Siklos (eds ) challenges in central banking; the current institutional environment and forces affecting monetary policy (2010)

Nevertheless, readers will noticethat, in 2007, when a conference entitled “Frontiers in Central Banking” washeld in Budapest at the National Bank of Hungary, the various papers, most of

This page intentionally left blank

of central banking and to consider some of the implications arising from the ongoing crisis.

Pierre L Siklos is Professor of Economics and Director of the Viessman European

Research Centre at Wilfrid Laurier University, Canada He is the managing editor of the

North American Journal of Economics and Finance, author of The Changing Face of tral Banking (Cambridge University Press, 2002), and coeditor with Richard Burdekin

Cen-of Deflation: Current and Historical Perspectives (Cambridge University Press, 2004) In

2008 Professor Siklos was named to the C.D Howe Institute’s Monetary Policy Council, became chairholder of the Bundesbank Foundation of International Monetary Eco- nomics at the Freie University Berlin, and became a Senior Fellow at the Centre for International Governance Innovation His research in macroeconomics emphasizes the study of inflation, central banks, and financial markets.

Martin T Bohl is Professor of Economics, Centre for Quantitative Economics,

West-faelische Wilhelms University Muenster From 1999 to 2006 he was a professor of finance and capital markets at the European University Viadrina Frankfurt (Oder), where he was also spokesman for the Ph.D program Capital Markets and Finance in the Enlarged Europe Professor Bohl focuses on monetary theory and policy as well as financial market research He has published in many international macroeconomics and finance journals and has been a visiting scholar at several universities in Europe and North America.

Mark E Wohar is the UNO CBA Distinguished Professor at the University of Nebraska–

Omaha, where he is director of the Division of Economic and Financial Analysis Professor Wohar has published more than 85 refereed journal articles, including those

in the American Economic Review, Journal of Finance, Review of Economics and Statistics, Economic Journal, and the Journal of International Economics He is an associate editor

of the Journal of Economics and Applied Economics and serves on the editorial board of Economic Inquiry and on the Editor Council of the Review of International Economics.

The recipient of several awards for research excellence, his areas of investigation include domestic and international macroeconomics, international finance, monetary theory, and financial institutions.

Challenges in Central Banking

The Current Institutional Environment and Forces Affecting Monetary Policy

CAMBRIDGE UNIVERSITY PRESS

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São Paulo, Delhi, Dubai, Tokyo

Cambridge University Press

The Edinburgh Building, Cambridge CB2 8RU, UK

First published in print format

ISBN-13 978-0-521-19929-2

© Cambridge University Press 2010

2010

Information on this title: www.cambridge.org/9780521199292

This publication is in copyright Subject to statutory exception and to the

provision of relevant collective licensing agreements, no reproduction of any partmay take place without the written permission of Cambridge University Press

Cambridge University Press has no responsibility for the persistence or accuracy

of urls for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain,

accurate or appropriate

Published in the United States of America by Cambridge University Press, New York

www.cambridge.org

eBook (NetLibrary)Hardback

From PLS to Nancy, James, and Patrick, as always.

From MTB to Melanie, Hannah, and Alexander.

From MEW to my parents, who have provided me with constant

encouragement throughout my life.

