Central Banking In the Time of Intervention

In recent years, governments across the world and of all types have been bullying their central banks. This Indian government must return the Reserve Bank to its intended independence. For, remember. Money is memory.

Over the last few years, an interesting—if little remarked-upon—set of interventions by various governments across the world on the independence of Central Banks has nearly become the norm. Those who watch emerging markets have noted this with increased alarm. Not just because the consequences go beyond the humdrum of fixed-income markets or the mechanics of policy decision making, but also because these moves affect the lives and welfare of millions.

Historically, governments the world over have often sought to influence monetary authorities, but it is unclear why, of late, there has been a surge in this streak of interventionism. And the fact that these governments are of various types tells us that it will take some time for a secular explanation to emerge and also an accurate estimation of the impact. It is, as the late Chinese Premier Zhou Enlai famously said of the French Revolution, too early to tell. (It is too delicious to correct the misperception that Zhou was referring to the 1789 Revolution when in fact, it was the student protests of 1968 Paris. Let truth not get in the way of a good joke.)

From Nigeria to Japan

Since January 2012, Turkish Prime Minister Recep Erdogan has struck a strident note against his country’s monetary authorities. With hints of paranoia that would have made Mahathir Mohammad, former Prime Minister of Malaysia and a man of rather, well, strong views, nod approvingly, he has repeatedly promised to “strike back at an ‘interest-rate lobby’”. He has openly argued for lower interest rates, which he deems necessary for growth—not withstanding the lira’s free fall and spikes in concomitant inflation. By June 2014, Erdogan had taken the fight with Erdem Basci,Governor of Turkey’s central bank, public. (Basci had raised rates by 5.5% to counter inflation) Erdogan continues to “berate“ Basci for being reluctant to aid growth.

In Nigeria, matters turned out differently. In February, President Goodluck Jonathan dismissed Lamido Sanusi, Governor of the central bank, who had over the past five years assiduously worked to clean up the post-2009 credit crises and restored confidence in Africa’s largest oil exporter. The dismissal also happened to be rather curiously timed, since Sanusi had brought to the fore the small matter of missing billions in oil revenues overseen by the Jonathan government.

A year earlier, in Japan, Prime Minister Shinzo Abe had appointed Haruhiko Kuroda with a tacit agreement that the two would be partners in the larger goal of spurring the economy through a planned carrot-and-stick approach. A double dose of an expansionary monetary policy on one side and debt control via increased taxes on the other would aid Japan’s macroeconomic housecleaning. But of late, on vital taxes that would help curb national debt, Abe and Kuroda have had open and public differences; and now the widespread perception is that Kuroda must tailor his policies to ameliorate the consequences of Abe’s reneging on raising taxes.

In Brazil, Dilma Rousseff had led an election campaign where she hectored the chief of the monetary authority Alexandre Tombini to bring rates to more “civilized” levels. Inflation has made a comeback and Tombini raised rates, catching many in the market by surprise. More subtly, one recognizes, part of this ‘orchestrated’ surprise was an effort by the Brazilian central bank to ‘regain’ credibility after being seen as an institution at the beck-and-call of Rousseff’s demands.

The Governor of the People’s Bank of China, Zhou Xiaochuan, too was reluctant to cut interest rates but was—by many accounts—forced by party bigwigs in Beijing to keep economic growth (~7% per annum) going. This, despite an excess of wasteful investments that have mushroomed across the mainland thanks to loose credit markets and low rates that have allowed banks to hide bad loans in their balance sheets without any structural correction.

It’s actually a familiar story in each of these cases. The fiscal authorities have bullied, interceded, cajoled, and insinuated policy moves (principally, levels of benchmark interest rates) that monetary authorities are expected to follow. More crudely, politicians are keen to flush the economy with easier credit, an expansionary monetary policy (thus equivalently adjusting the value of money) to engender policy-induced growth.

