Home / Opinion / The lessons from the Raghuram Rajan affair

The decision by Raghuram Rajan to not seek an extension at the Reserve Bank of India has set off a firestorm of controversy that will take some time to die down. This newspaper has already said in an editorial published on Monday that Prime Minister Narendra Modi and finance minister Arun Jaitley have failed to stand by one of their senior officials, even as he was the target of a vicious personal attack.

This is also a good time to step back from the immediate controversy to examine some of the deeper structural lessons from this sorry episode. These lessons are important if India is to move ahead to an era of more prudent management of its economy.

The Reserve Bank of India is by law tasked with maintaining monetary stability. Inflation control is its primary dharma. The problem is that the Indian central bank has had to pursue its inflation goal while successive governments have embraced fiscal profligacy. Money had to be printed to fund the ambitious Nehruvian plans. And then, deficits exploded after the 1970s as political parties used economic populism to buy votes. The automatic monetization of fiscal deficits is now history, but there is no doubt that loose fiscal policy has messed with prudent monetary management in India.

What is the way forward? There are three broad lessons from global experience in this ongoing discussion about how the RBI can be protected from political pressures.

First, modern central banks have been given instrument independence. Their inflation goals may be set by the political system, but central bankers are given the freedom to decide how to pursue that goal. One precondition for good monetary management is a fiscal law such as the Fiscal Responsibility and Budget Management Act that imposes statutory limits on fiscal profligacy.

Second, countries such as India with a distinct inflation bias would do well to move towards an independent central bank that gives more weightage to inflation control than the government does. This view is based on a landmark 1985 paper by Kenneth Rogoff on the need for a conservative central banker. Governments that have strong incentives to follow time-inconsistent policies—or when they try to meet goals through inflation shocks under conditions of nominal wage rigidity—will eventually push up inflation expectations. India is a classic case of this.

Third, the task of actually setting interest rates is now better served through monetary policy committees rather than a governor who is prone to mistakes. The tricky issue is how much representation the government has on such a monetary policy committee. There are some who believe that the government should have a majority, while others argue that there should be no government nominee on the monetary policy committee. The actual behaviour of the Indian government in terms of encouraging independent voices should be the best warning against it having too much say in interest rate policy.

The political economy of modern central banking is thus quite complicated. It assumes that a central bank has the freedom to pursue the goal given to it by the political system. It means that the government of the day should also stick to complementary fiscal policy. It assumes that countries with a strong inflation bias should seek a conservative central banker. And it works best when the government of the day has the wisdom to not pack the monetary policy committee with its yes men.

India has serious problems on all these fronts. Rajan is leaving his job just as the RBI is entering a new era with a formal nominal anchor for its monetary policy, a proper monetary policy agreement signed with the government and a monetary policy committee in the works. Making this new system work will need a political leadership that takes institution building seriously rather than being obsessed with personal loyalties.

That is the big lesson from the Raghuram Rajan affair.

Has the government placed too much emphasis on personal loyalty? Tell us at views@livemint.com

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