The latest monetary policy report of the Reserve Bank of India (RBI) published earlier this month began with a rather unusual chart.
The chart and the accompanying discussion highlighted the fact that the near-unanimity of decisions in the monetary policy committee (MPC) was not a uniquely Indian phenomenon. The report pointed out that the “recent experience of MPCs in the UK, Sweden, Brazil, Thailand, Czech Republic and Hungary suggests that rate decisions have been based on unanimity”.
The report’s reference to the unanimity in decision-making by other MPCs was perhaps a response to the barrage of criticism that has been directed at the MPC in particular, and RBI in general, over the past few months. Several influential voices questioned both the autonomy and the competence of the institution.
Indeed, a cursory glance at news headlines suggests that RBI has constantly found itself at the centre of controversy over the past year. First, there was the controversy about whether or not Raghuram Rajan would receive an extension, which ended with Rajan announcing that he would not be seeking another term as RBI governor. Then Rajan’s predecessor D. Subbarao published a book where he detailed his disagreements with the government over various issues, and how he had to pay a price for it.
The biggest of them all, however, was reserved for the end. With the Narendra Modi government demonetizing high-value banknotes in November, RBI began facing questions not just on its autonomy but also on its competence. RBI’s employees’ union and former governors joined the debate, expressing alarm over the dent to the institution’s credibility and autonomy. In such an environment, criticism of the MPC must have been like the proverbial last straw on RBI’s back, forcing a response from the powers-that-be at the central bank, even if the response was couched in typical central-bank speak.
The debate over the independence of RBI may have been rekindled only in the recent past, but the debate is as old as the central bank itself. The concept of an independent central bank for India “on a level of authority with the treasury” was first spelled out by one of the greatest economists of the 20th century, John Maynard Keynes. But Keynes’s wish for an independent RBI did not amuse the legendary chief of the English central bank, Montagu Norman. Norman was quite blunt in his assessment of how RBI should be structured, and proclaimed “a Hindoo marriage” between the Bank of England (the dominant spouse) and RBI (the subservient wife), whereby in return for formal advisory services, RBI was to yield to the Bank of England the right to determine the disposition of its funds.
“Norman’s graphic simile is… expressive of the RBI’s real status after its creation,” the late Anand Chandavarkar, who served as an economist with RBI’s research department, wrote in a 2005 article for the Economic and Political Weekly. “The GoI (government of India) became the male chauvinist husband and the RBI the ever docile traditional Hindu wife who had forfeited even the minimum right of nagging the husband—the supreme prerogative of a central bank, as so memorably stated by Norman himself.”
Chandavarkar observed that RBI was in fact more independent in the British Raj than in the post-independence period. As RBI assumed quasi-fiscal mandates in order to fulfil plan targets set by the powerful Planning Commission, it became an “emasculated fiscal agency”, in his words.
In the post-liberalization period, RBI regained a semblance of autonomy, partly owing to the chemistry between successive finance ministers and RBI governors, as one of RBI’s official historians, T.C.A Srinivasa Raghavan, notes in his latest book, Dialogue of the Deaf: The Government and the RBI.
As India opened itself up to the global economy, and the notion of having an independent central bank became part of conventional economic wisdom in the West, RBI too began enjoying greater clout, and significantly greater autonomy than before. The end to the automatic monetization of the fiscal deficit under governor C. Rangarajan, supplemented later by the enactment of the Fiscal Responsibility and Budget Management (FRBM) Act, helped RBI gain operational autonomy.
This phase ended after the great crash of 2008, as successive governors since then allowed the government to wrest back the autonomy RBI had begun enjoying in the post-liberalization era, according to Raghavan.
Economists have long argued that interference by the government in the functioning of the central bank could lead to low interest rates and stoke the fires of inflation. Governments driven by electoral calculations could, for instance, favour lowering of interest rates just before elections to provide a short-term boost to growth even if it comes at the cost of long-term inflation. Thus, there is a risk that monetary policy would become volatile, and lose credibility and effectiveness.
This view got strengthened after a 1977 paper by two economists, Finn E. Kydland and Edward C. Prescott, gained influence among economists and central bankers. In it, the duo showed that discretionary monetary policy, no matter how intelligently executed, will suffer from “time-inconsistency”. To illustrate, even if a central bank knows that the best policy in the long run is to maintain a steady monetary policy, discretionary powers could induce it to introduce surprise inflation into the economy for one year to increase employment in the short run, although in the long run it might only end up increasing inflation. Kydland and Prescott jointly won the Nobel Prize in economics in 2004 for their research. They recommended making central banks follow rules that would prevent them from causing inflation.
The time-inconsistency problem is exacerbated when the government exercises control over the central bank’s functions, research by other economists showed. Empirical research also began to point to a link between the degree of independence a central bank enjoyed, and its ability to tame inflation. But this posed a problem for democracies— how do you assign power to a group of unelected officials while at the same time ensuring their accountability and legitimacy?
The idea of an independent inflation-targeting central bank was mooted to deal with this problem, and in the subsequent decades began gaining acceptance across the world.
The deal was that central banks would be assigned an inflation target (or goal) by the sovereign, and they would be answerable to the executive or legislative arm of the sovereign on their performance in meeting that goal. But they would have operational freedom in the means they choose to attain that goal. While no central bank, with the exception of the European Central Bank (ECB), has de jure (legal) independence, most central banks in the developed world came to enjoy de facto (actual) independence from their respective governments, or at least claimed to have such independence.
