Chapter

IV. Credibility Cum Discretion

Author(s):
Carlo Cottarelli, and Curzio Giannini
Published Date:
December 1997
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The shift toward greater discretion observed over the last 25 years may appear (at first view) somewhat disturbing, given the increased recognition in the economic literature that credibility is an important component of a low inflation environment. But, as stressed in Section II, credible frameworks and rule-based frameworks are quite different things. The key to success is to set in place arrangements so that the private sector will believe that the margins of instrument flexibility left to the monetary authorities by relatively relaxed monetary frameworks will not be used to exploit the short-run tradeoff between inflation and output, or to raise seigniorage revenues. Here are discussed four strategies to attain credibility at the cost of no or limited loss of flexibility, which have become increasingly common in the last 25 years. Two of these strategies—granting instrument independence to the central bank and relying on IMF-supported programs amount respectively to modifying incentives or preferences through institutional action and to submitting key economic policy decisions to the scrutiny of an external agency with a well-established distaste for inflation. As Briault, Haldane, and King (1996) remark, the third strategy—inflation targeting—with its emphasis on accountability and transparency, aims at achieving credibility by words, while the fourth strategy—building an anti-inflationary reputation—amounts to revealing information about the authorities’ preferences by deeds.

The discussion will also highlight that differences in the economic and institutional environment, by shaping the feasibility set for monetary reform, go a long way toward explaining why credibility of purpose has been pursued in certain ways. The reason is that in a fiat standard, announcements about monetary policy run into a serious problem of enforcement—the main potential villain being also the ultimate enforcer. In these circumstances, as Elster (1995) aptly remarks, in order to attain credibility, the precommitting agency must of necessity act through the external environment. A resolute inner stance or a mere announcement will simply not do. We disagree, however, with McCallum’s (1996) remark to the effect that “if a precommitment technology does not exist, then it does not exist and no arrangement can entirely escape that fact.” Indeed, monetary history is replete with examples of institutional adaptation designed to constrain the monetary powers of the sovereign under changing circumstances. The experience of the last 25 years is no exception in that respect.

However, the external environment may vary markedly across countries. Thus, certain institutions, such as a truly independent central bank, are feasible only at specific levels of economic and institutional development. As Fischer (1995a) suggests, it makes little sense to provide for the legal independence of the central bank in countries where the law is flouted and where financial markets are undeveloped, if not altogether missing. Moreover, policymakers operating under a regime of political dictatorship or lacking an efficient financial sector that would rapidly sanction financial profligacy might find it insurmountably hard to precommit themselves even if they wanted to (Elster (1995)).19 Thus, in countries where “domestic delegation” is not feasible, it may be inevitable to search for an external source of credibility. Indeed, our data show that many developing and, in some cases, nondemocratic countries have been able to precommit themselves by submitting their economic policies to the conditionality implicit in IMF-supported programs.

Central Bank Independence

Probably the most visible institutional development associated with the current wave of monetary reform has been the revision of the role and status of the central bank. In the space of seven years, from 1989 to 1995, seven countries in the industrial group and ten in the developing group have significantly altered the legal framework within which the central bank operates (Table 7). At the time of writing, a number of other countries are in the process of doing the same. The revision has hinged on three pillars. The first has been a more precise definition of the central bank’s mission, with greater emphasis on the objective of price stability, in many cases indicated as the overriding objective of the central bank’s actions. The second has been a considerable widening of the degree of independence of the central bank from political pressure. In particular, the central banks whose status has been modified have generally been freed from any obligation to finance either the government or government-controlled bodies and have been given sole responsibility for setting policy instruments.20 Finally, greater emphasis has been laid on the means and forms through which the central bank accounts for its actions ex post.

