Central Bank Independence and the Global Financial Meltdown - is a new research of SKOLKOVO

Central banks have been both blamed and praised for their part in the global financial crisis, but how much did their independence in setting policy actually affect a country’s economic performance? This study shows that countries with more transparent central banks were more prone to higher credit and, for the most part, lower interest rates, in both developed and developing countries. Despite much of the hype over central bank independence and its supposed benefits for an economy, it appears that bank independence didn’t matter that much for how an economy weathered the crisis, and may actually have contributed to the asset bubbles in developed countries.

This study is based on an examination of 91 countries over 1989-2008 and the effects of an independent central bank on different variables, including growth rate of GDP per capita, inflation, and credit to the private sector extended by the banking sector. The study breaks new ground in utilizing several different measures of bank “independence,” including using a “transparency index” that measures the openness of a central bank to public discussion. The key results from the study include:

• A long history of both central bank independence and transparency lowers interest rates for all economies, while rapid turnover of central bank governors raises them by a large amount;
• Over the long run, an independent and transparent central bank should create the right conditions for growth, but in the short-term, price stability may lead to lower growth than would have been achieved if a central bank were acting politically;
• Growth in bank credit appears to be much higher with transparent central banks than with non-transparent ones, possibly because a central banker still has the incentive to please his audience, which is more “the economy” and less “the government.”
• Looking specifically at the BRIC (Brazil, Russia, India, China) economies, central bank independence from 2003 onward correlates with a strong positive effect on bank credit, meaning that independence appears to have fueled the root causes of the global recession rather than stemmed them.

In sum, the paper concludes that central bank independence may not even matter for growth or inflation if the policies pursued still are erroneous. If central banks were independent during the credit boom of the early 2000s, perhaps it’s more important to wean both developed and emerging market bankers off bad models rather than make them more independent. Experimentation with different term-limits for bank governors, as well, may help to avoid some of the problems seen in the run-up to the crisis, removing the temptation to play God with the economy.

The story of the global financial meltdown has been told in many different ways, but the basic facts and effects are familiar to all: the collapse of the real estate bubble in the United States became a financial crisis that reversed the growth of economies around the world and brought skyrocketing unemployment.

As Figure 1 shows, the effect of the crisis was varied depending on the particular economy, with advanced economies hardest hit and developing and emerging in the aggregate weathering the storm; however, even within emerging markets, there were wildly different effects.

In particular, the so-called BRIC countries (Brazil, Russia, India, and China) also had varying changes to their growth trajectory, with India and China seeing a mere bump in their blistering pace, but with Brazil and Russia contracting as a result of the world economic woes.

The role of central banks in the financial meltdown is a doubly interesting research question, as an extensive body of economics work has asserted that central bank independence in the policy process is a positive factor, good for fighting inflation (but with ambiguous effects on growth). It would thus stand to reason that an independent central bank would also help to ensure greater stability of economic outcomes through prudent macroeconomic management and insulation from political pressures. More about the role of central banks in the financial meltdown read on the page 16 of the Research.

You can read a full text of the research here