By Bhanu Pratap

Despite months of speculation over a term extension and rabid personal attacks calling him an ‘agent of doom’—Dr. Raghuram Rajan walked out in style, and with dignity. Some have lauded his successful efforts to reduce and stabilize inflation. Others have derided him for his lack of ‘aspirations’ for growth. This article is a modest attempt to add my two cents to this issue. I will do just what my training in economics has taught me – examine both theory and data, and then speak up. Everything else is just ‘noise’.

Individual v/s Institution

Walking out of his term with style, and dignity. | Photo Courtesy: Indian Express

Walking out with style, and dignity. | Photo Courtesy: Indian Express

It is certainly not the end of the ‘India Story’. After a few short-run hiccups, capital markets will continue zooming upwards. India would continue attracting foreign capital owing to its robust fundamentals and fast growth. Surely, no one is indispensable in public life, but the issue here runs much deeper. The aim here is not to talk about an individual, but about the institution. This episode sends out a wrong signal to the markets and the public, one which could potentially have long-run detrimental effects. It is a matter of serious concern regarding the independence of our central bank, in the face of political interference. This also hampers the credibility of the government and the RBI, in their pursuit of price stability. Based on the idea of central bank independence, there is a strong case—theoretically and empirically—to review and increase the term length of the RBI Governor.

There has been a growing body of empirical and theoretical evidence suggesting that the specifics of policy are highly dependent on institutional arrangements. One of the most important examples of this principle, concerns the balance of authority between the central bank and the executive branch of the government. It is here that the notion of an independent central bank comes into the picture. Here, we concern ourselves with policy independence, which relates to flexibility given to the central bank in the formulation and execution of monetary policy. A clear distinction must be made between goals and instrument independence. The former is the ability of the central bank to choose the objective(s) for monetary policy, while the latter means that it is only free to choose tools to achieve the objective(s) set by the government.

Is Inflation Affected by Central Bank Characteristics?

The most straightforward solution is for policy to be bound by ‘rules’. The policy cannot depart from what has been announced publicly.

The need for an independent central bank is based on the classic problem of ‘time inconsistency’. Time inconsistency arises from the policymakers’ incentive to exploit the short-run trade-off between inflation and output. Hence, they pursue expansionary policies. But such policies are bound to fail, leading to higher inflation with negligible changes in output (stagflation of the 60’s and 70’s is a classic example). The most straightforward solution is for policy to be bound by ‘rules’. The policy cannot depart from what has been announced publicly. Thus, there is no barrier to a low-inflation policy and the central bank is perceived to be independent and credible. Implicit in this, is the need to insulate monetary policy from political influence, delegating it to a central banker who is more inflation-averse than the society, and linking his tenure to his performance in achieving the goal(s) set by the government.

It has been convincingly shown that the policymakers’ ability to credibly commit to their actions, the government’s ability to delegate control of policy, and contracts between the government and policymakers can affect average rate of inflation. They can also influence various other macroeconomic indicators. Empirically, characteristics of central banks like their legal independence, the average tenure of their governors and the objectives as mentioned in their charters have been found to have strong associations with average rate of inflation and its variance.

Political Influence Over Monetary Policy

The RBI, in consultation with the government, adopted an explicit mandate to pursue price stability in the form of an Inflation-Targeting (IT) monetary regime. The proposed monetary policy committee (MPC) will lend a more institutional, accountable and a collective decision-making approach to the central bank. These are important steps forward to enhance the credibility and independence of the RBI. It, however, does not fully solve the problem of political influence over monetary policy. I use the word ‘influence’ for two reasons. First, the decision to pursue a clear target of price stability was taken collectively by the RBI and the government. Both indicated that they seek to maximize the same social objective function. Through the government, society’s preference for low and stable inflation is also revealed. Second, the IT regime clearly accords instrument independence to the RBI, granting it autonomy to use the necessary policy tools to achieve price stability.

A government may disagree with the policy stance of the bank but it cannot dictate monetary policy. It is here that the governor’s short tenure creates a possibility of political interference, since the decision to extend his/her term lies with the incumbent government. As a result, the governor may be pressurized to follow the dictates of the government.

Extending the RBI governor’s term to create long enough delays in the elected leaders’ control over policies, is, in my opinion, a necessary measure to permanently protect the institution from political influence and thereby increasing the degree of its independence.

Longer Lags, Lesser Bias

Having a longer term length creates long enough lags, which ensures that elected leaders cannot decide policies which will be adopted during their terms.

A longer term length for the central banker serves to insulate the central bank from political pressures to follow expansionary policies. Having a longer term length creates long enough lags, which ensures that elected leaders cannot decide policies which will be adopted during their terms. They have no incentive of trying to influence policy to exploit the public’s misunderstandings or vice-versa. For example, leaders who cannot influence policy until after they are up for re-election, have no way of catering to the public’s desire for low-interest rates during their terms.

Outlining the Term Length

Theoretically, it has been proven that, increasing partisanship creates policy uncertainty, given the inflation preference of the society. This could be countered by increasing the term length of the central banker. Indeed, the data supports the view, that the tenure length should be negatively correlated with the average rate of inflation. A longer term also provides the central banker with a long-term horizon, encouraging him/her to pursue policies aimed at maintaining price stability and overall development of the economy. The head of every major central bank around the world, almost always enjoys a term longer than the time between two elections. Undoubtedly, all these central banks score high on the indices to measure central bank independence. However, the tenure can also be linked to the minimum time required by the governor to make his/her impact. For India, this could be anything between 5-8 years.

Ultimately, the central bank’s autonomy depends on the government. A government can choose the strength of its commitment to price stability by ensuring independence for its central bank. Only in an environment of low and stable inflation can economy hope to achieve its long-term potential growth rate.

If history is any guide, the fight against inflation can only be won by putting in place an independent central bank to credibly conduct monetary policy.

Having said that, I would like to add that institutions in an economy cannot always avoid undesirable results or even guarantee a desirable one. However, the manner in which they assign decision-making powers within the government, eventually make some policy outcomes more probable and others less likely. The choice is ours to make.

Bhanu Pratap has done his M.Sc. Economics (2014-15) from the Madras School of Economics. His interests include topics such as Monetary Economics, Macroeconomics and Econometrics.


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Posted by The Indian Economist