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Why should central banks be autonomous and what are the consequences of the government infringing on such autonomy? This issue is front and centre not only in India but also in the US, where President Donald Trump has been engaging in a Twitter war with the Federal Reserve against its policy of raising interest rates. Interestingly, the Republicans complaining now were also railing against Ben Bernanke for keeping interest rates too low for too long when Barack Obama was the president. In India, the markets reacted with a murmur to the resignation of the Reserve Bank of India (RBI) governor and his replacement by an ex-bureaucrat who clearly is aligned with the current government’s agenda. This naturally raises questions as to whether central bank autonomy is all that it is cracked up to be.
In a democracy, the elected representatives should have the last word on how the country should be run. The government with a majority in the Lok Sabha should decide on the amount of emphasis on job creation versus inflation targeting. Given the immense power the central bank has in influencing the economy, a fully autonomous central bank can easily design policies to thwart the will of the people. For example, voters elect a government to create more jobs, but the central bank can keep interest rates high to stifle investment and, consequently, job creation.
Although the government is elected by the people and is supposed to act in the interest of the electorate, politicians whose chief concern is winning re-elections run it. Politicians will have a natural tendency to engage in deficit spending (free handouts, higher support prices, and investment projects by state-owned enterprises) just before or just after elections to boost their chances. Politicians can also use the state-owned banking system to benefit their constituents by granting loan waivers. These policies are not only inflationary but will also adversely affect the health of the banking system. The costs of these policies in the long run far outweigh their short-term benefits to a subsection of the population. India’s history since Independence is one of high state and central government deficits, a weak banking sector and high inflation.
Even during the current state election cycle, both the Bharatiya Janata Party (BJP) and the Congress state governments implemented farm loan waivers to win elections. Controlling the harm from such actions is the case for an independent and autonomous central bank. Such a central bank can fight the inflationary pressures resulting from deficit spending and also potentially reduce the benefits of such government handouts in terms of economic growth. This, in turn, will reduce the government’s incentives to engage in such handouts in the first place.
In the US, the tension is partly resolved by clearly specifying the dual mandate of the central bank in terms of price stability and full employment and also limiting the power of the government to interfere with its authority. Despite his railings, President Trump cannot remove Jerome Powell, the chairman of the Federal Reserve, without just cause.
In India, RBI does not have formal autonomy. While RBI’s mandate is to ensure price stability keeping in mind the objective of growth, its board is dominated by government nominees and, to my knowledge, the government can remove the governor at will. In effect, the government has formal control over RBI. Despite this, successive governments have limited their overt interference in the work of RBI. Given the historically high deficits and inflation in India, I cannot definitely say that the government has exercised similar restraint in exercising covert control over RBI. I am sure many governors looked the other way as governments engaged in deficit spending around election time.
Given the effective government control and the current government’s willingness to overtly exercise such control, why have the markets not reacted adversely to government meddling?
This, in my mind, is because of the market’s myopia or short-term orientation. Right now, India’s industrial growth is slowing and the non-banking financial companies (NBFCs) and the formal banking sector are struggling to deal with bad loans. This is dampening credit growth. Given this, the markets will cheer any short-term stimulus. A pliant RBI will enable such stimulus not only by going easy on the banks and NBFCs but also by transferring some reserves to the government and enabling greater deficit spending. While this is likely to be good in the short run, it is likely to be costly in the long run. While higher inflation and a weaker banking sector are obvious costs, the overt exercise of control over RBI by the government will also limit the willingness of independent-minded individuals to take up the post of RBI governor in future. Even if such an individual takes up the post, the threat of government interference will affect his or her willingness to act in an independent manner. India’s history clearly highlights the dangers of going down this path. This to my mind is a bigger cost.
Given the track record of India’s politicians, my vote would be to formalise RBI’s autonomy by reducing government control over its board and also clearly specify the reasons for which the government can remove the governor.
Radhakrishnan Gopalan, is a professor of finance in Olin Business School at Washington University in St Louis