POLITICAL ECONOMY OF INDUSTRIALIZED COUNTRIES

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I need help with a Political Science question. All explanations and answers will be used to help me learn.


Read the articles by Hall and Franzese (2003) and Copelovitch and Singer (2008). Your paper should address the following points: (readings are attached)

  1. Both Hall and Franzese (2003) and Copelovitch and Singer (2008) are interested in identifying the conditions under which independent Cen- tral Banks are effective. Summarize their answers. In your summary, focus on the main argument and the causal mechanism they suggest.

  2. Compare and contrast the causal mechanism proposed by Hall and Franzese (2003) to the causal mechanism suggested by Copelovitch and Singer (2008). What are the key dimensions in which these their argu- ments differ?

  3. Evaluate the causal mechanisms and form your own opinion regarding which mechanism is most convincing. Justify your answer on theoret- ical grounds and provide at least one example of a recent newspaper story that backs up your opinion. 

5 PAGES 

  • Properly document all sources, including websites, and attribute all quotations to their original authors. The bibliography does not count towards your page limit. 

Copelovitch_2008_The_Journal_of_Politics.pdf

Hall_2003_International_Organization.pdf

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Financial Regulation, Monetary Policy, and Inflation in the Industrialized World Mark S. Copelovitch David Andrew Singer University of Wisconsin – Madison Massachusetts Institute of Technology This article argues that the institutional mandates of central banks have an important influence on inflation outcomes in the advanced industrialized countries. Central banks that are also responsible for bank regulation will be more sensitive to the profitability and stability of the banking sector and therefore less likely to alter interest rates solely on the basis of price stability objectives. When bank regulation is assigned to a separate agency, the central bank is more likely to enact tighter monetary policies geared solely toward maintaining price stability. An econometric analysis of inflation in 23 industrial countries from 1975 to 1999 reveals that inflation is significantly higher in those countries with central banks that are vested with bank regulatory responsibility, although this effect is conditional on the choice of exchange rate regime and the relative size of the banking sector. We also conduct a case study of the Bank of England, which lost its bank regulatory authority to a new agency in 1998. We find that the new Labour government under Tony Blair imposed the institutional change on the Bank of England in part to remove the bank stability bias from its monetary policymaking. These findings suggest that the mandates of central banks not only have important influences on macroeconomic outcomes, but may also be modified in the future by governments seeking to impose their own monetary policy preferences. I n today’s world of global capital markets, political leaders face two primary challenges in regulating their economies. First, leaders must ensure the stability of their country’s financial institutions. The frequency and magnitude of banking crises have reached levels not seen since the interwar period (Bordo et al. 2000). The United States, for example, experienced a dramatic bout of banking instability during the 1980s, with more banks collapsing in 1985–87 than in the prior 30 years (FDIC 1998). The United Kingdom faced a similar crisis among small banks during the 1970s, followed by the sudden and dramatic collapse of a prestigious bank in the mid1980s. Such episodes of financial instability have prompted governments to place ‘‘prudential regulation’’—rules and policies designed to ensure the solvency and soundness of banks and other financial institutions—at the top of their economic policy agendas (Eichengreen 1999; Llewellyn 1999). Second, politicians face the age-old challenge of fighting inflation—an economic scourge that has become even more virulent in today’s environment of floating exchange rates and full capital mobility (Mosley 2003). In nearly all industrialized countries, politicians have granted their central banks a high degree The Journal of Politics, Vol. 70, No. 3, July 2008, Pp. 663–680 Ó 2008 Southern Political Science Association of insulation from political pressures, leaving them ostensibly to focus on keeping prices stable. The dual policy goals of financial stability and low inflation generate a challenge for monetary policy makers. The central bank’s main monetary policy instrument is the interest rate, which dampens inflationary pressures when raised. However, interest rate hikes are potentially harmful to banks’ profits and increase the probability of bank failures (Cukierman 1991; OECD 1992). A policy of financial stability may require a more gradual monetary tightening in the face of inflationary pressures, thereby allowing banks more time to adjust their balance sheets. On the other hand, a policy of strict price stability would require more aggressive interest rate adjustments. With one policy instrument and two potentially conflicting goals, a central bank must decide