european journal of political economy volume 14 issue 2 1998 [doi...

European Journal of Political Economy .Vol. 14 1998 241263

Inflation culture, central bank independence andprice stability

Bernd Hayo )Department of Economics, Uniersity of Bamberg, Feldkirchenstr. 21, 96045 Bamberg, Germany

Revised 1 January 1997; accepted 1 May 1997

Abstract

This paper proposes that central bank independence alone is insufficient to explain lowinflation. It argues instead that central bank independence may be interconnected withpublic attitudes towards inflation via a historical feedback process that has led to ananti-inflation culture and public consensus on monetary stability in countries with lowinflation rates. Using survey data from European Community members over the period19761993, I find supportive evidence of the existence of a stability culture in low-inflationcountries. In their assessment of the importance of price stability, people living in countrieswith a low inflation record appear to be more sensitive to an increase in the actual inflationrate than people in higher-inflation countries. q 1998 Elsevier Science B.V. All rightsreserved.

JEL classification: E42; E31

Keywords: Inflation; Inflation culture; Central bank independence; European Community

1. Introduction

Price stability is a central issue in the discussion of European Monetary Union .EMU . Many of the studies in the literature on EMU use an institutional or

) Corresponding author at present address: Rheinische Friedrich - Wilhelms - Universitat Bonn, ZEI,University of Bonn, Walter-Flex-Str. 3, D-53113 Bonn, Germany, Tel.: q49 228 731878; fax: q49228 731809; E-mail: [email protected]

0176-2680r98r$19.00 q 1998 Elsevier Science B.V. All rights reserved. .PII S0176-2680 98 00006-8

( )B. HayorEuropean Journal of Political Economy 14 1998 241263242

game-theoretic framework to analyse the optimal design of a European Central . 1Bank ECB that would ensure stable prices. The German Bundesbank Law is

often cited as an example for the design of a ECB and has influenced the relevant .articles Article 105 and following in the Treaty of Maastricht: the Treaty

postulates an institution which is at least legally as independent as the Bundesbank .see Eichengreen, 1993 . Such independence is often considered as sufficient to

.overcome problems of time-inconsistency and seigniorage see Fischer, 1995 , .although McCallum 1995 argues that time-inconsistency and optimal contracts

are not the most important issues, but rather the independence of the central bankfrom everyday political pressures. In this paper, I will refer to this selection ofarguments, centering on central bank independence for achieving stable prices, asthe orthodox view.

The theoretical literature on the orthodox view is supported by empirical . .studies. Alesina 1988 and Grilli et al. 1991 investigate the causal relation

between the degree of central bank independence and the rate of inflation also see.Alesina and Grilli, 1992 , and observe that the greater the independence of a

countrys central bank, the lower its inflation rate. Similar results are obtained by .De Haan and Sturm 1992 .

Yet although this orthodox view prevails within mainstream macroeconomics,there remain some doubts in the profession that this is the whole story. 2

One strand of thinking within the orthodox view questions the exogeneity of .central bank independence. As suggested for instance by Cukierman 1994b , there

may exist political and economic factors influencing the degree of legal indepen-dence granted to the central bank. The main trade-off here is between credibilityand flexibility of monetary policy for the incumbent governing party. A lack ofcredibility results in expectations of rising prices, causing an inflationary bias inthe economy. The inflationary bias leads economic agents to adjust their behaviouraccordingly, with the outcome being higher interest rates and wage increases.Granting more independence to the central bank raises credibility, but reduces thediscretionary use of monetary policy by the government, and vice versa. Twohypotheses relating to the inflationary bias are tested by De Haan and vant Hag .1995 using cross-section data from 19 countries. First, they investigate therelationship between central bank independence as dependent variables and prox-ies for the inflationary biases as independent variables. Second, they test thehypothesis that governments planning to incur higher deficits may wish to increasecredibility, to reduce the interest premium associated with expectations of highfuture inflation rates. No supporting evidence is found for either of the two

1 . . . .See, e.g., Bean 1992 , Cukierman 1994a , Treutler 1993 , von Hagen and Suppel 1994 .2 Obviously, I build up some kind of straw-man for a better focus of the discussion. As everyday

experience shows, most economists are not that fundamentally oriented anyway.

( )B. HayorEuropean Journal of Political Economy 14 1998 241263 243

hypotheses relating central bank independence and inflationary bias. This suggests .that the story of Cukierman 1994b may not suffice to explain why some

countries have independent central banks and low inflation rates, and others donot.

.A different approach, set out for example by Posen 1993 , questions thecredibility of the mainstream answer as to why central bank independence causeslower inflation rates. His view is that political interest groups have specificinflation preferences, in particular the interest of the financial sector lies inkeeping inflation low. Posen thus proposes that it is inappropriate to focus oninstitutional design in the creation of independent central banks, while neglectingthe political self-interest calculations. Hence the political-interest group hypothesisis a challenge to the economic orthodox view. But there clearly exist problems inidentifying agents preferences. Does the financial sector indeed benefit from lowinflation rates? There are of course the usual collective action problems as well.Changes in the structure of the financial sector should influence its effectivenessas a lobbying group, which should then be revealed by fluctuations in inflation

.rates. Based on some empirical tests, De Haan and vant Hag 1995 also raisedoubts about the generality of Posens claims.

Another approach, associated with political business cycles, suggests that .central banks, even if ostensibly independent, can be captured. Vaubel 1997

proposes that since overseers of central bank policy are political appointments,central bank policy may be politicised. Vaubel presents evidence with regard to

.the Bundesbank, which is critically evaluated by Berger and Woitek 1997 . Sieg .1997 formulates a formal model of such opportunistic behaviour by a capturedindependent central bank.

The approach which I wish to consider here takes as its point of departure a stilldifferent literature which points to a deep-rooted aversion to inflation in the

.population see, for example, Bofinger, 1992 or Treutler, 1993 . It is argued, forexample, that the experience of two hyperinflations during the 20th century havecreated a strong fear of inflation in the German population. The correspondinghypothesis is that peoples preferences with respect to price stability matteratleast in Germanyin explaining low inflation rates.

