Relevance : GS Paper III
Theme of the Article
The RBI must function independently and not be a slave to outdated ideas.
Introduction
The central bank of a country sits at the pinnacle of its financial system and is mandated with ensuring its stability.
Need of ‘capitals’
- From time to time central banks are directly or indirectly involved in shoring up stressed commercial banks with capital infusion.
- So, it may appear odd to suggest that occasionally even the central bank may need some of its own medicine. After all central banks make a surplus from their operations, and indeed pay a dividend to their governments.
- The puzzle is resolved, however, when we recognise that capital is not only funds but also ideas.
Time to reflect on role
- One of the ideas is related to the role of the central bank in the economy. An economic arrangement once made cannot be treated as settled for all time to come. This also holds true for central banks, often considered venerable beyond querying.
- The global financial crisis has led to a substantial re-thinking of macroeconomics. The main revisions are that monetary policy defined by inflation targeting can no longer be treated as the centrepiece of macroeconomic policy, that fiscal policy should be used to stabilise the economy when needed and that financial regulation is a must.
- The limitation of inflation targeting was understood when the ‘great moderation’, an extended period of low inflation in the west, ended in the financial crisis. It is this that has led to the view that light regulation of the financial sector can be a recipe for disaster.
- It has come to be recognised that assertions of the impotence of fiscal policy may be exaggerated. There could be times when the private sector is held back by the state of the economy. In a recession this would delay recovery. Now fiscal expansion would be necessary.
Lessons to learn
- It is hoped that the Reserve Bank of India and the economic policy-making establishment will take into account the evolving understanding of macroeconomics globally.
- A continuously declining fiscal deficit has not restrained the RBI leadership from paying hawk-eyed attention to it, constantly lecturing the elected government of the perils of even the slightest deviation from the path of fiscal consolidation, when strictly it is not its business to do so. It should instead focus on putting its own house in order.
- Ever since we have had de facto inflation targeting in India, from around 2013, the real policy rate has risen very substantially. This has been accompanied by declining borrowing in the formal sector likely affecting investment.
- Ironically, we have had in India the replay of a scene from the global financial crisis where a central bank focusing on inflation loses sight of brewing financial instability. The crisis at IL&FS, with a group company defaulting on its payment obligations jeopardising the interests of hundreds of investors, banks and mutual funds is only a specific case in point. The larger story is of the steady rise in the non-performing assets (NPAs) of banks even as inflation was abating.
Conclusion
What we need is not just a central bank that is left to function independently, but also one that is not a slave to some defunct school of thought.