The RBI’s (lack of) independence

In India too, the new government which has come with an explicitly reform-based agenda has begun to follow its global peers. Finance Minister Arun Jaitley, on repeated occasions, has said that the Reserve Bank ought to cut rates, thus presumably spurring the economy. Ironically, he walks on a well-trodden historical path where Delhi sees it well within its authority to affect perception and reality of policy independence of Reserve Bank officials. Lest one thinks the RBI has some magic wand to increase growth, it is instructive to remember that previous RBI Governor Duvvuri Subbarao had explicitly blamed the UPA’s inability to consolidate fiscally and perform fundamental changes to affect the current account deficit as the reasons why his tenure had ended in the dismal manner it did.

To wit, Jaitley’s public exhortations merely confirm the arrangement that Montagu Norman, Bank of England governor from 1920-1944, had in mind when the RBI was established. Norman believed that the arrangement would be “a Hindoo marriage”: a union between the dominant Bank of England (now, the Ministry of Finance) and a subservient RBI (Presumably, Norman believed that the Bank of England was the male in this relationship). In the years after Independence, T.T. Krishnamachari made this arrangement even more explicit when he publicly criticized the then governor Benegal Rama Rau, who went on to resign in protest.

Jawaharlal Nehru set the tone when he condoned Krishnamachari’s public harangues and since then there has been little doubt as to which side of the governmental see-saw calls the shot. H. M. Patel, Finance Minister under Morarji Desai, further underscored this with his public comments: “The Governor of the RBI held office at the pleasure of the government and there should be no problem in removing him.” During the tenure of P. Chidambaram as Minister of Finance, there was increasingly public evidence that the minister and the then Governor Yaga Venugopala Reddy were at odds on the levels of interest rates. (To his credit, in 2007, Chidambaram didn’t pull rank and let Reddy keep the rates high.)

In 2011, Finance Minister Pranab Mukherjee’s Chief Economic Advisor Kaushik Basu was of the view that rate hikes ought to stop, but the then RBI Governor Subbarao had argued for it to continue rising. Only history will tell if Subbarao’s decisions contributed to the fall of UPA-II, much in the same way as US Federal Reserve chief Alan Greenspan’s decisions in the early 1990s contributed to the defeat of George H.W. Bush.

There is an expectation about the Modi government that the ill habits which the Ministry of Finance acquired over the years will be a thing of the past. India, according to a study on central bank independence by the Bank of Korea, came in at 89th out of 89 countries. The authors comment: “The Reserve Bank of India, for its part, receives low scores for (the absence of) restrictions on the appointment of the governor, independence of policy formulation, and possession of an independent objective.”

Jaitley hasn’t been shy to lay down his expectations of the RBI, and one suspects that as a lawyer, Jaitley believes it is well within his right. After all, the 1934 RBI Act states: “The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.”

Jaitley’s constraints

Jaitley’s motivations for these public guidances are relatively transparent, and even understandable. With the economy still sputtering below the $2 trillion mark, tax revenues are expected to fall short of target (as of now, the fiscal deficit is 83% of full-year target). Like Odysseus, Jaitley had publicly tied himself in his budget speech to the mast of a fiscal deficit of 4.1% of GDP, so that he doesn’t weaken his commitment to get the deficit under control. To maintain his credibility, he has only three options: raise taxes, cut spending or divest Public Sector Units.

Of these, it’s too late for the first two and anyway, these moves are likely to be opposed across the board. As for PSU sales, which are marquee items that could qualify as “reforms”, the Modi government is faced with an equity market that doesn’t want to play along. As Debashis Basu writes, the markets, despite overall growth, see less than expected value in the PSUs that the government could possibly sell off. Like any good Finance Minister, Jaitley is reluctant to sell these PSUs at these low valuations. So, how does he cover the budget deficit shortfall?

It is in this context that Jaitley hopes that RBI Governor Raghuram Rajan can pull a rabbit out of the monetary policy hat by dutifully lowering rates and hopefully increasing economic growth. But what about inflation? And Rajan, one suspects, recognizes that the present dip in inflation isn’t due to any reform by the Modi government, but lower oil and commodity prices (courtesy, in parts, by the Saudis who are keen to make American shale gas explorations economically infeasible). Should Mr. Rajan lower the rates and were oil prices to spike, what we will have is a loose credit policy and a galloping price level.

