Central Bank Transparency: Good or Bad?

Submitted by Lune…

As central banks become more important in dealing with our global financial crises, one important question is how transparent the central banks’ decision-making process should be to the public.

Americans had grown used to the cryptic statements of Mr. Greenspan in his day, and the merest pause or grumble would be solemnly interpreted by semi-professional Greenspan-watchers for the rest of us waiting with bated breath.

When Mr. Bernanke assumed the chair, he promised to open up communications, and make Fed policy and it’s policy-making process more clear. But he learned the power of his words when off-hand remarks to reporter Maria Bartiromo in 2006 caused markets to dive.

While the Fed publishes minutes of previous meetings, other banks, notably the ECB, does not. As a result, in the U.S., we have far more information on the individual voting preferences of each Fed governor, and the dynamics of the meetings in which Fed decisions are made. The ECB is much more of a blackhole.

European politicians, notably Mr. Sarkozy in France, are now calling for greater transparency in the ECB. And he’s joined by several academics. In an article entitled Transparency and Governance in the Euro Zone, Profs. Geraats, Giavazzi, and Wyplosz argue that opening up the ECB to more public inspection would help it accomplish its goals:

The bottom line is that the ECB would find it easier to control inflation by doing more to shape market expectations.¹ Helping markets to anticipate next month’s decision is not enough, because markets care much more about the entire future course of action. The simplest and best way to shape expectations would be for the ECB to publish its anticipated interest rate path.² This would be much more effective than the current approach involving the use of code words. Code words may be misinterpreted and their very imprecision reduces the effectiveness of monetary policy.

Furthermore, they argue that increased transparency would allow for greater public support for ECB policies:

Greater transparency would have another important benefit for the ECB. The only defence for central bank independence in a democracy is popular support. This can be eroded by determined politicians, as evidenced by the declining trust in the ECB among French citizens. Such a development may tempt more politicians to earn popular support by criticizing the ECB, and the repetition of largely misguided attacks may succeed in denting the reputation of the central bank. It should not be so. The solution is better communication, and not just toward financial markets. Better communication, in turn, must rest on a clear strategy and a higher degree of transparency.

Richard Baldwin argues not so fast:

In modern economies central banks don’t control the money supply. Monetary policy works by influencing workers’ and investors’ expectations, as Mike Woodford explains. When it comes to managing expectations, a good communication policy is the biggest wench in the central banker’s toolkit. But, we are still in the trial-and-error phase; research has not identified the optimal communication strategy. As Alan Blinder writes:

Despite the benefits that communication can in principle generate, it is no panacea. Poorly designed or poorly executed communications clearly can do more harm than good; and it is for instance not obvious that a central bank is always better off by saying more. In practice, central banks do limit their communications. In most cases, internal deliberations are kept secret.”

One lesson is clear. More transparency doesn’t help when a central bank speaks with too many conflicting voices–the so-called cacophony problem. More information in this situation confuses rather than enlightens, with negative effects on economic performance. It is hard to think of a group of decision makers that fit this description better than the ECB’s Governing Council.

As the world’s central banks head into uncharted waters, important policy decisions such as the creation of various lending windows, the bailout of Bear Stearns, the proposed support to the GSEs, not to mention sundry decisions such as setting interest rates and inflation targets, virtually require the right of the public to know how these decisions have been made. Yet if much of the power of central banks rests on their ability to present a unified, clear message, then exposing the sausage-making behind that message might weaken the ability of the central banks to lead precisely when their leadership is most required.