List of Tables, Figures, and Appendices page xii

Pierre L Siklos, Martin T Bohl, and Mark E Wohar

1.2 Part I: Past, Present, and Future in the Conduct of

1.3 Part II: The Scope of Central Banking Operations and

PART I PA S T, P R E S E N T, A N D F U T U R E I N T H E C O N D U C T

O F M O N E TA RY P O L I C Y

Vitor Gaspar, Frank Smets, and David Vestin

2.2.1 The Optimality of Price-Level Stability in the New

vii

viii Contents

Georgios E Chortareas and Stephen M Miller

3.3 Time Inconsistency, Discretion, and Central Banker

3.4.2 Monetary Policy under Contracts and Incomplete

4 Implementing Monetary Policy in the 2000s: Operating

Corrinne Ho

4.3 The Operational Objectives of Monetary Policy

PART II T H E S C O PE O F C E N T R A L BA N K I N G O PE R AT I O N S A N D

C E N T R A L BA N K I N D E PE N D E N C E

Charles A E Goodhart and Dimitri P Tsomocos

5.1 Introduction: The Financial Stability Role of Central Banks 121

5.2 Historical Development of the Financial Stability Role of

5.3 The Functions of a Central Bank in the Provision of

David G Mayes and Geoffrey E Wood

6.9 Cross-Border Institutional Structures that Renationalize

Bernd Hayo and Carsten Hefeker

7.4.1 Fixed Exchange Rates, Currency Boards, and

x Contents

Donato Masciandaro, Marc Quintyn, and Michael W Taylor

8.2 Designing Supervisory Governance: Hints from the

8.3 Defining Independence and Accountability in Financial

8.4.3 Impact of the Location and Comparison with

PART III T R A N S PA R E N C Y A N D G OV E R NA N C E I N

C E N T R A L BA N K I N G

Carin van der Cruijsen and Sylvester C W Eijffinger

11 Institutional Rules and the Conduct of Monetary Policy: Does a

Pierre L Siklos

11.2.1 Trustworthiness in the Central Bank and Its

Tables, Figures, and Appendices

TABLES

2.2 The cost–benefit analysis of the transition to PLPS under

4.1 Institutional setup of monetary policy decision and operation

6.1 Summary of prompt corrective action provisions (PLA) of the

Federal Deposit Insurance Corporation Improvement Act of 1991 160

8.1 Overview of ratings on supervisory independence,

8.6 Standard deviations of total rating, independence and

8.7 Ordered logit estimates with total governance as the dependent

8.8 Ordered logit estimates with independence as the dependent

xii

List of Tables, Figures, and Appendices xiii

8.9 Ordered logit estimates with accountability as the dependent

10.2 Correlation between average inflation (2000–2006) and

2.1 Consumer prices in Canada, the euro area, and Sweden since 1999 23

2.2 Responses to a cost-push shock under different degrees of

2.3 Impulse response to a price-mark-up shock in the

2.4 Impulse response to a price-mark-up shock under different

2.5 Impulse response to a wage-mark-up shock in the

2.6 Convergence to the commitment regime: losses and estimated

3.1 Central banker’s reaction functions under commitment,

discretion, contracts, and delegation to a conservative central

xiv List of Tables, Figures, and Appendices

11.3 Average inflation and absolute cumulative inflation surprises,

APPENDICES

11B Data Availability and Samples: Institutional and Qualitative

Martin T Bohl,Westfälische Wilhelms-Universität, Münster

Georgios E Chortareas,University of Athens, Athens

Amsterdam, Amsterdam

Sylvester C W Eijffinger,CentER, Tilburg University, Tilburg

Vitor Gaspar,Banco de Portugal, Lisbon

Charles A E Goodhart,London School of Economics, London

Bernd Hayo,Philipps University, Marburg

Carsten Hefeker,University of Siegen, Siegen

Corrinne Ho,Bank for International Settlements, Basel

Philipp Maier,Bank of Canada, Ottawa

Donato Masciandaro,Bocconi University, Milan

David G Mayes,University of Auckland, Auckland

Stephen M Miller,University of Nevada, Las Vegas

Marc Quintyn,International Monetary Funds, London

Pierre L Siklos,Wilfrid Laurier University

Frank Smets,European Central Bank, Frankfurt

Michael W Taylor,Hong Kong Monetary Authority, Hong Kong

Dimitri P Tsomocos,Oxford University, Oxford

David Vestin,European Central Bank, Frankfurt

Geoffrey E Wood,Cass Business School, London

xv

The chapters in this collection attempt to survey and analyze some of thekey issues in central banking as of early 2009 Clearly, the ongoing globalfinancial crisis has, as this is written, raised a whole set of new questions thatare likely to be debated for years to come Nevertheless, readers will noticethat, in 2007, when a conference entitled “Frontiers in Central Banking” washeld in Budapest at the National Bank of Hungary, the various papers, most

of which appear in the present volume, already began to debate the largerquestions of concern to central banks then and to monetary policy moregenerally today Issues thought to be resolved, such as the role of central bankindependence, have again resurfaced, as demonstrated by debate in the U.S.Congress over Federal Reserve Bank actions in 2008 and 2009, and how tohold that institution more accountable As this book went to press, a bill wasmaking its way through the U.S Congress requiring the Fed to become moretransparent The state of the art as it pertains to central bank transparency isalso addressed in the present volume Other “big” questions, still unresolved,such as how to think about financial-system stability, its measurement, andits implications, are also front and center in this volume, as is the future of amonetary policy strategy focused on delivering low and stable inflation andthe prospects of replacing it with price-level targeting Finally, to name onemore pressing issue on the minds of academics and politicians everywhere,how to regulate and supervise banks, and the tension between the aims ofpreserving national sovereignty over these issues while acknowledging thepush for global reforms, is also considered in some of the chapters in thisbook

It would be presumptuous, of course, to suggest that the editors andcontributors were prescient about all the dilemmas that face policymakerstoday in the area of monetary policy That would be asking too much Nev-ertheless, the contents of this volume provide material that should permit

xvii

xviii Preface

interested readers to better understand which major issues currently lenge central banks and monetary policy more generally, to get a glimpse ofwhere we stand, and to become more aware of several of the larger questionsthat need to be addressed in future research Hopefully, this is a modest goalthat has been met

chal-There are, of course, too many people to thank for ensuring that thisbook saw the light of day Scott Parris of Cambridge University Press wassteadfast in his support for the topics covered and ensured that the necessaryand helpful reviews took place The many referees were constructive intheir criticisms The editors can only hope that the end product meets theirapproval and that we can expect the same from the rest of the profession.The editors are also grateful to various institutions, including the NationalBank of Hungary (NBH) and, especially, György Szapári, former Deputy-Governor of the NBH, for helping underwrite an international conferencewhere early drafts of the chapters in this book could be presented anddebated Last, but not least, many thanks to Susanne Thiemann, who hashelped us with the reference lists, the index, and the galleys

Pierre L Siklos, Waterloo, Canada, June 2009Martin T Bohl, Wallersdorf, Germany, June 2009Mark E Wohar, Omaha, U.S.A., June 2009