. Collins and Giavazzi 1993 try to identify different inflation preferences in the.form of attitudes in Europe. Using time-series data of inflation and unemployment

expectations to explain the publics assessment of the overall economic situation,they attempt to measure the corresponding weights of a widely used economic loss

.function see, e.g., Barro and Gordon, 1983 . They claim that in the 1980s astructural change occurred in the weights, towards increased preferences for lowerinflation. Moreover, they propose that their results indicate convergence of publicattitudes on inflation in Europe over time. Their approach and findings are

however controversial and not without critics see Fratianni, 1993; Thygesen,.1993 .

In this paper, I maintain only some parts of the orthodox framework, but


emphasise instead the role of a consensus on attitudes towards inflation. 3 Thealternative hypothesis put forward is based on the idea of a specific inflationculture in the respective societies. This will allow for a somewhat different and,

.arguably, more convincing reading of the various inflation histories of Europeancountries. The formal-institutional design of a central bank is thus only one aspectof a stability regime, to be supplemented with public attitudes towards the goal ofprice stability in explaining inflation differentials among countries, and publicperception that price stability is important becomes a significant precondition forachieving a low inflation rate.

The empirical literature on central bank independence cannot be used tocontradict this position, since it cannot by itself answer the crucial question of

..causality see also Forder 1996 . That is, is the prime reason for low inflation anindependent central bank? Or is it the case that countries with a population whichplaces a high value on price stability have designed their central banks accord-ingly?

With regard to the EMU, the implication is that ECB independence is notenough to achieve low inflation rate in Europe. A public consensus on the need forprice stability is required to make the formal independence of a central bankeffective. In the absence of such a consensus, interest groups may influencemonetary policy or decision makers may interpret fixed objectives as soft con-

. 4straints e.g., when is price stability endangered? .My principal aim is to cast doubt on the adequacy of the orthodox model as a

sufficient interpretation of recent monetary history. 5 The data sources are Euro-pean public opinion polls on how people in the different countries of the European

. Community EC value price stability annual observations from 1976 to 1993.taken from the Eurobarometer surveys . In Section 2 I consider the relationship

between the orthodox and my model, and present possible transmission mecha-nisms from preferences to monetary policy. Section 3 explains the research design,provides a short summary of the data, and compares the importance of inflation inthe members of the EC. Section 4 investigates the relation between the inflationgoal and actual inflation rates using alternative estimators. Section 5 discusses the

3 For convenience, preferences and attitudes are used interchangeably, though in principle, I regardattitudes as empirically measurable proxies of preferences.

4 From a different perspective, the importance of preferences towards inflation is stressed by .Morales and Padilla 1995 . Based on their theoretical model, they maintain that a majority voting

procedure in the governing council of a ECB leads only to an efficient outcome, if the members havesimilar preferences on monetary policy. If one assumes, as is usually done, that the members of thegoverning council reflect the public view towards inflation that prevails in their home countries, thenlooking at the preferences of people in Europe might be important in this respect too.

5 For the sake of simplicity, I do not take into account that inflation is not just a monetaryphenomenon and that it is influenced by other factors as well. I would maintain, though, that monetaryfactors are generally the most important ones, at least in the longer run.


relation between my results and indicators of central bank independence. Section 6provides a summary and suggests directions for further research.

2. Price stability, inflation culture and central bank independence

The attraction of the orthodox model lies in its combination of rigoroustheoretical foundations and empirical support, and that there is no other equallycoherent theory to explain diverging inflation records in the literature. I willtransform the orthodox view by placing public attitudes towards inflation at thecentre of the argument.

The rationale for my public-preference explanation is based on how centralbank independence and public attitudes towards inflation fit together. A straight-forward interpretation regards the independence of a central bank as a means toachieve the goal of low inflation rates as embodied in peoples preferences. Thistype of interpretation seems to be, at least implicitly, present in many specifica-

tions of public objectives functions in the literature e.g., Barro and Gordon, 1983.or Cukierman, 1992 . I refer to this as the preference-instrument interpretation,

and it can be regarded as being built on the literature on economic policy in ademocracy and political business cycles. 6 Two main submodels based on thepreference-instrument view can be identified.

In an election-oriented scenario, we assume that people havefor whateverreasona preference for low inflation. The voting process allows people toexpress their preferences for low inflation, either directly or indirectly. In the

former case, voters would directly elect the central bank governor see Downs,.1957 . In the latter case they elect a government with low inflation policies

.political parties as described by the partisan view, see Alesina, 1988 , and thegovernment appoints a conservative central banker who chooses an independent

. 7anti-inflation monetary policy as envisaged by Rogoff 1985 and others.A constitutional-oriented approach emphasises the institutional setting of the

central bank. We can assume a contract-based scenario, or a more evolutionaryone. In the contract-based scenario, we can imagine people deciding on thecreation of a central bank while being in, following the phrase used by Rawls .1971 , the original position. If the publics preferences favour low inflation,people will choose an independent central bank removed from direct politicalpressures, like demands for financing higher government expenditures via increas-ing the money supply. In the evolutionary constitutional scenario, people alsovalue the achievement of price stability from the beginning, but because ofdifficulties in understanding complexities of inflation, it takes some time for

6 . .A recent introductory summary of this literature is given in Keech 1995 ; also see Frey 1983 .7 Preferences of voters may determine the weights of an economic policy welfare function as

.assumed in most of the models in the tradition of Barro and Gordon 1983 .


people to get to know the usefulness of different instruments. From the alternativemeans tried over time, an independent central bank evolves as the bestat leastfor the momentway of keeping inflation low.

The question is whether the preference-instrument interpretationbased on oneof the above transmission mechanismsis a satisfactory explanation of prefer-ences for low inflation. An important problem with the preference-instrumentinterpretation is its clear-cut causal chain from preferences to outcomes. But it isby no means obvious why preferences towards price stability should exist au-tonomously, especially since even professional economists do not fully understandthe phenomenon and consequences of inflation. It seems unlikely that people haveinflation genes that determine their preferences. Preferences about price stabilityare rather part of the economic culture of a country, which is influenced byhistorical experience. Economic culture is defined here as the values and attitudesof a population on all aspects related to the economic system. 8 Consequently, thesub-concept of an inflation culture attempts to capture the values and attitudespeople have with respect to the economic phenomenon of inflation.

