literature on
international political economy, focussing on the power o f international financial
markets to constrain national economic policies, the ability of interest groups toinfluence the design of monetary institutions, and the international and domestic sourcesof economic policy. The third section concludes by discussing alternatives to central
bank independence for establishing policy credibility and pointing to areas for future
research.

9.1 Summary of Findings

This thesis has studied the debates surrounding central bank independence during the
1990s in four countries, New Zealand, Canada, Australia and the UK. All four countries
began the 1980s in a similar position, with central banks that were widely seen as

1Bundesbank President Karl Otto Pohl was forced to resign as in 1992 after resisting the popular policies
of Chancellor Helmut Kohl (Lohmann 1998, p.417).

306

politically influenced and with monetary policy frameworks that were in transition.
Due to their common history, these Anglo-Saxon countries shared economic andpolitical institutions, and had similar historical, cultural and ideological influences
during the period being studied, making a controlled comparison of their experiences aworthwhile endeavour. Two countries in this sample legislated greater independence for
their central banks and two countries rejected this paradigm in favour of the status quo.
The Reserve Bank of New Zealand (“RBNZ”) and the Bank of England (“BoE”) wereboth given greater legal independence in 1989 and 1997, respectively, with politiciansdelegating operational control over the setting of monetary policy to the central bankguided by a single objective of price stability set by the government. A decade separated
these changes, during which time the ruling parties in office in both countries switchedfrom the right end of the political spectrum to the left. By contrast, Canada andAustralia debated this institutional reform but both countries rejected it in favour of thestatus quo - namely a sharing of monetary policy responsibility between politicians andcentral bankers with broad mandates to pursue price stability, employment and output
goals. Canada and Australia also witnessed changes of government, although only
Australia had a swing from the left to the right end of the political spectrum.
Interestingly, all four central banks adopted inflation targeting at some point over the
1990s as the principle framework guiding monetary policy - New Zealand in 1989,
Canada in 1991, the UK in 1992 and Australia in 1993. This operational trend was notdiscussed in the case studies, which focussed primarily on the reform of the statutegoverning the central bank as suggested by the economics literature on central bankindependence. However, the discussion below will offer an explanation based on theview that an inflation target is an alternative to legal independence for central banks
perceived to have a high degree of de facto independence.

307

What explains the different outcomes in these four cases, and why did the reforms in the
UK follow so long after similar reforms in New Zealand? This study has approachedthis question from the point of view of both international and comparative political
economy, looking at the international and domestic sources of institutional reform. Four
explanations have been examined to explain the timing of this reform, namely due to:pressure from international financial markets, the ideas of a transnational epistemic
community, lobbying by domestic interest groups, and the electoral calculations ofpoliticians.

The results from the case studies are summarised in table 1. The first two rows of thetable show the 9 periods of political debates that took place concerning central bankindependence in the four case studies. For example, Canada debated the issue of central
bank independence on two occasions, in 1991-1992 and again in 1993-1994. Likewise,
politicians in the UK considered this policy reform on three occasions, under Chancellor
Lawson in 1988-89, in the aftermath of the ERM crisis in 1992-1994 and following theelection of New Labour in 1997-98. The hypotheses for explaining the outcome of thesedebates, and their accompanying corollaries, are shown in the first two columns of thetable. The outcome of each ‘observation’ is shown in the final row.

2 While some observers view the Liberal Party of Canada as a left wing party, it is near the politicalcentre, with the left represented by the New Democratic Party.

308

Table 54: Assessing the hypotheses in the four case studies
NZ
Row

Period o f Political Debate

1

H.I

2

CANADA

AUSTRALIA

UK

1988-90

1991-92

1993-94

1989

1991-93

1996

1988-89

1992-94

1997-98

Need to signal creditworthiness

M

Y

Y

N

Y

Y

N

Y

Y

H.II

Advocacy o f epistemic community

Y

Y

N

N

Y

N

N

Y

Y

3

A

Financial uncertainty or crisis

Y

N

M

Y

Y

4

B

Consensus on policy preferences

Y

N

N

Y

Y

5

C

Political champion

Y

Y

Y

M

Y

6

H.III

Lobbying by interest groups

Y

Y

Y

Y

N

7

A

Effective financial sector lobbying

Y

M

M

N

Y

8

B

Effective support o f coalition

Y

Y

Y

M

Y

9

C

Effective opposition o f coalition

M

Y

Y

Y

N

10

H.IV

Electoral Incentives to tie the hands

N

N

N

11

A

Right-wing with short time horizon

N

12

B

Left-wing with long time horizon

Y

13

C

Increase cabinet stability

M

14

C.I

Few checks and balances

Y

N

N

N

N

N

Y

Y

Y

O utcom e o f debate

Y

N

N

N

N

N

N

N

Y

Note: y = yes, n = no, m = mixed

N

N

Y

N

N

N

N

N •

. N

Y

309
Signalling Creditworthiness to International Financial M arkets

Hypothesis I argued that politicians with a long time horizon and a need for balance of
payment financing will give independence to the central bank as a mechanism forsignalling their creditworthiness to international financial markets. While pressure frominternational financial markets was a significant factor in the decision of governments tointroduce economic reforms in all the cases (row 1), only in the UK can this pressure beclearly linked to Bank of England independence. New Labour was aware that each post­
war Labour government had been put off-course by a financial crisis shortly after taking
office - in 1947, 1967 and 1976. In their efforts to make the Labour Party electable,
Blair and Brown reinvented (New) Labour, changing the party’s constitution andadopting a policy platform based on economic stability and prudence. To complete theirrepositioning and to avoid being blown off course by a financial crisis, New Labour
needed to signal its anti-inflationary commitment to international and domestic financial
actors as quickly as possible, in order to gain some breathing space to implement theireconomic policies. Operational independence for the Bank of England gained them thisreprieve, although the design in the UK allowed politicians to retain ultimate politicalcontrol of policy through their control of the inflation target, their right to issue a
directive and their control of key appointments.

In Australia and New Zealand, incoming left-wing governments were met with acurrency crisis in 1983 and 1984, respectively, leading both countries to float theircurrencies and deregulate their financial sectors. However, once inflation had beenbrought down and the government’s finances were under control, international financial
markets were satisfied and any electoral gains from changing the central banklegislation were seen as marginal. Australia did not see the need to reform the RBA at
all despite the 1983 currency crisis and Australia’s deteriorating credit ratings. Instead

310

the ALP government brought its finances under control and paid down its foreign
debt. Having removed this potential area of weakness, the government pursued adistinctive set of macroeconomic policies designed to protect the social wage of the
trade unions while controlling inflation through voluntary wage restraint. The informal
targeting of inflation by the RBA from 1993, formally endorsed by the in-coming
Liberal government in 1996, further mitigated any need to change the central bank’s
statute in the eyes of the international financial markets.

The incoming government in New Zealand was faced with a high and unsustainabledebt and rising deficits that were largely financed overseas. The cost o f servicing thisdebt was punitive and created a strong incentive for the Labour government to takeaction. Finance Minister Douglas therefore introduced a wide-ranging and rapid set of
economic reforms that liberalised the economy. He then sold state assets to reduceoverseas debt and supported a restrictive monetary policy implemented by the RBNZ.
By the time Douglas announced the government’s intention to reform the RBNZ Act in
1988, toward the end of the Labour government’s second term, the external debt had
been reduced, New Zealand’s credit ratings were improving and financial market
conditions were benign. Central bank reform, at this point, was not introduced to attract
balance of payments financing. Instead, this reform was designed to signal to a domestic
audience that politicians would no longer set interest rates for political reasons, as had
occurred under the National government of Muldoon. Th policy reform was introduced
for domestic, not international, reasons.

The case of Canada further demonstrates how international financial market pressure in
often more directed at fiscal policy than at monetary policy. The unsustainable path of
Canada’s public debts and deficits during the early 1990s put pressure on the Canadian311

dollar and led to a downgrade o f Canada’s credit ratings, but it did not spark afinancial crisis due to Canada’s floating exchange rate regime. This international
financial market pressure did lead the incoming Liberal government to focus on deficit
reduction and to pay down Canada’s foreign currency debt, but it did not lead tochanges in the Bank o f Canada Act. The Conservative government’s decision toabandon Bank of Canada reform in 1992 and the Liberal’s failure to reappoint Governor
Crow in 1993 did not spark a financial crisis, as predicted by the government’s critics,
largely because monetary policy was already directed to price stability as embodied in
the 1991 inflation targets. These findings provide only limited support for theinternational financial market hypothesis.

The conclusion drawn from this study is that hypothesis I is rejected. The need to signal
creditworthiness did not explain the outcomes in these four case studies. Generally,claims about the ability of international financial markets to influence domestic policy
must be carefully qualified. Any statements about the power of international financial
markets must take into account the type of exchange rate regime, the existence of
exchange controls, the state of the governments finances, and the structure of thedomestic financial system. Maxfield’s (1997) argument that the need for balance of
payments financing determines the degree of leverage by financial markets may apply
to developing countries or countries with a fixed exchange rate regime, but it has
limited usefulness for industrial countries or countries with a floating exchange rate.
Apart from the cases examined here, one need only look at the history o f the US balanceof payments to realise that large states are in a different position from small states intheir relationship with international financial markets. And even relatively small states
like Canada or New Zealand that had comparatively large current account deficits haveroom to manoeuvre based on their credit rating, their level of foreign borrowings and312

their willingness to pay a premium on these borrowings. This is consistent withother findings that international investors in the bonds of developed countries focus on
only a few economic variables when making the decision to invest (inflation, deficit toGDP, debt to GDP) and do not necessarily consider the status of the central bank
(Maxfield 1998; Mosley 2000; Oatley 1999).

Ideas of a Transnational Epistemic Community

Hypothesis II argued that politicians give independence to their central banks inresponse to the academic ideas concerning monetary policy that have been promoted bya transnational epistemic community of monetary experts. This epistemic community
consisted of central bankers, Treasury officials, economic advisers and academics. Suchan epistemic community was active in the debates on five occasions (row 2). However,
only three cases fulfilled all the criteria specified for explaining when the epistemic
community would be effective at influencing policy reform: in the New Zealand debates
during 1988-90 and in the UK debates from 1992-94 and again in 1997-98.