Table 7.Recent Changes in Central Bank Legislation
CountryYear of ReformYear of Previous Major ChangeMain Changes Introduced
Industrial countries
Belgium19931939The 1993 Act states that the government cannot oppose a decision taken by the central bank relating to its key tasks, i.e., the implementation of monetary and foreign exchange policy, the management of foreign reserves, and the promotion of the smooth operation of the payments system. The act also prohibits the extension of credit by the central bank to the government.
France19931945Under the 1993 Act, the central bank “shall formulate and implement monetary policy with the aim of ensuring price stability” (Art. I). The central bank “shall neither seek nor accept instructions from the government or any person in the performance of its duties” (Art. I). Under previous legislation, the government was responsible for formulating monetary policy, whereas the bank was only responsible for its implementation. Credit to the government is forbidden. Authority over monetary policy is now attributed to a nine-member monetary policy committee, chaired by the central bank’s governor.
Greece19921982According to the 1992 Act, the central bank is prohibited, starting from January 1992, from extending credit to the government. The central bank, however, still formulates and implements monetary policy on the basis of the government administrative guidelines and macroeconomic objectives.
Italy1992–931936The 1992 Act grants the governor the power to set the official discount rate, previously set by the minister of the treasury at the proposal of the governor. The 1993 Law prohibits the extension of credit to the government by the central bank and grants the central bank the power to set banks’ reserve requirements. The objective to be pursued by the central bank—in accordance with Article 47 of the Italian Constitution, but not stated in the latter’s statute nor in the law—is taken to be the maintenance of monetary stability.
New Zealand19891936According to the Reserve Bank Act of 1989, “the primary function of the Bank is to formulate and implement monetary policy directed to the economic objectives of achieving and maintaining stability in the general price level.” The target rate of inflation is jointly determined by the treasury and the central bank. While the bank has the sole authority to formulate and implement monetary policy, a formal “override” provision exists whereby the government may change this policy.
Portugal1990–951974–75Under the 1990 Act, central bank credit to the government was limited; the act was amended in 1993 to eliminate any form of direct credit to the government. The September 1995 amendment mandated the bank to mantain price stability as its primary objective.
Spain19941938According to the 1994 Act, the central bank “shall define and implement monetary policy with the primary objective of achieving price stability” (Art. 7). The central bank “shall pursue its activities and fulfill its objectives with the autonomy from the administration” (Art. I), but, without prejudice to the objective of price stability, the central bank’s “monetary policy shall support the general economic policy of the government” (Art. 7). Under previous legislation, the central bank was “to conduct monetary policy both domestically and externally in accordance with the general objectives set by the government.” The 1994 Act also prohibits the extension of credit to the public sector by the central bank.
Developing countries1
Argentina19921946–49In 1992, the Central Bank Law was amended to conform with the Convertibility Law of October 1992, which committed the central bank to sell foreign currency at a fixed exchange rate and maintain at all times unrestricted international reserves in an amount not less than 100 percent of base money.
Chile19891953The Organic Law of 1993 specifies that the objectives of the central bank are “the stability of the currency system” and “the due payment of internal and foreign debts.” Since 1975, the formulation of monetary and exchange rate policy is the responsibility of a five-member monetary council chaired by the central bank’s president.
Colombia1991–921926The December 31, 1992 Law, based on the 1991 Constitution, mandated the central bank “to maintain the purchasing power of the currency.” Moreover, it raised the legal status of the central bank to that of an independent public entity, granted full autonomy in the use of monetary instruments, and confirmed the tight ceilings on central bank credit to the government introduced by the 1991 Constitution.
Honduras1995As part of the IMF-supported adjustment program, the government is preparing draft legislation to grant higher autonomy to the central bank, and to recapitalize the central bank.
Israel19851954The 1985 amendment to the 1954 Law—known as the “prohibition of printing money law” (see Bank of Israel (1991), page 25)—introduced very tight constraints on central bank credit to the government.
Mexico19931985The Ley del Banco de Mexico of December 23, 1993 redefines as the bank’s primary objective the pursuit of the “currency’s purchasing power stability” and sets as secondary objective “promoting the financial system’s sound development and the proper functioning of the payment system.” Moreover, the law redefines the provisions concerning central bank credit to the government, introducing more stringent procedures for their enforcement.
Pakistan19941956The 1994 amendments substantially increased the State Bank of Pakistan’s autonomy by widening the powers of its board, and strengthening the position of its members. However, the government still retains primary responsibilities for the formulation of monetary policy.
Peru1992The December 30, 1992 Ley Organica del Banco Central de Reserva del Peru mandated the central bank to pursue monetary stability as its only objective. Moreover, it prohibited all forms of direct credit to the government and severely constrained the purchase of government securities on secondary markets.
Philippines19931950The new Central Bank Act defines as the primary objective of the central bank “to maintain price stability conducive to a balanced and sustainable growth of the economy” and, as the secondary objective, to “promote and maintain monetary stability and the convertibility of the peso”; the act also strengthens independence from the government as well as the bank’s financial position.
South Africa19891944According to the 1987 revision of the central bank statutes, the primary objective of the bank is “the pursuit of monetary stability and balanced economic growth in the republic.” However, there exists no formal division of monetary responsibilities between the bank and the government.
Uganda19931966The new Bank of Uganda Act mandated the Bank of Uganda to “maintain monetary stability,” within a broader objective of “achieving and maintaining economic stability.” The bank was given primary responsibility for formulating and implementing monetary policy (although the government also retains some responsibilities). Moreover, the act set legal ceilings on central bank credit to the government and strengthened the financial independence of the bank.
Venezuela19921939The 1992 revision of central bank legislation aimed at increasing the autonomy of the bank. It is now stated explicitly that monetary stability is one of the main objectives of the bank. To this end, the law grants extensive powers to the bank to regulate interest rates and bank reserves. The law also prohibits the bank from granting direct credits to the national government and from guaranteeing the obligations of the republic.
Sources : Eijffinger and Schaling (1993); Lindgren and Duenas (1994); Capie, Goodhart, and Schnadt (1994); Bank of Japan (1995); and Eijffinger and van Keulen (1995).

