Central Bank Independence in Transition Economies

Introduction

The newly established central banks in post-communist countries were provided with a considerable degree of legal independence. The reason for that was the empirical success of independent banks in developed countries in maintaining price stability. Theoretical support for independent central bank originates from the well known result on dynamic inconsistency of monetary policy (Kydland and Prescott 1977). Delegating monetary policy to “conservative” central banker reduces the inflationary bias in economy (Rogoff 1985). High and persistent inflation is one of the main problem faced by the transforming economies. Monetary expansion driven by political factors seems to be the main cause of current inflationary episodes. Institutional devises, such as an independent central bank, can impose necessary financial discipline on policymakers and restrict them from short-sighted monetary expansion. Of course, legal independence does not necessarily result in the actual independence i.e., effective protection from the political pressure. The legal provisions may be ineffective because observance of the law, the main public good in developed society, has been destroyed under the communist rule. The new institutions “transported in the suitcases of Western advisors into largely insolvent and administratively weak states” (Semler 1994) may not be able to withstand the political pressure of the transition period. Macroeconomic imbalances, credit-hungry governments and underdeveloped financial system produce an environment in which the CB independence is thoroughly tested. However, even in these  circumstances, proper institutional settings are likely to reduce discretion in monetary policy and create sound foundation for political and economic transformation.