Inflationary expectations will come off unhinged, and result in volatility levels that few can predict. Jaitley, as any seasoned politician ought to, sees the upside of every policy action; Rajan, as a seasoned academic and bureaucrat, sees the risks involved. It is useful to note that Rajan, before he became RBI Governor, had wisely noted: “When they (central banks) find that the governments are not going to budge (on cutting their deficits), few feel able to just walk away.” It is hard not to think he was intuiting his own future dilemmas.

It is at junctures like these that the question of independence of Central Banks becomes critical and legally protected. Central Bank Independence shouldn’t be the consequence of a generous dispensation by the Finance Minister, but a de jure and de facto reality. Why is this so?

There is a substantive amount of evidence that Central Bank independence is highly correlated with bringing average inflation levels down. In 1991, economists Alberto Alesina and Lawrence Summers found (using data for the years 1955-1988) that the more “independent” a country’s central bank is, the lower the average inflation rate. More recent research from 2006 by economists at the Cleveland Federal Reserve tells us that nearly 2/3rd of the decline in inflation in the OECD countries is attributable to increased central bank independence. The reasoning is straightforward. When the credibility of central bankers is suspect—ie. they are likely to be bulldozed by the fiscal authorities—every policy pronouncement is discounted, every claim is treated with suspicion.

When time comes to stand steady, such pliable central bankers are seen as likely to meet the demands of their political masters. And if there is one thing that a politician can be trusted on, it is to manufacture periods of policy-induced growth, irrespective of the inflationary surges down the road. As a result, we see upticks in inflationary expectations, which feeds into real observed inflation. Nowadays, there is a school (“neo-Fisherite revolution“) that argues that low rates mean low inflation in some circumstances, but for now no one is in a hurry to throw away the textbooks except for politicians like Erdogan.

The consequences of inflation, so far, in common press and markets, is often seen in terms of what it does to the wealth of lenders and borrowers, to the welfare of individuals, and so on. But there is another—and subtler—set of consequences too. Consequences that goes to the heart of how a financialized and monetized society sees and evaluates relationships between its members. It is clichéd, and true, to suggest that ‘money’ is the blood of the system. But what exactly is ‘money’?

The meaning of ‘Money’

At least since Adam Smith, the conventional view of money has been that it arises in societies where there is a double coincidence of wants. In such a worldview, when one unit of good A can’t be readily exchanged for x units of good B, money arises to lubricate the cumbersome barter system. It is a view that privileges money‘s role as a medium of exchange. Economists have run with this idea for over two centuries, despite little real evidence that money does indeed begin because of this reason. In contrast, anthropologists have for long seen money as a way of tabulating debts in society. Money, according to anthropologists, doesn’t emerge out of a barter system, but as means to know who owes what to whom.

It is only recently that economists have begun to think of money as a stand-in for memory of previous records. Narayana Kocheralkota, the current president of the Minneapolis Federal Reserve, wrote an influential paper that announced rather poetically that money is memory. In his model, and other similar ones, money is a technology that allows us to capture the history of all past transactions. These classes of models say that should there be complete information of all our past actions—an omniscient accounting book, if you will—money would be redundant, since we would know who has performed what service and thus owes what to whom. Money, thus, is a technology that is a proxy for memory.

But we don’t live in a world of complete information, perfect competition and demand independence. In presence of incomplete information, humans display various opportunistic behaviours. Our moral language calls such behaviour greed, avarice or plain old ‘Evil’. The Bible (1 Timothy 6:10) tells us that “money is the root of all Evil”. Notwithstanding the wisdom contained in the words of those ancient prophets, a view that modern monetary economists have come around to is captured in the memorably titled paper: Evil is the root of all Money by the economists Nobou Kiyotaki and John Moore.

