EPW JAN 2014
On 2 May 1997, the British Labour Party won a landslide election victory, sweeping away 18 years of Conservative rule. Rather like today’s Congress-led government in New Delhi, the air of “l’ancien regime” hung over the last few years of John Major’s government. Previously seen as having a safe pair of hands, the Conservative Party lost economic credibility four years earlier at 4 pm on 15 September 1992, when the sterling was rudely ejected from Europe’s Exchange Rate Mechanism. The United Kingdom government lost credibility in that event. While the economy recovered, the Conservative’s credibility did not. Instead, the media scented wounded prey. They had a field day over a deepening quagmire of moral indiscretions by Conservative MPs and a litany of corruption allegations. At the same time a new breed of Labour leaders had emerged, tired of the political wilderness and content to slaughter sacred cows in the pursuit of power. Tony Blair and Gordon Brown cozied up to the Murdoch press, supped with London’s financiers and ditched “Clause 4” of Labour’s 1918 constitution, which called for “common ownership” of the means of production and distribution. The British Tories are hardly the Congress of India, but there are a number of parallels between the political dynamics of Britain in 1997 and India in 2014.
Four days after sweeping to power Chancellor Gordon Brown announced the independence of the Bank of England, stripped it of its regulatory and debt management functions and established a new super-regulator and debt office. With that dramatic entrance, Labour’s economic credibility rode high for 10 years, only diminished by the “Great Credit Crunch” of 2007. Many urge the next government in New Delhi to add immediate credibility to campaign claims of reformist zeal and greater decisiveness by making the Reserve Bank of India (RBI) independent and putting its regulatory and debt management powers in separate, independent, institutions. Would that be a good idea?
Fashion in the Late 1990s
Central bank independence and the separation of monetary policy from regulation was the height of fashion at the turn of the last century. The world’s most powerful central banks, the US Federal Reserve and the Bundesbank were independent. The less powerful were routinely urged to gain greater independence by the International Monetary Fund and World Bank. The theory was that politicians were incentivised to generate short-term booms to carry them through an approaching election because the adverse inflationary consequences would only be realised long after – the problem of time inconsistency. Independence would bring anti-inflation credibility, lowering inflation with least cost in terms of lost output and jobs. Persuasively, the trend of greater central bank independence in the late 1990s appeared to coincide with a period of low inflation and shallow recessions.
The decision to bail out commercial banks or not, was seen as inevitably politicised and so it was argued that it would be hard to maintain political independence of monetary policy if the same institutions and its management were also responsible for regulatory policy. Although many of these arguments appeared intuitive, they were influenced as much by a few contemporary experiences rather than by wide empirical study as data was not plentiful. In particular the experience of the long drawn-out, heavily politicised resolution of three bank failures, Continental Illinois, BCCI and Credit Lyonnais, persuaded many of the benefits of separation.
Time has provided us a different perspective on central bank independence, and the separation of monetary policy and regulation, and suggests that it is not all that it was cracked up to be. First, the focus on inflation in the goods market to the exclusion of asset market inflation, a consequence of the separation, proved a serious mistake. It sowed the seeds of economic instability. Second, it created an “institutional” challenge to the capacity of the State to respond to a banking crisis. Specialisation of economists at the central bank and bank supervisors at the regulator made the central bank’s task of choosing who to bail out and how, tougher than need be. In the crisis, the instincts and wisdom of the old fashioned central banker who had spent stints on monetary policy, bank supervision, debt management were sorely missed. Third, in financial crises with conditional bailouts of banks using newly created cash or debt, fiscal, monetary and regulatory policies converge into one. Seamless coordination is required between the government, the central bank and the regulator – political independence was at times a liability and always a fantasy.
Costs vs Benefits
But does the benefit of political dependence and mixed policy objectives at times of rare crisis outweigh their costs the rest of the time? With 15 more years of data, the empirical evidence of the benefits of independence are not striking – especially if you exclude the Latin American experience of hyperinflation that is not so representative to safely draw general conclusions. Irrespective of long-run trade-offs between inflation and output, there is something to be said for the clarity of politicians setting, publishing and being held accountable for policy goals and technocrats, if perhaps in a single institution, having operational independence and accountability for achieving these goals. Some would say that this is always what central bank independence was about, but for a time at least, something more was hoped for and over the past decade or so, the reality has been less obliging.
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