Independent Central Banks, Democratic Politics and Deficit Financing in Post Communist Countries

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Independent Central Banks, Democratic Politics
and Deficit Financing in Post Communist Countries

• Cristina Bodea
• Michigan State University
• Prepared for presentation at the 4th IPES meeting
  - Texas AM 2009

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What the paper does

• Connects government deficit financing with the
  independence and credibility of the central bank.
  In particular
• Independent and conservative central bankers (i)
  prefer budget discipline and (ii) have the means
  to enforce their preference
• Legislated independent status of the central bank
  is essentially cheap talk in the absence of
  meaningful opposition and a free media, i.e. in
  the absence of democratic institutions.
• Tested hypothesis Independent central banks can
  be expected to contribute to lower budget
  deficits only in countries in which government
  authorities are accountable
• Uses data from former communist countries to test
  the hypothesis (EBRD 1990-2002 updated Cukierman
  et al. 2002 CBI index)

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Previous work

• Theory of Optimal taxation E.g. Grilli,
  Masciandaro and Tabellini 1991, Alt and Lowry
  1994, Kontopoulos and Perrotti 1999
•  
• Common Pool Resource Problem E.g. Olstrom 1990,
  Olstrom, Gardner and Walker 1994, Heller 1997,
  Hallerberg and Marier 2004
• Partisanship E.g. Persson and Svensson 1989,
  Kontopoulos and Perotti 1999
• Electoral systems E.g Milesi-Ferretti et al.
  2002, Hallerberg and Marier 2004  
• Elections E.g Clark and Hallerberg 2000
•  
• Budget institutions E.g. Von Hagen et al. 2002,
  Hallerberg and von Hagen 1999, Hallergerg 2003,
  Fabrizio and Mody 2006

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Previous work closer to this paper

• Much less work connecting the independence of the
  central bank to deficit financing
• Grilli et al. 1991 and De Haan and Sturm 1992
  find a negative but generally insignificant
  relationship between central bank independence
  and budget deficits in OECD countries
• Beyond industrialized countries, Sikken and De
  Haan 1998 find no relationship between legal
  independence and the level of budget deficits for
  a sample of 45 developing countries from 1950 to
  1994
• Above finding - similar with work showing that,
  in general, the negative relationship between
  central bank independence and inflation breaks
  down in developing countries (e.g. Cukierman et
  al. 1992, Cukierman et al. 2002)

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Deficits, central banks and democracy

• (i) CBs prefer fiscal discipline due to the long
  run link between deficits and inflation
• (ii) - Independent CBs can increase the costs of
  running a deficit by increasing interest rates
• See reactions of central bankers to fiscal
  deficits
• See business and financial analysts outlook
  on connection of fiscal deficits and central bank
  reaction
• - Usually, CBI comes with strings attached
  vis-à-vis the government borrowing from the
  central bank
• Drawing on Broz (2002) - Democratic institutions
  help with information revelation and improve the
  ability of the central bank to send credible
  signals regarding its reaction to deficit
  spending
• E.g. Belarus 1992-2000 one of the most (legally)
  independent central bank and at the same time one
  of the most autocratic regime in former Soviet
  Union

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Data and main variables

• Dependent Variable Budget Deficit or Surplus -
  EBRD (also used World Development Indicators,
  correlation 0.8)
• Main Explanatory Variables Central bank
  independence (Cukierman weighed index CBI
  index From 0 to 1 weighed, un-weighed, lending
  only) and Democracy (Freedom House Democracy
  Score FHDI From 3 to 12 Low values
  democracies)

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Basic Model
Linear regression with panel corrected standard
errors and lagged dependent variable.
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Adding economic and political controls

• Control for GDP growth, GDP/capita, capital
  controls, exchange rate regime, trade openness
• Control for number of parties in the government
  (one party, 2-3 parties), minority government,
  partisanship, electoral year, bicameralism
• CBI and FHDI - still positive and significant
  across the board CBIFHDI still negative
• What appears to matter GDP growth () Capital
  account liberalization (-) Bicameralism (-)
  Minority governments ()

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Discussion
Predicted Budget Deficit / Surplus for Democracies and Autocracies Predicted Budget Deficit / Surplus for Democracies and Autocracies Predicted Budget Deficit / Surplus for Democracies and Autocracies Predicted Budget Deficit / Surplus for Democracies and Autocracies
FHDI CBI Democracy FHDI 3 Middle of the road democracy FHDI 7 Autocracy FHDI 12
Low bank indep. CBI .3 -5.3 (-6.3, -4.3) -4.5 (-5.1, -3.9) -3.6 (-4.8, -2.3)
Average bank indep. CBI .5 -4.8 (-5.2, -4.3) -4.1 (-4.9, -4) -4.1 (-5.1, -3.1)
High bank indep. CBI .7 -4.2 (-4.8, -3.6) -4.4 (-5, -3.8) -4.7 (-5.7, -3.7

• Legal central bank independence reduces budget
  deficits, but the effect of bank independence
  disappears as countries become less democratic
• Democracies with dependent central banks tend to
  overspend the most

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Conclusion

• Only democracies benefit from the development of
  independent central banks
• For democratizing countries, my results suggest
  that to guard against overspending as political
  representation increases, newly democratic states
  should delegate more of their monetary policy to
  legally independent banks
• Examples Between 1999 and 2002 both the Czech
  Republic and Slovakia were very democratic
  countries. However, the Czech Republic had a very
  independent central bank (0.7) and an average
  deficit of -5 of GDP (with a ratio of debt to
  GDP of 21). Slovakia, on the other hand, had
  only a moderately independent bank (0.5) and an
  average deficit of 8 (with a ratio of debt to
  GDP of 47). Similar Estonia (FHDI 3,
  Deficit/GDP-0.76, Debt/GDP5.3, CBI0.76) and
  Latvia (FHDI 3, Deficit/GDP-3., Debt/GDP13,
  CBI0.46)
• The empirical results here suggest that countries
  like Slovakia and Latvia could increase fiscal
  discipline by making their central bank more
  independent

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