Polarised Politics Make Independent Central Bankers Dangerous

It is now conventional wisdom that an independent central bank led by a moderately conservative governor is good for society. But according to Christian Schultz, writing in the latest issue of the Economic Journal, a polarisation of politics in a country can have a profound and potentially dangerous influence on the choice of central banker, reflecting the colour of the government rather than the needs of the economy. This can have very damaging consequences as demonstrated in the Reagan-Thatcher years, when stabilisation policy was often the outcome of political attitudes rather than an appropriate response to economic shocks.

The benefits of a moderately conservative independent central banker underscore the philosophy behind the Federal Reserve, the new European Central Bank and numerous other central bank around the world. Such a conservative governor will not easily be tempted to raise inflation in order to decrease unemployment in the short run.

This is good, Schultz notes, since such policies only work in the short run, and have bad inflationary consequences in the long run. But there is a limit to this: if an economy is hit by a severe shock, it will be worthwhile to raise inflation temporarily. Thus the governor should not be too conservative. How conservative he or she should be depends on the likelihood of the economy being hit by very bad shocks.

Schultz shows that the appointment of a central banker in a democratic society will not always be optimal. If the political scene is very polarised, the choice of central banker will only reflect the colour of the government, not the likelihood for very bad shocks.

For example, if a left wing, Keynesian government comes to power, the central banker chosen will prefer an active stabilisation policy even if the likelihood of bad shocks is small. If a right wing, conservative government comes to power, the central banker will be very conservative regardless of the likelihood for shocks. Thus, the stabilisation policy of such a society will reflect the colour of the government appointing the central banker rather than the need for stabilisation policy.

A good example of Schultz''s model in action is its prediction that a right wing president like Reagan will appoint a central banker, who vigorously fights inflation even when the economy is at the bottom of the business cycle – something that actually seemed to occur just as it did during the Thatcher era in the UK. In the 1980s, the French government and central bank fought unemployment with very active stabilisation policies while the Bundesbank pursued the opposite policy, although under very much the same economic conditions.

In a society that is less polarised, the appointment of the central banker is optimal from the point of view of the median voter. The argument is that in a democratic society, a party can only carry out its policy if it wins an election. What''s more, voters are generally less informed about the economy than the parties, which have access to experts and the government bureaucracy and whose job is to collect information and make policy choices. In this way, policy proposals – such as which type of central banker to choose: very conservative or less so – informs voters about the economy.

If a leftist party suggests a very conservative central banker (or a conservative economic policy), this is a credible signal to left wing voters, that it probably is a good idea since the likelihood of very bad shocks is low. When a party that would like to win an election proposes policy, it takes its role as a provider of information into account. This role will be used strategically in the struggle to win the election.

But suppose the party is very conservative and the likelihood of very bad shocks is large. Suppose further that if the median voter was sure of this, he or she would vote left wing. The right wing party will not be happy to admit the truth by suggesting an only moderately conservative banker since it will then lose the election. It is better to suggest a conservative strategy, claim that the likelihood of bad shocks is small, and not lose the election for sure. Schultz shows that this argument has most strength in a polarised society, where the consequences of having the political opponent win the election is most severe.

''Monetary Policy, Delegation and Polarisation'' by Christian Schultz is published in the February 1999 issue of the Economic Journal. Schultz is at the University of Copenhagen.