When does policy reform work? The case of Central Bank independence.

Acemoglu, Daron ; Johnson, Simon ; Querubin, Pablo 等

ABSTRACT Questions of the effectiveness of economic policy reform are inseparable from the political economy factors responsible for distortionary policies in the first place. Distortionary policies are more likely to be adopted where politicians face fewer constraints. Hence reform should have modest effects in societies where the political system already imposes strong constraints, and in societies with weak constraints, because it does not alter the underlying political economy. Reform should be most effective in societies with intermediate constraints. Furthermore, effective reform in one dimension may lead to deterioration in others, as politicians address the underlying demands through other means--a phenomenon we call the seesaw effect. We report evidence that central bank reforms reduced inflation in countries with intermediate constraints but had no or little effect where constraints were strong or weak. We also present evidence consistent with the seesaw effect: in countries where central bank reform reduces inflation, government expenditure tends to increase.

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Institutional and policy reforms are often 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 include opening to trade, financial liberalization, judicial reform, privatization of state enterprises, reduction of entry barriers, tax reform, removal of targeted industrial subsidies, and central bank independence. The list thus includes not only those in the original Washington consensus, (1) but also a range of other reforms.

Although there are sound economic theories suggesting why these reforms might be important in improving economic performance, the experience of the last decade shows that such reforms rarely seem to have the effects anticipated by their proponents. Nicolas van de Walle, for instance, summarizes the ineffectiveness of reform in sub-Saharan Africa by noting that "at the dawn of the twenty-first century, most of sub-Saharan Africa remains mired in economic crisis despite two decades of donor-sponsored reform efforts.... Many if not most African countries are poorer today than they were twenty years ago." (2) Similarly, Andres Velasco, the current Chilean finance minister, articulates the widespread disillusion with the impact of reform in Latin America:

 Reformers argued, persuasively, that growth was being held back by
 distortions. Many of the distortions were government induced, the
 result of poorly conceived policies. Change policy and the economy
 will fulfill its potential.... A decade later the view is less
 sanguine: with fewer bad-policy distortions, the Latin American
 economies grew in the 1990s at half the rate attained during
 precisely those decades when the allegedly distorting policies of
 import substitution reached their peak: the 1960s and 1970s. (3)

Why do seemingly sensible reforms fail to generate the benefits they promise? The critics of reform emphasize, among other things, the potential negative effects of international trade on infant industries, the instabilities that might be induced by financial liberalization, and the usefulness of a variety of regulations, government ownership, and industrial policy in less developed economies. (4) Joseph Stiglitz, for example, argues that in many cases "the economic policies that evolved into the Washington Consensus and were introduced into developing countries were not appropriate for countries in the early stages of development or... transition [from central planning]." (5)

This is not the only way to interpret the apparent failure of reform, however. In this paper we emphasize that to understand why reforms do or do not work, it is necessary to investigate the political economy of distortionary policies. Our general argument is that the analysis of whether and which reforms will lead to improved economic performance should start with an understanding of why distortionary policies were in place to start with. We show that this perspective leads to some simple, testable ideas about when policy reform will be more effective, and we provide preliminary evidence consistent with these ideas. (6)

Much of the economic literature on policy reform and most of the advice given by international institutions assume, implicitly or explicitly, that distortionary policies came about by accident. Either these policies were put in place long ago and remain as a historical legacy, or they are the outcome of some mistaken economic theory or shortsightedness on the part of policymakers. But this perspective is limited at best. Although one can undoubtedly find instances where mistaken economic theories led to disastrous policies, few policymakers create hyperinflations or large budget deficits because they think these are good for the economy.

What, then, might explain the presence of bad policies? The literature on political economy suggests that bad policies arise because the preferences of politicians or others holding power are not aligned with those of the rest of the society. The politically powerful may have an incentive to distort policies or institutions so as to redistribute income or power to themselves. (7) Their ability to do so will depend on the constraints they face and, more generally, on the structure of political institutions. A potent source of policy failure is the absence of constraints on political officeholders, in the form of checks and balances on their actions and means of holding them accountable. (8) This perspective emphasizes that policy reform takes place in an environment where existing policies serve political purposes, such as redistributing resources to groups with power and influence. This implies that those who expect to see their economic rents or privileges disappear as a result of policy reform are likely to use their political power to prevent its effective implementation.