Only countries whose central bank legislation has undergone significant changes are shown in this table.

Sources : Eijffinger and Schaling (1993); Lindgren and Duenas (1994); Capie, Goodhart, and Schnadt (1994); Bank of Japan (1995); and Eijffinger and van Keulen (1995).

Only countries whose central bank legislation has undergone significant changes are shown in this table.

The tendency toward greater central bank independence and accountability has certainly been magnified by the Maastricht Treaty, which elevated the above principles to the rank of prerequisites for joining the European Economic and Monetary Union. However, one could argue that the current reforms of central banks would have been impressive even without the Treaty, the more so since our sample does not include Eastern European countries, where the phenomenon has reached sizable proportions as well. To find a comparable switch in the two-century long history of central banks, one must go back at least to the wave of nationalizations that marked the late 1930s and early 1940s (De Kock (1974)), if not to the mid-nineteenth century, when the model set by the British Bank Charter Act of 1844 rapidly spread throughout the Western World (Giannini (1995)).

There is a notable difference, though. In both previous instances, the aim of the reform was to reduce the degree of discretion allotted to the central bank. This was done, in the mid-nineteenth century, by setting very strict rules on the issue of banknotes, and, in the nationalization era, by subjecting the central bank management to the directives and control of political institutions. This time, instead, the reform has resulted, as stated above, in greater operational discretion of the central bank in the pursuit of its statutory goals.

Whether this kind of Copernican Revolution will last remains to be seen, of course. The strategy is clearly reminiscent of the Rogoff-Tabellini-Persson version of the delegation story, according to which a socially preferable equilibrium can be achieved by delegating authority over monetary policy to an independent central bank managed by a “conservative” central banker, that is, by someone who puts a higher weight on inflation (relative to employment) than society in its loss function.21 More than on its theoretical plausibility, however, the case for central bank independence seems to have been predicated on two bits of evidence. The first has to do with the fact that central bank independence, while negatively related to inflation, at least in the industrial countries (Cukierman (1992)), apparently has had no cost in terms of growth, or growth variability (Alesina and Summers (1993)), thus coming to be seen as a free lunch from a macroeconomic perspective. The second has been the truly remarkable performance in recent decades of the German economy, featuring at the same time what is arguably the most independent central bank in the world and the best inflation performance and comparatively high rates of growth in the industrial world.

Inflation Targeting or Increasing Transparency

Altering the legal status of the central bank reflects the attempt to establish credibility of monetary policy by modifying by law the incentive structure, or the utility function, of the policymaker. A number of industrial countries have found this path to credibility unattractive on two counts. First, it may be politically undesirable, or simply unfeasible, to concentrate so much power in the hands of nonelected officials. Second, the inverse correlation between actual inflation and the degree of independence of the central bank may in a longer-run perspective turn out to be spurious.

