Central Banking and Monetary Policy: Independence versus Political Economy

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A view of the Reserve Bank of India (RBI) seal on a gate outside the RBI headquarters in Mumbai in this October 29, 2013 file photo. The bold monetary experiment that the Chinese and Indian central banks engaged in this year might one day be hailed as a success. So far, the result has been unprecedented market volatility and little else. To match story ASIA-ECONOMY/POLICY REUTERS/Danish Siddiqui/Files (INDIA - Tags: BUSINESS POLITICS LOGO)

“Despite many protestations to the contrary, the RBI, far from being the exclusive domain of experts and technocrats, is actually a site of politics.”

In the past week or so there have been several articles in the press on whether Reserve Bank of India (RBI) governor Raghuram Rajan will get a second term, come September. Rajan came under fire from BJP MP Subramanian Swamy for, among other things, not being Indian enough and for trying to wreck the economy deliberately.

Theatrical claims aside, substantive disagreements between the RBI and the government seem to be of the usual kind. The central bank is focused on keeping inflation low and is therefore, reluctant to keep interest rates as low as the government, looking for more growth, wishes. This is nearly always a point of contention between politicians and central bankers. And it is expected given the usual division of responsibilities, at least within the framework of a capitalist economy and a parliamentary democracy.

But the general point that the present controversy illustrates, yet again, is that despite many protestations to the contrary, the RBI, far from being the exclusive domain of experts and technocrats, is actually a site of politics. In this article, I want to use the current controversy as an occasion to reflect briefly on this political economy aspect, and on what democratically accountable central banking should look like. In my opinion we, in India, have not debated this question enough.

In mainstream economic thinking today, the principle of “central bank independence” is sacrosanct. This principle mandates that monetary policy should be the domain of a body of experts that is as independent as possible from the elected government of the day. Two reasons are usually given for such an arrangement. First, the macro-management of money is a complex affair and is best left to experts. Politicians and ordinary citizens do not understand the technical aspects well enough to make decisions that will ensure that the nation’s monetary goals are achieved. And second, independence will ensure the central bank does not become beholden to short-termism but instead remains consistently focused on a long-term goal of price stability. The specter invoked is one of a fiscally profligate regime that leans on a willing central bank to finance its spending by printing money. This debases the currency and causes runaway inflation and economic collapse.

“The way money works in modern economies is complex and there are lots of ideas out there about money, some of them not well-thought out and some plain crazy. So the role of experts is certainly crucial.”

Both these arguments have some merit in them. The way money works in modern economies is complex and there are lots of ideas out there about money, some of them not well-thought out and some plain crazy. So the role of experts is certainly crucial. And as a society we hope that the RBI governor and his team have all the details about the functioning of money and banking system in their heads, while also having the interests of the vast majority at heart. The second fear is also understandable and we can find historical support for it. Indeed, central banking in India during the Planning period was much more subservient to the government’s overall economic plan and brought some well-known macroeconomic problems with it.

But neither argument is immune to challenge. First, economic experts are notorious for disagreeing on fundamental issues. Witness the deep disagreements over fiscal and monetary policy that arose between Nobel-laureates in the aftermath of the 2008 economic crisis. Second, monetary policy is a key factor in economic performance and governments are judged by the performance they deliver. So they will always have a strong interest in formulation of monetary policy.

“Interest rates, the primary intervention of the central bank in the economy, change the distribution of income and wealth in society.”

But the central point that the argument for central bank independence obfuscates is that central banking is always an intensely political activity. Indeed it cannot be otherwise, because interest rates, the primary intervention of the central bank in the economy, change the distribution of income and wealth in society. Harry Johnson, an American conservative economist once said,

“From one important point of view, indeed, the avoidance of inflation and the maintenance of full employment can be most usefully regarded as conflicting class interests of the bourgeoisie and the proletariat respectively, the conflict being resolvable only by the test of relative political power in the society.”

Thus class conflict in a society is reflected in its monetary policy. Further to argue today that monetary policy should be formulated by experts insulated from political pressures is to ignore the ever increasing crucial role of international finance capital. Even if a central banker were to be insulated from domestic politics, in today’s financially globalized world, how independent is a central bank really? Does “independence” only mean freedom from the constraints of popular democratic control? What about independence from the global financial elite? These days, barring a situation of a deep economic crisis, a central bank that tries to be accommodative of economic growth and goes easy on interest rates at the risk of some (moderate) inflation is likely to find itself the target of ire from international investors who will threaten to move money out of the country.

“In today’s financially globalized world, how independent is a central bank really? Does “independence” only mean freedom from the constraints of popular democratic control? What about independence from the global financial elite?”

Rapid movements of portfolio capital and ever reducing controls on capital flows across national borders in effect mean a loss of control over domestic monetary policy. India has historically relied heavily on capital inflows to balance its persistent current account deficits (since export-led manufacturing never really took off for us as it did for China). This makes us vulnerable to volatility in capital flows. In fact for many years it is the RBI that has, wisely, resisted freer flows of capital across our borders. But it may be a losing battle. Cries for central bank independence are not really demands for independence of experts to take a long-term view in the interests of the majority of the people. Rather they are about control over monetary policy by the financial investing class who want freedom from democratic constraints imposed by the citizens of a country.

If we accept that central banks are never really independent, but rather are sites where competing interests clash (domestic elites, international financial elites, the professional and middle classes, the poor) then what are the institutional mechanisms by which they can be made politically accountable? What would central banking under control of the majority of India’s people look like? This is not an unproblematic notion. Many liberal democracies, including India’s, are very unequal societies where power rests with a tiny elite. Under such circumstances, it is not unreasonable to suppose that governments will not have long terms interests of the people in mind, but rather will cater to their elite masters while throwing some populist policies to the people periodically. In such a case, a central bank that is under the control of such a government is obviously not democratically accountable either.

But if the founding principle of democracy is that the people are sovereign and that they are capable of making decisions in their own interest, we should be able to have democratically accountable central banking that is still a separate power center from the elected government of the day. But this will require RBI governors to be courageous enough to face ordinary people (not other economists, specialists, or politicians) and be clever enough to explain their policy stances. Maybe even stand for elections and win them! Then hiding behind technocratic jargon would no longer be an option. Is it unreasonable to expect a central banker to be directly accountable to the people? After all his or her decisions profoundly affects us all everyday.

Further reading

Blinder, Alan (1996) Central Banking in a Democracy, Federal Reserve Bank of Richmond Economic Quarterly Volume 82/4.

Ray Partha (2014) Political Economy of Central Banking in India, Paper prepared for the Conference on the Political Economy of Contemporary India, IGIDR, Mumbai, November 20-21, 2014.

Stiglitz Joseph (1998) Central Banking in a Democratic Society, De Economist 146, No. 2,

I thank Arjun Jayadev for drawing my attention to the Johnson quote and for comments and criticism.

Profile photo of Amit Basole
Prof. Basole is an Assistant Professor in Economics at the University of Massachusetts, Boston. His principal fields of concentration are Poverty and Inequality, Informality and Structural Change, and Political Economy of Knowledge. He works primarily on the Indian economy.