In this schemata of affairs, money emerges when we can’t fully commit to the promises we give to each other over time. Money, in such cases, becomes a means to work around the problem of what economists call ‘commitment constraint’. Historically, individuals have invented ways to overcome this problem of trust. In the early 1970s, Ireland faced a banking strike—there was a fear that without banks, the money supply might freeze up and the economy would come to a standstill. But nothing happened to the economy. Why? Bars began to issue IOU notes, and the economy went about just fine.

In jails, across the world, cigarettes play the role of currency and physical violence acts as the guarantor of commitment. At its extreme, however, this ‘commitment’ constraint can lead to complete collapse of markets and eventually non-existence of trade itself.

The one institution that provides an economy-wide technology—unbacked fiat paper that we call money—to circumvent the natural difficulties that arise from the inability to commit fully is Government. As economist John Moore noted in 2001: “Americans are more religious: on this dollar bill it says ‘In God We Trust’. In case God defaults, it is countersigned by Larry Summers.” (Summers, who I have referred to earlier here as ‘Lawrence Summers’, was Treasury Secretary in the Clinton administration.)

On the Indian note, it is the RBI Governor who signs as the guarantor of last resort. But in each currency note, the promise of value contained is described in 15 languages. This polyglot note is a tribute to India’s diversity, but it also marks the need to assert in as many tongues as possible that every note carries a specific value that can be a stand-in, a record of the transactions performed by the holder.

Central Banks in this sense are creators of a technology—money—that allows us to overcome all too human constraints of commitment and trust. By interfering with credit levels and value of money, to attend to its own limitations and needs, governments unintentionally endanger, not just the financial and general welfare of its citizens, but the very fundamental instrument —money—which enables modern society to overcome a deeprooted lack: a lack of trust. Viewed thus, interventionist governments become the financial equivalent of Luddites: ones who destroy this social technology to further their short-term agendas.

A Central Bank’s independence to adjudicate matters and take decisions as it sees it fit is all the more important in a country like India, where the monetary authorities have often been saddled with addressing the inadequacies and incompetence of the fiscal side. A reformist government must tend to the taxonomy of independence—functional, financial, institutional et al —that avoids the paternalism of previous governments.

Federalism, autonomy, and an opportunity

Jaitley, as Finance Minister with a majority mandate, has an opportunity to make his mark by breaking away from the pack of peer politicians by granting the mandarins of India’s monetary policy true independence. This will no doubt require some belt-tightening and creative thinking on his part to meet his obligations. But, for far too long, we have had a hub-and-spoke relationship between the authorities in Delhi who instruct other institutions on what is to be done. Our present government is uniquely positioned to rewrite the template of this relationship.

The RBI under Rajan has made efforts to carve out an independent space, but we are far from a truly independent central bank that serves only one master: the value of money. As of now, the RBI with its proliferation of tasks—financing, regulatory duties, monetary duties, rural banking—has been functioning, in Anand Chandravarkar’s words, as an “emasculated fiscal agency”.

The first step towards a modern economy is to depersonalize the relationships between its actors. Part of this modernization is a faith in the federalized structure. When Prime Minister Modi insists that more federalization is the answer, it is rightly borne out of his convictions as an administrator of a state. His instincts are correct, and comes not a minute too late.

But meaningful federalization goes beyond simple devolution of power from Delhi to Gandhinagar or Bengaluru, or any other state capital. Instead, it comes from creating a net of institutional structures, where each node is independent in its functioning. What we seek from this government—a Rightist one, if one may believe its self-description—is to eschew the interventionist overreach that comes naturally and is a legacy of Leftist command-control economics.

The goal ought to be facilitating better coordination between various nodes in the system rather than in overseeing every node itself. The lessons from Modi’s tenure in Gujarat are about acknowledging the limits and expertise of each department and holding each one accountable. Let that true conservative spirit then be found in returning our institutions to their intended independence. Starting with the RBI would be worth the trust, vote and, well, our money.