Central Bank Independence and inflation: the case of Greece.

• Author: Panagiotidis, Theodore
• Pages: 95(15)

Resumen. Este artículo presenta la justificación de la Independencia del Banco Central (CBI) para el caso de Grecia. Para su desarrollo se utiliza un enfoque de series de tiempo y se emplean datos disponibles antes de la unión de Grecia al EMU. La hipótesis que se desarrolla afirma que la Independencia del Banco Central es importante para controlar la inflación. Se emplean dos índices que sirven como variables proxy para la CBI: LegalCBI y TOR. También se confirma una relación inversa entre la CBI y la inflación y se presenta evidencia que sugiere que la tasa de cambio en la gerencia del Banco Central es causante, en el sentido de Granger, de la tasa de inflación.

Palabras clave: Independencia del Banco Central, inflación, Grecia.

Clasificación JEL: E58, E52.

Abstract. This paper discusses the argument for Central Bank Independence (CBI) in the case of Greece. Using a time series approach and the last data available before Greece joined the EMU, the hypothesis that Central Bank Independence is important for controlling inflation is examined. Employing two indices, which serve as proxies for CBI, LegalCBI and TOR, the inverse relationship between CBI and inflation was confirmed. The interactions between the variability of inflation and CBI were also investigated. Furthermore, evidence was found to suggest that the rate of turnover Granger causes inflation.

Key words: Central Bank Independence, inflation, Greece.

JEL classification: E58, E52.

1. Introduction

   Central Bank Independence (CBI) has become one of the central concepts in monetary theory and policy. It is widely believed that a high level of CBI along with an explicit mandate for the bank to restrain inflation is an important institutional strategy to assure price stability. Although one could suggest alternative mechanisms to reach low rates of inflation, CBI is the one most often recommended. Indeed, more and more countries in the OECD and beyond have recently changed their central bank laws accordingly. The theory underlying this view is the time inconsistency model by Kydland and Prescott (1977) and Barro and Gordon (1983). The basic message of this argument is that governments suffer from an inflationary bias and as a result inflation is suboptimal. Rogoff (1985) has proposed delegating monetary policy to an independent and 'conservative' central banker to reduce this inflationary bias. Conservative means that the central banker is more averse to inflation than the government, in the sense that the former places a greater weight on price stability than the government does.

   There is a lot of empirical evidence suggesting that countries with more independent central banks have lower rates of inflation. This evidence generally consists of cross-country regressions using proxies for CBI based on the statutes of the central bank and the turnover rate of central bank governors. Berger et al. (2001) provide an up-to-date literature review on this issue. They conclude that the negative relationship between CBI and inflation is quite robust.

   On the other hand Hayo and Hefeker (2002) survey critically the argument for CBI and argue that CBI is neither necessary nor sufficient for reaching monetary stability. Other critics, including Goodhart (1994) and Forder (1998), question this approach. The latter points out that: "The test might appear to show a statistical regularity, say between the content of the statutes of a central bank and the rate of inflation, but in the absence of a theoretical connection that would be of no interest. We might note that the European German-speaking countries (Germany, Switzerland, and Austria) have low inflation. This does not mean that if we all started speaking German, inflation would fall". A technical criticism of the structure of various CBI indices can be found in Mangano (1998).

   Cukierman, Webb and Neyapti (1992) (CWN hereafter), and Cukierman (1994) summarise the empirical regularities in the correlation between CBI on the one hand and inflation and economic growth on the other, as follows:

1. Among industrial countries, the legal CBI index introduced in CWN is negatively correlated with inflation, but the turnover rate (TOR) of central governors has no correlation with inflation.

2. Among developing countries, the legal CBI index of CWN is not correlated with inflation, but the TOR is significantly related to inflation.

   A number of authors such as CWN and Grilli, Masciandro and Tabellini (1991), GMT hereafter, have undertaken different types of research for a number of countries, including Greece, correlating CBI with various macroeconomic variables. Following a cross-section analysis, they found that more independence for the central bank is systematically associated with lower average inflation and less variable inflation. In GMT (1991), Greece is categorized as an industrial country, while in CWN, it is categorized as developing. In this paper we investigate which categorization is justified and compare the results with the findings of CWN for industrialized and developing countries.

   A time series approach is followed. (1) Our purpose is to highlight and investigate the relationship between CBI and inflation in the Greek economy over the last five decades using up-to-date data. This would be the last data available since Greece joined the EMU (Economic and Monetary Union) and the Central Bank (CB) participates in the European Central Bank (ECB). We update the legal index constructed by CWN and investigate whether the institutional setup of the CB makes a difference as far as inflation is concerned. Additionally, we study whether the stylized facts reported by CWN and GMT are justified.

   The paper is organized as follows: A brief historic note is presented in Section 2. Then, in section 3 is a description of the methods used to construct the Legal index for CBI, the turnover of the Central Bank governor and the inflation variable. The results of the empirical analysis are presented in Section 4 where we test whether CBI can explain the behaviour of inflation and its variability in Greece, and whether there exists Granger causality between the two variables in concern. In the last section there are some conclusions.

2. Brief history

   The Bank of Greece was founded on September the 15th, 1927 according to the Geneva Protocol, but it actually began operating May the 14th, 1928. Although the Statute of the Bank of Greece has been repeatedly amended, only recently its traditional operational framework changed (December 1997).

   Following liberation from foreign occupation in 1944 and the civil war, Greece's political and economic life was characterized by uncertainty and instability. From 1945 to 1953 five devaluations of drachma against dollar took place and at least four stabilization policies were introduced, none of which were able to accomplish stability and lower inflation. In 1953 a new monetary stabilisation programme was proposed which included the introduction of a new drachma (equal to 1000 "old" drachmas), the participation in the Bretton Woods system of fixed exchange rates and a 50 percent devaluation against dollar and all the currencies that were connected to it. The devaluation and the participation in the Bretton Woods system of fixed exchange rate, helped to maintain a 30 drachmas per dollar rate and low inflation until 1973. Monetary policy decisions were taken by the Currency Committee, which was formed in 1946. This was a powerful body whose mission was to control money supply, interest rates, drachma exchange rates and business credit. The Committee's President was the Minister of Coordination (responsible for the Economy) and its members included the Ministers of Finance (responsible for the Budget), Industry, Commerce and Agriculture and the Governor of the Bank of Greece (BoG). The policy guidelines laid by the Currency Committee were expected to be followed by the BoG and its governor was expected to resign when a new government was in office.

   Overall, the period between...