# **6. Independent Central Bank Governance, its Measurement and its Impact on Macro-economic Outcomes**

Over the last 20 years, there has been a huge literature on how independent central banks (ICBs) can be used to address the time inconsistency problem in macro-policy and inflation control that governments inevitably face. This literature goes back to the seminal articles by Barro and Gordon in 1983 and Rogoff (1985). In recent years, there has been some recognition that the time inconsistency problem faced by governments with regard to inflation is essentially the same as the one they face with regard to private investment in utilities<sup>57</sup> .

In both cases, the standard solution to the problem is to institute an independent agency – an independent central bank in the macro-economic case and an independent regulatory agency in the utilities case. Interestingly, it is recognised in both literatures that contracts can (at least in theory) substitute for an independent agency. More importantly, in both literatures, the questions loom large (a) of the degree of discretion of the agency and (b) the role of government in setting policy objectives, giving policy direction, etc.

In both literatures, having an independent agency seems to be crucial in combining credibility with the ability to respond to new developments with discretion rather than having to follow an inflexible pre-determined rule. In macro-economic policy, the rigid monetary growth rules of the 1980s proved disappointing and a zero discretion regime for utility regulation has also proved very difficult if not impossible to sustain in the medium to long-term. Hence, the search for bounded, accountable discretion has been common to macro-economic policy and utility regulation and this has led to a common focus on the key governance aspects that will enable this to be sustained.

From this perspective, effective governance of an independent agency is seen as the way to achieve lower and less variable inflation in the macro-economic case (as well as, hopefully, lower average unemployment and higher growth rates) and to bring higher average levels of (and/or lower cost) investment in the utility regulation case<sup>58</sup> . A well-designed ICB, often with an inflation target, is the mainstream recommended solution to the macro-economic commitment problem in the same way that a welldesigned regulatory agency is the conventionally recommended solution to the utility investment commitment problem. However, in both cases, it can be hard to sustain the institutions and their independence in difficult political environments There has been a huge literature on the macro-economic time inconsistency problem and a very large one on ICBs, their design and effectiveness. In this paper, we will concentrate on a few key points, drawing very largely on two major recent surveys: Berger, de Haan and Eijffinger (2000) and Geraats (2002). We will also concentrate on the evidence concerning developing countries not least because the commitment problem in DTEs is more acute than for developed countries and the empirical work on the determinants of ICB effectiveness addresses this issue directly.

> 57 See Stern and Trillas (2002) for an informal discussion and comparison and Levine, Stern and Trillas (2003) for a formal model as well as references to earlier papers.

> 58

> See Brown (2001) for a fine exposition of the macro-economic governance issues, Newbery (1999) Chapter 2 for a discussion of the utility regulation design issues, Stern and Trillas (2002) and Levine, Stern and Trillas (2003) for a discussion of the joint issues.

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