In both cases where central bank reform took place, there is evidence that the ideas of atransnational community of monetary experts influenced the design but not the timingof the reform. In New Zealand, the epistemic community consisted o f officials at theTreasury and the RBNZ, as well as advisers to Finance Minister Douglas. These
individuals shaped the overall direction of Rogemomics, as witnessed by Douglas’
Economic Policy Package and the Treasury briefings in 1984 and 1987. These
documents provided politicians with a road-map of reform based on theories fromacademia (notably the Chicago school), the work of international institutions such as theOECD, the IMF and the BIS, and the reform experiences in Latin America and otherindustrialised countries. The detail of the RBNZ Act 1989 reflects the state of theeconomic paradigm circa 1988, particularly its monetarist focus on a single objective of313

price stability, the time inconsistency literature on delegation, and the public-choicecontracting approach developed for the RBNZ Governor. These ideas were translated
directly into the legislation by an RBNZ team that was intimate with the state of theacademic literature. In addition to academic work, New Zealand policymakers emulated
the policies of low inflation countries with independent central banks, such as theimplicit inflation targeting approach taken by the Bundesbank and the Swiss National
Bank (Bemanke et al. 1999).

New Labour’s 1997 decision to given the Bank of England independence was heavily
influenced by the ideas o f economists, propagated by policy advisors and think tanks
while the party was in opposition. The work of economic advisors like Ed Balls andGavyn Davies were important for convincing Chancellor Brown o f the economic
benefits to be gained from this reform. Ball’s 1992 pamphlet, Euro-Monetarism,
provided a coherent, worked-out road map that New Labour then adopted in 1994 as its
economic policy platform. This pamphlet advocated an independent Bank of Englandwith a mandate to pursue price stability backed by a government escape clause,
devolution of bank supervision to a new agency, a restructured governance structure anda medium term fiscal strategy emphasising responsibility and investment (Balls 1992).

The only difficulty is explaining why ideas were influential in guiding New Labour’s
policies, but did not influence the Conservatives during 1992-94. An epistemic
community o f City bankers, practitioners and academics presented a coherent
framework in the Roll report. Likewise, the financial sector representatives and foreign
central banks contacted by the Select Committee recommended the same solution. The
motivation for these efforts was the 1992 ERM crisis, which heightened the uncertainty
facing policymakers. These ideas were supported in the ruling government initially by314

Chancellor Lamont. The difference between these two debates is that the proposal to
give the BoE independence was supported by Labour Prime Minister Blair, but opposedby Conservative Prime Minister Major (and not strongly advocated by his second
Chancellor Clarke). For Major, this policy reform did not offer electoral incentives but
only suggested electoral costs, due to the loss of the ability to set interest rates forelectoral reasons and the opposition from Eurosceptics. More will be said about thesefactors below. The conclusion is that the ideas promoted by an epistemic community bythemselves are insufficient for explaining the timing of this change, although they do
explain the content of the reform when it was finally agreed.

In the cases o f Canada and Australia, academics and central bankers were central to thedebates but their involvement did not result in any changes to the central bank’s
legislation. This failure to influence policy can be explained by two factors: a lack ofconsensus among the epistemic community on the need for reform, and the lukewarm
support that these proposals received from central bankers themselves. In Canada, theideas of economists like Laidler (1991) succeeded in creating a focal point around theneed to reform the BoC’s legislation during the 1991-92 period. The influence ofLaidler’s pamphlet is seen in the government’s agenda as reflected in the Conservative
government’s 1991 proposals. However, during testimony before a parliamentarycommittee, the epistemic community in Canada failed to show any consensus. While
the majority of academic and business economists agreed on the desirability of pricestability as the goal of monetary policy, they did not agree on the need to change the
Bank o f Canada’s legislation. Some vocal critics such as Fortin voiced strong
opposition to the proposal, while even a monetarist economist like Howitt had his
doubts. Likewise in Australia, many academics were opposed to the reform proposals
championed by Hewson and the opposition Liberals between 1991-1993. And those315

Australian economists who did favour reform could not agree on an alternative
framework, proposing instead a confusing array o f alternatives that did not provide
policymakers with a convincing road map of reform. The failure of the Liberals to getelected and the lack of consensus among the epistemic community led the ALP to stickwith the status quo.

The second factor that mitigated the need to change the central bank’s legislation was
opposition from central bankers themselves, who viewed themselves as operating with ahigh level of independence already. In Australia, senior RBA officials led by Governor
Fraser and Deputy Governor Phillips were opposed to a change in the central bank’s
mandate. Narrow targets were seen as constraining monetary policy discretion in an
unfavourable way, particularly given the RBA’s multiple objectives and Australia’s
historical and institutional context. Instead, RBA officials felt an inflation target would
be appropriate, which they adopted internally from 1993. Treasurer Keating highlighted
this opposition in debates with Hewson, demonstrating how a politician will often seize
on a lack of consensus among the experts to support or reject a proposal. In Canada,
Governor Crow did make a convincing case for giving the Bank of Canada a narrowmandate of price stability, but he rejected the other elements of the legislative packagethat were being considered at the time. Crow and other Bank of Canada officials felt thediscussion o f independence was misplaced, as monetary policy should always be
answerable to the democratic process. Finally, the Bank of Canada was already pursuingprice stability under an inflation-targeting framework adopted in 1991, which delivered
low inflation very quickly. Like Australia, the Bank of Canada was comfortable withthe dual responsibility for monetary policy put in place in the 1960s, and preferred thestatus quo to some unknown framework that might arise once the legislation was
opened up to scrutiny. Given the lukewarm support from the BoC and the clear division

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among Canadian economists, the Select Committee advocated sticking to the status
quo rather than trusting to some ‘ephemeral wisdom’ about monetary frameworks.

In summary, ideas were a central part of the debates in many of the cases over monetaryreform, and were a crucial factor in the two cases where the central bank legislation waschanged. An epistemic community was successful at influencing central bankindependence when two conditions were met. First, all the corollaries explaining when
the ideas of this epistemic community are effective must be met, namely heightened
uncertainty, a clear consensus on policy preferences and a political champion. If
economists or central bankers do not reach a consensus on the need to change thecentral bank’s legislation, politicians have no incentive to change it nor do they have aclear road map for reform. Under these circumstances, politicians will stick with thestatus quo. In Canada and Australia, inflation targeting pursued with greatertransparency was seen as a viable alternative to delegation for achieving antiinflationary credibility of monetary policy. The second condition relates to the role ofpoliticians as champions o f central bank reform. While ideas may be able to explain thecontent of reform, the timing remains in the hands of politicians. Politicians must
therefore have adequate incentives to champion this reform. Such an incentive may beprovided by the need for balance o f payments financing, the desire to be re-elected or an
ideological belief in the reform itself. In each case, the reform must agree with theworldview of a powerful politician who adopts this reform as his own. Without politicalsalience, ideas are barren. Hypothesis II must therefore be carefully qualified.

Lobbying by Domestic Interest G roups

The evidence of the four cases rejects hypothesis III that a central bank is given
independence in response to lobbying by the financial sector or other domestic interest
groups opposed to inflation. There was evidence of interest group lobbying on five

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occasions (row 6), of which the financial sector was active in four (row 7). The
financial sector presented evidence to parliamentary committees in New Zealand,
Canada and the UK. They also waded into the debate through the financial press and the
publications for clients. Finally, they may have engaged in quiet lobbying althoughfinancial associations and policymakers interviewed for this study (both current andretired) denied this activity. Financial sector lobbying, however,

was not a goodpredictor of the outcome. While the financial sector supported RBNZ reform, it also
supported this reform in Canada during both debates and in the UK during the 1992-94
debate. In Canada, the financial sector’s efforts were undermined due to the oppositionof the chief economist of Toronto-Dominion. This failure to speak with a common
voice allowed opposition politicians to discount these views. In the UK, representations
on behalf of the financial sector to the Treasury Select Committee had no impact on theoutcome, as the ruling government paid little attention to the final report (or similar
efforts in the Roll report).

The lack of effectiveness of financial sector lobbying is not surprising given the
structural changes taking place in the four countries during this period, a point raised ina similar study by Moran (1991). Financial sector reform was a common phenomenon
across the cases studied, with the liberalisation of exchange regimes, the deregulation offinancial markets and the greater competition from foreign banks and the other ‘pillars’o f the financial sector over this period. In general, all these countries were moving
towards a universal banking model dominated by a few, large firms. This type ofchange meant that financial sector firms were preoccupied with more pressing issues,
such as the detail o f reforms affecting their industry, the changing competitive
landscape and their declining profitability. This finding is consistent with the argumentthat the lobbying capacities o f banks varies over time (Moran 1991, p. 189). For this318

reason, representatives from financial sector associations did not get involved in allthese debates, as more pressing issues required their focus that had a clear impact on
their businesses, such as legislation or regulation affecting the financial sector.

This study has also argued that the financial sector did not necessarily hold unitary
preferences towards central bank independence. First, in all the cases studied except
Canada the central bank was also responsible for banking supervision, creating a
potential conflict of interest as discussed in chapter 3. Second, financial firms may have
had difficulty in determining how monetary policy affects their asset portfolios, leading
to unclear preferences. Inflation has offsetting effects on a portfolio of diversified assetsthat does not lead to a uniform preference against inflation (King 2000). While inflation
clearly reduces the value of fixed income assets in the long run, in the short run this is
not the case due to immunisation of portfolios whereby assets and liabilities are offset.
In the long run, real estate and possibly equity may be correlated with inflation, leading
to mixed preferences towards inflation among financial sector participants exposed tothese asset classes (King 2000; Maxfield 1998). Without clear preferences towards
central bank reform, it becomes impossible to lobby effectively on this issue.

Business and trade union associations were also active in the debates about the central
bank (row 8 and 9), but they suffered from two problems. In all the cases studied,business and labour interests were fragmented and were unable to speak with a single
voice on any given policy issue leading them to take opposing positions in these debate.
In New Zealand, the elitist NZBR and Federated Farmers supported greater RBNZ
independence with a single mandate, but the Manufacturers’ Association opposed it. In
Canada, the elitist BCNI supported BoC independence but the Canadian Exporters
Association and the Canadian Manufacturers Association opposed it. Only in the UK

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did the Confederation of British Industry (“CBI”) act as a peak association forbusiness (and finance), but then it did not get involved in this debate and did not give
testimony to parliament. The CBI’s declining political influence was not spent on issues
like Bank of England independence, which was viewed as an esoteric topic with little
practical influence for the CBI’s membership, but was directed instead at more practicalbusiness issues such as labour market legislation.