The State of Play in Central Banking and

the Challenges to ComePierre L Siklos, Martin T Bohl, and Mark E Wohar

1.1 Introduction

In 2006, the editors conceived the idea of holding a high-level conference toassess the state of play in central banking At the time, the world economywas in the midst of what has come to be called the “Great Moderation”

consider how central banking evolved over the past 20 years or so and thechallenges that lay ahead for monetary policy Little did we know that, soonafter the conference – which was co-organized with the National Bank ofHungary – ended, we would enter a global financial crisis, which, as this

is written, is still ongoing.1Therefore, it is perhaps even more appropriatenow not only to take stock of what has been accomplished and the lessonslearned, but, perhaps equally importantly, to look ahead and consider whatthe future of monetary policy might be governed by

At no time has the performance of central banks been more in evidencethan in the last decade Many central banks have embraced inflation tar-geting Nevertheless, central bank behavior around the world differs in anumber of respects (e.g., Siklos 2008, and references therein) These dif-ferences call for an up-to-date assessment of central banking This bookbrings together some of the top researchers in the area of central bank-ing; the chapters emphasize some of the most pressing issues in monetarypolicy today The topics covered include the present challenges facing cen-tral banks, namely the role of price stability, transparency, governance,

1 Details about the original papers presented at the conference are available at http://www wlu.ca/viessmann/html_pages/MNB.htm The conference was jointly organized by the Viessmann European Research Centre at Wilfrid Laurier University, the Chair of Monetary Economics at the Westfälische Wilhelms-University, Münster, and the National Bank of Hungary, which graciously hosted the conference in May 2007.

1

2 Pierre L Siklos, Martin T Bohl, and Mark E Wohar

central bank independence (CBI), the conduct of monetary policy, financialstability, the importance of monetary policy rules, and supervision.The book is divided into three parts Part I examines the conduct ofmonetary policy in the past, present, and future Part II considers the scopeand limits of central banking Part III explores transparency and governance

in central banking This book takes a comprehensive look at and debatessome of the most important questions in the economics of modern centralbanking The various chapters offer a mix of new research and a generalsurvey of issues faced by central banks today It is also hoped, of course, thatthe contents of this book will provide a launching pad for future scholarlyresearch in this field

1.2 Part I: Past, Present, and Future in the Conduct of

Monetary Policy

Vitor Gaspar, Frank Smets, and David Vestin provide an overview of thecase for price-level path stability (PLPS), also referred to as the policy of

price-level stability induces increased volatility in inflation and in the outputgap when compared with a regime of inflation targeting However, Svensson(1999) shows that, under rational expectations, price-level targeting can lead

to lower inflation and output variability Clarida et al (1999) and Svenssonand Woodford (2005) have shown that in a new Keynesian model, optimalmonetary policy under commitment leads to a stationary price level Theidea here is that when a central bank commits itself to price-level stability,rational expectations become an automatic stabilizer

Using a standard hybrid new Keynesian model similar to that described

in Woodford (2003), Gaspar, Smets, and Vestin argue that price-level bility provides a framework for monetary policy under commitment Galiand Gertler (1999) and Gali, Gertler, and Lopez-Salido (2001) show thatsuch a hybrid new Keynesian–Phillips curve fits the actual inflation pro-cess in the United States and in the euro area quite well Gaspar, Smets,and Vestin present two main arguments in favor of a PLPS regime First,under rational expectations, price-level stability leads to macroeconomicstability in general by making expectations operate like automatic stabi-lizers Second, a PLPS regime implies that changes in the price-level actlike an intertemporal adjustment mechanism, reducing the magnitude ofrequired changes in nominal interest rates The commitment to price-levelstability helps to lessen the restrictions posed by the lower bound on nom-inal interest rates The arguments made in favor of PLPS are dependent

sta-The State of Play in Central Banking and the Challenges to Come 3

on endogenous expectations The stabilizing effect of PLPS on nominalinterest rates stems from the fact that fewer adjustments to policy ratesare necessary Consequently, the frequency with which the lower bound onnominal interest rates is attained for a given inflation target is also dimin-ished When the nominal rate is at zero, the price level will continue tooperate as an automatic stabilizer

Gaspar, Smets, and Vestin also review the arguments against PLPS First,PLPS is costly when there is imperfect credibility It has been argued thatthe determination of whether PLPS is beneficial depends on the credibility

of the reversion to the price level Numerous papers have argued that thebenefits of price-level stability are close to zero when the degree of credibility

of the monetary policy regime is low, or expectations are backward lookingrather than forward looking A related argument against PLPS is that thetransition costs of moving to such a regime are too large in the presence

of private sector learning A second argument against PLPS stems fromuncertainty and ongoing learning about the economy by the central bank.Policymakers make mistakes that lead to greater volatility in the price level.Hence, price-level stability makes past policy mistakes very costly to reverse.Gaspar, Smets, and Vestin point out, however, that the above argument doesnot take into account the positive effects that PLPS may have on expectationformation by the private sector in response to central bank mistakes They

price-level targeting are increased rather than reduced when the central bankfaces uncertainty about the economy These results are also confirmed byOrphanides and Williams (2007)