For example, in the case of Germany it is often argued that peoples attitudes .are affected by experience with high inflation. De Haan and vant Hag 1995

attempt to capture this by showing that countries with high inflation rates duringthe period 19001940 are more likely to create an independent central bank lateron. Aversion to inflation may have its origins in past times of hyperinflation.However, historical circumstances in themselves are not enough. The collectiveeconomic history of a population must be translated into an economic culture.Indeed, the historical evidence, even for Germany, indicates that central bankindependence does not reduce inflation as long as there exists no public consensuson the primacy of this policy objective. 9

Therefore, I propose a different integration of the orthodox model and peoplespreferences, a transmission mechanism which allows for a feedback relationshipbetween the institutional framework of the central bank and attitudes towardsinflation. A historical-feedback interpretation assumes a world of change, whereneither preferences nor institutional structures are fixed, and the two elements canreinforce one another. An explanation for the creation of independent centralbanks based on such an historical-feedback interpretation runs along the followinglines. From their everyday experience, people perceive that inflation is bad, for

8 .This reflects the seminal definition by Almond and Verba 1963 for the concept of a politicalculture.

9 For example, in Germany, the directorate of the Reichsbank was given independence through the .Autonomiegesetz from 26 May 1922 see, e.g., p. 160 and following of Pfleiderer, 1976 . However,

hyperinflation increased further since the directorate considered the monetization of national budgetdeficits as a necessity. Interestingly, the independence was granted due to pressure from the reparationcommission, which acted in the interest of the victorious countries of World War I. Thus it cannot beunderstood as a reform law based on a public consensus in Germany.


instance by having to adjust their spending behaviour to ever rising prices. Theythink of ways to achieve more stable prices in a complex world, under conditions

where economic policy is subject to short-run political pressures cf. the interest-.group argument of Posen, 1993 . In view of the interest groups, society may wish

to tie its own hands with respect to short-run policy considerations. A solution isto create an independent central bank committed to stable prices. Although such an

institution may achieve a somewhat lower rate of inflation and here is the.orthodox aspect , it will not be able to undertake a firm monetary policy without

public support. Over time, people begin to give credit to the independent centralbank for achieving lower inflation, especially if real costs of a stable anti-infla-tionary monetary policysuch as lower economic growth or more unemployment

.are low on average: Grilli et al. 1991 , for example, show that countries with arelatively low inflation rate do not seem to experience corresponding output losses,

.and Alesina and Summers 1993 conclude that there exists no obvious, directrelation between central bank independence and income growth, unemployment orinterest rates. Such outcomes strengthen peoples beliefs that fighting inflation isworthwhile, which again feeds back to increase support for an independent centralbank. Support for the independent central bank as an institution increases policyeffectiveness and the inflation rate can be further stabilised, and so forth. Theoutcome is a consensus on price stability within the inflation culture of acountry. 10 As long as there are no exogenous shocks, society will support theanti-inflationary policies of an independent central bank, even if this harms somepeople in some circumstances. 11 Seen within this framework, an independent

central bank need not be viewed as an undemocratic institution cf. p. 1443 and.following of Cukierman, 1994a , even if voters have no direct control over

monetary policy.However, can a stability consensus be achieved? In p. 422 and following,

.Cukierman 1992 presents, for instance, a finding that the empirical relationshipbetween central bank independence and inflation is much weaker in developingcountries. He interprets this as due to a high turnover-rate of central bankgovernors, reflecting a weakening of legal central bank independence by highactual inflation. I interpret the empirical relationship differently, namely that a

.consensus within society on the importance of fighting inflation has not yet beenachieved in these countries. The performance of independent central banks has notbeen impressive enough for people to support stabilising monetary policies, and,due to a number of rigidities, monetary stabilisation in these countries induces

10 This type of mechanism offers connections to the literature on political culture and constitutional .economics. As an example of the former, see the influential work by Lipset 1988 , where he attempted

to divide political support into aspects of legitimacy and efficacy. For the constitutional approach to .economics, see Buchanan 1977 .

11 This does not, of course, exclude the possibility that everyday politics influences such an .institution. Again we can point to the view presented by Posen 1993 .


high real costs, at least in the short-run, which works against the stabilityconsensus. 12

Some of the countries in the empirical analysis which follows have more or lesstied their currencies to the German Mark, notably the Netherlands. One may arguetherefore that the Netherlands imports price stability via the exchange rate and notthrough central bank independence. This argument does not constitute a problem

.for my hypothesis. The exchange rate link external anchor is just another way tofoster price stability. But it is only sustainable because it is supported by amajority of people in the Netherlands who believe that fighting inflation isimportant.

To conclude, even if one is not persuaded that attitudes towards inflation andcentral bank independence are interrelated, it is apparent that we know less aboutthese issues than the economists talking solely of time-consistency problems andcentral bank reputation would have us believe. What needs to be stressed is notthat these issues are generally irrelevant for understanding inflation, but rather thatthey cover only some parts of the story, and perhaps not the most important partsfor explaining differences in inflation rates across countries.

Section 3 is concerned with the construction of an empirical indicator for theimportance people in the EC member states place upon the achievement of lowinflation.

3. Database and descriptive analysis

.The database consists of public opinion polls Eurobarometers from 1976 to1993 in nine countries of the EC. For Greece we have observations since 1980 andfor Spain and Portugal from 1985 onwards. From the often large surveys, we focuson the so-called Inglehart Index, which attempts to measure the change in peoples

.values. Four goals of a state are presented to the respondents: 1 Maintain order, . . .2 More democracy, 3 Fighting rising prices, and 4 Protecting freedom ofspeech. 13 The respondents are asked to name the goal which they consider to bethe most important for their country in the long-run. In another question, theychoose the goal which they consider to be of second priority.

The goal of inflation is measured relative to the other objectives. One couldargue that this is a disadvantage, since we are interested in an absolute indicator of

12 .Cukierman 1992 does not propose simple causal explanations like my sketch of the orthodoxview. On the other hand, in his account of central bank independence on p. 445, a mechanism as

.outlined above is not discussed. However, towards the end of his book p. 455 , he mentions theconsensus within a society as a possible influence on successful stabilisation programmes in countriessuch as Argentina or Brazil.