This statement about the lobbying effectiveness of business may underestimate theextent to which politicians take implicit business preferences into account when
designing economic policy. According to Lindblom (1977), business sits in a privileged
position due to their control of investment and employment, both valuable resourcesthat impact the popularity and success of politicians. A clever politician, it is argued,
takes into account the wished of business even when they are unstated. This argument
may be seen in both the New Zealand and the UK cases, where Douglas and Brown
needed to signal their credibility domestically to this key audience. The extent to which
Brown and Blair listened to business concerns is shown by their extensive canvassing ofbusiness opinion prior to the 1997 election, and their decision to issue a separatebusiness manifesto - the first such manifesto issued by the Labour Party in the UK. As
Moran (1991) states, “[The] power of business can never be accurately gauged byexamining the activities of business as a political lobby alone” (p. 188). This view of the‘structural’ power of business applies equally to the financial sector in both New
Zealand and the UK, as the financial sector was seen as a key opinion maker that signals
to the public the credibility o f politician’s and their policies.

Organised labour was vocal in opposition to central bank independence in Canada and
New Zealand, but they had little political influence. Organisations like the CLC in

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Canada and the NZCTU in New Zealand were not encompassing associations, andso lacked legitimacy as insiders. In both countries, multiple unions representing
different sectors of the economy claimed to speak for organised labour, but worked atcross-purposes, diminishing any potential political influence. As a result, organised
labour was ‘relatively disorganised’, cut off from any strong institutional ties with theleft-wing political parties, and faced with declining union membership. In the UK, thetrade unions had lost their privileged position with New Labour, and their peakassociation - the Trades Union Congress - was retrenching. The TUC did not get
involved in the debate over the Bank of England, being more concerned with issues
such as the minimum wage and adoption of the EU social chapter. The TUC preferred
to stay out of the spotlight on political issues like monetary policy, and it is doubtful ifthey would have been listened to if they tried. Only in Australia were trade unions apolitically influential interest group, due to their representation by a single peakassociation - the Australian Council of Trade Unions - and their close institutional andpersonal ties with the ruling Australian Labour Party. This influence was reflected in
the Accord negotiated with the Labour government that underpinned economic policy
from 1983 to 1996. Organised labour’s voice in opposition to a narrow mandate for theReserve Bank was a factor in the Labor government’s decision to stick with the status
quo.

Politicians 'Tying the H ands'

The fourth hypothesis offered to explain the trend in central bank independence
highlighted the importance o f incentives for leading politicians to adopt this reform.
Politicians must see clear electoral gains from this institutional reform that exceed theelectoral costs of giving up control of interest rates before they are willing to delegate to
the central bank. This hypothesis received only partial support in only one of the twocases where central bank reform took place, namely with the election of New Labour in321

the UK in 1997 (row 10). The New Zealand case appears to falsify this hypothesis,as the reform was introduced by politicians who did not stand for re-election after
central bank independence had been legislated. The other 7 observations where
politicians chose to stay with the status quo appear to provide some support to the ‘tying
the hands’ hypothesis. However, the partisan versions of this hypothesis are rejected,
while the non-partisan corollary concerning cabinet stability was not adequately testedby these cases. These conclusions are discussed in greater depth below.

This rationale of electoral gains was most clear in the reform of the Bank of England.
For New Labour, the reform improved the party’s electoral prospects and the future
political ambitions of Chancellor Brown. It provided New Labour with credibility withfinancial markets and businesses, and more breathing room to pursue fiscal policies thatwould provide the basis for a second term (which they won in June 2001). BoE
independence also suited New Labour’s desire to shed the party’s historical reputation
as the ‘party of devaluation’, while symbolising a new approach. For the Conservatives
the political benefits of BoE independence did not exceed the costs. For Thatcher, it
implied the loss o f the ability to alter interest rates for electoral purposes to gain the
support o f home-owners and other key Conservative Party supporters. Major shared thisview. Major faced an additional electoral cost, namely the threat that central bankreform would lead to further damaging confrontations with the Eurosceptics in his
party. In both cases, Thatcher and Major hid their political motivations for opposition tothis move under the rhetoric of the need to ensure ministerial accountability of monetary
policy in a democracy. Given that many democracies have independent central banks,
including the Fed and the Bundesbank, this objective rang hollow.

322

The case of New Zealand appears to falsify this hypothesis based on electoral gains.
Independence for the RBNZ was introduced and championed by Finance Minister
Douglas, and his supporters in cabinet, Caygill and Prebble. However, Douglas andother members o f his faction resigned from the government after the RBNZ Act 1989
was safely through Parliament, and did not contest their seats in the 1990 election(McLeay 1991, p.6). They did not wish to be re-elected, removing the main incentive
for this hypothesis. Apparently, Douglas introduced this reform because heideologically believed that it was the best policy for the country, not necessarily because
it would benefit him personally. In fact, many of the reforms introduced by Douglas had
the opposite effect, as they increased the instability of the government by leading todamaging divisions between the left and the right-wing of the NZLP. Prime Minister
Lange was forced to resign after his effort to oust Douglas over the proposed tax reform
had backfired. Similarly, Anderton left the party to form the New Labour Party thatcompeted for the votes o f traditional Labour Party supporters in the 1990 election. Thus,
introducing a reform that was opposed by the trade unions and other traditional NZLP
supporters was not designed to improve the NZLP’s chances of re-election.

Both the cases of Canada and Australia, as well as the debates under the Conservatives
in the UK, support the hypothesis that politicians will not introduce a policy that isbelieved to harm their electoral chances. The Bank o f Canada Act was not changed as
this reform was considered risky or politically unpopular by both the Liberals and theProgressive Conservatives. During the 1991-92 debates, the Progressive Conservatives
recognised that the timing for pursuing such a reform was wrong due to theconstitutional debates that were dividing the country at the time. Central bank reform
was divisive, and the Progressive Conservatives were already lagging in the polls due totheir implicit support o f the BoC’s high interest rate policy. Embedding a narrow323

mandate of price stability that was not fully endorsed by other central banks oracademic economists was a political risk that was not worth taking. By contrast, theLiberals increased their electoral popularity by attacking Governor Crow during the1993 election campaign. They then replaced Governor Crow with Governor Thiessen inorder to symbolically assert their control over the central bank in the eyes of the public.

Finally, Australian politicians did not tie their hands because they did not have to. The
decision to stick with the status quo reflected political calculations of the electoral
advantages to be gained from such a policy. No politically influential interest group waslobbying in support of greater independence, while the most important lobby organised labour - was opposed. Central bank reform was against the interests oforganised labour, and it reduced unnecessarily the government’s policy flexibility.
Given that the Liberal opposition publicly advocated this reform, any move in thisdirection would be a politically damaging admission of their guilt in interfering inmonetary policy. Nor did the Liberal-National opposition see the need to change the
RBA’s legislation when it was elected in 1996, despite their earlier contrary policy
stance. By 1996, inflation was low and the economy was growing so the government
did not need to do more than issue a public statement in support of RBA independence
and its inflation target.

The partisan versions o f the ‘tying the hands’ explanations contained in corollary A and
B were rejected in all cases except the UK in 1997. First, partisanship in itself was is nota good predictor o f central bank reform as seen in table 3. While so-called 'Labour'
parties introduced the reforms in New Zealand and the UK, the Labour government inAustralia rejected this reform. The only consistent finding from this case study is thatright-wing politicians did not ‘tie their hands’ in any o f the cases studied. Second, the324

incentives to delegate based on time horizon were not supported. Right-wing
politicians with a short time horizon were expected to delegate in order to reduce theroom to manoeuvre of an incoming left-wing government. This was not the case in New
Zealand, the UK and Canada. The National government under Muldoon did notconsider this reform, but then the case study has argued that Muldoon’s government
was so confused in its policies that it was right-wing in name only. And by the time the
National government of Bolger was elected in 1990, the RBNZ was alreadyindependent. The UK Conservatives failed to pass this reform despite their likely defeat
in the 1997 election, perhaps because they did not believe that they could lose. In
Canada, while the Progressive Conservatives were willing to discuss this reform prior to
the 1993 election, the incoming Liberals never seriously considered it. However,Canada does not have a left-wing party that is politically viable, so this incentive was
not truly present.
Table 55: Partisanship and Central Bank ReformCountry

Date

Nature o f Change

Party in PowerNew
Zealand

1989

Central bank given legal independence with a narrowmandate o f price stability based on an inflation target agreed
between the Governor and government.

Labour Party(left)

Canada1991

Joint announcement o f inflation targets, jointly agreed bygovernment and central bank, but no change to legislation.

Progressive
Conservatives(centre-right)

Australia

1996

Joint announcement o f independence and government
endorsement o f inflation target set by central bank, but nochange to legislation.

Liberal Party(centre-right)

UnitedKingdom

1997

Central bank awarded legal independence in setting o finterest rates, under management o f a M onetary Policy
Committee, based on narrow mandate o f price stability with
inflation target set by government.

New Labour(centre-left)

Left-wing politicians with a longer time horizon were expected to delegate in order toreduce the cost o f financing government debt. This prediction was not supported by anyof the case studies. The Labour government in New Zealand passed the RBNZ Act 1989
towards the end of its second term, when it had already paid down much of the325

country’s foreign debt and it seemed likely they would lose the 1990 election. In thiscase, the main reason given for RBNZ independence was as a mechanism to eliminate
political interference by the National Party whose past political interference in interest
rates was seen as one of the principal causes of New Zealand’s economic
underperformance. Finance Minister Douglas may have also seen a need to 'tie thehands' of his own party in order to prevent Labour opponents of Rogemomics from
subsequently undoing his reforms. This case is somewhat of a conundrum as it does not
fit any simple explanation based on ‘tying the hands’ arguments in the literature. This
thesis argues that ideology, not electoral incentives, explains the New Zealand outcome.
Likewise, the Australian Labor Party never seriously considered this reform, despite
their strong mandate that lasted from 1983 to 1996 and the punitive costs charged on
Australia’s overseas borrowing. Rather than reform their central bank, ALP politicians
preferred to pay down their debts and remove this source of weakness. Only the electionof New Labour in the UK satisfied this hypothesis, and then the rationale for adopting
was to signal their anti-inflationary credibility, not to reduce the cost on their relatively
low levels of debt outstanding.

