Independent Central Banks, Democratic Politics and Deficit Financing in Post Communist Countries Cristina Bodea Michigan State University Prepared for presentation at the 4 th IPES meeting - Texas A&M 2009

What the paper does Connects government deficit financing with the independence and credibility of the central bank. In particular: -Independent and conservative central bankers (i) prefer budget discipline and (ii) have the means to enforce their preference -Legislated independent status of the central bank is essentially cheap talk in the absence of meaningful opposition and a free media, i.e. in the absence of democratic institutions. -Tested hypothesis: Independent central banks can be expected to contribute to lower budget deficits only in countries in which government authorities are accountable -Uses data from former communist countries to test the hypothesis (EBRD ; updated Cukierman et al CBI index)

Previous work Theory of Optimal taxation: E.g. Grilli, Masciandaro and Tabellini 1991, Alt and Lowry 1994, Kontopoulos and Perrotti 1999 Common Pool Resource Problem: E.g. Olstrom 1990, Olstrom, Gardner and Walker 1994, Heller 1997, Hallerberg and Marier 2004 Partisanship: E.g. Persson and Svensson 1989, Kontopoulos and Perotti 1999 Electoral systems: E.g Milesi-Ferretti et al. 2002, Hallerberg and Marier 2004 Elections: E.g Clark and Hallerberg 2000 Budget institutions: E.g. Von Hagen et al. 2002, Hallerberg and von Hagen 1999, Hallergerg 2003, Fabrizio and Mody 2006

Previous work – closer to this paper -Much less work connecting the independence of the central bank to deficit financing -Grilli et al and De Haan and Sturm 1992 find a negative but generally insignificant relationship between central bank independence and budget deficits in OECD countries -Beyond industrialized countries, Sikken and De Haan 1998 find no relationship between legal independence and the level of budget deficits for a sample of 45 developing countries from 1950 to 1994 Above finding - similar with work showing that, in general, the negative relationship between central bank independence and inflation breaks down in developing countries (e.g. Cukierman et al. 1992, Cukierman et al. 2002)

Deficits, central banks and democracy (i)CBs prefer fiscal discipline due to the long run link between deficits and inflation (ii)- Independent CBs can increase the costs of running a deficit by increasing interest rates … See reactions of central bankers to fiscal deficits … See business and financial analysts outlook on connection of fiscal deficits and central bank reaction - Usually, CBI comes with strings attached vis-à-vis the government borrowing from the central bank (iii)Drawing on Broz (2002) - Democratic institutions help with information revelation and improve the ability of the central bank to send credible signals regarding its reaction to deficit spending E.g. Belarus one of the most (legally) independent central bank and at the same time one of the most autocratic regime in former Soviet Union

Data and main variables Dependent Variable: Budget Deficit or Surplus - EBRD (also used World Development Indicators, correlation 0.8) Main Explanatory Variables: Central bank independence (Cukierman weighed index – CBI index; From 0 to 1; weighed, un-weighed, lending only) and Democracy (Freedom House Democracy Score FHDI; From 3 to 12; Low values = democracies)

Basic Model Linear regression with panel corrected standard errors and lagged dependent variable.

Adding economic and political controls -Control for GDP growth, GDP/capita, capital controls, exchange rate regime, trade openness -Control for number of parties in the government (one party, 2-3 parties), minority government, partisanship, electoral year, bicameralism -CBI and FHDI - still positive and significant across the board; CBI*FHDI still negative -What appears to matter: GDP growth (+); Capital account liberalization (-); Bicameralism (-); Minority governments (+)

Discussion Legal central bank independence reduces budget deficits, but the effect of bank independence disappears as countries become less democratic Democracies with dependent central banks tend to overspend the most Predicted Budget Deficit / Surplus for Democracies and Autocracies FHDI CBI Democracy FHDI =3 Middle of the road democracy; FHDI =7 Autocracy FHDI =12 Low bank indep. CBI = (-6.3, -4.3) -4.5 (-5.1, -3.9) -3.6 (-4.8, -2.3) Average bank indep. CBI = (-5.2, -4.3) -4.1 (-4.9, -4) -4.1 (-5.1, -3.1) High bank indep. CBI = (-4.8, -3.6) -4.4 (-5, -3.8) -4.7 (-5.7, -3.7

Conclusion -Only democracies benefit from the development of independent central banks -For democratizing countries, my results suggest that to guard against overspending as political representation increases, newly democratic states should delegate more of their monetary policy to legally independent banks Examples: Between 1999 and 2002 both the Czech Republic and Slovakia were very democratic countries. However, the Czech Republic had a very independent central bank (0.7) and an average deficit of -5% of GDP (with a ratio of debt to GDP of 21%). Slovakia, on the other hand, had only a moderately independent bank (0.5) and an average deficit of 8% (with a ratio of debt to GDP of 47%). [Similar Estonia (FHDI =3, Deficit/GDP=-0.76%, Debt/GDP=5.3%, CBI=0.76) and Latvia (FHDI =3, Deficit/GDP=-3.%, Debt/GDP=13%, CBI=0.46)] -The empirical results here suggest that countries like Slovakia and Latvia could increase fiscal discipline by making their central bank more independent