how much emphasis to place on fighting inflation versus maintaining financial stability. In this article, we focus on the institutional tension between the dual goals of financial stability and low inflation. Specifically, we argue that monetary policy makers have a less aggressive stance toward inflation when governments combine the bank regulatory- and monetary-policymaking functions doi:10.1017/S0022381608080687 ISSN 0022-3816 663 664 mark s. copelovitch and david andrew singer within the central bank. Such ‘‘regulatory central banks’’—which exist in more than one-third of industrialized countries—have incentives to be especially sensitive to the profitability and stability of the banking sector when setting monetary policy. We therefore argue that the presence of bank regulatory authority in the central bank’s mandate generates a bias in its monetary policymaking. On the other hand, in countries where bank regulation is assigned to a separate agency, the central bank is less likely to be biased by bank stability concerns and more likely to enact tighter monetary policies geared toward maintaining low inflation. Policy makers’ success in fighting inflation therefore varies with the institutional locus of bank regulatory authority. We further argue that the effect of a central bank’s mandate on inflation is conditional on the government’s choice of exchange rate regime. Assuming full capital mobility, countries that adopt floating exchange rates maintain the ability to conduct autonomous monetary policy. Under such conditions, a central bank’s regulatory responsibilities play a significant role in shaping its monetary policy choices. In contrast, a central bank operating under fixed exchange rates will not have the ability to pursue an independent monetary policy, and therefore its institutional features will be of little importance (O’Mahony 2007). We also test an ancillary hypothesis regarding the effect of the central bank’s regulatory mandate conditional upon the size of the domestic banking sector. We hypothesize that when banks represent a larger share of the national economy, a regulatory central bank will be particularly sensitive to bank stability when setting monetary policy. In focusing on the relationship between central banks’ regulatory mandates and monetary policymaking, this paper contributes to two theoretical literatures in political economy. The first literature, which examines the politics of central banking, has focused overwhelmingly on the relative degree of political independence as the driving influence on the central bank’s monetary policymaking (e.g., Broz 2002; Clark 2002; Cukierman 1992; Franzese 1999; Grilli, Masciandaro, and Tabellini 1991; Henning 1994; Maxfield 1997). This literature depends critically on the implicit assumption that all central banks have the same responsibilities; thus, the ‘‘institutional structure’’ of the central bank can be equated solely with its degree of insulation from the political whims of politicians (Bernhard, Broz, and Clark 2002).1 Politicians, who view monetary policy from the perspective of political expediency, will encourage a dependent central bank to adjust interest rates for political purposes (e.g., to provide a temporary boost to the economy before an election). In the absence of political interference, central banks are assumed to be aggressive inflation fighters.2 While we do not dispute the importance of a central bank’s political independence on its monetary policymaking behavior, we argue that the institutional locus of regulatory authority also strongly influences how central bankers make decisions—even for central banks with high degrees of independence. This argument essentially turns the central banking literature on its head: rather than assuming a uniform political influence on monetary policymaking, we argue that central banks can be pulled in different directions as a result of their institutional mandates. The second relevant literature pertains to the dynamics of principal-agent relationships, specifically those that arise when elected governments delegate important tasks to bureaucratic agents. There are many studies of the challenges inherent in the delegation of authority to an agent whose preferences may differ from those of the principal and of the strategies available to principals to ensure the obedience of their agents (e.g., McCubbins and Schwartz 1984; Weingast 1984). The paper does not challenge this literature; instead, it illustrates how politicians’ initial choice to delegate multiple tasks to a single bureaucratic agency can have significant consequences for policy outcomes (Dewatripont, Jewitt, and Tirole 2000). The ‘‘multitask’’ dilemma exists in many policy domains, including environmental and energy policy, financial regulation, and health and safety. Consider, for example, the consequences of delegating responsibility for energy efficiency and environmental conservation to the same agency. If policies designed to minimize environmental damage have the side effect of raising energy costs, then an agent could find itself compromising one objective in favor of the other. A similar tension can be found in the mandates of financial regulators, who are frequently held accountable for the competitiveness and stability