13 A detailed discussion of the two positions, materialism and postmaterialism is given, e.g., in . . . . .Inglehart 1977 . The items 1 and 3 should capture materialist thinking and 2 and 4 postmaterial-

ist ideas.


importance of the inflation goal. But it is unlikely that a question like howimportant do you consider the achievement of price stability? will yield moreinsight. In answering this type of question, people experience no sanctions; it is asoft question. Although the Inglehart Index does not really use hard questions,it entails at least a trade-off. People have to decide on a specific item. If theychoose inflation, it is at the expense of other goals. Importance can a priori only bemeasured on a relative scale, and the Inglehart Index sets out the underlying scale.

One potential problem with this framework is that an abnormal situation in acountry might bias peoples decisions. Since we cannot allow for special circum-stances, apart from actual inflation, we confront possible measurement errors. Anexample is Northern Ireland, where people put a much stronger emphasis onmaintaining order than in other countries. It is clear that the political situation inthis region cannot be called normal and I have excluded observations fromNorthern Ireland from the analysis. 14

We also cannot be sure whether people, when naming the fight against inflationas the first priority, express their aversion to rising prices or just their dislike of

.decreasing real incomes. As argued by Cukierman 1996 on p. 22, it may be thecase that historical experiences of high inflation only lead to institutional reformsif they were accompanied by large losses in real income. The data at hand do notpermit us to disentangle these conceptually different types of motivations.

Another problem is the selection of alternative goals given in the question.Maybe these are not the most significant goals. Then, even if people say that thefight against inflation should be the first priority, it may not be worth much, sincethe importance of the inflation goal is measured against low-valued alternatives.For instance, it would have been interesting to have unemployment as an

. .alternative item. However, Hibbs 1979 and Fischer and Huizinga 1982 reportthat inflation is perceived by the U.S. population as a more important issue thanunemployment. I maintain that the above goals are useful and any bias introducedthrough this channel is likely to be small.

In the following sections I refer, for reasons of brevity, to the importance of theinflation goal, but what is actually meant is the relative importance of fightingrising prices versus the other objectives. I will look at two types of variables. Oneis the share of people who consider price stability as the most prominent long-termgoal. The other includes the share of respondents who either believe fightinginflation is the first or second most important objective. 15 The second variablemight give a more stable measure over time, since it is less influenced by currentevents than the first.

14 In any case, including the appropriately weighted observations on Northern Ireland to the onesused here for Great Britain does not change the country average very much.

15 See Tables A1 and A2 in Appendix A for a summary of the shares of the inflation goal in publicopinion.


.Fig. 1. Development of share of people in % who consider the fight against inflation as the mostimportant goal of the state.


Table 1 .Mean in % and standard deviation of the share of people who consider the fight against inflation as

. ..the most important goal 19761993, Greece 19801993 , Spain and Portugal 19851993Fra Bel Net Ger Ita Lux Den Ire GB Gre Spa Por1 1 1 1 1 1 1 1 1 1 1 1

Mean 30.8 40.8 15.7 19.4 23.0 23.1 13.3 34.6 24.1 32.0 19.8 38.1Standard deviation 3.9 7.9 6.0 8.5 4.4 9.2 5.2 7.2 7.8 4.5 2.8 4.5

Variables containing only the fight against inflation as a first priority aremarked with an index 1, e.g., Fra stands for the share of people in France who1consider keeping prices stable as the most important long-term goal of the state.Correspondingly, variables including people who say the inflation goal is their firstor second priority, are indexed by 12, e.g., Ger denotes the share of the public12in Germany which believes that anti-inflation policy should be either the first orthe second most important objective.

In Fig. 1, the indicator for the importance of inflation in the EC countries is .plotted over time. Nine graphs Greece and Spain excluded suggest a negative

trend. In Greece and Spain the series looks stationary. A similar structural pictureemerges if we look at the variables containing first and second priorities. Todescribe the series in somewhat more detail, we find in Table 1 the mean andstandard deviations for the top priority variables. On average, about 25% of the

people in these European countries without taking account of the relative popula-.tion size considered the fight against rising prices to be the most important goal

of the state. The inflation objective plays a relatively prominent role in Belgium,Portugal and Ireland, but is relatively unimportant in Denmark, the Netherlandsand Germany.

Table 2 gives the corresponding numbers for the variables containing first orsecond priority. Here the simple mean across the EC countries is about 57%, i.e.,more than one half of Europeans believe that the fight against rising prices shouldbe the first or second priority of the state. The highest proportion is found inPortugal, followed by Greece and Belgium. Once again in Denmark, the Nether-lands and Germany less importance is placed on this objective.

These results do not indicate that the absolute shares reflect the actual inflationperformance of the countries. It rather seems to be the case that the weight given

Table 2 .Mean in % and standard deviation of the share of people who consider the fight against inflation as

. ..the first or second priority 19761993, Greece 19801993 , Spain and Portugal 19851993Fra Bel Net Ger Ita Lux Den Ire GB Gre Spa Por12 12 12 12 12 12 12 12 12 12 12 12



Table 3 .Mean and standard deviation of inflation rates in the EC 19761993, Greece 19851993 , Spain and

..aPortugal 19841993FraIn BelIn NetIn GerIn ItaIn LuxIn DenIn IreIn GBIn GreIn SpaIn PorIn


. .Source: OECD Economic Outlook 1988 and OECD Economic Outlook 1995 .a The numbers given for mean and standard deviation are based on an arithmetic mean. The use of the .correct geometric mean would not change any of the following results

to the goal of stable prices is relatively small in countries with a low inflation rateand vice versa.

To make this point, in Table 3 the inflation averages of the EC countries arerecorded. 16

One can showthe actual numbers are omitted herethat there exists asignificant positive correlation between the importance of the goal of pricestability and actual inflation performance. Since it does not make any sense topostulate a theoretical relation where a higher importance of the inflation goalleads to higher inflation, it is presumably actual inflation that drives public opinionon this issue. Hence in Section 4 we investigate the influence of actual inflation onthe two importance variables.

4. Importance of the inflation goal and actual inflation

It is interesting to assess the effect of actual inflation on the public opinionvariables. We would like to obtain a fundamental indicator of priorities, indepen-dent of everyday changes in inflation. To achieve this, we regress the importance

. .variables on actual inflation. The basic estimated equations are Eqs. 1a and 1b :

Importance sa qb Inflation qu 1a .1it 1 1 it 1it

Importance sa qb Inflation qu 1b .12 it 12 12 it 12 it

where: isFrance, . . . , Portugal; Importance sshare of people who consider the1itfight against inflation as the first priority of the state; Importance sshare of12itpeople who consider the fight against inflation as the first or second priority of thestate; u and u swhite noise error terms.1i 12i

16 The numbers given for mean and standard deviation are based on an arithmetic mean. The use of .the correct geometric mean would not change any of the following results.


