The financial crisis that ripped through the world in 2008 has left many reputations in tatters. Central banks are nursing wounded reputations.
The Reserve Bank of India (RBI) is an exception. It made many enemies for its caution during the boom years, but is now recognized to have helped protect India’s financial system from the mistakes that wrecked banks in many other countries.
A recent article in The New York Times by Joe Nocera, which was republished in Mint on 22 December, credits former RBI governor Y.V. Reddy for not following contemporary policy fashions. “Unlike Alan Greenspan, who didn’t believe it was his job to even point out bubbles, much less try to deflate them, Reddy saw his job as making sure Indian banks did not get too caught up in the bubble mentality,” writes Nocera.
Reddy sensibly tightened lending standards during the boom, and warned banks about lending too much against real estate and shares. In contrast, former US Federal Reserve chairman Greenspan now admits that his mental model of the way an economy functions was wrong.
This newspaper had usually supported Reddy against his critics in 2007 and 2008. But there is more to it than the good sense of one man. RBI has been more cautious about financial sector reforms than most other central banks. It also insisted that a central bank must keep an eye on financial stability besides supporting economic growth and keeping inflation expectations under control.
The latest Report On Trend and Progress Of Banking In India, an annual review published by the central bank, has one chapter devoted to financial stability.
There are two ways policymakers can respond to financial instability of the sort that can emerge as a threat to the economy. One, they can move to prevent the build-up of imbalances and excess leverage in a financial system. Two, they can move to provide capital and liquidity after a bubble pops. The central banks in the rich countries have been fast in the second instance, but they were clearly napping when a bubble was building up.
True, there are still several grey areas. It is hard to define financial stability. It is not easy to identify a bubble till it bursts. There are trade-offs between regulation and financial innovation that are not properly understood. But these ambiguities make the case for caution even stronger.
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