Association for Public Policy Analysis & Management

A large strand of the political economy literature on macroeconomic policy has praised central bank independence (CBI) as an ultimate institutional mantra to safeguard macroeconomic stability. We challenge this conventional wisdom by examining two ways in which central bank independence may lead to enhanced risk taking in financial markets. First, although CBI solves the time inconsistency problem faced by policymakers, it does not solve policy makers underlying incentives to manipulate the economy for electoral gains. Being unable to use monetary policy, and often limited in their ability to use fiscal spending, governments can resort to financial deregulation and direct credit market interventions, such as credit subsidies, to generate short term economic booms. Second, in a low inflation-interest rate environment, incentives for banks to innovate outside of the regulatory sphere might lead to a shift towards more speculative financial instruments. Drawing on the cases of Colombia, Hungary, and the United Kingdom in combination with a large-N empirical analysis, we show that CBI is systematically followed by a weakening of financial regulations and enhanced financial risk taking. According to this line of argument the financialization of the economy and the growing political power of the financial industry might be regarded as a by-product of central bank independence.