Indeed, critics of the concept of central bank independence often point out that, on the one hand, a distaste for inflation has in some cases predated the enhancement of central bank independence. For instance, in New Zealand, inflation fell from 16 percent to 6 percent before any change in legislation was enacted. Analogously, in Italy, inflation fell in the course of the 1980s from above 20 percent to less than 5 percent, while the first legislated steps toward enhanced central bank independence were taken only in the early 1990s. Similar stories could be told for other countries (Pollard (1993)). On the other hand, a commitment to low inflation by an independent central banker may lack credibility if the announced policy ostensibly conflicts with other government policies.

Since, as seen in Section II, one may trace the inflation bias of the fiat standard back to agents’ uncertainty (or misinformation) about the true intentions of monetary authorities, greater transparency of the policymaking process has appeared an obvious alternative to altering the institutional structure. As pointed out by Briault, Haldane, and King (1996), transparency, in addition to revealing information on the authorities’ inflation preferences, may also be useful in revealing the authorities’ model of how the economy works, thereby leading to greater social welfare.

A concern for transparency is easily detectable in countries that have espoused inflation targeting, in rapid rise in recent years (Table 2). For example, ever since inflation targets have been adopted by the U.K. government, in 1992, the Bank of England has published a quarterly report containing a detailed record of the authorities’ performance in controlling inflation. In addition, since April 1994, the minutes of the key monthly meetings between the Chancellor and the Governor of the central bank have been made available to the public (Ammer and Freeman (1995)). Similarly, in Sweden, the Riksbank publishes three times a year its inflation report (Svensson (1995)); quarterly assessments of economic developments and inflation are also published by the Bank of Finland (Akerholm and Brunila (1995)), which has also recently started publishing its inflation forecast. In Canada, though no inflation report is published, the central bank has striven ever since the inflation targeting regime has been adopted to bolster the standing of price stability as a policy goal and the overall credibility of monetary policy through regular press releases and other publications (Ammer and Freeman (1995)).

In some of the above countries, influential proposals for reforming the legislation governing the central bank put forward by parliamentary committees have been spurned. This suggests that inflation and central bank independence should not be regarded as necessary components of one and the same strategy, as Leiderman and Svensson (1995) seem to argue. New Zealand may be counted as the one exception to this proposition, since the 1989 Reform Act at once mandated central bank independence, the adoption of inflation targeting and explicit procedures for disclosing information about the conduct of monetary policy. Even in the case of New Zealand, though, there is some debate as to whether the 1989 Act actually resulted in greater central bank independence, given that under current legislation, the government has the right to participate in the setting of the inflation target, the faculty to override the central bank, and the power to dismiss the governor if he fails to fulfill his goals.

IMF Conditionality

As noted in Section IV, empirical research has established a clear negative empirical correlation between central bank independence and inflation performance in industrial countries. However, the same relation does not seem to hold in developing countries (Cukierman (1992)). Several explanations have been suggested to account for this phenomenon. Fischer (1995b), for example, blames it on imperfect law enforcement in many developing countries and on the involvement of the central bank in the financing of government deficits, a feature common to many central banks in the developing world irrespective of their nominal independence. Mas (1995) mentions shallow financial markets as an additional factor constraining the actual room for maneuver of monetary policy in developing countries. Notably, both sets of factors would equally undermine any attempt to establish credibility by resorting to inflation targeting.

By no means, however, does all this imply that developing countries have no option other than to remain stuck in a low-credibility, high-inflation equilibrium or accept a severe limitation of instrument flexibility (as in the case of an exchange rate peg). Both theory and past experience suggest that the authorities in these countries can enhance the credibility of a disinflationary effort by “delegating” policy responsibilities to an international enforcer.22

In this respect, Figure 3 highlights the strong time correlation between the number of developing countries included in framework 9 (full discretion) and the number of countries with IMF-supported programs in place (the correlation index is 0.83 on levels and 0.28 on first differences). There is a clear, and even stronger, increase in the share of program countries among those involved in disinflation policies (Figure 4). Is there a relation between these trends? We believe so, because of the role that IMF programs can play as a credibility-augmenting device.