Finally, these cases have not provided a direct test of the hypothesis in corollary C thatpoliticians will 'tie their hands' in order to increase the stability of the ruling coalition.
Bernhard’s arguments are based on the assumption that backbenchers or coalition
partners can credibly threaten to bring down the government. This is not the case in theWestminster-style parliamentary systems considered here where power is concentrated
in the hands of the executive and backbenchers have little power. In addition, theplurality electoral rules in these four countries led to consistent majority governments,
which did not have to rely on coalition partners to stay in office. However, these cases
provide an indirect test of Bernhard’s hypothesis, as two majority governments did give326

independence to the central bank in the absence of a threat to the stability of thegovernment. And in the case of the UK, the Conservative government under Major did
face a credible threat from Eurosceptics within the ruling coalition, who threatened tobring down the government over the Maastricht Treaty, but Major faced them down
without making any concessions on the government’s policies.

Impact of Institutional Variables

One of the constraints highlighted by the political economy literature concerned thenumber of checks and balances imposed by the political institutions. Political systems
with federal systems, bicameral legislatures or higher party fractionalisation were
expected to find it more costly and difficult to pass the legislation required to give thecentral bank independence, leading them to stick with the status quo. The four casestudied provided support for this institutional constraint. New Zealand and the UK had
unitary structures that did not require compromises with either provincial or state
governments. New Zealand has a unicameral legislature, while the upper house in the
UK plays a largely supportive function to the lower house, making it easy for the
executive to push through its preferred legislation. Many studies of New Zealand’s
economic reforms note that they were more radical and far-reaching than similarreforms in Australia. Castles et al (1996) argue that the slower pace of reform inAustralia is explained by Australia’s restrictive bicameral parliament and federal
division o f powers versus the lack of checks and balances inherent in New Zealand’s
unicameral system and first-past-the-post voting rules. Similar points were made by
Bollard (1994), Goldfinch (2000) and Nagel (1997).

This lack o f checks and balances in New Zealand and the UK made it easier forpoliticians in these countries to push through central bank reform. However, Australia
and Canada are federal systems with bicameral legislatures, which creates a number of327

hurdles that must be overcome to approve legislation. The Australian Senate has
shown its ability to bring down a government, as it did in 1975, while constitutional
battles between the federal government and the Provinces in Canada meant that theexecutive did not pursue an additional institutional reform that was seen as potentiallydivisive. Both Australia and Canada stuck with the status quo, as predicted. In fact
neither country has introduced significant changes to their central banking legislation
since the 1960s.

9.2 Questioning Legal Measures of IndependenceThis thesis has argued that an epistemic community promoted central bankindependence as a solution for controlling inflation, by convincing private actors of theanti-inflationary intentions o f monetary policy. Given this starting point, it is interesting
to look at the inflationary record of different countries during the 1990s to see if thispolicy prescription was supported ex post. Table 2 shows the inflationary performanceof a range of OECD countries, which have been loosely categorised by theirpredominant monetary framework over recent history. This classification is notdefinitive, as many of these countries changed their monetary framework as well as thedegree o f legal independence of their central banks over this period. As a result, table 2
is only meant to be suggestive.

The most striking conclusion to be drawn from this table is that inflation was brought
down significantly between the 1980s and 1990s across all these countries, regardless ofthe monetary framework put in place. This outcome does not appear to be explained by
the level o f central bank independence. For example, Belgium, France and Norway
achieved levels o f inflation at the same level or below the record in Germany,
Switzerland and the USA over the 1990s, despite being rated among the more

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politically controlled central banks through the mid-1990s when their legislation
was changed.
Table 56: Inflation Performance of OECD Countries, 1970-1997
Year

CBI Index 1

OECD Average

1970-79

1980-89

1990-97

10.1

8.8

3.3

Exchange Rate Peg
Austrian

67

6.1

3.8

2.6

Belgium

47

7.1

4.9

2.3

Denmark

79

9.3

6.9

2.1

France

45

8.9

7.3

2.1

Ireland

n.a.

12.7

9.2

2.4

Italy

41

12.2

11.1

4.4

Netherlands

67

7.0

2.8

2.5

Norway

37

8.4

8.3

2.5

8.9

6.8

2.6

AverageMonetary Target
Germany

100

4.9

2.9

2.7

Switzerland

96

4.9

3.3

2.5

4.9

3.1

2.6

Average
Inflation Target
New Zealand

292

11.4

11.8

2.3

Canada

55

7.3

6.5

2.2

United Kingdom

44

12.5

7.4

3.9

Sweden

n.a.

8.6

7.9

3.6

Finland

61

10.3

7.3

2.2

Australia

42

9.8

8.4

2.6

Spain

29

14.3

10.2

4.4

10.6

8.5

3.0

Average
Floating Exchange Rate
USA

74

7.1

5.5

3.1

Japan

52

9.0

2.5

1.4

8.0

4.0

2.2

Average

1. The CBI rank is taken from chapter 1, table 2, and is an average of four indices. 2. Pre-1989 reforms.
Source: IMF International Financial Statistics, Cottarelli and Giannini (1997), Grenville (1997).

One possible conclusion from this table is that these economies have experienced acyclical downturn in inflation (following the recession of the early 1990s). Inflation has

329

declined for all these countries during the 1990s, regardless of the monetary
framework they have in place. This cyclical downturn, combined with the widespread
support for price stability, may be responsible for low inflation and not the institutionalframework for monetary policy. Of course, practitioners have long been sceptical of thetime inconsistency literature and the suggestion that policymakers will use discretionover interest rates to spring inflationary surprises on the public (Goodhart 1994b;
McCallum 1995). But academics have not paid much attention to the views of central
bankers, preferring to mine instead a rich vein of theoretical research without trying torelate it to actual practice. And political scientists, who are in a better position to judge
political behaviour, have chosen to steer clear of monetary policy, as it is an
intimidating and technical issue area without much general appeal to their field.

A second interpretation is that legal measures of central bank independence do a poor
job of capturing the de facto independence of central banks (Banaian et al. 1998; Forder^
1998b; Temple 1998). Central bankers in Canada and Australia and have argued that theoperate with a high degree of de facto independence that is not reflected in the legal
rankings assigned by academics. According to this view, the whole economics literature
on coding statutes is doomed to failure as it fails to recognise that private actors view
the BoC and the RBA as independent. While the case studies have provided ample
evidence in support of the opposite position, the inflation records of these countries - aswell as the long standing anomaly of the Bank of Japan - have demonstrated that there
are alternatives to changing the legal statute of the central bank for gaining credibility.
In Australia, the wage and incomes accord negotiated between the ALP and the unions
played a key role in controlling wage inflation. It also created a constituency in favourof low inflation, as any inflation greater than the amount factored into the Accord meantthat unionised workers experienced a decline in real wages.

330
Convergence in Policy Frameworks or Diffusion?

This thesis has been premised on the paradigmatic view that legal measures o f central
bank independence were a significant proxy for de facto independence, as assumed by alarge body of empirical literature reviewed in chapter 2. Given the findings o f the casestudies, and the evidence of a secular decline o f inflation across a range o f central
banks, it may be time to reject this null hypothesis in favour o f the view that legal
indices are a poor indicator of de facto independence. This ‘heterodox’ position is
supported by a variety of academics and practioners, particularly central bankers inthose institutions seen as being open to political influence (Crow 1993b; Fraser 1994b;
Macfarlane 1996).1 If legal measures are a poor indicator, then it is possible to argue
that the operational changes introduced in all the cases reflect a variety o f alternatives tostatutory independence for increasing the anti-inflationary credibility o f policy. Two
alternatives will be discussed briefly, although a more thorough examination will need
to be carried out in the future. These two alternative strategies are increasing thetransparency and accountability of the monetary policy framework, and developing a\

reputation for conservativeness through actions taken to control inflation.
Inflation T argeting with G reater T ransparency

An alternative approach for achieving monetary policy credibility has been to increase
the accountability of monetary policy by adopting an inflation target, supported by anincrease in the transparency of the central bank’s decision making. This strategy was
pursued by Canada in 1991, by the UK in 1992 and by Australia in 1996 (although it
was informally in place from 1993). In all cases, inflation targets were introduced after
inflation had been brought largely under control, as a mechanism for embedding thegains of disinflation and as a domestic anchor for private sector expectations. And in all

1 One academic, James Forder o f Oxford University, has written a number o f articles making this case,and even edited a special issue o f Oxford Economic Papers on this topic (Forder 1998a, 1998b, 2000;
Forder et al. 1998).

331

cases, this framework introduced under a conservative government that resisted thetrend towards legislation greater central bank independence.

Canada announced the adoption on an inflation target in early 1991 after inflation had
been brought down but prior to the political debates over the BoC’s legislation. The
credibility of this framework was demonstrated when medium-term expectations for
inflation fell despite the jump in headline CPI to 12% resulting from the introduction of
the GST (BoC 1991a, p.9). The credibility (and legitimacy) of this framework wasboosted by Governor Thiessen who took a number of steps to increase the transparencyof monetary policy as described in chapter 6. In the UK Chancellor Lamont introduced
the inflation target after Prime Minister Major repeatedly rejected the Chancellor’s
requests for Bank of England independence following the ERM crisis (Lamont 1999).
Australia was slow to adopt an inflation target due to the presence of the Accord put inplace by the ALP in 1983 which lasted until 1996. While the RBA pursued an inflation
target internally from 1993, it was only endorsed after the Liberal government waselected in 1996. The joint Statement with the RBA at this time was intended to signal
the government’s support of this framework. From this point, the RBA went to great
lengths to increase the public understanding of monetary policy and the central bank’srole, increasing the number ofspeeches and publications and agreeing to give

testimony before a Parliamentary committee on a regular basis.

