Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Opinion | The government should respect the RBI’s stand

It is not legal autonomy, but functional autonomy and common sense that require the government to respect the RBI's stand

The Reserve Bank of India (RBI) and the finance ministry are once again in conflict, this time over the reserves of the central bank. This is not their first confrontation, nor will it be the last. There is little doubt that the RBI is not an independent central bank. Economists and historians have pointed out time and again that the RBI was a creation of the politics of its time, heavily influenced by events in England. So, the question to evaluate today is not really one of complete or partial independence; but that given the RBI is not legally an independent central bank, what are the lines that the ministry of finance, the RBI board, and the RBI leadership should draw, and then never cross? 

Adam Smith, the father of modern economics, made famous the idea of division of labour and specialization in markets. In Book V of The Wealth of Nations, he extended some of these ideas to the separation of powers in government. Smith argued that there are two reasons why we need a separation of power—the first is functional, and the second is to create checks and balances. 

Functionally, there is much division of labour and specialization required in governance. Different departments of government engage in different tasks, which require specialized knowledge, and one department cannot easily substitute for another. This is even more true for authorities with specific mandates such as election commissions, auditors and, of course, the central bank. There is a reason that once the government appoints its “chosen candidate" it generally defers to his judgement and decisions. The governor and his team simply know more about maintaining monetary stability. 

The minutes from the RBI board meeting just prior to the demonetization announcement sheds some light on how the government may have control and decision rights, but lacks the functional knowledge. A fundamental misunderstanding between real rates of economic growth and nominal rates of currency growth was one major gaffe by the government. Also, the consequences of banning 86% of the value of currency on the circulation of money were not considered. The prime minister claims to know the will of the people, but the decision of how many notes must circulate, and in what denomination, to make easy change in an economy, is utterly unknown to him. He has no specialized knowledge in this matter. The RBI, given the time, would know the number of 100 and 50 notes required to ensure that circulation is not affected by demonetizing large denominations. Our prime minister, who decided that no experts needed to be consulted, almost led the Indian economy off the cliff.

In the most recent squabble, the government feels the need to tap into the RBI reserves. Who is more likely to understand two issues—the best current use of those reserves and the consequences of leaving the RBI short of those reserves? It is quite clear that on both counts the RBI has the requisite functional and specialized knowledge. On the other side, the relevant individuals to take the same decision are the prime minister and finance minister who are likely illiterate of macro-economics. 

Adam Smith also forwarded a second, much better-known reason for the separation of powers—to avoid concentration of power in the executive and provide checks and balances to democratically elected governments. While the government suggests that the lack of legal autonomy makes the RBI a subordinate to the finance ministry, both convention and common sense seem to suggest otherwise. The RBI is supposed to maintain monetary stability—and very often that can be achieved only by keeping a check on the government. This mandate for the RBI is a statutory creation, enforced by elected governments. And this leads the RBI to sometimes be in conflict with the wishes of the government, in order to fulfil its statutory mandate. 

In conflicts with every institution, especially those not democratically elected, governments typically reference their mandate as the “will of the people" and then move on to quash the checks placed by other institutions, which are mostly just going about fulfilling their mandate. The RBI is not simply the banker for the government. Nor is the RBI the parent of an errant child, looking the other way when the child overspends. It serves the whole country and has responsibilities beyond writing cheques to the government. 

A third reason to err on the RBI’s side is to reflect on the role it plays. The RBI is also bound by the will of the people that did not elect a particular government. The democratically elected government only received about 35% of the actual vote share (or mandate) of the 60% of the eligible voters who voted. Even though the current ruling party got the most votes, its constituents don’t comprehensively represent the interests of all Indians. This is why democratically elected governments who facing pressure to spend and announce programmes to benefit their constituents just prior to elections should be constrained. Even more importantly, the RBI, given its mandate of monetary stability, also represents the interests of the yet-to-be-born Indians—those Indians who will foot the bill tomorrow for today’s follies. Oddly, it is at such times when non-democratically elected officials actually preserve the long-term interests of the country.

Publicly fought spats between important institutions have both costs and benefits, and the latest RBI-finance ministry squabble shines the light on those trade-offs. It is not legal autonomy, but functional autonomy and common sense that require the government to respect the RBI’s stand. 

Shruti Rajagopalan is an assistant professor of economics at Purchase College, State University of New York, and a fellow at the Classical Liberal Institute, New York University School of Law.

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