Alternatively, political realities may make it impossible or impractical for those entrusted with the implementation of reform to carry it out. This implies a potentially large gap between de jure reform and de facto reform. In particular, only those policy reforms that the politically powerful beneficiaries of the distortionary policies cannot easily override, circumvent, or ignore are likely to achieve their objectives. Whether or not these groups can thwart reform depends in turn on the constraints on politicians and on the policymaking process. This argument suggests that in societies such as many in sub-Saharan Africa, where politicians and politically powerful groups face only a few constraints on their power, policy reform is unlikely to be very effective. This is consistent with the case study evidence and argument presented by van de Walle, (9) who illustrates that for African politicians, "restoring economic stability and growth has often taken a back seat in government motivations to preserving political power." (10) In the context of structural adjustment, van de Walle argues,

 Often, the policies have changed on paper, but in practice,
 something resembling the status quo ante continues to prevail. In
 some cases, the old policies were reinstated under a new name or
 with some new policy objective.... In other cases, governments
 ignore the spirit of their own liberalization efforts by continuing
 to interfere in officially deregulated markets. (11)

Under these circumstances, the ineffectiveness of reform is not surprising; few people would expect privatization, financial liberalization, or central bank independence (CBI) to have fundamental effects in Zimbabwe as long as Robert Mugabe is in power, for example, or in Sudan as long as Omar al-Bashir's kleptocratic and genocidal regime remains in place. To illustrate, figure 1 plots the inflation rate in Zimbabwe; the vertical line at 1995 indicates when the Central Bank Act was modified to grant the Reserve Bank of Zimbabwe greater independence. (12) Clearly, increased CBI did little to restrain Zimbabwe's subsequent monetary policy. This somewhat extreme example illustrates that a major reason why policy reform often fails is the absence of a functioning system of accountability and a lack of constraints and checks on politicians. (13)

[FIGURE 1 OMITTED]

Does this imply that better political institutions and transparency will increase the impact of reforms? Not necessarily. Policy reform has its greatest potential effect when the prereform policies are highly distortionary. However, one would not expect a society with a functioning system of accountability and with checks on politicians to be pursuing highly distortionary policies in the first place. For example, inflation was already low in the United Kingdom in the 1990s, before the Bank of England became independent in 1998. (14) Thus room for a large effect from CBI was limited. Rather, high inflation or even hyperinflation is much more likely in societies with weak institutions than in those where politicians are accountable, through elections or other means, to the population at large.

These arguments suggest that from a political economy perspective, policy reform should not be expected to be equally effective in every society; rather, the functioning and success of reform should depend on political institutions and political constraints. More specifically, these arguments suggest a potentially nonmonotonic relationship between the extent of constraints on politicians and the effectiveness of reform. The importance of political economy factors in understanding and evaluating the success of policy reform is this paper's main message.

We develop this perspective by investigating, both theoretically and empirically, the interplay between policy reform and institutional constraints on politicians. We first delineate the main issues using a simple theoretical model that illustrates how the relationship between constraints on power and the impact of reforms could be nonmonotonic. The model also highlights how effective reform may sometimes lead to the deterioration of other, unreformed policies--a phenomenon that in previous work we have called the seesaw effect. (15)

We then investigate the validity of these ideas by focusing on reforms related to central bank independence. CBI is a natural type of reform for us to study. Most other reforms, such as financial liberalization, judicial reform, or removal of targeted subsidies, have relatively broad mandates and try to improve, among other things, the overall functioning of the economy, investment, and growth. CBI, in contrast, has a much more clearly delineated target: inflation. We can thus judge the success of CBI by whether or not it has reduced inflation. Nevertheless, even this investigation is complicated by the fact that countries often introduce CBI not as a stand-alone policy reform, but as part of a broader anti-inflation package. (16) In such cases, therefore, we interpret the regression evidence on the implications of CBI as corresponding to the effects of this broad package.