In spite of the obvious desirability of adopting a monetary policy strategygeared toward achieving price-level stability, there are few indications thatany central bank will adopt such a regime any time soon Although the topic

of PLPS is on the research agenda at the Bank of Canada, as it prepares todiscuss the renewal of the inflation control objective in 2011, there exists anumber of practical hurdles that stand in the way of adopting such a pol-icy First, the case for PLPS is less well analyzed in the open economy caseand, as Parkin (2009) points out, it is unclear whether there is sufficientconsensus among politicians, let alone economists, on the inherent superi-ority of this monetary regime Second, it is unclear what the implicationswould be for a country that ends up being the first adopter of this form

of price-level targeting while the rest of the world does not Third, muchthough not all (as the authors make clear) of the theoretical rationale isbased on the current canonical new Keynesian model that lacks a financialsector, let alone allowing for the possibility of a financial crisis Although

4 Pierre L Siklos, Martin T Bohl, and Mark E Wohar

some advances have recently been made in this direction (e.g., Cúrdia and

permitted to exogenously influence existing models

In Chapter3, Georgios E Chortareas and Stephen M Miller point outthat recent studies of central banking have raised the issue of the endogene-ity of the central bank’s decision-making process This work has focused oninstitutional structure and incentive constraints A large body of researchdeals with attempts to lessen the time-inconsistency problem and relatedpolitical-economy problems This research has implications for the insti-tutional framework of central banks (e.g., accountability, transparency)and the delegation process (e.g., inflation targeting, conservatism, incen-tive contracts) Berger et al (2001) discuss the difference between CBI andcentral bank conservatism Conservatism reflects the weight that the centralbank places on controlling inflation relative to output fluctuations Inde-pendence reflects the importance of central bank preferences (as opposed

to society’s preferences) in determining monetary policy Chortareas andMiller adopt the principal-agent approach to central banking and discussits relationship to other institutional designs that attempt to eliminate thetime-inconsistency problem, where the principal is the government and thesociety and the agent is the central bank They also present an extensivereview of the literature on central bank contracts and discuss the relatedequivalence propositions, as well as presenting some new approaches thatfocus on the optimality of delegation versus the consistency of delegation.Chortareas and Miller review the literature that offers proposed solu-tions to the time-inconsistency problem, which include conservative centralbankers, inflation targeting, and explicit contracts Much of this literaturefocuses on design of policy rules and shows how these rules dominate dis-cretionary policy There continues to be an ongoing debate on the issues(e.g., Athey et al.2005; Persson et al.2006) Even if a central bank adopts

a rule, there is still the problem of commitment Delegation of such a rulecan address the commitment issue

Chortareas and Miller’s modeling framework yields some interestingfindings First, they find that granting independence to the central bankmay or may not achieve optimal outcomes The outcome depends on theobjective function of the central bank Indeed, one aspect of the specifica-tion of a central bank objective function not considered is the possibility ofinterest rate smoothing, evincing a concern for real exchange movements,

or even permitting the discount rate of the monetary authority to change.Whereas the broad conclusions of their analysis would doubtlessly remainunchanged, the implications of alternative objective functions remain

The State of Play in Central Banking and the Challenges to Come 5

understudied Second, the conservative central banking solution alone not achieve optimal outcomes It simply alters the trade off between hittingthe inflation and output targets, with greater weight placed on the inflationtarget Third, the inflation targeting strategy does not achieve optimal out-comes That is, the expected values of the target variables are not equal tothe optimal outcomes As a result, the central bank selects targets for outputand inflation that are unattainable Fourth, the explicit contracting solution(either inflation or output incentive contracts) does, in fact, achieve optimaloutcomes

sum-marizing the “contractual” relationship between the central bank and thegovernment omits the possibility that there exists another implicit contract,namely one between the central bank and the public Few doubt, for exam-ple, that a “special” relationship existed between the Bundesbank and theGerman public while that institution was responsible for the conduct ofmonetary policy in Germany, and there is a strong sense that the Euro-pean Central Bank is attempting to follow the same path Finally, as will beevident to readers of this book, the theoretical apparatus employed by theauthors does not explicitly consider the fact that central banks have manyroles to play, including the maintenance of financial system stability andbanking supervision, and that any maximization exercise will be unable tocapture the richness of the calculus that central banks must actually face.Corrinne Ho examines in Chapter4how the day-to-day implementation

of monetary policy has undergone significant changes over the past 15 years

Ho presents an in depth and comprehensive discussion of numerous aspects

of central banking covering 17 central banks Monetary frameworks andother aspects of policy making in 14 Asia-Pacific central banks, the EuropeanCentral Bank, the Bank of England, and the Federal Reserve are considered.One might well ask why a focus on central banks in the Asia-Pacific regionversus the usual suspects in the rest of the industrial world The reason issimple This is the part of the world that has most recently undergone afundamental transformation: in part because of the momentum generated

by the changes made in the conduct of monetary policy at major centralbanks, but perhaps more so as a result of the wrenching impact of the 1997–

1998 financial crisis That crisis did not spread worldwide, as did the crisis

of 2007–2008, but it nevertheless led to a substantial rethinking about thepractice of monetary policy

Ho finds that a number of trends in the day-to-day operational work and the choices of instruments have emerged For example, manycentral banks now express their official monetary policy stance in terms

frame-of an interest rate target Almost all frame-of the central banks in her study make