Ironically, New Zealand’s inflation targeting framework undermined the credibility of
the independent RBNZ over the 1990s.2 On two occasions, the terms of the inflation

2 Debelle’s (1996) analysis of New Zealand’s 1989 reforms presents a mixed picture. He found that thedrop in inflation expectations did not occur until one year after the new legislation was passed in 1990,
but then expectations fell rapidly suggesting there was a credibility gain from the new framework(Debelle 1996). New Zealand ex post real interest rates declined and the long term premium relative to332target were changed following an election - first in 1990 and again in 1993, when
first the time horizon for achieving price stability was extended and next the target band
was widened.3 Both these episodes demonstrate how politicians are still able toindirectly influence policy under an independent RBNZ. Then two breaches of the 1 to
3 % band occurred - the first in the second quarter of 1995 and the second in the fourth
quarter of 1996. The first breach led to an exchange of letters between the Governor andthe Minister o f Finance, and some calls for the dismissal of the Governor which thegovernment ignored. The second breach caused no such activity, despite being larger
and lasting longer, suggesting that the threat contained in the RBNZ Act 1989 to dismiss
the Governor was not credible (Bemanke et al. 1999). These events led to criticisms as
the Governor had considerable flexibility to exclude inflationary items from theoperational CPI target based on a number of escape clauses, further reducing theaccountability and credibility of the framework (Bemanke et al. 1999, p.95). The lesson
from this episode is that the definition and operation of the inflation target are more
important than the announcement of the target itself, which has led many observers tocomment that ‘actions speak louder than words’. Ultimately credibility is derived fromresults (Nicholl and Archer 1992, p.319).
ReputationJ

A second and related strategy for achieving monetary policy credibility involved
developing a reputation for conservativeness. Delegation as an alternative ‘commitment
technology’ was identified by Rogoff (1985) who recommended appointing a
conservative central banker who has a reputation within the financial community for
defending price stability. This conservative central banker would place a larger weight

US interest rates narrowed after the reforms were introduced in New Zealand. Both indicators reflect
positively on the reform.
The time horizon for achieving the target was lengthened from year-end 1992 to year-end 1993
following the election of the National Party in 1990. Then the target range itself was widened from 0 to 2

333

on price stability relative to employment stabilization than is implied in the public’s
social loss function. A conservative central banker will then set out to ‘reveal’ thispreference at the earliest occasion. This reputation for toughness is revealed when thecentral banker’s commitment is tested at an early stage and then is re-tested often. The
disadvantage of reputation as a strategy for credibility is that price stability is achieved
at a higher social cost, as measured by a higher sacrifice ratio (Debelle et al. 1994;
Posen 1993).

The Bank of Canada’s pursuit of price stability under Governor Crow can be seen as a
strategy to build a reputation for conservativeness. Crow revealed his preference forprice stability over the other objectives in the Bank of Canada Act in his Hanson lecture
in 1988. This commitment was tested through the years 1988-1991, when interest rates
were pushed up to punishingly high levels in order to squeeze out inflation. The Bank’s
policy was aimed at achieving inflation that was ‘clearly below 2 per cent* with Crow
insisting that not even a low level of inflation was credible, which Crow’s critics took tomean a target of zero inflation. The cost of Crow’s toughness, critics argue, was the
1990-91 recession which was deeper and more painful than it needed to be. Fortin notes
how the Canada-US short term interest rate differential averaged 0.9 percent from 198088, but increased to 3.6 percent from 1989-1996 under Crow and Thiessen as the Bankof Canada strove to establish its reputation as a tough central bank in capital markets
with no concern for the disinflationary costs (Fortin 1996, p777).

The import of Crow’s strategy was not lost on academic economists familiar with theliterature. “[Since] assuming office, Governor Crow has taken a number of steps tobolster his reputation as an ‘anti-inflationist’, presumably in the belief that achieving

per cent to 0 to 3 per cent following the 1996 election, in exchange for the National Party government

334

this reputation will reinforce any anti-inflationary policies that the Bank actuallyfollows” (Lipsey 1990, p.40).4 Crow used rhetoric, in the form of public announcements
and speeches, to signal his commitment to price stability to private actors (Laidler 1997,
p.211). But this strategy was not initially successful. “[Rhetoric] was not enough togenerate the increase in credibility in Canada that the major legislative reform achieved
in New Zealand.. .[The] Bank of Canada had to support their rhetoric with the vigorous
application of tight monetary policy. That is, to signal their true anti-inflation aversion
and reduce the uncertainty, the Bank may have been overly conservative, thusincreasing the disinflation cost” (Debelle 1996, p.75). The need to back-up rhetoric with
toughness meant that Canada had the highest sacrifice ratio of the 19 industrialised
countries studied by Ball (1993), as predicted by the academic literature.

The strategies adopted by conservative politicians in Canada and Australia are similar tothe steps taken by the Conservatives in the UK. Rather than statutorily changing thelegal independence o f the central bank, politicians introduced a series o f consecutive
reforms - some might say ‘hesitant’ reforms - that had the ultimate impact of increasing
the de facto independence of the central bank over time. This observation raises twopoints. First, do private actors give right-wing politicians the benefit of the doubt when
judging their anti-inflationary credentials while forcing left-wing politicians to makemore radical, institutional changes to achieve the same standing? This appears to havebeen the case in the four cases studied here. Inflation targeting alone was sufficient in
Canada, Australia and the UK under the Conservatives, while New Labour in the UK

receiving the support of a key coalition partner (Bemanke et al. 1999).
4 Fortin and Osberg (1998) describe an allegorical tale to capture the costs paid by the Bank of Canada in
the pursuit of reputation. “Let’s think of Credibility Mountain as an enormous construction project, aimed
a building a mountain of sand just outside Ottawa to symbolise our national willingness to tolerate highunemployment in the hope that inflation will disappear...[Since] the cumulative amount of output
foregone due to excess unemployment over the period 1989 to 1997 was approximately $475 billion, by
now Credibility Mountain would be rather large and growing” (Fortin and Osberg 1998, p. 163).

335

and the NZLP in New Zealand instituted central bank reform. In Australia, the ALP
negotiated an alternative institutional mechanism - the Accord - to reinforce their
credibility. This line of questioning deserves to be researched and tested in greater depth
in subsequent work.

Second, have central banks been converging on preferred policy model, as suggested by
the globalisation literature? Or have we witnessed instead a diffusion of best practices
among central bankers that have emulated the features of other countries, such as the
Bundesbank and the Fed, while adapting them for historically and culturally different
settings? This diffusion, as opposed to convergence, was witnessed by Moran (1991) in
his study of the financial services revolution. He found that the UK and Japan adopted
the form of regulatory reforms from the US, which was the site of ‘best practice* in theregulation of banks. Likewise, the adoption of inflation targets, with or withoutaccompanying statutory independence, reflects a process of policy emulation that beganwith the Bundesbank and was passed to the RBNZ, the BoC and the RBA, among
others. In this case, it appears that there has been a substantial move among central
banks towards greater transparency, greater accountability and greater de facto
independence. This view is tentative, and remains to be tested in future empirical work.

9.3 Contribution to internationai Political Economy

The main issues that have preoccupied IPE over the last thirty years have been therelationships “between wealth and power, states and markets, interests and institutions,the international political economy and domestic politics” (Katzenstein et al. 1998,
p.684). This study has made a contribution to two of these categories. First, it has
looked at the impact of international financial markets on national policies in the key
area of monetary policy. Second, it has considered the relevant importance attributed to336international and domestic factors when determining economic policy in this issuearea. Each o f these contributions will be addressed in turn.

International Financial M arkets and National Policies

Globalisation describes the increased interdependence or integration of sovereign states.
One way to measure globalisation is to look at flows across borders, whether they be
trade in physical or financial assets, migration of people or the transfer of information.
A more narrow focus on financial globalisation considers the process whereby statescompete to attract the savings and investment of private actors, which take the form ofequity, bonds, foreign exchange and foreign direct investment. A main debate in IPE
concerns how financial globalisation affects the policy autonomy of states. Are
governments able to pursue distinctive and partisan macroeconomic policies or are theyhindered by financial globalisation? And do international capital flows force states toconverge on a specific set o f policy preferences, such as the neo-liberal institutionalarrangements associated with the Washington consensus (Ikenberry 1992; Williamson
et al. 1993)?

A structuralist (or globalist) school within IPE views the dramatic increase in crossborder capital flows as a new structure in the international system that limits the room tomanoeuvre of states (Andrews 1994; Cemy 1993; Goodman 1993). “Capital mobility is
fully consistent with Waltz’s underlying conception of a structural feature ofinternational politics: a constraining condition that rewards certain behaviours andpunishes others” (Andrews 1994, p.202). 5 This school includes Gramscian andhistorical-materialist authors who view financial globalisation as part of a hegemonic
bloc controlled by capitalists. For example, Gill and Law (1989) argue that the so-called337

power of international capital mobility to constrain states has been encouraged orreinforced by shared ideas about state powerlessness. A more liberal school provides aless ideological and more qualified view, arguing that rising financial globalisation
restricts the ability of states to pursue inflationary fiscal and monetary policies and has
caused the roll-back of the Keynesian welfare state (Crotty 1989; Kapstein 1994; Kurzer
1993; Oatley 1999; Scharpf 1991; Schwartz 1994).

Opposed to this ‘convergence view’ are a wide spectrum of authors who contest the‘myth of the powerless state’ and view the claims of financial globalisation as
overstated. 6 The state retains some measure of autonomy due to the existence ofinstitutions such as encompassing trade unions, the state of the government’s finances,or the size of state (Garrett 1998b, 2000; Garrett et al. 1999; Hay 2000b; Katzenstein
1985; Mosley 2000).

Garrett’s studies of partisan politics found no support for theconvergence thesis: “My basic claim is that the globalisation of markets imposes far
fewer constraints on the range of feasible economic policies than is commonly thought”(Garrett 1998c, p.72). Frieden (1997) argues that politicians are only constrained byinterest groups and the electorate, not by international financial markets. The ability to
manage the exchange rate, for example, depends on political will and electoral support,
not on capital market constraints.

“While politicians and observers often presentinternational monetary events as though the markets were tossing and turning currencies
at will, in fact governments are almost always capable of sufficiently affecting traders’
incentives to drive currencies as they wish”(Frieden 1997, p.82). Large states such as
the US retain the ability to act, such as running current account deficits over extended

5 Andrews is referring to the Waltz (1979). The view that international capital constrains states has beendeveloped from the economics work of Mundell and Fleming, which was introduced most vividly into
IPE by Cohen as ‘Unholy Trinity’ (Cohen 1995; Fleming 1962; Frenkel et al. 1987; Mundell 1962,1963).
6 For the pluralist view, see Kapstein (1994), Strange (1996) and Weiss (1998). For the corporatist view,
see Alesina et al (1997), Baker et al (1999), Garrett (1998), Katzenstein (1985) and Goldthorpe (1984).

338

periods with no negative side-effects (Gilpin 1987; Nye 1990). Financial
globalisation was encouraged by hegemonic states like the USA that retain the ability toreverse it (Helleiner 1994; Walter 1991).

This study supports the authors who find that states retain policy autonomy - such as
the ability to have politically-influenced monetary policy - when certain conditions are
met. International financial markets have the ability to influence politicians through theexchange rate or through the government’s overseas borrowings. These two pathways
were examined in the cases studies. These case studies were consistent with Mosley’s
argument that international financial market pressure is strong but narrow. International
financial markets have the ability to sanction states, but financial market actors only
focus on a few economic indicators when evaluating economic performance, namely thelevels of inflation, government debt and deficits (Mosley 2000). Financial markets
punish states that follow unsustainable or inflationary policies, which were associatedwith Keynesian policies during the 1970s and 1980s.