Two interpretations of the regressions can be considered: First, we could arguethat the intercepts a and a capture the fundamental evaluation of the inflation1 12goal. If this explanation were correct, the orthodox view would imply that weshould not find any pattern in the data with respect to the estimators for theconstant term. My hypothesis would argue that the countries with a low inflationrate should instead have a larger constant term than the high-inflation countries.

Second, we could concentrate on the sensitivity of the importance variableswith respect to actual inflation by looking at the estimates of the slope parametersb and b . The orthodox view would maintain that there should not be any1 12significant differences in the parameters, whereas my hypothesis predicts higherparameter estimates for the low inflation countries.

Table 4 summarises the estimates of the importance variables. The t-testsindicate highly significant parameter estimates. For both importance variables, theresults are very similar. A glance at the intercept estimators makes clear thatcountries with a high constant term are those countries exhibiting high inflation.Neither the orthodox nor my hypothesis are supported by this measure. The use ofthe a and a parameters does not appear to be successful. 1 12

With respect to the slope parameter, we do find an interesting relation:Countries with a relatively low inflation rate tend to have a higher slope parameterestimate. This result contrasts with a naive version of the orthodox view andcorresponds to what one would have expected under my alternative hypothesis. Inother words, countries where the population reacts rather sensitively to an increasein the inflation rate are performing better in keeping prices stable. This resultpoints to a stability consensus within the economic culture of low-inflationcountries.

Table 4OLS-regression of first priority on inflation and first and second priority on inflation 19761993,

. ..Greece 19801993 , Spain and Portugal 198519932 2

State a b R DW State a b R DW 1 1 12 12Fra 18.4)) 1.81)) 0.69 0.7)) Fra 46.7)) 2.05)) 0.75 0.9))1 12Bel 30.8)) 2.09)) 0.49 0.6)) Bel 59.2)) 2.06)) 0.47 0.6))1 12Net 8.3)) 2.09)) 0.79 1.0) Net 27.0)) 3.59)) 0.72 0.6))1 12Ger 8.7) 3.28)) 0.44 0.3)) Ger 28.8) 5.81)) 0.52 0.3))1 12Ita 16.2)) 0.62)) 0.68 1.5 Ita 45.0)) 1.28)) 0.73 1.0)1 12Lux 14.7)) 1.78) 0.32 0.4)) Lux 39.7)) 2.84)) 0.35 0.5))1 12Den 4.9)) 1.30)) 0.84 1.5 Den 17.2)) 3.4)) 0.84 1.21 12Ire 27.4)) 0.82)) 0.54 1.0) Ire 59.4)) 0.92)) 0.53 0.7))1 12GB 11.9)) 1.47)) 0.87 2.1 GB 36.5)) 1.82)) 0.84 1.91 12Gre 25.5)) 0.34 0.08 1.9 Gre 61.8)) 0.43 0.14 1.81 12Spa 19.6)) 0.04 0.0004 2.6 Spa 45.9)) 1.35 0.16 1.41 12Por 27.6)) 0.92) 0.56 0.6)) Por 70.1)) 0.33 0.13 1.01 12

)Rejection of the null hypothesis at the 5% significance level.))Rejection of the null hypothesis at the 1% significance level.


The finding that all of the slope coefficients are positive could also be regardedas in accord with the often-found quadratic specification of the public objective

function within the framework of the orthodox view e.g., Barro and Gordon, 1983.or Cukierman, 1992 . The implication is that a societys aversion to inflation rises

with the inflation rate. However, typically preferences are assumed to be given inthese models andas has been outlined abovethis cannot be considered asatisfactory explanation for the existence of differing inflation rates and thecreation of independent central banks across countries.

To analyse the robustness of the estimates, diagnostic tests were performed, .namely the DurbinWatson test DW , an LM-test for autocorrelation of first and

second order, an LM-Test for ARCH, a test for normality, the White-test forheteroskedasticity, and the RESET-test. The DW test statistics are given in thetable, while most of the other tests, which do not indicate a serious problem, havebeen omitted. However, the DW statistics point at first-order autocorrelation for anumber of regressions, which, even if OLS continues to be unbiased, invalidatesthe tests of significance.

To account for that problem, the same regressions were reestimated allowing . . .for an autoregressive error term RALS . The error term in Eqs. 1a and 1b is

now assumed to be of the form u sd u q and u sd u q ,1it 1 1it 1 1t 12it 12 12it 1 12twith and being white-noise errors. The results are displayed in Table 5. It1t 12tis clear that the estimates with low DW-statistics in the OLS-regression have asignificant autoregressive error term. Substantial changes in the slope parameterestimates can be found, especially for Belgium and Luxembourg and in theintercept for Belgium and Denmark. In general, the RALS-estimators of the

Table 5RALS-regression of first priority on inflation and first and second priority on inflation 19761993,

. ..Greece 19851993 , Spain and Portugal 198419932 2

State a b d Pseudo R State a b d Pseudo R 1 1 1 12 12 12Fra 19.2)) 1.49)) 0.52) 0.83 Fra 47.4)) 1.80)) 0.46) 0.841 12Bel y8.8 0.41 0.98)) 0.78 Bel y952.2 0.10 0.99)) 0.821 12Net 9.3)) 1.3) 0.70)) 0.81 Net 21.8 2.05) 0.90) 0.861 12Ger 5.04 1.57) 0.90)) 0.89 Ger 27.3 2.82) 0.89)) 0.911 12Ita 16.3)) 0.59)) 0.20 0.67 Ita 47.4)) 0.92) 0.72)) 0.801 12Lux 11.9 0.16 0.84)) 0.79 Lux 32.9 y0.02 0.89)) 0.841 12Den 5.0)) 1.27)) 0.23 0.84 Den y851.8 0.77 0.99)) 0.881 12Ire 27.8)) 0.33 0.78)) 0.61 Ire 45.3 0.24 0.94)) 0.721 12GB 11.4)) 1.53)) 0.13 0.85 GB 35.9)) 1.93)) y0.04 0.841 12Gre 27.5)) 0.21 y0.19 0.04 Gre 64.4)) 0.27 0.02 0.061 12Spa 20.3)) y0.11 y0.35 0.14 Spa 54.3)) y0.26 0.43 0.221 12Por 27.6) 0.55 0.84) 0.72 Por 73.6)) y0.10 0.55 0.341 12

)Rejection of the null hypothesis at the 5% significance level.))Rejection of the null hypothesis at the 1% significance level.