6 Pierre L Siklos, Martin T Bohl, and Mark E Wohar

policy decision announcements at predetermined dates Central banks havefocused on stabilizing some short-term interest rate rather than focusing

on a quantity such as reserves Reserve requirements have played a muchsmaller role than in previous years Reserve ratios differ widely among coun-tries In a number of countries, required reserves no longer act as a tax onthe financial institution Ho finds that among more than half of the sampledcentral banks that impose reserve requirements, there is explicit remuner-ation of required reserves A few of the 17 central banks in the sample stilluse quantities (e.g., reserves, M2) as operating targets

Not all of the central banks signal their policy stance with an interest rate.Central banks that are running exchange rate-based regimes with no capitalcontrols cannot use an interest rate For example, policy in the currencyboard regimes of Hong Kong and Macao employ the spot exchange rate asanchor Ho concludes that there are some widely used practices within thesecentral banks, there is no unique “best” way to implement monetary policy.More importantly, central banks in both the developed and developingworld continue to refine monetary policy in response to changing economicconditions

As Ho points out, the events of 2007–2008 make it impossible to keep upwith the remarkable new instruments and approaches central banks havetaken to stem the implications of the severe credit crunch that has seized theworld financial system However, she helpfully provides a link to some recentdevelopments, and these are likely to need updating as time goes on It is

has not led all central banks to adopt a homogeneous set of principles.Considerable diversity remains, and it is possible that, when the dust settles,some elements of central bank operations that were better able to withstandthe impact of the crisis will be scrutinized for clues about the set of policiesthat reflect best practice in the conduct of monetary policy

1.3 Part II: The Scope of Central Banking Operations and Central

Bank Independence

This part of the book deals with the scope and limitations of central banking

In Chapter5, Charles A E Goodhart and Dimitri P Tsomocos argue thatcentral bankers seem to have developed a consensus about the theoreticalframework for analyzing the transmission mechanism of monetary policy,and that there is considerable agreement in the profession about how a cen-tral bank should carry out its policies (e.g., an independent central bank and

a target for inflation) However, there is no consensus about the theoretical

The State of Play in Central Banking and the Challenges to Come 7

framework for achieving a financial stability objective, a requirement thatmany central banks also have to meet

Goodhart and Tsomocos investigate why it has been so difficult to achieveconsensus on this point First, they provide a historical outline of centralbanks’ role in ensuring financial stability They discuss the reasons why therehas been, in recent years, such a diversity of views on the best way to ensurefinancial stability They find that the institutional structure of commercialbanking supervision is extremely diverse, with central banks sometimesplaying no supervisory role and sometimes having full responsibility forcommercial bank supervision The authors also argue that regardless ofthe supervisory role, central banks must have an operational role in themaintenance of the stability of commercial banking, of the payments system,and in dealing with financial crises Second, central banks should play a role

in designing the regulations under which commercial banks operate, even

if the supervision of these banks is conducted by a different agency

theo-retical basis to address financial stability issues The first main part of anytheory is that a model must be based on the probability of commercial bankdefault The authors then outline how such a model might be developed.Their general equilibrium model incorporates heterogeneous banks andcapital requirements In addition, their model contains incomplete mar-kets, money, and default in a two-period framework where all uncertainty

is resolved in the second period In the first period, economic agents eitherborrow or deposit money into commercial banks in order to achieve a pre-ferred time path of consumption Banks also trade among themselves Thecentral bank intervenes in the interbank market to change the money supplyand the interest rate Bank capital adequacy requirements are set by regu-lators who may or may not be the central bank Goodhart and Tsomocosconclude by suggesting that banking and finance have become increasinglyinternational in nature, whereas regulation and supervision have to be based

on a specific legal structure, which is at the national level Crises also depend

on how they are dealt with nationally

Clearly, an outline of a model aimed at addressing the issue of financialsystem stability must omit a number of complications That these exist willbecome readily apparent to readers in the next three chapters In particular,the idea of attaining and maintaining financial system stability is partly apolitical-economy question Moreover, there is the issue of how to deal withfinancial shocks when banks deal with several financial systems simultane-ously Finally, there is the problem of regulation and its diversity around theworld – notwithstanding the attempts by the Basel Committee to aim for

8 Pierre L Siklos, Martin T Bohl, and Mark E Wohar

some international consensus on best practices that has, in spite of their bestattempts, now been fundamentally put into question as a result of recentevents The sensibly defined balance sheet the authors rely on, necessitated

to keep the analysis at a tractable level, does, however, omit real-worldcomplications that have emerged as central to undermining trust amongfinancial institutions since the summer of 2007 These complications arenot easy to deal with, but at least the chapter begins by asking the rightquestions and providing some initial answers; elsewhere related works donot directly deal with the analysis of financial system stability in such anexplicit manner

most part, central banking remains national, while commercial banking hasbecome international They then investigate the problems this developmentcreates for today’s central banks First, the authors lay out the functions ofcentral banks to better understand which of the functions may be impeded

by the internationalization of commercial banking They focus on twomajor functions, monetary stability and financial stability As Goodhartand Tsomocos point out in Chapter5, there is no single accepted or rig-orous definition of financial stability Mayes and Wood then examine whatshould be done to deal with how the internationalization of commercialbanking impedes central bank policies They conclude that international-ization of commercial banking does not prevent a national central bankfrom carrying out the lender of last resort function by which to stabilize thecommercial banking system In addition, bank internationalization doesnot expose countries to financial crises