This association explains why the partisanship literature argues that international
financial markets are suspicious of left-wing governments. However, international
financial markets also punish right-wing governments with poor economic performance,such as New Zealand under the Muldoon government

or Canada under theConservatives, as well as unsustainable policies such as the UK’s commitment to the
ERM under the Conservatives. A recent OECD study shows clearly that countries with
big budget deficits, big current account deficits, and a history o f high inflation 'now pay
a penalty in the form of higher real interest rates', but this outcome is not dependent on
the party in power (Brash 1996a). Market pressure, therefore, does not focus onpartisanship, but on indicators of poor economic health.

339

During the

1990s, a number of left-wing governments have pursued fiscal

consolidation, such as Australia and New Zealand, which led to budget surpluses andprovided these governments with room to move (Alesina 1999).7 It provided the means
to pursue more redistributive policies so long as these policies were not inflationary or
fiscally unsustainable. Australia guaranteed its room to move by institutionalising wage
restraint and funding deficits domestically with a floating exchange rate regime.
Likewise, New Labour in the UK has retained room to move by sticking to Brown’s‘Golden Rules’ for fiscal spending. What this study concludes is that central bankindependence is not a direct outcome of partisanship or financial market pressure on
left-wing governments, although international financial markets may affect the
incentives of politicians for pursuing such a change as seen in the case of the UK.

RBNZ Governor Brash argues that the power of financial markets is hugely exaggerated
and that the unchanging reality is that debtor countries yield influence to their creditors,
with higher borrowing ceding more influence (Brash 1996a). He points to the variationof economic policies across states to support this claim.
[There] are, even among OECD countries, countries which are running public
sector deficits o f 10 percent of GDP and New Zealand which is running asurplus; countries whose net public sector debt is in excess of 100 percent of
GDP and others where the ratio is less than 30 percent; countries where thegovernment spends more than 60 percent of GDP and others where government
spends little more than 30 percent; countries with inflation running at more than
10 percent annually and others where inflation is less than 2 percent; countries

7 These economic reforms towards liberalism have come from both sides of the political spectrum.In theOECD, liberalisation measures have been implemented by left-wing governments in France, Sweden,
Australia, Spain, Ireland, Greece, Portugal, Finland and the UK (Henderson 1998, p.69).

340

where unemployment is above 20 percent of the work-force and others
where it is less than 6 percent; countries whose exchange rate is pegged toanother currency and others where the exchange rate is freely floating. It would
therefore be untrue to suggest that the international financial market had
somehow forced a common set of economic policies on the world (Brash
1996a).
This study o f central bank independence found that international (and domestic)
financial markets are not concerned with the status of the central bank or the
institutional arrangements governing monetary policy provided that inflation is low andstable. In this regard, fiscal discipline and the coordination of macroeconomic policies
are more important for ensuring low inflation than the status of the central bank, a point
made by Sargent and Wallace (1981). Without the coordination o f monetary and fiscal
policies, the central bank’s pursuit of price stability is not credible, as seen in Canada
during the late 1980s when the BoC’s high interest rate policies contributed to large andgrowing deficits. In all the cases studied, politicians took steps during the 1980s and1990s to reduce government debts and to institutionalise fiscal discipline. The
Australian government committed to balance the budget over the course of the businesscycle and to reduce net debt. Canada’s government reduced the deficit and virtual
eliminated foreign debt. New Zealand passed the Fiscal Responsibility Act. And New
Labour in the UK adopted of the ‘golden rule’ of borrowing only for investment. It isnoteworthy that both left wing and centrist governments undertook these fiscal
consolidations, which has also been the case worldwide (Alesina et al. 1999; Henderson
1998).

Although this study was not primarily concerned with regulation, it is important tohighlight that state agencies retain the ability to structure the ‘rules of the game’ within

341

which the financial markets act through their control of regulation (Helleiner 1994,
Kapstein 1994, Moran 1984a, Moran and Wright 1991).8 By shaping the incentives andthe profitability of the financial sector in the cases studies, politicians in these four cases
controlled the pace and the direction of change. Note how Douglas in New Zealandmade the float of the currency inevitable by removing exchange controls and de­regulating the foreign exchange market. Similarly, the Canadian and Australian
goverments removed legal barriers that existed between the different pillars of thefinancial system, and encouraged the entry of foreign banks, increasing the level ofcompetition and reducing banking profitability. Both countries also rejected mergers
among their major banks, in the interests of the consumer. In the UK, New Labour
radically changed the regulatory structure for banking supervision - stripping the BoEof this responsibility and creating a new ‘super-regulator’ under the FSA. These moves
demonstrate how politicians play a role in shaping financial markets through structural
power (Moran 1984a, Strange 1993).

International and Domestic S ources of Econom ic Policy

Many works of political economy have noted how institutional change follows from an
economic crisis, generally originating in the international sphere. This view is found inmuch of the two-level games literature (Milner 1997; Putnam 1988). Labour
governments in Australia and New Zealand were led to pursue radical, neo-liberal
economic and financial reforms by currency crises in both countries. In Canada, foreign
concern about the size of Canada’s deficits and debts led the Liberal government toabandon its election pledges and made deficit reduction its key priority. New Labour
introduced a wide-ranging set of economic reforms, including giving independence tothe Bank of England, partly out of fear of an international financial crisis. These342

examples appear to demonstrate how pressure from the international system leads
politicians to abandon their electoral pledges in order to adopt the economic policies
preferred by international markets.

This view of international factors, however, is overstated. It fails to recognise twopoints. First, an international financial crisis may signal the need for economic reform
but the crisis is often triggered by domestic factors such as an election. In the cases
discussed above, economic reform always followed an election - in 1983 in Australia,
1984 in New Zealand, 1993 in Canada, and 1997 in the UK. In many cases the so-called‘international’ financial crisis was led or involved a heavy component of domestic
speculation, as suggested by Brash in New Zealand and by research on the ERM crisisin the UK (or past peso crises in Mexico). Elections sometimes play an important role intriggering a financial crisis, signalling the need to undertake economic reforms. As one
observer put it, the international financial markets are the final check on domestic
interest group demands for economic policy. This view suggests that politicians use thethreat posed by international financial markets as a bargaining tool for resisting thedemands of domestic interest groups, as suggested by the ‘two-level games’ literature.

Second, an financial crisis does not determine the content of economic reform, which isdetermined by domestic politics and constrained by existing institutions (Williamson
1994). Both the 1983 ALP and the 1984 NZLP election manifestos contained somedegree o f commitment to economic reform along neo-liberal lines, suggesting that they
were influenced by these ideas while in opposition rather than being captured by themarket once they were in office (Easton et al. 1996, p.30). These reforms had many

8 This view is rejected by the work of Goodman and Pauly (1993) and the contributes to Cutler et al(1999) who argue that increased financial interdependence and rising capital flows has forced the state to
reduce its role in regulating financial markets, and to delegate this task to private actors.

343

significant similarities, such as the floating of the currencies and the deregulation of
the financial sectors. However, the differences are starker. Hawke’s consensual
approach, contrasted with Douglas’s ‘blitzkrieg’ approach, is explained by the different
power of interest groups, particularly organised labour (Castles et al. 1996, p. 10). Dueto the strong institutional ties with organised labour, the ALP rejected contractionary
fiscal policies and expanded the social wage in exchange for negotiated wage restraint
generating a better economic performance than New Zealand during the early 1990s(Debelle 1996; Easton et al. 1996, p.45). The point to be made is that the contents ofthese economic reforms were dictated by domestic factors in these two countries, not byinternational actors. The conclusion is that domestic politics continue to matter,particularly when it comes to the content and timing of domestic political reforms. Thisfinding reinforces the IPE body of literature examining the interaction of domestic andthe international politics that was inspired by the early work of Gourevitch (Gourevitch
1986; Martin et al. 1998; Simmons 1994).

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Appendix: Political Economy Studies of Central Bank IndependenceYear

AuthorDependent Variable

Independent Variables

Methodology, Hypothesis and Findings

1983

Banaian, Laney& W illett

Inflation (price deflator, CPI,
nominal national GNP)

Fiscal deficits / savings
Unionisation
Change real income per capita
Income inequality (Gini coefficient)
Imports / GDP
CBI (dummy variable 1,0)

17 Industrial countries from 1960-80. Compared structuraland economic explanations o f pressure for monetaryaccommodation against CBI. In each case CBI was
significant and negative, suggesting inflation could be about
4% less. None o f the other variables were significant, except
real income per capita which was sensitive to choice of
proxy.

1984

Woolley

Adopts an institutional and interest group approach. Argues
that despite de jure independence, Fed is involved in politics
and is influenced by politicians (President, Congress),bankers and economists.

1985

Woolley

CBI cannot be reduced to numbers, and do not remove theneed to study the politics between policymakers and interest
groups. Changes in the relationship between the central bankand politicians have been precipitated by periods o f crisis.
Central bank independence is a ‘fapade’ that primarily servesa political function. The central bank, which uses twovaluable political resources to bargain with government: its
expertise and the support o f the financial community.

1987

Protopapadakis& SiegelCentral banks do not have to accommodate budget deficits.
Found only a weak association between increases in debt
growth and either money growth or permanent increases in
inflation, suggesting that “central banks in industrialised
countries with moderate deficits can pursue an independent
monetary and inflation policy over long periods o f time,notwithstanding the size o f government deficits.

1988

Barnhart &Darrat1988

Masciandaro &Tabellini

Budget deficits Public
expenditure Government
debt
Real interest rate
Inflation

Fiscal dominance o f central bank (CBI).

5 countries (Australia, Canada, Japan, New Zealand andUSA) between 1970-85. If fiscal authorities dominate adependent central bank, the bank will fund government
deficits.

1989

Alesina(1) Inflation

CBI
Deficits
Political instability

1968-86 for 12 countries Builds an index o f politicalinstability and borrows one on CBI to test rationalexpectations augmented theories o f partisan politics (RPT)against political business cycle theories (PBC). There is apositive correlation between political instability and O kun’s
misery index. Alesina also finds a correlation between CBIand inflation

Lagged values of:Rate o f growth o f monetary baseBudget deficit / GDP
CPI growth rate
Government spending / GDP
3 M onth T-bill rate or equivalent
Unemployment rate
Exchange Rate
Current account deficit (or trade deficit
where not available)
Floating exchange rate dummy variable(1971-74, 1974-85)

Eight OECD countries from 1960-1985, using quarterly data.
Lagged variables specified using OLS and Final Prediction
Error criterion. Three equations Estimated simultaneously bygeneralised least squares using maximum likelihood
procedure. Authors claim central bank policy appears to be
directed more toward price stability and less toward
accommodation o f government budget deficits in countries
with a central bank that is independent o f government.

