When does policy reform work? The case of central bank independence

Daron Acemoglu, Simon Johnson, James A Robinson, Pablo Querubín 25 June 2008

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Institutional and policy reforms are promoted as a way to improve economic performance and growth in poor countries. Reforms that have received substantial attention over the past decade or so are often referred to as the "Washington consensus". These include trade opening, financial liberalisation, judicial reform, privatisation, reduction of entry barriers, tax reform, removal of targeted industrial subsidies and central bank independence. Although there are sound economic theories suggesting why these reforms might be important in improving economic performance, the experience of many developing nations that have embraced these reforms over the last two decades shows that the gains anticipated by the proponents of reform have often not materialized.

Why do seemingly sensible reforms fail to generate the benefits that they promise?

Although one can undoubtedly dream up reasons why sensible reforms will lead to bad economic outcomes because of "second best" reasons, it is fairly implausible that the removal of the very high entry barriers and the corruption-ridden targeted industrial subsidies or putting an end to hyperinflation will be counterproductive. So why has the result of the Washington consensus reforms been so dismal?

To provide a satisfactory answer to this question one first needs to consider why there was a need for reform in the first place. Reforms are necessary because of the serious and endemic policy distortions in many developing nations. One can find instances where the root of these distortionary policies is in mistaken economic theories. But this is the exception rather than the rule. Few policymakers create insurmountable entry barriers, hyperinflations or large budget deficits because they think this is good for the economy. Instead, the root of distortions lies in political economy.

In most instances, bad policies are adopted because of political economy constraints and distorted incentives facing politicians in many societies with poor general institutions, such as weak checks and balances and lack of political accountability. These institutional weaknesses make it possible for certain constituencies to demand policies that are costly for the society at large and make it beneficial or convenient for politicians to pursue such distortionary policies to satisfy these constituencies or to enrich themselves. The success and effectiveness of policy reform have to be understood in the context of these existing political economy problems.

In this light, the ineffectiveness of many sensible reforms is not surprising. Few people would expect privatisation, financial liberalisation or Central Bank independence to miraculously transform the economy and jumpstart growth in Zimbabwe as long as Robert Mugabe is in power or in Sudan as long as Omar al-Bashir’s kleptocratic and genocidal regime remains in place.

Lessons from political economy

Political economy models inexorably lead to the perspective that effectiveness of reforms should be studied in the context of the political economy problems leading to distortions in the first place. When we do this, a number of intuitive lessons emerge.

To start with, there will be strong political resistance against reforms from the constituencies initially benefiting from the distortions. These can often negate the potentially beneficial effects of reforms. The extent to which these constituencies can achieve their aims despite reform will depend not only on the nature of policy reform but also on political institutions. When these institutions are weak and fail to place checks on politicians and their interactions with politically powerful constituencies, reforms will be undermined and generally ineffective.

This does not imply a monotonic effectiveness of political institutions on the effectiveness of reform, however. When political institutions place strong checks on politicians and the political system, initial distortions will be limited, and thus there will be less room for major improvements from policy reform.

Therefore, the relationship between effectiveness of policy reform and political institutions is nonmonotonic. We expect policy reform to be most effective when political institutions are sufficiently weak that major distortions are present, but not so weak that any attempt at reform can be undermined.

Potentially more surprising is the backlash against effective reform in specific dimensions of policy. Policymakers around the world have access to multiple policy instruments not only to steer the economy but also to curry favours with political power for constituencies. This leads to a possible seesaw effect: reform in one dimension of policy against the background of powerful and largely unchanged political demands can lead to more intensive use of other distortionary instruments to satisfy the same politically powerful constituencies. For example, when politicians are unable to use monetary policy or cheap loans from the central bank to favoured business and regional interests, they may use more fiscal transfers to satisfy politically powerful constituencies.

The case of Central Bank Independence

Central Bank reforms provide an attractive setting to study these ideas. Central Bank independence has been introduced in many countries, with a clearly delineated and easy-to-measure objective – to curb inflation.

An empirical analysis on the effect of Central Bank independence reforms shows that they tend to reduce inflation, but this effect is small or absent in countries with strong or weak political institutions (as measured by average constraints on the executive from the Polity IV dataset over the 1972-2005 period). In contrast, there is a large effect of this reform on inflation in countries with intermediate political institutions. This pattern is generally robust to different ways of measuring Central Bank independence and political institutions and to the inclusion of different controls. It suggests that, consistent with our expectations based on the political economy perspective, there are important interactions between political institutions and effectiveness of reform.

The seesaw effect

More intriguingly, there is also evidence consistent with the seesaw effect. In countries where Central Bank independence is associated with reduced inflation, there is also an increase in government expenditure.

This empirical pattern is best illustrated by the recent economic history of Colombia and Argentina. In both countries the introduction of Central Bank independence in 1991 was followed both by significant falls in inflation and increases in government expenditures as a percent of GDP.

Conclusion

Basic political economy theory suggests that policy reform can be effective only when the political context is right. If the context provides political constraints and accountability mechanisms so that there is a strong tendency to adopt good policies, there is little room for reforms to have major effects. If the context is bad, so that politics and policymaking are highly non-representative, reforms are likely to be irrelevant because they can easily be undermined. It is in intermediate situations that reforms will have bite: constraints are weak enough to generate bad policy, but not so weak that all reform is undermined. However, even when policy reform is effective in one dimension, it can create countervailing distortions via the seesaw effect. Policymakers can make use of other distortionary instruments in order to satisfy the same politically powerful constituencies served by the previous distortions.

The most important lesson from the political economy perspective is that contrary to what many of the critics of the Washington Consensus reforms claim, these reforms did not fail because of second-best reasons or because they were not the right remedies for the ills of developing economies. Rather, they are more likely to have failed because they were implemented in the context of the same political economy problems and political circumstances that led to the distortions in the first place. These political circumstances undermined the reforms either directly, or as in the seesaw effect, indirectly through the use of alternative instruments.

Reference

Acemoglu, Daron, Simon Johnson, Pablo Querubin and James A. Robinson (2008). “When Does Policy Reform Work? The Case of Central Bank Independence”, National Bureau of Economic Research, Working Paper No. 14003

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Topics:  Institutions and economics Politics and economics

Tags:  inflation, central bank independence, seesaw effect

Professor of Applied Economics, MIT

Professor of Entrepreneurship, Sloan School of Management, MIT and CEPR Research Fellow

Pablo Querubín

Academy Scholar, Harvard Academy for International and Area Studies

James A Robinson

David Florence Professor of Government, Harvard University; and Research Fellow, CEPR