Central banks battling inequality? West might be catching up with India

A paper asks whether central banks should care about inequality. In India, the RBI has been doing it for decades

It is a matter of constant wonder to me how far ahead of the curve India and the Reserve Bank of India (RBI) have been. I say this because I recently read a research paper asking if central banks should have the reduction of inequality as their mandate. Apparently, this is a hot-button topic in some Western policy circles. So the question the paper (by Roberto Chang) asks is, "Should central banks care about inequality?"

The paper suggests that central banks can perhaps be assigned "a mandate under which agents with higher nominal wealth are given a higher relative weight than under the social welfare function. In other words, society should choose a central banker that is less egalitarian than itself." That is, its head should be very traditional and conservative to balance the role.

It goes on to say that "including a concern for redistribution in the central bank's mandate can enhance policy credibility, but the details can be unexpected and should reflect the role of the mandate in overcoming policy distortions." That is, how can a central bank fix the mistakes of governments?

These matters have been debated in the RBI since at least 1960, and the consensus that has been reached is that "financial repression" is a necessary policy instrument for redistributive objectives. But this idea was half abandoned after the reforms of 1991 or, as PM Nehru once said in a different context, "Not wholly but in substantial measure".

Interestingly, the Indian way is now being discussed in the West as if they have discovered something startlingly new. So the paper says, "Our analysis reveals that it may be socially beneficial to give central banks a mandate that incorporates distributional concerns."

But the author adds a condition that if there is no selection bias in the central banks on whatever grounds and if "the central bank lacks commitment power."  

Both conditions have been met in India for over 45 years. There is no bias in its policies, and the RBI does lack the power to fully commit to a particular policy because of the overweening power of the government.

An interesting message of the research is that "in the presence of time inconsistency, the central bank mandate should be less egalitarian than the social welfare function." This means if the central bank is likely to flip-flop, having a more conservative central bank is preferable.

The problem is that central banks abroad can, and do engineer, inflation to fix government debts. This affects the poorer people more than the richer ones. So a strong central bank that sticks to its guns is needed if it is mandated to tackle inequality. In short, don't engineer inflation.

We need to examine this in the context of India. Inflation of over 8 per cent had been a more-or-less constant feature in India until the reforms of 1991 led to a gradual increase in output. The norm then came down to 6 per cent. Most of the inflation was caused either by loose monetary policy or supply shocks, both internal (drought) and external (foreign wars).

While the RBI couldn't do anything about the latter, fiscal policy condoning loose monetary policies has been an abiding fault. The relationship with the government has been cooperative rather than adversarial. And the RBI has seldom been proactive in fighting inflation. It has usually waited for a nod from the government.

But it has never engineered inflation to reduce government debt. In that sense, it meets the research paper's criteria. Things are somewhat different now since the RBI has constituencies other than the government, like the money market and the forex market.

Therefore, we can expect a more committed central bank to fight inflation. In any case, now it is required by law to do so.

As to fighting inequality, that's been in its DNA now since 1970. It's a grandmother who doesn't need to be taught how to suck eggs.