Movements in money growth do not influence fiscal policy,
suggesting that monetary and fiscal policies are set
independently in the OECD economies(2) M isery Index

1990

Burdekin &W ohar(1) Inflation (CPI)(2) M onetary base (proxy formonetary policy)(3) Fiscal deficit (proxy forfiscal policy)

1990

HetzelA public choice analysis o f the relationship between
Congress, the Fed and the executive. His views on theredistributive effects o f inflation and strategies adopted by
the Fed to protect its independence foreshadow Posen.

346

Unexpected inflation redistributes income among societalgroups. Incentives to organise vary across interest groups,
which suffer from collective action problems. The mostactive lobby against high interest rates during the 1960s and1970s were the construction industry, purchasers of homes
with fixed-rate mortgages, S&Ls, owners o f small businesses
and farmers. The commercial banking sector and small
savers are two groups opposed to inflation.
1990

W illett & KeenFound evidence o f political pressure on interest rates using
90-day T-bill rate, which contradicts the findings o f Beck
(1987) who found no evidence o f an election cycle in the fed
funds rate

1991

GoodmanCBIcoalitions o f societal actors
expectations o f political leaders regarding
tenure in office

Theoretical case to explain CBI. He argues that the existenceo f a strong conservative societal coalition is necessary forthe creation o f an independent central bank. To be sufficient,however, political leaders must also expect that their party
will be in office only a short period o f time.

1991

Grilli,M asciandaro &Tabellini

Inflation
Budget deficits
Debt
Employment
GDP

CBI
Political regime type
Frequency and significance o f politicalchangePolitical fractionalisation

Study 18 OECD countries from 1950-89. CBI promotes low
inflation with no apparent costs in terms o f real economic
performance. Rising debts are associated withrepresentational democracies and fractionalised party
systems which lead to short term coalition or minority
governments with high turnover. CBI does not restrict therise o f unsustainable debts, nor is there any relationship with
output growth or its variability, or unemployment, whichleads the authors to compare it to a ‘free lunch’.

1991

HellerUses simple comparison o f 16 countries from 1980-87 toshow how “central banks without supervisory
responsibilities were more successful in attaining a low
inflation rate than central banks with shared or fullsupervisory responsibility.” (p.65) MRK: comparisons o f347

Heller classification with others show many discrepancies.
1991

Swinburne &CastelloBranco

1992

GoodmanPoliticians give independence in context o f domestic andinternational environment. Banks keep independence byallying with private financial community. CBI is a two way
exchange - promote interest o f financial community against
inflation in exchange for support against politicians who may
wish to revoke independence, (p.8) Monetary policy is
explained by institutions, esp. central bank, and politics. The
degree o f CBI is the key explanatory factor. PBC andpartisan politics existed and labour militancy (interest group)
was effective in influencing policy when central bank wasdependent in UK and Italy, but not in Germany where it was
independent.

1993

Cukierman

Political influence over the central bank may be subtle orovert. Signalling from the executive or proposals to limit
independence are subtle pressures. Overt pressure is seen
when governor o f the central bank is routinely replacedfollowing a change o f government despite legal restrictions
against this possibility. There is empirical evidence
supporting political turnover o f the central bank governor
following a change o f regime in both industrial anddeveloping countries

1993

Havrilesky

Found evidence that the Fed responds to signalling by theTreasury, to congressional threats to Fed’s independence, tothe signals from Senators at biannual Hearings, and to
signals from the banking sector delivered through theFederal Advisory Council to the Fed. Suggests but cannot
support that financial sector actively lobbies the Fed.

CBI

Public Opposition to Inflation
Federalism

348

1993

Havrilesky &GranatoInflation

CBI (BP)
Corporatism (% unionisation,
centralisation, labour index, cabinet
portfolios held by le f t, left % o f vote inelection)
Size o f Public Sector (Public expenditures/ GDP, public expenditures per capita)
Dependence on Oil imports (Oilimports/GDP)

Test 18 industrial countries for 1955-87. Used Chow tests to
identify two distinct groups o f countries based on inflation
then used canonical discriminant analysis to test which
variables explain the breakdown. Checked their results using
stepwise analysis to identify the dom inant variable. Found
that only CBI explained inflation. Corporatism, size of
public sector and dependence on oil imports were notsignificant.

1993

Posen

(1) Inflation (CPI)(1) Effective FOI (universal banking,regulatory power, political regime, party
fractionalisation)
CBI (CWN measure)
Significant government change
Frequency o f government change
Fixed exchange rate dummy(2) Effective FOI
Significant government change
Frequency o f government change

Tested two hypotheses for 17 industrial countries from 195089 using OLS regression. In first regression, Posen foundthat effective FOI was significant and negative while CBI
was insignificant. A fixed exchange rate regime was alsosignificant. Significant government change showed mixed
results while frequency o f government change was not
significant. In second regression, effective FOI was
significant predictor o f CBI with adjusted R2 o f 0.47-0.52.
Government change variables were not significant.

(2) CBI (CWN)

1994

Alesina &PerottiBudget deficits are best explained by political conflicts
between social groups and the set o f budgetary institutions.
Need to reform the institutions governing the budget, such as
introducing a balanced budget rule, reducing the number ofveto players or giving independence to the central bank

1994

Cukierman

CBI is higher when the size o f government debt is greaterand when the government relies more on borrowing in thecapital markets. CBI lower the interest cost on the debt (via
the inflation premium). Second, the larger the value o f
unexpected inflation to politicians, the greater the
inflationary bias and the larger the benefits to delegating to
the central bank. Third, when party polarisation is greater, or349

the political regime is unstable, outgoing parties delegate
more to the central bank to tie the hands o f incoming
governments.
1994

Cukierman

1994

Henning

M aintain peg or devalue

CBI
Domestic financial structure (universal /commercial banking, credit / capital
market-based, concentration)
Financial interests

Henning provides theoretical argument that foreign
constituencies ally with domestic interests in countries withcapital market-based financial systems, principally banks, tocreate a transnational coalition against devaluation or
depreciation. Connections between banks and industry incountries with credit-based systems, on the other hand,
prevent a transnational coalition forming and favour an
exchange rate level that is competitive.

1994

Simmons

Adherence to interwar gold
standard “rules o f the game”

Political stability
CBI
Partisanship (left)
Labour unrest
Regime type (federal / unitary)

Simmons found that degree o f political stability, central bankindependence and the influence o f the Left were the moststatistically significant. Labour unrest and regime type were
not significant

1995

Alesina &
Gatti

1995

Al-Marhubi
and Willett

Why CBI trend now? (1) success o f Bundesbank and Swiss
National Bank, (2) inflationary experiences o f 1970s, (3)Latin American countries want to secure gains fromstabilisation, (4) EMU and Maastricht, (5) breakdown o f
Soviet Union, (6) removal o f capital controls and desire to
attract potential investors and creditors.

Develops a theoretical model to support Alesina’s empirical
work showing that an CBI reduces output volatility by
reducing ‘political’ variability caused by partisan politics ina two-party system, coalition governments or interparty
struggles between factions.
Inflation(mean GDP deflator
1973-89)

CBI (BP, GMT, CWN, Willett)Union centralisation (hump-shaped index)
Openness (imports/GDP)

20 industrial countries for 1973-89. Find that CBI, openness
and union centralisation are significant, while FX regime andsize o f budget deficits are not.

350

Budget deficit (as % GDP)FX regime (years o f peg as % of total
years 1973-89)
1995

Cukierman &
Webb

1995

De Haan &V an’t Hag

CBI(1) inflationary bias(2) stock o f government debt
(3) political instability(4) rate o f inflation(5) experience with high inflation(6) universal banking system(7) regulatory role o f central bank(1) Not significant.
(2) Not significant(3) Lower political instability is associated with higher CBI.
(4) Not significant(5) Using average inflation over the period 1900-40 as aproxy, found that experience with high inflation is associatedwith CBI.
(6) Universal banking was associated with CBI when using
CWN index, but not other measures(7) W hen central bank does not regulates banks, CBI ishigher when using CW N index, but not other measures

1995

De Haan &V an’T Hag

CBI (various)

Inflationary bias
Government debt
Level o f political instability
Inflation
Experience with high levels o f inflation
1900-1940
Universal banking
Regulation o f financial system

Found that high political stability, measured as the frequency
o f government changes in the 1980s, leads to lower central
bank independence, not higher as suggested by Cukierman.
Countries that experienced high inflation between 1900-1940
established independent central banks. Posen’s arguments
were only supported when Cukierm an’s 16-variable (CWN),
weighted legal index was used, not the others.

1995

Mas

In developing countries, 35% o f CB governor changes occur
within six months o f change o f government, compared to
10% for industrial countries, (p.406) Found no significant
relationship between central bank vulnerability and politicalregime change, (p.408) Low and medium political change do
not affect the central bank.

The institutional design o f a central bank is not sufficient for
ensuring credibility and low inflation in developing

351

countries. Government policy should focus on financial
sector reforms which bolster effective FOI, such as financial
liberalisation, privatisation, development o f financial
markets and limits on lending to government
1995

1996

Posen

Bernhard(1) CBI (various)

Effective FOI (universal banking,regulatory power, political regime, party
fractional isation)
Decade dummies
Exchange rate regime dummy(2) Inflation (CPI)

Effective FOI (universal banking,regulatory power, political regime, party
fractionalisation)
CBI (CWN measure only)(1) Cabinet durability(1) Time to election
Party system attributes (majority /minority / coalition)
Fractionalisation
Polarisation
Economic openness (capital accountopenness, trade/GDP)
CBI (CWN measure)Unionisation(2) CBI(2) Economic openness (capital accountopenness, trade/GDP)
Left partisanship (Alford index)
Strong bicameralism
Punishment (polarisation, coalition /m inority govt, committee strength)
Financial sector strength (Posen FOI)

Analysed 32 low-to-moderate inflation countries from 196089, of which 17 were OECD. Using OLS regression Posenfound that effective FOI is positively related to CBI and
negatively related to inflation in both OECD and developing
countries. Regressions using only the components o feffective FOI showed mixed results between the OECD andlarger samples. CBI is not significantly related to inflation
using time weighted least squares regression when effective
FOI (or its components) are included. The adjusted R2 is thesame as found by other studies o f inflation.
Found that only fractionalisation, polarisation, CBI,
unionisation and time to election were statisticallysignificant. Party system attributes and partisanship were
not. Economic openness measures were marginal orinsignificant.
Politicians will choose an independent bank: (1) ifgovernment ministers, party legislators, and coalition
partners possess different monetary policy incentives and (2)if government ministers fear that party legislators andcoalition partners will withdraw their support over a policy
dispute.