of the regulated industry. We apply this reasoning to central banks and examine how their anti-inflation policies might vary as a function of their regulatory responsibilities. In the case of central banking in the developed world, governments generally decided their delegation structures in the early twentieth century, long 1 2 Central bank independence is not always treated as a single analytical concept; see, e.g., Hallerberg (2002). For a discussion of central bankers’ preferences based on their varied career backgrounds, see Adolph (2005). financial regulation, monetary policy, and inflation in the industrialized world before the emergence of prudential regulation as a politically prominent issue. As regulation gained political salience, the preferences of regulatory central banks began to change. We note below that the mandates of central banks have been largely static over the years, but the evolution in the preferences of regulatory central banks has led some governments to alter their longstanding delegation decisions—specifically by removing regulatory authority from the central bank—to ensure that monetary policy outcomes remain in line with government preferences. The remainder of the article proceeds as follows. In the next section, we discuss the significant variation in the regulatory responsibilities of central banks, emphasizing that this variation has, until very recently, been entirely cross-national rather than intertemporal. We then explore the theoretical reasons why this variation in the central bank’s institutional mandate might influence its monetary policymaking choices, after which we move on to empirical tests of our argument. Using data from 23 industrialized countries from 1975 to 1999, we show that inflation has been systematically higher in countries where the central bank is vested with bank regulatory authority; as expected, however, we find that this effect is conditional on both the choice of exchange rate regime and the size of the domestic banking sector. An important policy implication of this finding is that the removal of bank regulatory responsibility from the central bank is a potential strategy for countries seeking to enhance the inflation-fighting credibility of their central banks. We test this logic by conducting a case study of the Bank of England, which lost its bank regulatory authority to the newly formed Financial Services Authority in a major British government initiative in 1998. We find that the new Labour government under Tony Blair was eager to control inflation and imposed the institutional change on the Bank of England in part to remove the bank stability bias from its monetary policymaking. Finally, we conclude with a discussion of the broader implications of these findings for our understanding of the politics of bureaucratic decision making. Regulatory Responsibilities of Central Banks Across the world, central banks vary in the responsibilities delegated to them by politicians. Central banks are generally responsible for implementing a country’s monetary policy by controlling the money supply and setting interest rates based on current economic 665 conditions. In addition, some—but not all—central banks serve as bank regulators with responsibility for implementing rules and restrictions on banking activity, supervising compliance with prudential regulation and applicable laws, and otherwise safeguarding the stability of the banking sector. This variation has been understudied in the literature on the political economy of inflation.3 Some scholars have examined the central bank’s regulatory mandate in the context of measuring its overall degree of independence from political pressures (Banaian, Burdekin, and Willett 1995). Other scholars have grappled with the interplay between monetary policy and financial stability more generally (Cukierman 1991, 1992). However, in empirical analyses of inflation, central bank independence reigns supreme, and the central bank’s regulatory responsibilities are generally ignored. The regulatory responsibilities of central banks are rooted in history. Until the early 1800s, the focus of central banks was predominantly on wartime finance. For example, the British government created the Bank of England in 1694 to raise funds for war and conquest (North and Weingast 1989). Norway’s central bank, the Norges Bank, was created in the wake of the Napoleonic Wars to stabilize the currency after a period of highly inflationary wartime expenditures (Capie, Goodhart, and Schnadt 1994). The exigencies of wartime finance eventually gave way to the more general goal of maintaining the internal and external value of the currency, which often involved ensuring convertibility in commodity-based exchange rate regimes. For many central banks, maintaining the value of the currency was closely intertwined with the regulation of the banking system, since commercial banks play a major role in the implementation of monetary policy (Capie, Goodhart, and Schnadt 1994). Central banks in countries such as Italy and the Netherlands gradually assumed bank regulatory responsibility in the twentieth century. The Bank of England operated for decades as an informal but powerful bank regulator and gained statutory authority to regulate banks with the Banking Act of 1979. In the United States, Congress created the Office of the Comptroller of the Currency—the regulator of nationally chartered banks—in 1863, but later delegated the statutory authority to regulate state-chartered 3 An exception is Di Noia and Di Giorgio (1999), which offers mostly descriptive statistics and no theoretical argument. Posen (1995) includes the central bank’s regulatory mandate as part of a broader measure of financial opposition to inflation. In addition, there are several analyses of the pros and cons of separating the monetary-policy and regulatory functions, including Abrams and Taylor (2000); Barth et al. (2002); Goodhart (2001); Goodhart and Schoenmaker (1995); and Peek, Rosengren, and Tootell (1999). 