The Reserve Bank of India (RBI), like any other central bank, is conservative when it comes to public utterances by its officials. Recently, the duties of a deputy governor were “reallocated” allegedly for his outspoken behaviour. So it was unusual that RBI governor D. Subbarao used a public lecture to highlight the danger to the autonomy of monetary policy from fiscal dominance.
In a speech last Thursday in Hyderabad, Subbarao said: “…It will be less than honest not to acknowledge that the autonomy of monetary policy from fiscal compulsions is once again under threat, and resolving that threat requires credible efforts by both governments and central banks.” This was a central banker’s version of ringing an alarm bell.
In most democracies, conflict between fiscal and monetary authorities is the norm. Politicians often want to spend way beyond what is prudent and want the central bank to monetize deficits and debts. This is the essence of fiscal dominance. Monetary dominance involves the central bank forcing the political authorities to rein in spending and cut deficits. Monetary dominance is rare and most central bankers know they can’t force governments to spend less and raise more taxes.
India was hostage to fiscal dominance for the better part of the 1980s. It was only in the mid- to late 1990s that monetary policymaking came into its own. That happened after the economy opened after 1991 and became subject to what economists call the “impossible trinity”: the impossibility of having a fixed exchange rate, free movement of capital and an independent monetary policy. Then, in the late 1990s, the government stopped issuing ad hoc treasury bills to raise money. Today, the danger is that the clock is being turned back once again. It would be wrong to say that we’re back to the bad days of the 1980s, but Subbarao’s speech indicates that we are heading in that direction.
There is much evidence for that. The huge and unending government spending of the last few years is clear evidence. But cramping in the conduct of monetary policy too is evident: The gap between policy rates and the benchmark prime lending rates clearly indicates that fiscal imprudence is killing the effectiveness of monetary policy. In a country such as India with an underdeveloped bond market, there is a narrow zone in which monetary transmission is effective. Fiscal recklessness is very capable of derailing monetary policy. This is happening in India now. The government may point to the extraordinary global events of two years ago, but increasingly that looks like a lame excuse to spend more.
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