Table 6 .SURE-regression of first priority on inflation and first and second priority on inflation 19761993

State a b s State a b s 1 1 12 12Fra 20.4)) 1.51)) 5.31 Fra 48.6)) 1.79)) 5.081 12Bel 31.4)) 1.96)) 5.91 Bel 62.2)) 1.43)) 6.051 12Net 8.5)) 2.03)) 2.82 Net 28.3)) 3.22)) 5.991 12Ger 8.3)) 3.4)) 6.53 Ger 29.1)) 5.71)) 9.771 12Ita 16.2)) 0.62)) 2.59 Ita 48.1)) 0.99)) 4.991 12Den 4.6)) 1.33)) 2.12 Den 20.4)) 2.93)) 5.861 12Ire 28.1)) 0.74)) 5.07 Ire 62.5)) 0.56)) 6.211 12GB 11.9)) 1.46)) 2.90 GB 36.6)) 1.81)) 3.991 12log-like y116.02 log-like y161.64

. .VecAR 11 1.45 VecAR 11 1.61VecNorm 19.6 VecNorm 20.9

)Rejection of the null hypothesis at the 5% significance level.))Rejection of the null hypothesis at the 1% significance level.s is the standard error of the respective equation, log-like the value of the log-likelihood function forthe system.

sensitivity parameters are lower than their OLS-counterparts. Therefore, the forceof the OLS-results seems to be somewhat reduced but not necessarily contradicted.

We cannot be sure that by using RALS we have treated the cause of theautocorrelation. Other possible reasons, like omitted variables or a lacking dy-namic adjustment, may be important too. Since the sample size is very small, thereis no scope to estimate a dynamic model with any precision. Accordingly,preliminary tests with first-order lags indicate that in some cases the autocorrela-tion cannot be fully removed from the residuals.

An analysis using unit-root tests and graphical inspection of the spectrum pointstowards possible non-stationarity in the series. Since the sample size is much toolow to distinguish between the processes, no detailed analysis will be presented. 17

. .Repeating the regressions in Eqs. 1a and 1b for the variables in first-differencesleads to similar results as in the RALS-estimation. Only the coefficients for theNetherlands, Germany, and Great Britain turn out to be significant. One shouldnote that the interpretation of the regression in differences would entail a reactionof the change in inflation attitudes caused by a change in actual inflation.

.However, Hibbs 1979 on p. 725 presents results showing that the respondentslook at the level of inflation when forming their attitudes, and not at the changes inthe growth rate of prices. The correlations between actual inflation rates and

17 .See, for example, the survey by Campbell and Perron 1991 and especially the comments by . .Cochrane 1991 and Miron 1991 .


estimated parameters from the equations in differences are somewhat higher than . 18the ones computed for the RALS-regressions given later in Table 7 .

Further analysis of the OLS-residuals reveals contemporaneous correlationamong the residuals from the different equations. To enhance the efficiency of the

estimates, the SUR-estimator has been employed see, e.g., p. 363 and following.of Darnell, 1994 . In Table 6, the SUR-estimates for only eight countries are given

to avoid degrees-of-freedom problems. The resulting parameter estimates aredifferent but still relatively close to the OLS-estimates. While we do not discover

.. .autocorrelation VecAR 11 or non-normality VecNorm for the vector ofresiduals, we find evidence of first-order autocorrelation for all of the single

.equations not given in the table , and thus are still confronted with a possible biasin the variance estimators.

5. Evaluating the results with respect to central bank independence

To summarise the discussion of the previous sections, I will demonstrate howthe estimated indicators relate to the indices of central bank independence used inthe literature. The utilised indicators for central bank independence have beenproposed by the following: Bade, R. and Parkin, M., 1982 in Central Bank Laws

. .and Monetary Policy unpublished , Grilli et al. 1991 on p. 366, and Alesina and . .Summers 1993 on p. 154. As is described by Cukierman 1992 on p. 422, his

index for legal independence is very similar to these indicators. Therefore, we donot explicitly consider Cukiermans index in the following analysis.

While Bade and Parkin and Alesina and Summers try to construct an overallindicator of central bank independence, Grilli et al. distinguish between political

.and economic independence. Political independence PolIn is defined as theautonomy of the central bank to pursue a policy of price stability without being

.influenced by the government. Economic independence EcoIn reflects the abilityof the central bank to select its monetary policy instruments. The index of Alesina

. .and Summers AleSu is a combination of Bade and Parkins Bade and Grilli etal.s index.

In Table 7, correlation coefficients between the estimated indicators for impor-tance of the inflation goal and the average inflation rates are calculated. As isusually the case, the Spearman rank correlation estimates are lower than the onescalculated using Pearsons statistic.

From the table, we can draw the following conclusions.fl The central bank indices are negatively correlated with the average inflation

rate. A significant correlation exists only for economic independence.