666 banks and bank holding companies to the U.S. Federal Reserve, founded in 1913. In contrast, central banks and regulatory agencies emerged as completely separate entities in countries such as Canada and the Scandinavian countries. Canada, in fact, developed a bank regulator first—in 1925—and waited nine years before establishing its central bank in 1934. For countries such as Sweden and Norway, central banks have existed for centuries, yet bank regulatory authority lies with independent agencies subsequently established in the nineteenth and early twentieth centuries.4 Today there is considerable cross-national variation in the institutional mandates of central banks. Of the 23 industrial countries listed in Table 1, 14 currently have separate central banks and bank regulators, while nine have unified systems. It is interesting to note that levels of central bank independence do not appear to be associated with regulatory structure. Countries with unified systems have central banks ranging from highly independent (Germany and the United States) to relatively dependent (Spain). The regulatory responsibilities of central banks in industrialized countries have demonstrated very little variation over time. This path-dependent characteristic stands in marked contrast to other aspects of central banks, such as their degrees of political independence, which have experienced more frequent changes over time (see Bernhard 1998). Indeed, altering the institutional mandate of the central bank is costly, both politically and financially. To remove the regulatory responsibilities of the central bank, governments must enact highly detailed legislation to establish a separate bank regulatory agency with its own staff, budget, and bylaws. In the industrialized world, there are only three exceptions to the endurance of the central bank’s mandate: the United Kingdom and Australia, both of which transferred bank regulatory responsibilities to newly created separate agencies in 1998, and Iceland, which made a similar change in 1999.5 In the 4 The Riksbank was established in Sweden in 1668, while the Royal Inspectorate of Banks was founded in 1907, and continues to operate today as the Swedish Financial Supervisory Authority (Finansinspektionen). In Norway, the Norges Bank was founded in 1816, while the Banking Inspectorate was founded in 1825; it operates today as the Banking, Insurance, and Credit Commission under the Ministry of Finance. 5 The new agencies are called the Financial Services Authority in the United Kingdom, the Australian Prudential Regulatory Authority in Australia, and the Financial Supervisory Authority in Iceland. Korea also experienced an institutional change in 1998, but it was not considered an industrial country for much of the time period of our analysis, and thus is not included in our sample. mark s. copelovitch and david andrew singer T ABLE 1 Location of Bank Regulatory Authority, Industrial countries (2005) Central bank Separate agency France1 Greece Ireland Italy Netherlands New Zealand Portugal Spain United States5 Australia2 Austria Belgium Canada Denmark Finland Germany3 Iceland4 Japan Luxembourg Norway Sweden Switzerland United Kingdom6 1 The Banking Commission (Commission Bancaire) is a composite body chaired by the Governor of the Banque de France, with representatives from the Treasury. While the World Bank data classify this as a separated regime, we follow Goodhart and Schoenmaker (1995) in treating this as unification. However, our results are not sensitive to the alternative specification. 2 Prior to 1999, the Reserve Bank of Australia regulated banks. This authority now resides with the Australian Prudential Regulatory Authority. 3 The Federal Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFIN), established in 2002, united the three previously independent supervisory agencies for banking, securities, and insurance. BaFIN is entrusted with control over the ‘‘sovereign measures’’ (licensing, issuing regulations) whereas the Bundesbank only participates in the ‘‘operational tasks’’ of supervision (e.g., collecting and processing banks’ prudential returns). See Goodhart and Schoenmaker 1995, http://www.bundesbank.de/bankenaufsicht/ bankenaufsicht_bafin.en.php, and http://www.bafin.de/bafin/ aufgabenundziele_en.htm#n6. Goodhart and Schoenmaker classify this arrangement as a separated regime, while the World Bank treats it as ‘‘unification.’’ We follow the former, but our results are not sensitive to the a ...
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