Although explicitly pointing out that cooperation and coordination arenot the same thing, Chapter6leaves the complications of deciding which

is better when a central bank has less than complete jurisdiction over thebanking and financial sectors Moreover, as this is written, governments andcentral banks have embarked on much more heavy-handed interventions

in the financial sector, and there are, as yet, untold implications for tral banks and the renewed emphasis on their historical role as lenders oflast resort The authors do make an effort to lay out some of the broadimplications of recent developments, a hopeless task under the present cir-cumstances, but one might worry about their “pessimistic” conclusion inthe aftermath of the failure of Lehman Brothers Although AIG was rescuedshortly thereafter, this puts paid the notion that central banks can and willsolve a problem created by the internationalization of commercial banking.Bernd Hayo and Carsten Hefeker begin Chapter7with the observationthat, in the last 20 years, many countries have made their central banks more

cen-The State of Play in Central Banking and the Challenges to Come 9

autonomous Most economists agree independence is important because it

is a device that can assist the central bank in achieving the goal of price

a number of arguments questioning some aspects of the conventional view

of CBI, and its beneficial impact on inflation control They argue that CBI isneither necessary nor sufficient for ensuring monetary stability CBI is justone monetary policy design instrument among many that can be employed

to achieve price stability Therefore, no one policy instrument is optimalunder all conditions They argue that CBI should not be treated as anexogenous variable, but instead attention should be given to the question

of why central banks are made independent

It is well known that the empirical literature finds CBI to be correlatedwith low inflation In this book, Mayes and Wood also argue that CBI isnot the only cause of low inflation By taking the endogeneity of CBI intoaccount, there is little reason to believe that the correlation between CBI andlow inflation tells us anything about causality Their approach is somewhatreminiscent of the argument that the success of the euro area has nothing

to do with whether it is an optimal currency area Rather, once the politicalwill exists to introduce a common currency, the single currency area willeventually become more like an optimal currency area Hence, the usualoptimal currency area criteria are endogenous

Hayo and Hefeker first review the theoretical foundations of CBI Theyoutline serious theoretical problems with the conventional argument thatCBI is the optimal instrument of monetary design Next, they show alterna-tive monetary design instruments that can cause low inflation In particular,they note that these alternatives are fixed exchange rate and currencyboards, inflation targeting, and inflation contracts These have more favor-able (or equal) theoretical properties than CBI and have been put intopractice Strictly speaking, this is true However, what the authors donot emphasize sufficiently is the quite small shelf life of these types ofexchange rate regimes In addition, the world has moved away from rigidexchange rate regimes to ones that permit greater flexibility The reasonseems clear A central bank with considerable autonomy under a flexi-ble exchange rate regime at least can choose an independent path for itsmonetary policy The alternative monetary policy strategies cannot do so,even if they are able to deliver, in theory, the same inflation outcomes Ofcourse, a more independent central bank does not automatically imply thatcredibility will be established Siklos (2002), for example, finds that thelinkage between CBI and inflation has been reversed in the 1990s and isnegative

10 Pierre L Siklos, Martin T Bohl, and Mark E Wohar

Hayo and Hefeker’s main conclusion, then, is that there are alternativemeans of keeping inflation low other than simply via the granting of CBI.Society has to make two decisions about monetary policy First, it mustdecide how important the fight is to keep inflation low Second, it mustchoose the best institutional arrangement to achieve price stability Thefirst decision implies that CBI is not a sufficient condition for price stabilitybecause it is one of many instruments to achieve price stability The sec-ond decision makes it clear that CBI is not a necessary condition for pricestability, although it might be what some countries need

investigate recent trends and determinants of financial supervisory nance with special attention to the role of the central bank as supervisor

gover-A considerable amount of research has been devoted to the relationshipbetween CBI and accountability Much less, however, has been written aboutsupervision Indeed, recent work has argued that the supervisory func-tion is, under a variety of circumstances, best delegated to an independentagency

One issue raised is whether it is beneficial to have monetary policyand commercial bank supervision under one roof In many countries,the supervisory function is performed by institutions other than the cen-tral bank Building on the work of Quintyn et al (2007), the authors ofChapter8provide ratings for independence and accountability for com-mercial bank supervisory agencies in 55 countries Their empirical analysis

of the determinants of emerging independence and accountability ments indicates that the quality of public sector governance plays a decisiverole in establishing accountability arrangements more than independencearrangements The more mature a democracy is, the more likely it isthat a higher degree of independence and accountability will be granted.Their results also show that accountability is driven by crisis experiences,whereas independence is influenced by a kind of “bandwagon”effect Finally,their findings also indicate that the likelihood for establishing governancearrangements suitable for the supervisory task seems to be higher when thesupervisor is located outside the central bank

arrange-It should be clear that rules establishing good governance practices aredesirable What remains unclear is the precise relationship between a centralbank on the one hand, the government on the other, and the supervisorybody A further complication that cannot be easily captured by the kind ofanalysis carried out here is that the financial sector has changed so greatlyaround the world that it is more difficult to identify firms for which theprimary function is a financial one from firms that combine financial and