Figure 3.Number of Developing Countries with IMF-Supported Program and Under Framework 9

Source: Appendix: Country Data.

Figure 4.Percentage of Developing Countries Under Disinflation with IMF Program

Source: Appendix: Country Data.

Fund programs are based on the concept of conditionality (Guitián (1979) and (1995)), a term used to indicate that loans are granted provided governments follow certain macroeconomic policies. These policies are monitored and assessed against a set of criteria, referring to a combination of what could be considered as final policy targets (foreign exchange reserves) and intermediate targets (such as domestic credit expansion and domestic credit to the government). These targets, however, are not fully disclosed to the public. What is typically announced through press releases is that the IMF has agreed to extend credit to a country, together with some broad information on the main macroeconomic targets (GDP growth, inflation, public deficit-to-GDP ratio, and, sometimes, targeted reserve-to-import ratio). While IMF programs can be as short as one year, it is quite common that a new arrangement comes into operation when the old one expires. Moreover, multiyear programs have become increasingly common. For example, at the end of 1994, about three-fourths of the outstanding programs had a duration of over one year (and about 60 percent of at least three years).

What are the implications of such an arrangement in terms of instrument flexibility? Contrary to what is sometimes believed, IMF programs involve a fairly high degree of instrument flexibility. First, it is remarkable that the monetary discretion index of countries with IMF programs is significantly higher than the average (Figure 5). The difference is significantly lower in the most recent period but this is entirely due to the need for IMF-financing of CFA countries (which, as members of currency unions, have a fairly low level of monetary discretion). Excluding these countries, the difference remains broadly constant throughout the period. To a large extent this is because, again contrary to common wisdom, exchange rate pegs are not an integral component of IMF programs:23 during 1970–94, exchange rate pegs were used on average in about 55 percent of IMF programs, while in the same period the relative frequency of pegs in developing countries was about 73 percent.

Figure 5.Monetary Discretion Index in Countries with IMF Program

Source: Appendix: Country Data.

As to the performance criteria set by the program, Guitián (1994a) notes that:

it is of course advisable to supplement quantified policy action with an opportunity to exercise judgement, that is, an opportunity to assess the validity of the agreed quantitative policy commitments. This supplement is always included in IMF programs in the form of so called review clauses. These clauses call for consultations between the member and the institution to evaluate, inter alia, the appropriateness of the quantified criteria and reach understandings on the circumstances under which modifications or adaptations are warranted.

Thus, IMF programs allow, in principle, the Fund and the program country to agree on changes in the program design to take into account more updated information on recent economic developments, including shifts in behavioral parameters (such as the demand for money). Program reviews tend to be quite frequent (usually quarterly or twice a year), thus allowing for a substantial amount of flexibility and discretion. Moreover, the breaching of performance criteria can be waived at the discretion of the Board of Directors. This typically occurs “in situations of small or reversible deviations” (Guitián (1995)).

More discretion, however, need not impair credibility. The reason is that the agency in charge of assessing the desirability of deviating from the initially defined targets (the International Monetary Fund) does not benefit from those deviations.24 In other words, as in the case of Rogoff’s conservative central banker, the IMF Board’s utility function tends to differ from the average utility function of the country in question. Thus, for example, the (domestic and international) public knows that the Fund will not agree to accommodate a monetary expansion aimed at temporarily boosting employment, as the Fund (which is interested in recovering the resources invested in the country) will not benefit from such an expansion. In this respect, while Fund arrangements may be as short as one year, the repayment period extends to several years beyond the program period. Thus, there is a natural concern for the long-run evolution of the country.

The increased number of IMF programs is related to a number of reasons whose analysis goes beyond the scope of this paper. Nevertheless, this increase is likely to have satisfied to some extent the need for credibility that is inherent in monetary policymaking and which in the past had been satisfied primarily by pegging the exchange rate. Indeed, Figure 3 also shows that the increase in the number of countries following a discretion-based monetary policy (framework 9) is much more contained after excluding those under an IMF program.