Our main empirical results are consistent with the hypothesis of a nonmonotonic relationship between political constraints and the effectiveness of policy reform. We create an index of the quality of general institutions by using constraints on the executive from Polity IV data. Although the highly serially correlated nature of data on inflation makes statistical inference difficult, the evidence is broadly consistent with a pattern in which CBI reduced inflation in countries with intermediate levels of constraints on the executive but appears to have had no effect in countries with the strongest institutions. For countries with the weakest institutions, the general pattern is likewise one of no effect, although some specifications show a statistically significant, but generally nonrobust, negative effect. Our empirical results reject the hypothesis that the effect of CBI is the same in countries with strong as in those with medium constraints, but we are generally unable to reject the hypothesis that the effect is the same in countries with medium and weak constraints.

Overall, our approach and empirical results suggest that reform of economic institutions will be effective only if the political context is right. If the context already provides political constraints and accountability mechanisms that produce a strong tendency to adopt good policies, there will be little room for reform to have major effects. If the context is poor, so that politics and policymaking are highly nonrepresentative, reform is likely to be irrelevant, because it can easily be undermined. It is in the intermediate situations that reform may have some bite: constraints in such cases are weak enough to generate bad policy, but not so weak that all reform can be undermined.

In this light, our findings point to a different interpretation of the apparent failure of the various reforms implemented throughout the 1990s and early 2000s than those argued by either the skeptics or the advocates of reform. First, contrary to the skeptics, it is not true that all reforms have failed. In the case of CBI, the empirical focus in this paper, it appears that policy reform is associated with a significant decline in inflation in societies with intermediate (and sometimes those with weak) constraints on politicians. Second, our results suggest that even in countries where reform has failed, it has not done so because it was inappropriate from an economic point of view. Rather, potentially sound economic reform may often be politically nonviable in certain societies, at least if it does not take into account the political context.

Nevertheless, we emphasize that all of the evidence provided in this paper corresponds to the conditional correlations in the data consistent with declines in inflation at the same time as or following central banking reform (and not to the causal effect of CBI on inflation). As we stress further below, policy reform in general and central bank reform in particular are endogenous, determined as part of the political economy equilibrium in the society. Consequently, one should be cautious about reaching strong conclusions on the basis of such evidence. Having said that, the fact that CBI is correlated with contemporaneous and future declines in inflation mostly in societies with intermediate levels of constraints on politicians is intriguing and, at the very least, requires further investigation.

After reporting these basic findings, we go on to investigate whether there is any evidence of a seesaw effect following CBI. The seesaw effect suggests that when successful policy reform takes place in one dimension and the political equilibrium remains largely unchanged, politicians may try to use a different instrument to attain the goal previously targeted with the instrument now being reformed. In general, the seesaw effect implies that as policy gets better in one dimension, it may get worse in another. A natural candidate for the seesaw effect in the context of CBI is fiscal policy. We therefore investigate whether or not fiscal policy changes significantly after CBI is introduced. We provide some evidence that CBI is associated with greater government expenditure as a percentage of GDP in countries with intermediate constraints, and unrelated to government expenditure in countries with weak or strong constraints. This evidence is consistent with some worsening in other dimensions of policy in countries where CBI reform has been effective in reducing inflation, although the effect of CBI on government expenditure is less robust than its impact on inflation.

The recent economic history of Colombia and Argentina, depicted in figure 2, illustrates the seesaw effect. In both countries the introduction of CBI in 1991 was followed by both a significant fall in inflation and an increase in government expenditure as a percentage of GDP. In the Argentinean case, as in many other countries in our sample, inflation started falling before the central bank reform, which, as mentioned above, suggests that CBI is part of a broader package of reforms aimed at controlling and stabilizing inflation.

In Colombia it is widely alleged that, in the mid-1990s, President Ernesto Samper engaged in extensive clientelism in an effort to remain in power following the revelation that he had received large amounts of money from the Cali drug cartel. (17) The situation somewhat resembled that in the 1970s, when President Misael Pastrana used clientelism to broaden his political support following a disputed election. (18) But Pastrana was able to direct the central bank, which was not then independent, to give easy credit to various firms and sectors; this, in combination with increased expenditure financed by seigniorage, caused inflation to accelerate. (19) Samper, in contrast, came to power after the central bank had become independent. As a consequence, he had to rely more heavily on increasing expenditure, largely in the form of wage increases for public employees and increased military spending. (20) The central bank largely offset the inflationary effects of this expansionary fiscal policy with contractionary monetary policy. (21)

[FIGURE 2 OMITTED]