The State of Play in Central Banking and the Challenges to Come 11

nonfinancial roles This not only makes the task of supervision more ficult, but it also complicates defining accountability and independence ofsupervisory institutions

dif-The authors are surely correct to point out that, whereas there is a largeliterature that measures every aspect of central bank behavior, there hasbeen noticeably less emphasis on measuring and evaluating the behavior

of supervisors The ongoing global financial crisis not only sheds new light

on failures in regulation and supervision but suggests that much is gained

by studies of the kind undertaken here Indeed, in addition to a focus onaccountability, future research ought to go where research on central bankperformance is now located, namely the role and potential benefits of trans-parency Much blame has been laid at the failure of agencies of all kinds inunderstanding and informing policymakers and the public about the dan-gers of complex financial instruments and transactions How supervisioncan be designed to mitigate the kinds of shocks world financial marketshave been experiencing is, of course, unclear, but will be on the agenda forfuture research Finally, just as Hayo and Hefeker point out the endogeneity

of the CBI criteria, there is similarly an endogeneity in the determinants ofgood governance in supervision The authors do mention this as a draw-back of their empirical analysis; however, more effort needs to be invested

in ascertaining the implications of this possibility for the estimated resultspresented in this chapter

1.4 Part III: Transparency and Governance in Central Banking

The final part of this book deals with transparency and governance in central

arguably represents the first survey of its kind dealing with the large body

of literature concerning the economic impact of central bank transparency

As central banks became more independent, transparency emerged as animportant issue because, as some have argued, transparency is necessary toensure accountability The authors first examine how the theoretical litera-ture in this area has evolved over time They begin with the seminal work

of Cukierman and Meltzer (1986) who argue that the case for ability is ambiguous Arguments have been put forth in favor as well asagainst transparency van der Cruijsen and Eijffinger rely on a classification

account-of transparency developed by Geraats (2002) Transparency is classified intofive categories: (1) Political transparency includes information about centralbank goal(s), a formal statement of targets and institutional arrangementssuch as independence (2) Economic transparency exists when the central

12 Pierre L Siklos, Martin T Bohl, and Mark E Wohar

bank reports information about the state of the economy (3) Proceduraltransparency concerns the degree of openness about the procedures used

to conduct monetary policy, and how the central bank presents its activitiesthrough, for example, minutes of committee meetings (4) Policy trans-parency concerns how the central bank explains its policy decisions to thepublic and the extent to which it provides information on future policyactions (5) Operational transparency considers openness about how wellpolicy actions are implemented

The findings about the net benefits of economic transparency are mixed.Transparency influences economic outcomes through its effect on the for-mation of inflationary expectations, which turns out to be the crucialelement The authors also review a new strand of literature that analyzesthe effect of transparency on the formation of expectations and is based

lit-erature models decision making within committees to analyze whethermore procedural transparency is wanted On the one hand, the publica-tion of minutes may be desirable if it leads to accountability On the otherhand, the publication of minutes may be harmful as disagreement withinthe committees would become public, which could threaten central bankcredibility

The most recent literature on central bank transparency examines theimplications from learning behavior This literature takes the view that therational expectations assumption is too strong and that economic agentsneed to learn how the economy works Most of the literature in this areasupports more transparency because it improves learning Hence, moretransparency is better (although disagreement still exists about proceduraland preference transparency) Blinder (2007) emphasizes that while onetype of transparency might work for one type of central bank, it might notwork for another

Van der Cruijsen and Eijffinger then turn their attention to a survey

of the empirical literature A number of different indices for central banktransparency has been developed All of these indices have a disadvantage

in that they were computed at a single point in time and do not sure changes in central bank transparency Eijffinger and Geraats (2006)constructed time-varying transparency indices Dincer and Eichengreen(2007) arguably not only improve on the Eijffinger and Geraats classi-fication but also provide a much longer time series Unfortunately, weknow too little about the substantive differences between these indices andtheir connection with variables, such as inflation, that define central bankperformance

mea-The State of Play in Central Banking and the Challenges to Come 13

Another strand of literature looks at the long-lasting effects of parency on macroeconomic variables With more transparency, the centralbank has more flexibility to offset economic shocks because its credibility isnot harmed The empirical literature also finds that increased transparencycan reduce interest rate volatility, make forecasts more synchronized,lead to better macroeconomic outcomes, and improve credibility For themost part, however, the empirical work supports greater central banktransparency

trans-It remains to be seen how far transparency can go In particular, van derCruijsen and Eijffinger do not explore in great detail the controversy overwhether the release of forward interest rate tracks represents an improve-ment in transparency or whether this complicates the task for a centralbank in maintaining its credibility On the basis of the work by Karagedikli

evi-dence from Norway there is little reason to believe that markets necessarilyexpect the central bank to deliver the interest rates implicit in these data.Both of these central banks have led the way on reporting future inter-est rate predictions, conditional on different scenarios for inflation, andother macroeconomic aggregates Perhaps more worrisome is one impli-cation of the Morris and Shin (2002) hypothesis, which suggests that, as

a central bank becomes increasingly transparent, the private sector willinvest fewer resources in forecasting the future macroeconomy Such anoutcome is clearly undesirable, but it is too early to tell whether this is indeedthe case

