An Interest-Group Theory of Central Bank Independence

This paper considers a central puzzle of central bank independence: why politicians would agree to establish such a bank, when the consequence is giving up a substantial degree of control over the money supply and price levels. I suggest that politicians agree to establish independent central banks because it serves their interests to do so. Without an independent central bank in place, politicians have an incentive to create unexpected bursts of inflation that disrupt interest group deals previously negotiated. In the face of such inflation, the interest groups have to return to the politicians to obtain new deals, and the politician can extract rents as the price for supplying the desired legislation and regulation. However, politicians, ex ante, would prefer not to face the temptation to extract rents through inflation. The reason is that the interests groups know that the politicians face this temptation and accordingly discount the amounts they are willing to pay for political deals in the first place. With an independent central bank in place, politicians can provide the interest groups with assurances that they will not subsequently upset deals by creating inflation. The interest groups, in turn, are willing to pay more for the deal upfront, since they have reasonable confidence that it will be durable. Because politicians have a short time horizon, they prefer to tie their own hands by creating an independent central bank, since by doing so they can maximize rents in the short run. The paper conjectures that the growth of independent central banks over the past decade is due to the establishment of more effective legal regimes. If a country operates under a rule of law, politicians find it in their interest to extract rents through legal means rather than merely stealing them. They therefore favor independent central banks as effective devices for facilitating legal rent extraction