The central bank-finance ministry relationship is not a zero-sum game. Central bank autonomy is in the government’s enlightened self-interest.
Avinash M Tripathi
With the news that the government has initiated consultation for issuing direction under a rarely invoked Section 7 of the RBI Act, the tension brewing between the Reserve Bank of India (RBI) and the Union government has become public. This news was preceded by a speech of RBI deputy governor Viral Acharya which ostensibly dealt with the theme of the central bank independence, though it was widely interpreted as an oblique comment on the contemporary issues.
Many commentators have written on the specific issues involved — regulatory forbearance for certain infrastructure companies, liquidity support to NBFCs, transfer of RBI reserves to the government and so on. However, it is important to spell out the case for central bank autonomy in its own right; otherwise, one may miss the woods for the trees.
To those who are accustomed to seeing the RBI through the prism of US Federal Reserve and European Central Bank, it may come as a surprise that the RBI’s autonomy is extremely circumscribed vis-a-vis the Union government, legally speaking.
Due to idiosyncratic historical reasons, the central bank-government relationship in India evolved very differently from other countries. The RBI Act, passed in 1934, was aimed at giving control of the central bank to the governor general-in-council. It contained many provisions to this effect. For example, the viceroy could appoint and remove governor and the deputy governors at will; and in exceptional circumstances, he could even supersede the RBI board.
After the nationalisation of the RBI, these powers naturally devolved on the Union government. Further, its control became tighter, as Section 7 was amended authorising it to give such direction to the RBI as are ‘necessary in the public interest’. This very provision is reportedly being invoked now, and it has become a bone of contention.
While the legal provisions may favour the government, the economic logic for the de-facto autonomy of the RBI is very strong. There are at least two reasons why the finance ministry should think twice before upsetting the delicate relationship with the central bank.
An autonomous central bank is what economists call a “commitment device”. Like most of the ideas in economics, this can be readily explained with an everyday example. Suppose a customer is purchasing a durable electronic good, say a refrigerator. The seller can easily demonstrate that it is functioning properly by giving a demonstration. However, a smart customer would want to know more: how will this refrigerator work say six months after she has purchased it? Can the seller convince her about the after-sales performance at the time of selling? A seller can by giving a replacement warranty.
“There is nothing more deceptive than an obvious fact”, Sherlock Holmes had quipped. Warranties are such an obvious fact that we often miss their underlying ingenuity. However, notice two facts about them. First, effective warranties must impose some restrictions on the seller. A warranty that can be repudiated costlessly, at will, is not even worth the paper it is written on. Second, such restrictions are ultimately in the seller’s self-interest, as they boost the sales revenue and profit by building customers’ trust.
Generally, a commitment device — of which warranty is a particular example — is an arrangement where someone voluntarily restricts one’s own future choices in order to further his self-interest. This seems counter intuitive, but as the warranty example suggests, it happens all the time.
A good deal of economic development depends on two key variables: saving and investment. Like the purchase of a durable good, the decisions to save and invest are based on the long-terms considerations: a saver worries about his savings being inflated away, not only in the present but also in the future.
Just as the replacement warranties are an ingenious way of promising future functioning of the goods being sold, an operationally autonomous central bank with a clearly defined mandate provides a credible assurance that despite the political cycle, policies promoting price and financial stability will be pursued in future. This assurance may seem restrictive, even costly, to the finance ministry mandarins, but it ultimately pays off by encouraging domestic saving and attracting foreign savings, at a cheap interest rate.
The second reason why the perceived autonomy of the central bank is important is because it depoliticises certain difficult decisions. Students of economic history may remember that the devaluation of the rupee used to be an enormous political decision. Nowadays, these adjustments are seen as routine and a matter of technocratic detail.
When the autonomy of the central bank erodes, we will be back to the days of yore. Many decisions which seem technocratic today — say increasing the benchmark interest rate for fighting inflation — will be subject to the heavy political slugfest, and will have to be adjusted to the electoral cycle. Ultimately, the monetary policy will become non-credible and ineffective.
The central bank-finance ministry relationship is not a zero-sum game. The central bank is autonomous precisely because it in the finance ministry’s enlightened self-interest. This is why the powers theoretically granted by the RBI Act are never invoked by the Union government in practice. However, as the current level of stress in the relationship suggests, the autonomy that is based on norms and conventions is fragile; it may break down in the times of turbulence, precisely when it is needed the most.
Central banking is too pivotal a service to be based on soft constraints such as custom and precedent. If international experience is any guide, the RBI autonomy will have be given a firm legal footing sooner or later. The transition period between breaking down of the old norm and emergence of a new normal will likely be turbulent however.
(Avinash M Tripathi is associate research fellow (economics) at Takshashila Institution. Views are personal)For more Opinion pieces, click here.