18 More information about the estimation in differences can be obtained from the author uponrequest.

()

B.Hayor

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ofPoliticalEconomy

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Table 7 .Pearsons and Spearmans correlation coefficients between central bank independence and the OLS-estimators OLS , OLS for importance of the inflation1 12

. . .goal, the SUR-estimators SU , SU , the RALS-estimators RA , RA and average inflation Inflat1 12 1 12PolIn EcoIn Bade AleSu OLS OLS SU SU RA RA Inflat1 12 1 12 1 12

PolIn 1 0.18 0.52 0.68 0.48 0.72) 0.44 0.65 0.39 0.62) y0.41EcoIn 0.01 1 0.74) 0.66 0.82)) 0.74)) 0.78) 0.59 0.59 0.54 y0.72)Bade 0.24 0.87)) 1 0.96)) 0.91)) 0.90)) 0.92)) 0.91)) 0.65 0.75) y0.55AleSu 0.52 0.65 0.90)) 1 0.84)) 0.98)) 0.89)) 0.99)) 0.61 0.72) y0.62OLS 0.18 0.80)) 0.88)) 0.76) 1 0.84)) 0.99)) 0.84)) 0.74)) 0.77)) y0.67)1OLS 0.47 0.77)) 0.85)) 0.95)) 0.78)) 1 0.89)) 0.99)) 0.69) 0.77)) y0.73)12SU 0.22 0.68 0.80) 0.67 0.99)) 0.83)) 1 0.89)) 0.53 0.66 y0.87))1SU 0.44 0.49 0.80) 0.95)) 0.69 0.90)) 0.74) 1 0.68 0.75) y0.74)12RA 0.28 0.56 0.79) 0.68 0.76)) 0.64) 0.57 0.79) 1 0.90)) y0.471RA 0.56 0.41 0.71) 0.69 0.63) 0.64) 0.55 0.76) 0.87)) 1 y0.4612Inflat y0.38 y0.72) y0.52 y0.60 y0.69) y0.91)) y0.93)) y0.81) y0.40 y0.37 1

Pearsons correlation coefficient is given above and Spearmans below the main diagonal.)Rejection of the null hypothesis at the 5% significance level.))Rejection of the null hypothesis at the 1% significance level.


fl The estimated indicators for the importance of price stability are alsonegatively related with the inflation rate. Except for the RALS-estimates of thesensitivity parameters, all correlations are statistically significant.

fl The highest correlation coefficient with average inflation is computed forSURE . 19 Then we have the OLS-estimators and economic independence. The12lowest correlations are found for RALS-estimators and political independence.

fl The indicators for economic and political independence of the central banksare positively correlated with the estimated sensitivity parameters. In most cases,though, this correlation is not significant.

In Section 6, these findings are put into a broader perspective.It is tempting to include the competing variables together in a regression model

to assess their respective shares in explaining the variation of the inflationvariable. Unfortunately, the number of observations is much too small for mean-ingful results from a multivariate analysis involving these highly collinear vari-ables.

To summarise the results of such an analysis, most of the central bank indicesare insignificant and often display a positive sign when put together with asensitivity estimator in a regression. The coefficients on the sensitivity estimatorsare typically more often significant and exhibit a negative sign. This finding doesnot hold in the case of the index variable capturing economic independence, whichtends to be as equally important as the sensitivity estimators, as long as anintercept is included in the model. In a model without an intercept term, thesensitivity estimators show again higher t-values and the expected negative sign ofthe coefficient.

6. Conclusions

We are faced with the problem of observational equivalence, since the empiri-cal results are consistent with both the orthodox and economicculture hypothesis.However, previous findings for the orthodox hypothesis have only been replicated,while the evidence in favour of the economicculture hypothesis is new.

As discussed above, the observation of a negative relation between central bankindependence and inflation rates does not imply causality. Moreover, the empiricalresults do not exclude different stability cultures in the EC countries as the primeunderlying explanation for observed outcomes. That the sensitivity estimates aremore highly correlated with the inflation rate than the independence indices raisesfurther doubts about the dominant role given to the independence argument in theliterature.

19 This is due to the fact that only eight countries are included in the SURE-estimate. Computing allcorrelations for these countries only brings out the OLS-estimators as having the highest correlationwith average inflation.


Still, we cannot conclude that public opinion is the most important key toexplaining different national inflation records. There may be reverse causation. Itcould be the case that the design of the central bank influences peoples assess-ment of the importance of keeping prices stable. In other words, people couldconsider the inflation goal to be of greater importance, if it were demonstrated tothem that the achievement of stable prices is feasible. But this brings us back tothe historical-feedback interpretation sketched above, only with more emphasis oncentral bank independence.

As outlined in Section 2, a hypothesis based on publics preferences opens uptwo competing interpretations of how central bank independence and preferenceshang together, the preference-instrument and the historical-feedback interpretation.Statistical causality analysis could help to shed some light on which of thepositions are preferable on empirical grounds. The finding of a two-way causalitybetween attitudes on inflation and central bank independence would accord withthe feedback-mechanism, while a unidirectional causality from attitudes to thelegal basis of central banks would support the preference-instrument view. No-causality relations would fit into the orthodox view.

Given the restraints of the data, we cannot meaningfully investigate Granger-causality relationships. We cannot even trust Granger-causality tests betweenactual inflation and attitudes, since the test is very weak for small samples andthere are no degrees of freedom left to perform a specification search over

.different lag length see, for example, Thornton and Batten, 1985 . On the otherhand, few philosophers would accept Granger-causality as a true representation of

.causality anyway cf. Holland, 1986 . Still, with more data at hand, furtherinvestigations along these lines could be interesting.

We can nonetheless try to say something on this issue using a more heuristicapproach. From the results given in Table 7, it can be seen that there sometimesexists a high positive correlation between the indices for central bank indepen-dence and the sensitivity indicators. This suggests that a large amount of variationis common to both types of variables. If a correlation coefficient between centralbank indices and sensitivity parameters is not that high, for example in the case ofOLS and political independence, the correlation between the latter and average1inflation tends to be rather low. A possible explanation for this finding is thatformal and actual independence can drift apart. This could be taken as tentativeevidence that, if the negative association of sensitivity parameters and central bankindices with average inflation is high, it is likely to be based on common variationof the two types of variables. This implies that sensitivity parameters andindependence indiceswhen both correlate highly with inflationmay capturesimilar influences, pointing towards the position that central bank independenceand public attitudes towards inflation are interconnected. These arguments giveindirect empirical support for the historical-feedback interpretation.

On the issue of EMU, the conclusion from this analysis is that it may notsuffice for price stability to create an independent ECB. Also of importance in


ensuring low inflation in Europe is the inflation culture in the participatingcountries. Convergence on the opinion that inflation should be kept downas

.suggested by Collins and Giavazzi 1993 would improve the chances of theECB performing successfully. An additional question is whether it is sufficient, forachieving low inflation rates, that a majority of countries have anti-inflationarycultures, or whether unanimity is required among member states. As Morales and

.Padilla 1995 emphasise, if a majority voting procedure in the governing councilof a ECB were adopted, similarity in preferences on monetary policy will foster anefficient outcome. Therefore, the question of convergence appears to be a fruitfulfield for further enquiry.