There is, in principle, a constraint on the role that IMF programs can play to enhance monetary credibility. A condition for an IMF program is the existence of a balance of payments need, rather than the pursuit of price stability. Thus, in principle, a country that does not have a balance of payments need cannot use Fund arrangements as a credibility-enhancing device. However, this problem is often of little practical consequence. In reality, balance of payments disequilibria and inflationary pressures tend to be combined. Moreover, empirical evidence confirms that the role of the Fund as provider of credibility, rather than as provider of balance of payments resources, has increased considerably, particularly in the last 10 years.

In this respect, Figure 6 reports the ratio between actual and potential borrowing for all Fund arrangements during 1955–95. Fund arrangements involve the opening of a line of credit from which countries can draw, with repayments starting only after the expiration of the arrangement. The figure refers to the simple average, across arrangements, of the ratio between the outstanding stock of drawings at the time when the arrangement expired and the amount of the line of credit (that is the maximum amount of drawings). The average for each year refers to the arrangements that were initiated in a certain year. This ratio, which had increased rapidly in the early 1980s as a result of the debt crisis, dropped dramatically in the second half of the 1980s, while at the same time the number of arrangements remained high or even increased (Figure 3). This is an indication that countries turned increasingly to the Fund to enhance the credibility of their policies, rather than for borrowing.

Figure 6.Transactions of the IMF: Borrowing Ratios

(In percent of amount agreed)

Source: IMF, 1996.

1Ratio between maximum amount borrowed during the arrangement and potential borrowing; simple average across all outstanding IMF arrangements.

2Ratio between borrowed amount outstanding at the end of the arrangement and potential borrowing; simple average across for all outstanding IMF arrangements.

Investing in Reputation

As emphasized by McCallum (1995), a discretion-based approach does not necessarily lead to a higher inflation equilibrium if the monetary authority recognizes the futility of trying to fool systematically the private sector, and as a consequence the benefits that can be drawn from an anti-inflationary reputation. Most theoretical treatments of the subject, however, conclude that reputational equilibria may prove hard to establish and even harder to maintain. As it turns out, the required initial investment in reputation may be quite demanding in terms of forgone output; even if the authorities were willing and able to make it, the strategy would be workable only if they heavily discounted the future and if the reversion to high inflationary expectations in case of even a single instance of “cheating” could be expected to last long enough (Persson and Tabellini (1994)).

Thus, in point of theory, one should expect reputational equilibria to be attractive only in a small set of countries, namely those (1) whose economy is robust enough to be able to absorb any short-run loss of output resulting from the frontloaded investment in anti-inflationary reputation; (2) that have already delegated to a large extent monetary powers to a central bank whose planning horizon can be expected to be longer than that of elected governments; and (3) where a well-developed and reactive financial sector is capable of punishing the authorities for cheating.

Our data set seems broadly to confirm this prediction. In 1994, there were 22 countries characterized by full discretion (framework 9) and absence of Fund programs. However, many of these countries entered this group only recently. The group includes, for example, Costa Rica, Tunisia, and the Dominican Republic (which recently ended an IMF-supported program), Trinidad and Tobago (which shifted to a flexible exchange rate only recently), Turkey (which had an IMF program in place starting in July 1994), Brazil (which in the second half of 1994 introduced an exchange rate based stabilization program), Denmark and Portugal (orphans of the exchange rate mechanism), and Zaïre25 (where the shift to discretion was accompanied by hyperinflation). In Portugal and Denmark, the exchange rate constraint is still regarded as the main policy objective, even if in reality the fluctuations around the parity remained relatively large in 1993–94. The hard core group of countries that has practiced full discretion for a number of years includes only 12 countries: Australia, Indonesia, Japan,26 Lebanon,27 Malaysia, Mauritius, the Maldives, Paraguay, Singapore, Taiwan, Western Samoa, and the United States. In addition, quite a few of these countries seem to have joined the group more as a result of institutional inertia than out of reputational considerations. For example, some of its members (Paraguay and Western Samoa) did experience relatively high (and variable) inflation rates. Others, like the Maldives, experienced at some stage a sharp deterioration in overall economic conditions.

