A V Rajwade: The 'illusion' of independence

The world over, there are several limitations to central bank autonomy

The issue of autonomy/independence of the Reserve Bank of India (RBI) is being debated in the Indian media since the announcement of demonetisation of old Rs 500 and Rs 1,000 currency notes on November 8. As for whether the RBI Board was given adequate time to consider it, it is important to remember that, often, policy issues get informally discussed in Board meetings for several months before a formal proposal comes for approval. Also, perhaps the two most important functions of the central bank are monetary policy and banking regulation — the Board seems to play little role in the former and the latter is being decided in Basel. In its role as manager of public debt, the RBI is, in any case, an agent of the central government. Again, as for note issuance, the governor’s “promise to pay the bearer…” is accepted as medium of exchange because of the implicit backing of the sovereign, not so much on the strength of the RBI’s balance sheet.

Looking at the issue of central bank independence in a historical context, in an earlier era, most central banks were privately owned and their note issuance was limited to the quantity of gold they held. In the interwar years, perhaps the most powerful — and ambitious — central banker was Montagu Norman, the governor of the Bank of England from 1920 to 1944. To quote from Carroll Quigley’s Tragedy and Hope, governor Montagu desired “nothing less than to create a world system of financial control in private hands able to dominate the political system of each country and the economy of the world as a whole. This system was to be controlled in a feudalist fashion by the central banks of the world acting in concert, by secret agreements arrived at in frequent private meetings and conferences”. In that era, “each central bank, in the hands of men like Montagu Norman of the Bank of England, Benjamin Strong of the New York Federal Reserve Bank, Charles Rist of the bank of France, and Hjalmar Schacht of the Reichsbank, sought to dominate its government by its ability to control Treasury loans, to manipulate foreign exchanges, to influence the level of economic activity in the country, and to influence cooperative politicians by subsequent economic rewards in the business world”. Governor Norman’s decision in 1925 to restore the pound’s exchange rate in the gold standard era to its prewar level was aimed at maintaining London’s importance as the global financial centre; it was disastrous for the economy, leading to millions of unemployed people, a deep recession, and had to be abandoned a few years later. (Overvalued exchange rates, often liked by inflation-targeting central bankers, can be costly for the real economy.) Again, in March 1939, after Nazi Germany occupied Czechoslovakia, governor Norman transferred some Czech assets to Germany in defiance of government orders. Independent central banks have obviously not been too virtuous or wise in their activities, at least in an earlier era.

What about the relationship between governments and central banks in more modern times? Perhaps, the best example is the 1951 Accord between the US Treasury and the Federal Reserve. The background to the Accord was post-war fiscal deficits to create employment by investing in infrastructure, monetisation of government debt and inflation, issues of great relevance even today. The more important conclusions on the Accord and its lessons for central bank independence, drawn in a paper by Thorvald Moe (January 2013, Levy Economics Institute), include the following:

* There is a permanent need for coordination between fiscal and monetary policy (and on issues like demonetisation?);

* Central banks should not be omnipotent;

* History should… encourage central bankers to be more supportive of government efforts to fight mass unemployment — and,presumably tax evasion.

This apart, there is enough evidence to suggest that the “independence” of the professionals in at least the two major international central banks, namely the International Monetary Fund (IMF) and the Bank for International Settlements (BIS), to express their opinions frankly, is limited. The IMF’s Internal Evaluation Office (IEO) has commented on several reports on the issue (“Following the path of rationality”, The Other Side, March 31, 2016). As for BIS, which provides advice to the world’s central banks, an independent external review of its analytical and decision-making processes came to the conclusion that “there was a ‘house view’ justified by only rather flimsy theory or limited evidence”. The staff felt they “should not challenge that house view but find evidence to support it”.

Clearly, central bankers’ independence has many facets.

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com