352

1996

Bleaney(1) Inflation (CPI)(2) Unemployment

CBI (CWN)
Corporatism
Centralisation o f wage bargaining

Tests 17 OECD countries for 1973-82, and 1983-89. CBI is
negatively associated with inflation and has no significant
effect on unemployment. Wage bargaining is significant for
unemployment, and associated with higher inflation in first
period only. Results are robust when using other proxies,
controlling for outliers or controlling for fixed exchange rate.
Pegged rate is alternative to CBI for controlling inflation.

1996

Burdekin &Burkett

View inflation as the outcome o f conflict between groupscompeting for income, first proposed by Tobin. Different
domestic actors will compete for a greater portion o f theincome available in an economy (presumably through rents,
wages and interest) creating excess aggregate demand forincome. The excess demand may then be accommodated bymonetary authorities through increased money supply, or thegovernment through increased budget deficits. The strategies
adopted by policymakers to fight inflation depend on how
different interest groups within society are affected.
. .controlling inflation is not ju st a matter o f technicalmanipulation o f fiscal and monetary instruments, but also
hinges upon the degree o f (implicit or explicit) distributional
consensus among the m ajor income claimants” (p.225). The
success o f any strategy hinges on accommodating orprotecting these key interest groups.

1996

Garrett &Lange

The predictions from interest group models only hold in alimited number o f cases as they do not consider the effects o finstitutions. Private sector institutions (“socio-economic”)
such as labour unions or public sector institutions (“formal”)
such as central bank independence will effect the impact o finternationalisation on political policy. These effects havebeen ignored in IPE. Other formal institutions are politicalregime type (democratic, totalitarian, authoritarian); numbero f veto players; and the election formulae (proportional

353

representation, single member districts, geographic
representation).
1997

Maxfield

1998

Banaian,Burdekin &Willett

The authors suggest that a public choice approach should be
employed to answer the critical question o f what institutional
aspect o f central bank independence is the most important.

1998

Bernhard

Politicians will choose an independent bank: (1) ifgovernment ministers, party legislators, and coalition
partners possess different monetary policy incentives and (2)if government ministers fear that party legislators andcoalition partners will withdraw their support over a policy
dispute.

1998

Broz

Origins o f central banks,
1688-1850

Wartime finance
Monopoly rents
Political regime (unitary / federal)

Broz argues for the joint-products model o f collective action
where creation o f the central bank provided both a public
good (protection o f property rights) and an excludable
private good (monopoly rents through control o f currency)
which was used to motivate a sub-group o f financial interests
to petition for the creation o f the central bank. Suggests thatunitary systems founded banks first because they did notface the political conflicts within parliamentary systems.

1998

Clark et al

Political business cycles

CBI
National policy autonomy (floatingexchange rate regime)

Authors argue that as national policy autonomy decreases orcentral bank independence increases PBCs become lesslikely. They test 18 OECD countries. They found that none

CBI (???)

Effectiveness of signallingcreditworthiness
Financial regulation (capital controls)
Capital mobility
Competition among states
Politicians tenure
BoP conditions (debt, export capacity andforeign exchange reserves)

Politicians use central bank independence as a signallingmechanism to increase their creditworthiness withinternational investors and creditors.

354

o f the eight countries in which the central bank is highly
independent demonstrated any evidence o f a PBC.
1998

Hall &
Franzese(1) Inflation(2) Unemployment(1) CBI (average o f CBI, GTM, BP)
Index o f co-ordination o f wage bargaining(CWB)
Interaction term CBI * CWBOpenness (exports + imports as % ofGDP)Real GDP per capita
Left cabinet representation
Union density (% o f labour force
unionised)

Examined 18 OECD countries from 1955-90. Left out
Greece, Spain and Portugal due to authoritarian regimes,
claiming that CBI will not be credible under thesecircumstances. In all models, CBI and CWB have a negativeand statistically significant relationship to the rate o f
inflation. Unemployment is also higher with increased CBIin the absence o f co-ordination.

(2) same variables as (1) plus
Terms of trade (export prices / importprices)Interaction term (terms o f trade x
openness)
1998

Hayo

Societal preference for low
inflation(1) Inflation(2) CBI (BP, GMT, Alesina)
OLS estimators from (1)Autoregressive error terms from (1)SUR-estimators (not explained)
Average inflation

1998

Keefer andInflation (rate o f depreciation

CBI (CWN measure)

Hayo uses data from 1976-93 collected in Eurobarometer
surveys o f nine European countries which ask respondents torank their goals for the government among four choices:maintain order, more democracy, fight rising prices andprotect freedom o f speech. In (1) Hayo runs OLS regressionso f the average first or second priority assigned to pricestability against average inflation over the same period, withand without autoregressive error terms due toautocorrelation. The results were inconclusive. In (2), he
calculates correlations o f the terms from (1) with measures
o f CBI, but again can neither confirm or reject his hypothesis
due to the data.
Test 3 hypotheses using a regression o f 72 countries from

355

Stasavageo f money)

Effectiveness o f checks & balances(executive constraints, party
fractionalisation)
Polarisation (income inequality, ethnolinguistic fractionalisation)
Political instability (rate o f executive
turnover, freq. o f regime transition)
Real income / capita (control variable)
Decade dummies

1950-90: (1) delegation has more credibility the greater thenumber o f veto players; (2) credibility from delegation isenhanced by moderate political instability and polarisation,and (3) CBI is more likely to endure in countries exhibiting
conditions 1 and 2. Individual terms were not significant but
interaction term between CBI with checks & balances was.
Mixed results when controlling for real income / capita.

1998

Lohmann

Lohmann disagrees with Posen (1993) that institutions do
not matter due to the influence o f interest groups. Interest
groups are only influential when the central bank isdesigned, but thereafter “elected politicians deliberately set
up veto points in order to insulate monetary policy fromcounterproductive political pressures”. German monetary
policy is subject to electoral pressures. There is no evidence
that partisan preferences are influential via the power o f
appointment. The Bundesbank council is staffed withpartially independent technocrats whose independence
decreases with the partisan support for the federal
government in the Bundesrat” (p.440) Central bankappointees are de-politicised by the internal peer grouppressure within the Bundesbank. The Bundesrat’s veto points
protects the Bundesbank’s independence.

1998

Miller

CBI is a mechanism used by politicians to protect thesubsidies awarded to interest groups so as to maximise the‘rents’ that the politicians receives, in the form o f campaign
contributions. M iller treats banks as a special case o f interest
groups, linking his argument to Posen’s FOI. Banks have anasset-liability mismatch which leads to exposure to inflation

1999

Bernhard and

Choice o f exchange rate

Domestic political institutions

Studied 20 OECD countries 1974-95. Conclude that in356

Leblang

regime(majoritarian / proportional, committee
system, exogenous electoral timing)
Economic openness (trade dependence)
Vulnerability to shocks (real effective
exchange rate, variability of domestic
credit, economic size)
Capital mobility (capital controls,international borrowing)
Domestic political factors (partisanship,
electoral cycle, EC membership)
CBI (CWN measure)systems where the electoral system decisively determines thecomposition o f government and the cost o f electoral defeat ishigh, politicians will be unwilling to relinquish policy
control with a fixed exchange rate. In systems wherecoalition governments are common and the policy process is
open, politicians adopt a fixed exchange rate.

1999

Broz

Choice o f exchange rate
regime

Autocracy
W ealthTrade openness
Inflation differential
Financial openness
Policy inertia (lagged dependent variable)
Political stability

Ran regression o f 100 states from 1973-95. Broz argues thatstates where political decision making is opaque(autocracies) will adopt the transparent exchange rate peg as
a commitment technology, while transparent politicalsystems (democracies) will opt for CBI. Found that
autocracies are 18% more likely to adopt fixed exchange
rate, richer countries opt for fixed exchange rates, and larger
countries opt for floating exchange rates.

1999

Broz

Inflation

Domestic political regime (democratic /autocratic)
CBI (CWN measure)Exchange rate regime
W ealth (GDP per capita)
Financial openness
Political stability

Ran regression o f 69 states from 1973-89. Broz found that
CBI is only effective against inflation in democracies, while
an exchange rate peg constrains inflation regardless o fregime type.

1999

Franzese(1) Inflation (GDP deflator)- linear-additive model

CBI (average o f CWN, GMT, BP)
Government partisanship
Trade openness (exports + imports as %GDP)
Financial sector employment (as % o f

He looks at 18 OECD countries from 1972-90, using annual
data. Acknowledging the “severe multicollinearity” o f his
variables which led other researchers to abandon similar
efforts, Franzese argues that the weighted-average model o f
inflation dominates the other two models. He interprets his(2) Inflation - weighted
average model

357(3) Inflation - interactive
model

1999

Moser

(1) CBI (various)(2) Inflation (average 197389)

total)Inflation abroad
Union density
Co-ordination o f wage bargaining

results to support his hypothesis while disproving the linearadditive theory and Posen’s effective FOI. “Specifically,
central bank independence has most anti-inflationary bitewhen (a) the government is most left, (b) union density ishighest, (c) the economy is least open, (d) inflation abroad ishighest, (e) the financial sector is smallest, and (f) wagebargaining co-ordination is lowest, and visa versa” (p. 19).

(1) Dummy variables for political system(strong checks & balances, weak, none)
Experience with inflation (average
inflation 1900-40)
Control variable for external shocks(standard deviation o f growth)

Examines 21 OECD countries, which he splits into the threegroups based on the existence and strength o f checks andbalances. (1) Countries with strong checks and balances havemore legally independent central bank than countries withweak or no checks and balances. A variable proxying forexperience with inflation is not significant.
(2) Evidence supports the thesis that the negative relation
between legal central bank independence (degree o fbehavioural independence) and inflation is stronger incountries with strong checks and balances than in countries
with no checks and balances. However, there is no difference
between those countries with strong and weak forms o fchecks and balances. There was no systematic evidence o fother causes o f inflation for the other variables.

(2) Dummy variables for political system(as above)
Interaction term between dummy
variables and CBI (various measures)
Openness (following not shown)
Inequality
Government debt / GDP
Dummy variable for membership in EMS

359

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