Admittedly, the group features a number of important economies, where indeed investing in reputation has been a conscious policy choice, resorted to after previous dismaying experiences with purely discretionary strategies. If one were inclined to consider the monetary targeting framework still formally prevailing in Germany as a kind of smoke screen raised around the discretionary pursuit of price stability by the central bank, as argued in Section V, then another important country could be added to the list.28 A further candidate is Italy, where authorities have since 1995 emphasized the need to keep a tight monetary stance regardless of cyclical conditions in order to eliminate deeply-rooted inflationary expectations (Fazio (1996)).

On balance, the evidence suggests that reputational equilibria may be practically unattainable under a fairly large set of circumstances. However, in some, by no means negligible, cases reputation has played an important role as a credibility-enhancing device. Whether such a role could be sustained in the long run is of course a separate issue, on which the jury is still out.

Institutional Environment and Long-Run Credibility

The above discussion suggests that institutional devices (central bank independence, inflation targeting, IMF-supported programs) can enhance the credibility of low-inflation policies. However, full reliance on institutions runs into a conceptual difficulty. If the inflation bias is ultimately rooted in democratic policymaking, as is widely agreed to be the case (Smith (1992)), how can democratic institutions be expected to enforce sets of rules meant to eradicate the inflation bias itself? This point clearly goes to the heart of the matter: institutional design is often regarded to improve economic performance by raising the costs for policymakers deviating from the socially preferable policy course. But what if there is widespread social consensus on the desirability of the deviation?29 Should we conclude that monetary institutions work effectively only if they are for all practical purposes redundant?

Advocates of central bank independence often shrug off this type of objection by pointing to the apparently strong correlation between central bank independence and inflation. If the mechanism worked in the past, so the story goes, why should it not be expected to work in the future? But this is clearly a weak counterargument. First, on methodological grounds, it is not obvious that one can infer the desirability of a given arrangement by looking at its impact over a period in which that arrangement was not perceived as operating. A study by Johnson and Siklos (1992), for instance, finds that the reactions of central banks (as measured by changes in interest rates) to shocks to unemployment, inflation, and world interest rates were not closely related to standard measures of central bank independence. If central banks did not regard themselves as being positioned differently depending on their degree of statutory independence, why should the market have reacted differently on the basis of the same parameter? Moreover, Posen (1993) is probably right in arguing that a certain degree of public aversion to inflation can be seen as a precondition to the establishment of an independent central bank. We have seen that this has indeed been the case not only in Germany, the country he studies, but also in Italy and New Zealand.

Underscoring the endogenous character of a given institution, however, is not ipso facto evidence of that institution’s practical irrelevance. Indeed, that monetary frameworks evolve in response to changing needs has been the key theme throughout the previous sections. Rather, it is a reminder that arrangements meant to credibly constrain governments probably work not so much by raising the cost of breaking their promises as by increasing the perceived benefit of a given policy course or objective, that is, of the promise itself.

This being the case, probably the best yardstick against which to evaluate alternative strategies is the extent to which they can contribute to generate and sustain consensus on the desirability of the social goal they revolve around. In other words, what really matters for the success of monetary reform aiming at price stability is that it be perceived not only as economically meaningful, but also as technically feasible and politically legitimate. One needs only recall the easiness with which the highly autonomous central banks set up in the early 1920s under the auspices of the League of Nations were turned into subjugated governmental agencies as the Great Depression unfolded, to understand that lack of legitimacy can be a serious problem.

From this perspective it may well turn out that the main lesson to be drawn from recent experience is that, given the intrinsically anchorless nature of the fiat standard, creating an ethos of price stability, performing the same function as the ethos of convertibility under the gold standard (Eichengreen (1992)) is really the key issue. It should therefore not come as a surprise that central banks in our days invest considerable amounts of resources in maintaining autonomous and effective research skills, explaining the economic logic underlying their actions (Proske and Penker (1995)), and fostering, even explicitly, a dislike of inflation in the population. An interesting case in point is the recent effort of the Bank of Finland to distribute free publications to the population, even of schooling age, discussing in simple form the costs of inflation and the need for low inflation policies.

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