In recent months, the country has witnessed a raging debate on the > independence of the central bank . It raises an important question: independence of whom, and independent of what? In literature, independence of a central bank has to be contextual, and has four main dimensions: a) statutory independence from the state with respect to nomination, tenure and termination of the Governor; b) independence of monetary policy instruments, implying managing of the interest rate or liquidity; c) independence of monetary policy objectives — > inflation targeting , credit control, priority sector lending or any other objective which is stipulated by the government; and d) financing of government deficit. If the central bank has to ensure a responsible policy formulation, then to whom is the accountability?
Roots of central bank autonomy The science of central banking is still evolving. The evolution, as always, has not been easy and has had its share of challenges. In 1900, there were hardly a dozen central banks and each had been initially created to dispense some specific function of the government, mainly to issue currency and coinage or manage foreign exchange reserves. Regulation and supervision of banks came later, and later still inflation targeting and fixation of interest rates. The concept of an independent central bank evolved in advanced economies and finds its roots in the successful anti-inflationary policy of Paul Volcker in the U.S. between 1979 and ‘82. Mr. Volcker’s policy was institutionalised in legislation and practice that argued for greater independence to be granted to central banks. However, according to economic literature that developed thereafter, and which was extended to other countries including developing countries, the most independent central banks are those of Latvia, Hungary, Armenia, and Bosnia. India, Saudi Arabia, Singapore, and the U.S. are the countries with the least independent central banks.
The need is to recognise that there is a clear distinction in the functioning of central banks in advanced and emerging market economies (EMEs). In advanced countries, financial markets are not only developed but seamlessly integrated, and financial institutions, established a long time ago, are mature, which ensures that the transmission mechanism is efficient. Therefore, central banks can focus on a single objective to be pursued by a single instrument, and hence the quick adoption of inflation targeting by many central banks. However, even in advanced economies, because of global spillovers, the challenge is of how to define independence of a central bank. Illustratively, with the “savings glut” in China as former U.S. Federal Reserve Chairman Ben Bernanke had once called it, the financial markets in the U.S. were directly impacted, and Congress had to consider harsh steps/sanctions in 2004 and 2005. Similarly, the transmission of implications emerging from the sub-prime crisis in the U.S. to the rest of the world.
Additionally, except in a few countries like Germany, the U.S. and Switzerland, the government directed monetary policy function until a few decades ago. In the U.K., independence evolved over a period of time and the Bank of England, set up in 1694, was offered operational independence only in 1997, implying that the interest rate was fixed by the Treasury until then. Even in case of the U.S. Federal Reserve, as is well known, independence is within the overall authority of Congress.
In emerging economies In EMEs, characterised by underdeveloped financial markets, with inefficient transmission mechanism and government ownership of financial institutions, independence could rather be harmful. Consequent to ineffective transmission of monetary signals, central banks of EMEs have to intervene in different isolated markets. In practice, central banks of EMEs have to pursue very diverse activities — diverse not only from advanced economies but also from other EMEs. Illustratively, central banks in emerging markets have to ensure development of financial markets and carry out financial sector reforms. They have also to ensure that the financial system, including banks, is robust and stable. In many EMEs, especially those transitioning from socialist economies, banks and financial institutions are owned by the government. The government-owned banks lend extensively to other government-owned companies, compromising standard commercial viability criteria. The central banks of EMEs also have to focus on macroeconomic variables like capital inflows and balance of payments because most of them follow a managed exchange rate system. And simply to ensure that banking penetration is extensive, financial inclusion also becomes an important objective.
If the central bank has a single objective, independence is understandable for a focussed approach, but if the central bank has multiple objectives, then there is an increased need for coordination with the government to jointly face challenges. In fact, government ownership of many financial institutions and public sector enterprises and extensive financial interaction, supervisory and regulatory authority vested in central banks cannot operate independently. In addition, it is difficult to practise independence in one activity and not in another.
When interest rates are zero or near zero in advanced economies, then distributional and allocational issues related to monetary policy arise which necessitate coordination with the government. In a situation, globally, where the main objective of macro policy is > GDP growth , financial stability, financial inclusion and trade-off between inflation and employment, then critically high coordination is necessary between different apex institutions, not independence.
Most importantly, in any democratic system, government institutions and government policies have to strike a compromising balance between diverse interests and be sensitive to the use of public resources. Seeking independence from the elected representatives is rather difficult in any democracy. Therefore, joint and consultative effort, despite some differences, as illustrated in the monetary history of the U.S., the U.K., Canada, should be the norm. In India, the objective of macro policy is enhancing economic welfare, and any one wing of macro policy, monetary or fiscal, cannot independently work without active support of another. In fact, the concept of an independent central bank has different implications for different EMEs and advanced economies, depending on the level of development of the economy and markets. Unfortunately, this distinction has neither been recognised nor researched in economic literature so far.
Charan Singh is RBI Chair Professor of Economics, IIM Bangalore.
