Making central banks legitimate

Independent central banking has been one of the great success stories of applied economics in recent times. It provides one of those rare occasions when economic theory and economic practice come together and produce demonstrably superior results in the real world. True, there are some economists who point to benign factors in the external environment putting downward pressure on consumer prices that have helped central bankers to deliver low inflation. Nevertheless, there are few who would deny that transferring the task of achieving price stability from the hands of politicians to the hands of independent technocrats has played a large part in the success.

The sense of disquiet

This sense of satisfaction in the economics profession about the virtues of independent central banking is not matched by any similar sense of achievement in the political-science community. On the contrary, independent central banks are seen by some political scientists as part of a disquieting trend to take away many important tasks from politicians and to give them instead to unelected bodies.

It is not just the responsibility for price stability that has been removed from the domain of democratic politics, but a host of other tasks that are now carried out by independent economic and other regulators, risk management bodies, independent service providers and extra-judicial tribunals. Governments increasingly turn to such bodies to demarcate the boundaries between market and state, to resolve conflicts of interest and to take decisions even in sensitive areas such as genetic engineering or personal privacy. In the jargon of political scientists there has been a worldwide growth in "non majoritarian" bodies.

Nor has this trend apparently yet run its full course. In Britain, the latest example of a new proposal for an independent body to run a service is the idea to turn the guardianship of the National Health Service over to an independent body. State pensions have also been identified as ripe for turning over to an independent body on the grounds, familiar to central bankers, that time-inconsistencies in the political horizons of elected politicians will always stand in the way of a fair resolution of inter generational conflicts on pension benefits. A similar logic might apply in relation to environmental targets.

Independence gained

The conventional explanation for this trend towards relying on unelected bodies to carry out important tasks refers to the influence in the 1990s of the so-called "new public management" that emphasised the limitations of relying on central government departments for delivering services. But a more convincing explanation looks at the changing nature of the policy formation process where independent bodies, such as independent central banks, have a comparative advantage in mobilising and evaluating the empirical evidence that feeds into the framing and execution of public policy. Whatever the explanation, the trend is disturbing to many political scientists who see it as a shift away from democracy towards elitism.

Central bankers themselves may well feel that they can ignore this current of disquiet in a tangential academic discipline as long as they continue to deliver low inflation. Nevertheless it would be unwise for them to ignore it. The risk of political interference continues to stalk independent central banking and politicians will be more inclined to issue their challenges if they feel it is condoned or encouraged from respectable academic quarters. In a less-benign economic environment the challenges may receive more general support.

The disquiet among political scientists springs in part from the general historical background where elitism, (under which government is entrusted to the wise and to the technically competent), has always been the main rival to democratic organisation and the main source of challenge to democratic theory. Representative democracy of the sort established by the American founding fathers is sometimes viewed as an ingenious compromise between the two, where the people do not wield power directly, but instead trust better qualified representatives to take decisions for them. However, the current trend to give important tasks to unelected bodies appears to go much further in the direction of elitism. More than a general discomfort is involved. The disquiet and the debate centre on two key words - "legitimacy" and "accountability."

The roots of legitimacy

Legitimacy is about how powers are justified. Elected bodies justify their powers through their claim to represent the peoples' choices expressed through the ballot box. Unelected bodies have to find a different basis for their legitimacy. One influential view about the justification of the powers of unelected bodies is that their legitimacy flows from their "output". This means that as long as what they do is acceptable to public opinion and as long as they perform according to the intention when set up, then they earn their legitimacy. Another view is that their legitimacy flows from the need of democratic societies to be able to harness a variety of sources of authority including the authority that goes with technical competence.

Up to a point, each of these two approaches to the legitimacy of unelected bodies is reassuring for central banks. They imply that as long central banks act in a technically competent way and continue to deliver low inflation, their powers can be justified. The downside is that such a base is inherently fragile. If independent central banks fail to deliver low inflation their legitimacy can be challenged just at the moment when they may be facing a particularly difficult environment and need all the support they can get. Moreover, no central banker would wish to claim in advance that they will be able get it right all the time. Yet the institution needs to be seen as legitimate even if particular managers make mistakes.

Rigorous tests

In addition, although technical competence is a necessary part of central banking it does not fully capture what is involved. It seems to rest legitimacy on technical aspects, such as the skill with which open market operations are conducted, rather than the broader-based dimensions of central banking knowledge. The need for central bankers to be able to assess information from a wide variety of sources, with widely varying degrees of reliability, to relate imperfect information to both theoretical and practical knowledge of financial market behaviour and to navigate between disputes among economists over whether to be guided by monetary indicators, or price indicators, or a broader set of data, goes well beyond technical competence.

