The government is bound to resist such a move. Does that make the government villainous? Certainly not. It only means the government differs from the central bank on where the short-run trade-off between growth and stability must lie.
In his recently published book, Quest For Restoring Financial Stability in India, Dr Acharya gives a compelling exposition of the many channels through which fiscal dominance undermines financial stability. Governments lack the fiscal space to raise expenditure. They will lean on the central bank to push growth by facilitating credit expansion. Bad loan norms will be diluted so that banks don’t need to be re-capitalised. And so on. The result of all this is a banking crisis down the road, and growth is stalled.
All very true. But the story is not unique to India. Credit booms happened in the US and other developed economies, with varying degrees of fiscal dominance, in the run-up to the global financial crisis. The US Federal Reserve
can be said to have more autonomy than the Reserve Bank of India
(RBI). That did not prevent the Fed from tinkering with regulations in ways that allowed rapid expansion in credit. Private bankers lobbied furiously towards that end.
Illustration: Binay Sinha
Banking crises don’t happen only where the political authority uses a public-sector dominated system to accelerate growth under the benign gaze of the central bank. Politicians everywhere tend to favour economic growth. Private bankers have every incentive to boost credit growth — that’s where the bonuses are. Supposedly independent central banks too are not free from a bias towards credit growth. (Pressures from private banks can be as intense as those from politicians— and central bankers are not above eyeing post-retirement sinecures at private banks). The incentives, whether for government or bankers or the central bank, favour credit expansion.
If only we had fiscal discipline and central bank independence, Dr Acharya suggests, financial stability would be secure and growth would not falter every now and then. How many significant economies have graduated to such a paradise? How many market-oriented, democratic countries have grown without boom-bust cycles? An International Monetary Fund study has documented 140 episodes of banking crises in 115 economies in the period 1970-2011. The median cost of recapitalising banks was 6.8 per cent of gross domestic product.
These are overwhelmingly private bank-dominated economies, many with independent central banks. The one success story that leaps to mind is China. It is not a democracy, it has opted for state capitalism and its banking sector is dominated by public sector banks even more than India’s.
Credit expansion fuels growth and helps banking systems grow out of a crisis. This entails an element of kicking of the bad loan can down the road (as with the loan restructuring scheme recently announced by RBI). Governments and banks bet on growth — and, often, the bets do work out. For reasons of financial stability, the central bank may be averse to kicking the can down the road. Governments will be unhappy and mount pressure on the central bank. This is not a contest between good and evil. It’s a difference in perspective between somebody who has to answer to the electorate and somebody who doesn’t have to.
When governments differ from the central bank, the motivations are not always mala fide. There can be genuine differences over the trade-offs between conflicting objectives, the weights to be attached to the short-term versus the long-term and the prospects of policy gambles succeeding.
So who is to take decisions on monetary policy and regulation? Cerebral types seem to think that these decisions are best left to members of their fraternity, the technocrats. Technocrats, they believe, are better placed to take the long view, unlike politicians who are thinking of elections around the corner. Dr Acharya uses the analogy of the Test match player versus the T-20 player.
Is this true of India? Here, political parties have to face the electorate frequently. They have to worry, not just about general elections, but about elections in states and municipalities. Can they afford to jeopardise financial stability and long-term growth in order to win power at the Centre? The dominant political party in the country today would like to hang on to power for the foreseeable future. The leading opposition party has been around for well over a century and a quarter. One wonders who the Test match player really is: The political party with long horizons or the technocrat on a three-year term?
Dr Acharya would like the central bank to be given independence by law. It’s possible to disagree. In a democracy, monetary policy and regulation cannot be entirely left to technocrats any more than war can be left to generals. It is the tempering of the technocratic input by political judgement that makes for sound political economy and gives legitimacy to policies. We have learnt over the years that the one thing that is worse than technocrats accountable to the elected authority is technocrats who are accountable — and subordinate —to none.
The writer is a professor at IIM Ahmedabad. email@example.com