Bank's independence not the complete answer: Peter A Hall contends that a central bank cannot operate satisfactorily unless the country possesses a system of co-ordinated wage bargaining

ANY downturn in the economy sets in motion a search for the culprit and a cure. This recession is no exception. Everyone's favourite culprit in these cynical times is the political class - not just the Government but all politicians. The fashionable cure is greater independence for the central bank.

Free of electoral temptation, an independent central bank would be able to administer the medicine, however distasteful, needed to secure lower rates of inflation.

On this point, many British newspapers and analysts now agree. The European Community has taken a similar position in its plans for monetary union.

But the case for an independent central bank, in Britain or the EC, is not overwhelming. Is it primarily the independence of the central bank that has secured low rates of inflation in Germany? And do the favourable expectations of low inflation associated with independence from political control allow such banks to curb price rises with relatively smaller costs in terms of growth or employment?

The growing number of academic studies that lend superficial support to these points neglect other institutional arrangements that may have an impact on inflation.

There is good reason to think that the institutional structures underpinning wage bargaining affect rates of inflation and economic performance at least as much as central bank independence.

In Sweden and Norway a highly centralised trade union movement plays a crucial role. In Japan and Switzerland trade unions remain weak but powerful employers' associations co-ordinate the annual wage round.

There are a variety of ways to co-ordinate wage bargaining, but each of them confers power and authority on associations of employers or unionists.

For example, Germany's workforce is organised into 17 large industry-wide unions and 80 per cent of all employers belong to highly influential employer associations. Wage bargaining generally takes place in the first quarter of the year at industry level, and its tone is usually set by a leading settlement, often involving IG Metall, the large engineering union.

Since both unions and employer associations encompass an entire industry they have strong incentives to bear in mind the overall health of the sector and its competitiveness. Both the unions and employers' associations also have considerable leverage over their members, who generally depend on them for services.

True, the Bundesbank plays an important role because both employers and unions know that over-inflationary wage settlements will be met by higher interest rates or a higher exchange rate, slowing growth and jobs.

But the important point here is that it is not the independence of the Bundesbank alone that is responsible for Germany's historically low rates of inflation.

The bank operates in tandem with a system of labour market institutions that contribute substantially to the overall outcome. The system of co-ordinated wage bargaining lowers the cost in terms of unemployment or economic growth associated with securing a given inflation rate.

The table illustrates the point by dividing a sample of OECD nations into three groups, each of which displays a certain level of central bank independence. On the one hand, the figures suggest that nations with more independent central banks tend to have lower rates of inflation.

On the other hand, within each group those nations with more co- ordinated systems of wage bargaining perform much better than others in that group on a 'misery index' which adds inflation and unemployment.

Sweden and Norway, for instance, with central banks much like the Bank of England or the Bank of France, have managed to attain rates of inflation roughly similar to those in Britain or France at half the equivalent levels of unemployment.

Among nations with relatively independent central banks, Germany and Switzerland score significantly lower on a misery index than the US, where wage bargaining is not so well co-ordinated.

We can readily see why. Co- ordinated wage bargaining encourages the key negotiators to develop a concern for the overall state of the economy and enables them to incorporate that perspective into wage agreements. It also provides an especially effective mechanism for transmitting the views of the monetary authorities into the process of industrial bargaining.

Whatever the level of independence of the central bank, it will operate efficiently only when it can interact with a system of co- ordinated wage bargaining.

This analysis has important implications, for both Britain and the EC more generally. Where independent central banks work best they have been combined with a particular set of labour market arrangements.

Innovations could include a co- ordinated annual wage round as well as legislation fostering stronger employer associations.

The consequence of establishing an independent central bank focused on inflation without these other arrangements is likely to be a harsher macro-economic regime and poorer economic performance than is commonly associated with such an institution.

These figures also contain a cautionary tale for the EC and its plans to establish a monetary union. The Community at present intends to set up a European central bank whose general structure and level of independence is modelled on the Bundesbank.

However, the Community has shown little or no interest in acquiring the kind of labour market institutions that are critical to the control of inflation in Germany.

As a result, even with an independent European central bank being established, the control of inflation may prove to be more difficult in a European monetary union, or more costly in terms of unemployment and growth, than many of those who are inspired by the German example currently envisage.

Indeed, the image that Germany presents today of a government locked in fiscal combat with the Bundesbank to the detriment of the economy may be far more pertinent to the prospects of European monetary union than the rosy image of Germany in the past.

A European monetary union will resemble unified Germany. High-wage and highly-skilled economies will be joined to less developed regions of the Community under a single monetary authority.

The temptations facing many national governments to pursue expansive fiscal policies will be substantial, especially since some of the monetary effects of such an expansion will be borne by the Community as a whole.

A European central bank may have to pursue policies even more draconian than those of the Bundesbank today to attain low inflation.

Setting up an independent central bank that tries to impose its views on a reluctant government or a recalcitrant workforce is no more than a second-best solution to problems that need to be tackled in wider terms. We should not forget the value of economic co- ordination either in wage bargaining or between fiscal and monetary policy.

Independence for the central bank may be the easiest of innovations to implement, but it is not a panacea for the ills of the economy and those who move in that direction should do so with their eyes open.

Peter A Hall is a Fellow at the Centre for Advanced Study in the Behavioral Sciences, Stanford, California.

(Photograph omitted)