This consensus on the issue of central banking independence was challenged by several economists, but it was not until the great crash of 2008 that the critics began gaining ground. Questions have been raised over the competence, or rather priorities, of the central banks as they failed to prevent the biggest financial crisis in recent history despite being independent from political influence. Indeed, the major economies with the most independent central banks—the US, UK and Europe—found themselves in far greater trouble than countries such as India, China and Brazil which had far less autonomous central banks, as pointed out by Joseph Stiglitz, Nobel laureate and professor of economics at Columbia University, in a speech delivered in Mumbai in 2013 .
The reputation of central banks suffered both because of their inability to foresee the crisis and the manner in which they chose to respond.
The Federal Reserve faced criticism because it intervened aggressively in this as well as past crises, building up the problem of “moral hazard”, which meant that firms knew they would be considered too-big-to-fail and hence could afford excessive risks. The way the Fed took over the tasks of the Treasury in trying to rescue the banks and the US economy was also criticized by economists. The ECB faced the opposite charge of not doing enough, or worse, not knowing what to do, in response to the crisis.
The independence of central banks in the developed economies, in a world where high inflation is no longer the paramount risk, is today being questioned. It is worth noting that initial academic work advocating central bank independence had gained thrust in the 1970s, which was a decade of high inflation.
Today, the main concern afflicting the people in the developed world, apart from slow economic growth, is worsening inequality. And, not without reason, it is believed that central banks have had a great role in accentuating the inequality, especially in the post-crisis world.
The problem, according to some, is that central banking is no longer confined to managing growth and inflation. Instead, in the post-crisis world, it is engaged in distribution of wealth; it is picking winners and losers, according to Stiglitz. Savers, pensioners and old people are being penalized by very low interest rates; while the rich, who own assets like stocks and bonds, benefitted from the asset-buying programmes of the major central banks.
Questions on both inflation-targeting and the independence of central banks have only grown louder over the past few years as even the unconventional policies pursued by several leading central bankers have failed to deliver sustainable growth. Several economists have pointed out that inflation-targeting itself is not adequate if the central bank ignores risks to financial stability. And in economies such as West Germany, where inflation-targeting has apparently been successful, there might not have been any causal link between central bank independence and low inflation even if they were correlated. Research suggests that it was actually the widespread support for low inflation owing to the pre-War history of that country which enabled the Bundesbank to attain autonomy and deliver low inflation.
Others have argued that independence from the government need not mean independence from markets and bankers. According to this view, the very idea of an independent inflation-targeting central bank was patronized and promoted by influential bankers to ensure “predictability” in monetary policy that would help them make money on their bond market bets.
Economists such as John Goodman and Adam Posen have long argued that banks are often the staunchest supporters of a low-inflation regime because their balance sheet structure (maturity mismatching of assets and liabilities) render them particularly vulnerable to inflation. Of course, in an economy with a high proportion of stressed assets, banks and other financial institutions may desire higher inflation to lower their burden of debt.
Ironically, India has moved to an inflation-targeting framework just when the intellectual consensus underpinning it has weakened. Perhaps, this has been prompted in part by concerns and questions around RBI’s own autonomy and performance in the post-crisis era. While RBI has fared better in maintaining financial stability during the crisis years, its anti-inflation record has been mixed over the past decade. It is perhaps to correct the perception of being an ineffective force against inflation that the flexible inflation targeting framework has been adopted. However, the adoption of this framework does not settle the issue of autonomy.
Chandavarkar, in his essay, had argued for a new commission that would-re-examine the role of RBI in independent India, and suggest ways to give constitutional protection to RBI’s autonomy, and legislate a federal structure for the bank with representation from different regions, which may be impacted differently by monetary policies.
But at a time when support for central bank independence seems to be waning globally, with one Financial Times commentator calling it an “end to the era of central bank independence”, it may not be easy for RBI to demand and gain greater autonomy in this brave new world. Nor will legislators be keen to bestow greater autonomy upon it.
Legislating autonomy can also work only when the Indian economy does not have as much fiscal dominance as it has today. As the economist Ignacio Mas of the World Bank argued in a 1994 research paper , simply proclaiming central bank independence without imposing fiscal discipline might lead to a “game of chicken” between the central bank and the government.
In such a scenario, the central bank will try and raise interest rates to discourage fiscal profligacy by the government, while the government will continue to spend and borrow, testing the central bank’s resolve to raise interest rates.
Maybe India witnessed something similar during the latter half of the United Progressive Alliance (UPA) regime, when the then finance minister P. Chidambaram famously remarked in 2012 that the government would “walk alone”, if need be, to drive growth. Thus, developing countries such as India may be better off by institutionalizing fiscal discipline.
“A more credible FRBM will allow better fiscal-monetary coordination”, according to Ashima Goyal, economist with the Indira Gandhi Institute of Development Research, Mumbai. She suggests that an active monetary policy can support growth “if fiscal policy passively follows the path of consolidation”.
Legislating autonomy in an economy such as India is also difficult as a large part of the banking system is state-owned and functions under the directions of the finance ministry. If RBI is at loggerheads with the ministry, and the finance minister is unable to remove the RBI governor, it is possible for him or her to frustrate the efforts of RBI through directives issued by the banking division of the finance ministry.
How autonomous RBI will be in the future will depend not just on how and who is appointed governor, but also on how we decide to iron out these institutional wrinkles.
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