A more robust approach is precisely to rest the legitimacy of unelected bodies on the way in which they follow knowledge-based principles and procedures analogous to those of the social and physical sciences. This means that they must be rigorous in observations and about data quality, try to test findings empirically, point out the uncertainties and probabilities, distinguish between empirical analysis and normative assumptions and connect observations and hypotheses to professionally accepted bodies of theory. They should be transparent about any key assumptions they make in their analysis and any models used should be replicable.

This approach to legitimacy emphasises that it is the rigor of the attempts of unelected bodies to apply the latest knowledge in their field to problem-solving that distinguishes them from elected bodies. Conversely, it is when unelected bodies discard the discipline of procedures and principles that they forfeit their claim to legitimacy.

Towards true accountability

Accountability is about how powers are exercised. Probably the most widely accepted view of what makes unelected bodies accountable is that they exercise their powers under some kind of democratic "overhead" provided by elected politicians. This is because they mostly owe their statutory terms of reference to elected assemblies, their budgets often come from the public purse, they are under an obligation to report periodically to parliaments and congress and their chief executives may be political appointees. In line with this approach there is an extensive academic literature based on principal-agent theory that traces the pathways by which the elected political principals can exercise some kind of continuing democratic control over unelected bodies

As far as central banking is concerned, it is probably only the New Zealand model that fits comfortably within the principal-agent model. In the New Zealand case the minister of finance setting the Policy Targets Agreement can be seen as the principal and the governor of the central bank as the agent. The board, appointed by the principal, monitors agent performance on behalf of the minister and can recommend that the agent, the governor, should be dismissed in cases of failure to perform. In New Zealand also the board is no longer chaired by the governor, but has a 

For unelected bodies more generally, the idea of the democratic overhead is barely plausible. There is a tension between the advantages of independence and the idea of control built into the notion of the "overhead" that cannot convincingly be resolved. Contracts themselves are often vague and contain conflicting objectives. In addition, in most cases, more than one principal is involved with an unelected body. With multiple principals come multiple objectives and the possibility for the agent to play one against the other and to pursue its own agenda. Furthermore, the connection between the ultimate principal in a democratic society, the electorate, and the activities of independent bodies is remote and tenuous. The fondness of political scientists for the principal-agent model seems to owe more to the convenience of the tool rather than to its fit to the real world.

A new separation of powers

A different approach is to see unelected bodies, including independent central banks, as together forming a new branch of government, held to account in a new separation of powers. Under this approach, as in the traditional separation of powers, each branch respects the core competences of the other, and each will arise to defend its own territory if another branch encroaches. If each branch does its own job, the sum of the total is more than the sum of the parts.

"Accountability" in a separation of powers involves answerability in the sense of a need to be able to explain and give reasons for actions, acting within defined limits and the possibility of external sanction, for example from the judiciary, if bounds are overstepped.

An important advantage of this approach is that it reminds us that democratic societies do not rest on electoral politics alone and democracy should not just be associated with elections. An independent judiciary, the traditional unelected branch of government, has long been seen as a necessary component of democratic societies. Perhaps the rise of a new unelected branch bringing the latest empirical knowledge and better information into the public domain should be seen as equally indispensable for the health of democracies. This does not mean that the elected bodies have a less important role to play in democratic societies. It focuses their functions more on the basic ethical and normative choices to be made in society and the more general "macro" political framework within which societies try to tackle their problems.

The least dangerous branch

The founding fathers of the American system of government famously referred to the judiciary as "the least dangerous" branch of government. Writing in the Federalist Papers, the first secretary of the US Treasury, Alexander Hamilton, argued that it was more likely that the judiciary would be the target of encroachments from the legislature and executive rather than itself encroach on the other branches. The new breed of unelected bodies can be seen as the latest claimant for the title of "least dangerous" branch and more in need of protection from the other branches than likely to stray on to their territories. Accordingly, political scientists should be less concerned about the independence of unelected bodies from politicians and more vigilant about the dangers of political interference. Then, they too can join economists in feeling a quiet satisfaction from the advent of independent central banks.

Frank Vibert's latest book, The Rise of the Unelected: Democracy and the New Separation of Powers, is published by Cambridge University Press. (2007 forthcoming).

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