An Interest-Group Theory of Central Bank Independence

Abstract

This paper presents an interest group theory of central bank independence. The theory is grounded in the concept of rent extraction. In the absence of an independent central bank, politicians can benefit in the short run by creating an unanticipated burst of inflation that unravels many interest group deals. The interest groups then have to return to the politicians to renegotiate the deals, and the politician can extract a portion of the rents as a price for renegotiation. However, while politicians can benefit from creating unanticipated inflation, they benefit even more by credibly precommiting not to inflate the currency ex post. If they do not inflate the currency ex post, they can obtain more in payments for their services ex ante, because the interest group or groups that are paying for the deal will not discount their upfront compensation by the risk that the deal will lack durability due to future inflation. It is not enough for a politician to promise not to create inflation in the future, because ex post, given the opportunity, self interested politicians may do so anyway. Thus the politician needs a mechanism for reliably precommiting not to engage in inflationary actions. The independent central bank is a relatively reliable (although not perfect) precommitment mechanism. Thus, self-interested politicians may favor independent central banks even though, in doing so, they relinquish the enormously important power of price level control. Politicians would even prefer for the independence of the central bank to be embedded in some durable (i.e., constitutional) fashion in order to tie their own hands against the possibility that at some future point they will be tempted to unravel all the previous deals by revoking the central bank's independence. The pronounced recent tendency of countries around the world to adopt more independent central banks may be due, in part, to the fact that political systems are moving in the direction of greater democracy and higher adherence to a rule of law, conditions that favor legal rent extraction strategies by political actors.