Philipp Maier’s contribution (Chapter10) begins by remarking that thecomposition of a committee that implements monetary policy, along withthe structure of the meeting, can affect the decision-making process in asubstantial fashion He notes that more than 80 central banks make mon-etary policy decisions under a committee-type structure When puttingtogether a monetary policy committee, one needs to consider its size, aswell as whether voting records should be disclosed

Maier reviews economic, experimental, empirical, sociological, and chological studies of committee-based decisions in an effort to identifycriteria for the optimal institutional setting of a monetary committee Onthe basis of review of empirical and experimental studies, a number of crite-ria can be derived to explain how monetary policy committees and meetingsshould be structured Relying on an investigation of the composition andoperation of monetary policy committees at over 40 central banks, Maierfinds that some central banks have taken measures that would increase theeffectiveness of their monetary committees Nevertheless, he also reports

psy-14 Pierre L Siklos, Martin T Bohl, and Mark E Wohar

that a large number of central banks could take measures to improve theircommittee framework An important finding is that the monetary policycommittee of the Bank of England is the best-practice committee On thebasis of this metric, the committee structure of other central banks could

be improved

It is clear, however, that much remains to be learned about tee behavior and structure Indeed, Maier’s review makes clear that this

commit-is an area that commit-is particularly multidcommit-isciplinary in nature There are also

a number of unanswered questions For example, the notion that singledecision-maker central banks are more dictatorial understates the gover-nor’s desire to maintain, if not improve, their reputation Hence, it is notobvious that such structures need necessarily be less effective Moreover, thecommittee structure at some central banks is more formal than others TheBank of England’s monetary policy committee is an example of a highly for-malized committee structure In contrast, the Bank of Canada, mentioned

as a central bank with a monetary policy committee, is one in which thecommittee structure is not mentioned in the legislation and has no legalstanding In addition, it is the governor who is the sole spokesperson ofthe central bank Yet, the Bank of Canada’s performance in delivering goodmonetary policy has been stellar

Two other considerations not emphasized in Maier’s contribution need

to be made First, the adoption of fixed announcement dates has no doubtmitigated the tendency for inertia in decision making Second, central banksmay make actual decisions in the context of a formal meeting, but there isconsiderable discussion among committee members before the meeting,and this aspect can have a decisive influence on the outcome of a meeting

Pierre L Siklos’ chapter (Chapter11) first reports that there is no clearnegative relationship between average inflation and an index of CBI cover-ing a sample of over 100 countries for the period 1990–2004 As is remarked

in several chapters of this book, it has been argued that CBI alone is notsufficient to deliver an optimal monetary policy Consequently, attentionhas now shifted to the governance of central banks Siklos reports that goodgovernance should enhance the trustworthiness of a central bank

Siklos proposes indicators of central bank governance based on anexpanded data set complied by Siklos (2005) covering over 100 countries

He uses a large set of quantitative and qualitative variables With this dataset, he empirically evaluates the determinants of trust in central banks Thetestable proposition is that governance is partially determined by the par-ticular economic, institutional, and political climate Siklos defines these by

The State of Play in Central Banking and the Challenges to Come 15

the existence of democratic institutions, the degree of corruption, and thelevel of economic and political stability He shows that a linear combination

of these factors can serve as an indicator of central bank governance Themeasure of trust is defined by the absolute value of accumulated inflationsurprises over the period 1990–2004 The empirical evidence supports theview that many principles of good governance matter and that no singleindicator of central bank behavior (e.g., its autonomy) suffices to explaininflation performance

Indeed, Siklos finds some interesting regional differences For example,cumulative inflation surprises are much larger in European countries thatdid not join the European Union Siklos also reports that pegged exchangerates have the smallest absolute value of inflation surprises This result iscompatible with some of the findings reported by Hayo and Hefeker in thisbook This implies that pegging an exchange rate regime can, under certaincircumstances, increase the confidence one has in the performance of centralbanks Institutional and socioeconomic differences across countries meanthat one size does not fit all

There are at least three difficulties with the evidence presented so far First,

dif-fers greatly, such as between developing versus industrial countries Hence,

it is possible that the relationship, estimated in a linear fashion, may in fact

be inherently nonlinear in nature Second, there have always been questionsraised about the accuracy of qualitative determinants of central bank perfor-mance These play a crucial role in the empirical investigation Finally, datalimitations necessitate the resort to forecasts published in the InternationalMonetary Fund’s World Economic Outlook Even if the forecast record ofthe World Economic Outlook is a good one, the quality and methodologiesused to generate these forecasts are likely to be significantly different acrossthe world It is conceivable, therefore, that it is not, strictly speaking, possible

to rely on cross-country comparisons of such forecasts

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Monetary Policy,” Econometrica 73: 1431–1475.

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Analysis,” Journal of Monetary Economics 44: 195–222.

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Lunch?,” Journal of Money, Credit and Banking 31: 277–295.

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PART I

PAST, PRESENT, AND FUTURE IN THE CONDUCT OF

MONETARY POLICY