The historical example of Germany shows that it is possible to create a stabilityconsensus. Assuming that the historical-feedback interpretation is correct, theperformance of the ECB shortly after the introduction of the common Europeancurrency will have an important influence on public opinion. If people have theimpression that the ECB is managing monetary policy responsibly and success-fully, the feedback process can further strengthen a stable monetary environmentin Europe.

Acknowledgements

Thanks to three anonymous referees, Arye L. Hillman, Matthias Wrede, the .participants of the Bamberg Economic Colloquium January 1996 , and to the

participants of the annual Money, Macro, and Finance Conference in London .September 1996 for helpful comments. The usual disclaimer applies.

Appendix A

The database is taken from European Communitys Eurobarometers 5, 7, 9, 11,13, 15, 17, 19, 21, 23, 25, 27, 29, 31, 33, 35, 37, and 39. Countries analysed inthis study are: France, Belgium, the Netherlands, Germany, Italy, Luxembourg,

.Denmark, Ireland, Great Britain UK without Northern Ireland , Greece, Spain andPortugal.

The original questions in the questionnaires are presented below. .There is a lot of talk these days about what OUR COUNTRY s goals

should be for the next ten or fifteen years. On this card are listed some of thegoals that different people say should be given top priority. Would youplease say which one of them you yourself consider to be most important inthe long-run? And what would be your second choice?

fl Maintaining order in the countryfl Giving the people more say in important government decisionsfl Fighting rising prices


fl Protecting freedom of speechfl Dont know

.Table A1. Development of the share in % of answers in the Inglehart index,which considers the fight against inflation as the most important goal

Fra Bel Net Ger Ita Lux Den Ire GB Gre Spa Por1 1 1 1 1 1 1 1 1 1 1 11976 46.6 45.9 28.0 29.9 27.4 41.1 17.1 42.1 35.4 y y y1977 42.9 53.7 22.0 28.1 25.7 31.0 17.1 39.1 36.5 y y y1978 38.2 45.9 19.3 29.7 26.3 28.6 14.3 41.4 30.4 y y y1979 39.7 46.7 20.1 31.6 25.2 30.7 20.2 35.9 31.8 y y y1980 44.0 47.3 24.6 31.3 29.6 32.9 22.4 43.6 36.0 38.5 y y1981 41.6 44.5 24.4 29.5 28.2 29.3 20.4 46.4 33.8 37.4 y y1982 29.1 46.0 15.8 24.9 22.5 24.8 16.0 34.0 22.9 25.8 y y1983 27.9 44.8 14.7 16.0 27.9 28.6 14.5 36.3 23.0 31.6 y y1984 32.0 46.3 15.2 16.1 25.4 24.8 13.3 37.1 19.5 32.8 y y1985 27.0 46.7 12.4 14.6 24.7 24.1 13.3 32.8 18.3 34.4 21.7 44.71986 21.3 39.2 11.7 8.5 20.0 25.8 12.2 35.7 18.6 31.6 20.5 39.71987 26.5 37.1 9.8 12.3 23.3 18.8 12.6 37.5 14.5 29.3 17.9 39.51988 27.1 39.0 11.5 15.1 18.9 20.5 9.2 34.5 16.4 33.6 24.7 40.11989 21.8 33.9 8.4 10.4 21.4 12.2 11.3 29.8 22.5 25.1 17.9 42.71990 21.4 34.1 11.8 11.2 20.0 13.6 10.2 28.3 21.8 28.1 20.9 38.71991 22.6 29.7 11.7 12.6 17.8 9.9 6.0 25.5 20.0 31.8 15.0 33.71992 20.5 27.5 11.8 13.1 15.9 9.7 5.4 23.5 17.3 27.5 18.7 32.61993 24.4 26.0 8.9 13.5 14.6 9.3 4.1 18.9 14.3 39.3 21.2 31.6

.Table A2. Development of the share in % of answers in the Inglehart index,which considers the fight against inflation as the most or second most importantgoal

Fra Bel Net Ger Ita Lux Den Ire GB Gre Spa Por12 12 12 12 12 12 12 12 12 12 12 121976 75.7 72.8 57.9 65.5 64.6 75.2 52.3 74.5 63.3 y y y1977 74.7 77.3 52.8 66.2 64.6 70.7 53.2 73.7 67.2 y y y1978 66.3 74.1 46.1 63.2 64.4 64.4 48.2 72.5 58.9 y y y1979 69.8 72.6 45.8 64.0 64.7 58.2 59.2 67.2 59.9 y y y1980 76.2 77.1 57.1 65.8 70.8 69.0 59.1 78.3 69.1 75.9 y y1981 72.8 74.6 53.8 66.5 72.1 65.8 50.5 77.9 65.4 76.0 y y1982 60.4 73.9 43.4 53.8 61.2 55.1 44.3 69.2 49.3 64.1 y y1983 60.4 75.6 41.4 42.7 69.9 60.9 43.8 71.6 49.0 70.2 y y1984 63.6 76.8 42.9 42.9 65.3 62.4 45.1 72.1 50.3 71.6 y y1985 58.7 74.4 35.3 38.4 61.1 55.2 38.0 68.2 45.9 71.7 61.3 76.91986 52.7 69.6 33.2 29.8 56.4 55.1 36.8 70.1 45.8 71.7 59.5 76.01987 55.9 64.6 31.1 32.3 57.0 46.6 36.0 70.7 39.4 70.2 56.3 74.51988 55.1 67.7 32.0 38.0 52.1 44.3 31.6 65.7 41.5 74.0 60.3 76.81989 48.3 60.5 26.5 32.5 53.2 37.7 32.0 61.6 48.6 61.4 52.0 77.5


1990 50.3 61.5 29.5 35.8 49.9 35.2 28.3 59.2 48.7 66.5 53.3 72.41991 51.9 58.4 30.5 38.8 49.0 31.3 19.2 58.1 44.9 66.2 44.6 67.21992 49.0 55.9 29.5 40.2 45.3 32.3 18.4 52.3 44.1 66.8 51.7 70.91993 53.2 54.7 25.9 42.3 43.0 35.5 14.6 50.1 38.2 72.1 52.0 72.3

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european journal of political economy volume 14 issue 2 1998 [doi...

Documents

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