Central Banks

Since the establishment of the first central bank in Sweden in 1668, the number of central banks has increased to 178 (in 2008). The emergence of new sovereign states saw a corresponding increase in the number of central banks. Central banks have legitimate power to create national currency, an integral part of monetary sovereignty. These banks play pivotal roles in domestic and international economic management. In the past, they financed government war expenditures and economic development projects. Today, the central banks' main responsibility is to keep the rate of consumer-price inflation low and stable to accomplish and maintain economic and financial stability.

The majority of central banks are state-owned. Thus, a central bank governor is essentially a government official. Politicians and governors may have different and conflicting policy preferences. In times of conflicting views between a governor and politicians, central bank independence (CBI) vis-à-vis political authority becomes significant. The key factor behind the move to increased independence has been the theoretical argument that an independent central bank restricts the avenues for political interference in monetary policy decision making. In doing so, monetary policy making can be insulated from electoral [Page 251]effects (i.e., political business cycles) and partisan politics (i.e., economic growth and employment-oriented policies of leftist parties). Central bankers with legal autonomy from the executive and legislative branches of the government are assumed to have the ability to follow objectives that may conflict with these branches.

Not surprisingly, there has been a significant worldwide trend toward increased central bank independence, transparency, and accountability through legal reforms and actual practices. Introduction of legal reforms granting independence to central banks has been a universal temptation for the majority of sovereign states. Especially from 1990 onward, CBI has become a legal standard, and there has been an international trend toward legal independence. The governments in both developed and developing countries deliberately reformed the statutes of central banks to grant them more autonomy in order to achieve and sustain their primary objective: price stability.

A normative support for CBI revolves around the assumption that central bank governors, who place a greater weight on price stability, are more averse to inflation than politicians. However, the trends toward CBI are built on flawed neoliberal economic theory. It is assumed that inflation is caused by money supply growth, which is determined by the central bank. Conversely, in a world of global finance where financial capital moves freely, money supply increase and credit creation are not solely under the control of the central banks. Further, this view omits other inflationary pressures such as increases in primary goods and energy prices.

In regard to empirical evidence, early studies found that CBI and inflation are strongly negatively correlated in developed economies. These findings are questioned by subsequent studies that there is no correlation and causal link between CBI and inflation. Further, there has been no empirical evidence showing a negative correlation between CBI and inflation in developing economies. Nevertheless, in spite of the questions about the theoretical foundations and the mixed empirical evidence for the merits of CBI, the dominant practice of monetary governance is based on the maintenance of price stability where an independent central bank plays a pivotal role.

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