Subramanian Swamy’s call to dismiss Reserve Bank of India governor Raghuram Rajan, while wholly misguided, is not the first instance of disaffection within the current government with regard to the conduct of monetary policy.
In 2015, the government proposed the formation of a panel of seven members who would be tasked with setting interest rates. At present, the governor of the RBI retains sole discretion to set policy rates. This view of Swamy’s, that the growth promises of Prime Minister Narendra Modi have failed to materialise because of the intransigence of Rajan, is one shared by senior government officials as well; it would be wrong to dismiss it as Swamy’s view alone.
Central bank’s independence
The independence of monetary policy from fiscal authority is a cornerstone of the modern economy, yet one that the government is evidently distrustful of. In the short run, raising interest rates to contain inflation trades off growth for price stability. In the long run – or so the mainstream theory goes – maintaining a firm commitment to price stability ensures greater investment and growth as wealth-holders and business people feel confident in the prospects of the economy. Independence of the monetary authority is important here to ensure that the move towards long-term stability is not thwarted by the short-termism of governments seeking electoral votes.
A Central Bank governor who listens to political authority could well oversee reckless spending as elections approach, leading to inflationary pressures that would erode the real value of wealth-holders. In this framework, an independent Central Bank is vital to ensure that the trade-off between growth and price stability vanishes over the long-run.
However, events in the developed economies of today outline how inimical to democracy an independent Central Bank can be. The excessive focus – or monomania – of the European Central Bank on combating future inflation led them to impose austerity and monetary tightening on the depressed Eurozone, leading to massive economic and human costs in countries such as Greece. In the US, commentators watch with bated breath the deliberations of the Fed [the Federal Reserve]; a premature increase of interest rates in response to rising prices might just jeopardise the ongoing recovery. In the UK, Labour leader Jeremy Corbyn has called for a “people’s QE [quantitative easing]”, arguing that recovery efforts undertaken by the Central Bank in the wake of the crisis benefited banks and wealth-holders rather than the common people.
Beneath Swamy’s confused nationalist ramblings lies a genuine frustration with the power of Central Banks to stymie growth by maintaining a high level of interest rates.
The question is, if workers were willing to accept the dangers of potential inflation in exchange for the surety of better growth and employment outcomes, does the current structure of monetary policy allow for their preferences to be heard? The independence of Central Banks, much praised for ensuring economic stability, can actually stand in the way of democracy at a time when the goals of the monetary authority stand directly opposed to the preferences of the people.
Contradictions of monetary policy
But this iota of sense in Swamy’s letter should not distract from the larger problems of the present government. First, Rajan is not to blame for the economy’s slow growth; the current government is at fault too. In a time of falling external demand – exports have fallen for more than 16 straight months now – the government seems unwilling to shift towards promoting domestic demand, as its obsession with tightening the deficit and its unforgivable lapses in expediting NREGA payments at a time of drought indicates.
Moreover, there is a clear contradiction the government is caught in. If economic policy is geared towards opening itself to private investment and foreign capital flows, then it has no other option but to respect the independence of the Central Bank. If private capital were to simply perceive that the new head of the Central Bank would be one amenable to taking orders from the fiscal authority, then they would fear the onset of greater inflation brought about through monetary expansion to aid political goals.
Higher rates of growth of prices would erode the real value of their investments, leading them to withhold investment in the economy. Foreign capital might withdraw from the domestic economy, leading to pressures on the exchange rate which could only be solved through raising interest rates, ironically the very policy that Swamy has a problem with currently.
Even if all these events do not come to pass, the very expectation of it occurring is enough to affect the investment decisions of private capital. The fact that most of the corporate sector has come out in support of Rajan indicates the emphasis private capital places on an independent Central Bank. The Modi government cannot have its cake and eat it too. If it desires a pro-business economy built on private enterprise, it must allow an independent Central Bank that might sometimes work at cross-purposes to it.
Rahul Menon is an assistant professor with the Department of Economics, St Xavier's College, Mumbai.
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