The rest of the paper is organized as follows. The next section discusses the relevant literature on the political economy of reform, on the role of CBI in combating inflation, and on possible interactions between institutional factors and the effectiveness of policies. The following section presents a simple model illustrating why policy reform may be most influential in societies with intermediate levels of political constraints. We also use this model to show how policy reform in one sphere can lead to a deterioration of other dimensions of policy, creating a seesaw effect. The next section discusses our data sources and the construction of the CBI variable. The next presents our main empirical results, which suggest that, consistent with our theoretical expectations, CBI has little effect on inflation in societies with the strongest and the weakest constraints on politicians, but tends to reduce inflation in countries with intermediate levels of constraints. The penultimate section investigates the seesaw effect, looking for evidence, in societies where CBI has reduced inflation, of deterioration in other policies. The final section concludes.

Related Literature

Our paper is related to two broad areas of research, one on the political economy of reform in general and the other on the consequences of central bank independence. We now give a brief overview of these literatures and how our findings add to them.

Political Economy of Reform

A great deal of theoretical and case study work examines the political economy of reform. (22) Most of the theoretical research focuses on developing explanations for why socially beneficial reforms do not occur or are delayed. (23) Sharun Mukand and Dani Rodrik, however, develop a model in which policymakers adopt reforms they know to be inefficient in order to avoid being thought corrupt. (24) Other work, taking political impediments to reform as given, discusses their implications for the sequencing of reforms, whether or not gradual or radical reform is desirable, and whether or not reform can be sustained.(25) Most closely related to our paper are those by Maxim Boycko, Andrei Shleifer, and Robert Vishny, (26) who examine the circumstances under which privatization increases efficiency. In their model, politicians derive political benefit from high employment, and even though the managers of a privatized firm may maximize profits with less employment, politicians can bribe them to employ more people. The same authors also study the circumstances under which employment falls after privatization. Stephen Coate and Stephen Morris, formalizing an intuition of George Stigler, (27) develop a model in which policy reform can reduce efficiency when politicians are initially using policy instruments to redistribute income in an optimal way. A key difference between our approach and Coate and Morris's is our emphasis on the role of political institutions. None of the papers mentioned above derive the nonmonotonic relationship between reform and outcomes that is at the heart of our model.

At a general level, the entire empirical literature on the impact of policy and policy reform on economic variables--for example, on economic growth--provides relevant and useful background to our work. That policy reform might be desirable is implied from regressions showing that variation in policies can account for variation in economic growth. Although certainly some papers argue this, the cross-country literature is far from a consensus. (28) For instance, because policy variables exhibit multicollinearity, it is generally difficult to find robust relationships between particular policy measures and growth. Moreover, the empirical analysis in most of these papers is based on cross-sectional regressions, so that omitted-variable bias may be a significant concern. (29)

Most of the empirical work on reform focuses on specific instances of either failed or successful reforms. (30) Among cross-national empirical studies, David Dollar and Jakob Svensson show that political factors, particularly whether or not a country has a democratic government and how long the government has been in power, are important for the success of World Bank programs. (31) In the related context of the effectiveness of international aid, Craig Burnside and Dollar offer evidence that aid increases growth when combined with good institutions and policies, (32) although William Easterly, Ross Levine, and David Roodman show that their results may not be robust. (33) The idea that the implications of policies or shocks depend on the institutional environment has also appeared in other empirical papers. For instance, Geert Bekaert, Campbell Harvey, and Christian Lundblad, and Halvar Mehlum, Karl-Ove Moene, and Ragnar Torvik, show that the effect of natural resource abundance on economic growth depends on the quality of institutions in the society. (34)

Our research is also related to the case study literature on Latin American politics, which has argued that the appearance and the reality of policy reform in Latin America may be very different. Several scholars have argued that the adoption of Washington consensus reforms in Latin America was accompanied by the continuation of populist policies and politics as usual. (35) The adoption of these reforms did constrain which policies could be used, but politicians such as Carlos Menem in Argentina and Alberto Fujimori in Peru realized that even policy reform could be adjusted to the demands of clientelism: for example, government-owned firms could be privatized but sold relatively cheaply to those with political connections. Populism and clientelism persisted even though the instruments that they used changed, an argument clearly related to those we make in this paper.