Central Bank Independence as Agency Capture: A Review of the Empirical Literature

Abstract

This article questions the model of central bank independence by considering the mainstream empirical literature that purports to correlate central bank independence with lower inflation rates. The studies, conducted mostly prior to the 2008 financial crisis, mimic the flaws in the risk management models that contributed to the crisis by relying on far too limited time periods of historical data. By so doing, these models overlooked the possibilities of so-called “black swans” – those outlier events that do not fit neatly within the bell-shaped curves of probabilities, but which occur and reoccur in history. Studies conducted since the 2008 collapse largely overlook the role of independent central banks in fueling unsustainable bubbles and bailing out private sector actors, while also missing the rise of China and other major economic powers without central bank independence. The lessons of the financial crisis, its contributing factors and aftermath, suggest that the Federal Reserve (and other major central banks, such as the European Central Bank) are not all that independent of the private financial interests that dominate its own governing boards. The line between regulator and regulated industry has become blurred as the central bank enabled the housing bubble with low interest rates and ever-lower lending standards, and then provided trillions of dollars in opaque subsidies on its private constituencies.

Keywords: central banking, the Federal Reserve, monetary policy, fiscal policy, banking and financial regulation, history, reform, empirical studies

JEL Classification: E5, E58, E60, F4, G2, K2, N1, N2