Losing independence: A slippery slope

The recent resignations by the top guys at the Reserve Bank of India have raised questions on the independence of the Central bank. Navni Kothari and Chiraag Mehta of ISBF share their thoughts on this topic. 

The Reserve Bank of India (RBI) in the past three years has seen resignations from the top guys, including that of former governors Raghuram Rajan in 2016 and Urijit Patel in 2018. While Rajan returned to academia at University of Chicago Booth School of Business, Patel, an alumnus of the London School of Economics, University of Oxford and Yale University, resigned citing 'personal reason'.

However, there were enough media reports citing constant government hectoring and intervention in the RBI decision-making as the real cause for one to read between the lines. Patel’s decision was the first instance of a ‘political’ resignation by a Governor since 1990, and RBI deputy governor Viral Acharya putting down his papers prematurely, made for eerily similar reading. This has raised the question on the Central bank losing its independence. 

Is RBI losing its independence?

The first question that arises here is that why is the Central bank’s independence desirable? To begin with, because the Central bank generally has primary responsibility for managing inflation in an economy, while governments tend to focus on output growth, and these objectives are at odds with each other. As is the outlook of the two institutions, with governments having shorter horizons in sync with electoral cycles, and Central banks generally taking a longer-term view. In fact, Acharya himself contrasted these approaches quite vividly at the A D Shroff Memorial Lecture in Mumbai, by comparing them to a T20 match and a Test match, respectively, and went on to make a case for Central bank independence and caution against governmental efforts to undermine it. Ironically, many view this as the point where the end began for him.

Un-digressing though, achieving the Central bank’s long term macroeconomic objectives requires it to carefully build up and maintain its credibility, and factor this into every decision and policy announcement. This, in turn, gives it the ability to successfully alter the expectations of the real economy, mainly investors and consumers, which is crucial for the effectiveness of the monetary policy it conducts. To this end, it is also in the interest of the Central bank to use its policy instruments sparingly – the Fed’s success in driving an economic recovery using ‘unconventional’ monetary policy following the 2008 global financial crisis bears testimony to this.

This is because the financial markets are quick to factor in this loss of independence. The consequent frequent and short-term ‘tinkering’ tends to dilute the credibility of the central bank’s inflation target. This means that inflation expectations are revised upwards, and the economy could end up with higher inflation without much improvement in output growth, a lose-lose outcome.

In fact, once the Central bank’s independence is undermined, it can become a slippery slope, because it becomes attractive for the government to use the reserves to pay for its obligations. This is not merely a theoretical risk – such a demand was allegedly one of the factors that precipitated Urjit Patel’s resignation. In grimmer scenarios, most hyperinflations, from Germany in the 1920s to Zimbabwe in the 2000s, have resulted from badly conducted fiscal policy, which ended up with the government leaning on the Central bank to finance its budget deficits. Such episodes of high and variable inflation have severely debilitating effects on economies, as great uncertainty accompanies them and this makes people postpone spending.

The need of the hour

It is precisely the risk of such crippling macroeconomic events that has led central banks to be made independent of governments, around the world over the last century or so. Incidentally, it was the German Central bank, in the aftermath of the Great Depression, the hyperinflation and World War II, that in 1951 first enjoyed full independence and spawned the eponymous Bundesbank model of central banking. To drive home their independence and help them steer clear of political influence, most central banks are even set up and vested with powers through separate legislation and are headed and staffed by technocrats with relevant expertise.

However, without an alert media and citizenry, it is not difficult for governments to encroach upon the Central bank’s space nonetheless. In 2019 in India, RBI Governor Shaktikanta Das, cut rates at three consecutive meetings, with the first two being in the lead-up to the Lok Sabha elections. The latest announcement also changed the RBI’s policy stance to “accommodative”, from “neutral”. And was followed by Acharya’s departure, which had been preceded by those of Patel and Rajan, despite the international media proclaiming the RBI as the most credible Central bank during the latter’s tenure, and naming him central banker of the year in 2014.

But it is up to us, the sovereign citizens of this country, to stay vigilant, heed Thomas, and rage against the dying of the light, the light of Central bank's independence.

About the authors:

Navni Kothari, Assistant Professor of Economics, Indian School of Business & Finance, has completed her Master in Economics from Barcelona Graduate School of Economics, Universitat Pompeu Fabra, Spain. She holds a BSc (Hons) in Economics from the University of London and was an undergraduate student at Indian School of Business and Finance.

Chiraag Mehta, Associate Director, Indian School of Business & Finance, obtained his Bachelor’s degree in Economics (Hons) at St Stephen’s College, University of Delhi, following which he completed a Master’s degree in Economics at the London School of Economics and Political Science (LSE). As Associate Director, he currently looks after all dimensions of student welfare, development and learning.