Many argue that there is an inherent contradiction between accountability of the central bank to the executive and its autonomy from the finance ministry. In this context, the macroeconomic literature on ‘time consistency of policy’ and the game theoretic literature on ‘sub-game perfect equilibria’ has much to say.
Let us examine a two-stage game in which workers’ unions set wages in stage 1—high wages based on high inflation expectations, or low wages based on low inflation expectations. The government sets interest rates in period 2 resulting in an actual level of inflation that may be lower or higher than the expected inflation. This setup encapsulates the truth that many decisions have to be made in anticipation of policy rather than with full knowledge of it.
If the unions set a high wage rate, then costs are likely to increase across the board and result in high inflation. Hence, the government is forced to keep interest rates high. But if the unions set a low wage rate, then the government has the choice of setting a high or low interest rate. In all, there are three possibilities—low wages and low interest rates, low wages and high interest rates, and high wages and low interest rates. The first possibility results in higher-than-expected inflation, while the second and third possibilities result in an inflation rate that matches expectations.
Governments tend to favour the possibility with low interest rates and low wage rates because that tends to reduce unemployment levels, the interest burden of the government and the fiscal deficit. According to the political business cycle theory, this tendency of the government gets exacerbated on the eve of elections. Hence, when unions choose low nominal wage rates, the government will choose low interest rates resulting in low real wages. This is the best outcome for the government and the worst outcome for the workers. Anticipating this, workers will negotiate higher wages in stage 1. This results in a high-cost economy where output and employment levels are no greater than they would be if workers had chosen low wages and the government had chosen a high interest rate, but inflation is much higher. The situation is suboptimal for all concerned. This game has one other Nash equilibrium in which unions choose low wages in stage 1 and the government keeps interest rates high in stage 2. This equilibrium not only gives both the government and workers a higher payoff than the equilibrium described previously, but also maximizes overall social welfare, described as the sum of the payoffs to the workers and the government.
However, the operationalization of this equilibrium requires the government to credibly commit to keeping interest rates high in stage 2 (after unions have irreversibly committed to low wages in stage 1), even though it is not in its short-term interest to do so. This is the ‘time inconsistency’ problem, referred to as ‘sub-game imperfection’ in game theoretic literature.
Ceding authority to an autonomous apolitical central bank is an institutional mechanism that allows the government to make a credible commitment to a conservative monetary policy. This institutional fix enables the socially optimal outcome to be achieved and results in the maximization of the welfare of the citizens to which the government is accountable.
There are, of course, counter-narratives that question the need for central bank autonomy. Repeated interaction between citizens and the elected government could resolve the time inconsistency problem without an independent central bank, provided the government is far-sighted and so long as there is a positive probability that the government will get re-elected. Further, the impact of fiscal policy on inflation and of monetary policy on output growth suggests that a measure of coordination needs to be achieved between the fiscal and monetary authorities.
But what is astonishing is that a government which had earned plaudits for institutionalizing a new monetary policy framework with a clear and transparent mandate for the central bank is now involved in dismantling that very edifice. The ‘partisan theory’ enunciated by Hibbs in 1975 postulates that left-leaning governments tend to be more focused on employment, while right-wing governments tend to be more cognizant of the adverse impact of inflation on the savers in the economy. This suggests that if severe pressures on the Reserve Bank of India (RBI) were to be felt, they should have come in the previous United Progressive Alliance government, not in the current dispensation.
Let there be no doubt on the magnitude of the demands the government is making. As enunciated by Ronald Hasse, central-bank independence relates to three areas in which the influence of government must be either excluded or drastically curtailed. Personnel independence refers to the influence the government has in appointment procedures. Financial independence refers to the ability given to the government to finance government expenditure either directly or indirectly through central-bank credits. Policy independence refers to the elbow room given to the central bank in the formulation and execution of monetary policy. The current demands, which include the appropriation of RBI reserves to ease the fiscal burden, the relaxation of credit norms on SMEs, and the easing of capital adequacy requirements, blow even the veneer of financial and policy independence of the central bank out of the water.
A certain measure of tension was only to be expected on election eve. But the magnitude of the current flip flop borders on the schizophrenic.
Rohit Prasad is a professor at MDI, Gurgaon. Game Sutra is a fortnightly column based on game theory. Read Rohit’s previous Mint columns at www.livemint/gamesutra
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