India’s Central Bank Debates Remind Us the Fed Is Far From ‘Independent’

Published in Real Clear Markets.

Should central banks be “independent” from the elected parts of the government?  If so, should they be independent in all things, or just some things?  Or should they not be independent at all? These are classic questions.  Of course, central bankers themselves like the idea of independence, as do many economists, who believe they know better about economic and financial affairs than mere politicians.  Larry Summers, a leading economist, former Secretary of the Treasury and former contender for the office of Federal Reserve Chairman, recently wrote about President Trump’s criticism of Federal Reserve policy:

“No self-respecting central banker can be seen as yielding to pressure from a politician.”

Of course Professor Summers knows that there have been many instances over the decades of U.S. presidents and administrations exerting pressure on the Fed.  As Allan Meltzer wrote in his monumental A History of the Federal Reserve, “Missing from most explanations by economists is the political dimension.  By law the Federal Reserve was an independent agency.  In practice, it responded to political pressures.”

Interestingly, at the same time as President Trump’s criticisms, half a world away, the government of India’s Prime Minister Narendra Modi is putting much more pressure on India’s central bank, the Reserve Bank of India.

So India, a huge country with a big economy, a parliamentary democracy and a sophisticated central bank, has been having a highly interesting debate of the issue.  The Reserve Bank has maintained that its independence is a central principle, with its Deputy Governor Viral Acharya pronouncing that “Governments that do not respect the central bank’s independence will sooner or later…ignite economic fire and come to rue the day.”  Does this mean he thinks a central bank has no boss, no political accountability?

Under the original Federal Reserve Act of 1913, the executive branch was assumed to have an important voice in central bank affairs, since the Secretary of the Treasury was by law the Chairman of the Federal Reserve Board. This provision was removed in the Banking Act of 1935, which certainly pleased the new Fed Chairman, Marriner Eccles, when he assumed the role in that year.

In the Indian context, the Prime Minister’s government has a stronger hand than does a U.S. administration.  The central bank’s chartering act, the Reserve Bank of India Act of 1934, provides:

“The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.”

Although this power apparently has never been explicitly used, it could not be clearer: Have a discussion about the issues with the central bank, and then if you think it “necessary in the public interest,” tell the bank what to do and the bank has to do it.  While “the market and the banking system have been abuzz that the rift between the government and the RBI had reached a point of no return,” as India Today put it, the government has been forcefully and publicly reminding the Reserve Bank about this unambiguous provision of its chartering act.

Professor Summers, in the same essay as quoted above, added like a good two-handed economist, that on the other hand:

“There is a need for pragmatism regarding the independence of central banks.”  And: “It is foolish to suppose that a nation’s financial policies should be conducted independently of its elected officials.”

So the unelected central bankers should not be so independent, after all?  Arthur Burns, Chairman of the Fed in the inflationary 1970s, reportedly characterized such pragmatism, or political realism, in these memorable terms:  “We dare not exercise our independence for fear of losing it”!

What does the present Indian government consider necessary in the public interest?  First, it wants to get its hands on what it says are the “excess” retained earnings of the Reserve Bank, and more of the bank’s annual profit, in order to have the money to spend.

It may be of interest to compare the Federal Reserve’s situation in this respect.  The Congress has three times taken some of the retained earnings of the Federal Reserve Banks—half of their surplus in 1933 to fund the new Federal Deposit Insurance Corporation; $19 billion in 2015 to fund highways in a transportation act; and another $2.5 billion in 2018 to fill a gap in a budget deal.  Although it was “a raid on the capital base of the nation’s central bank,” as one critic said, it happened anyway.  As for profits, the Fed pays almost all of its annual profit, about 99%, right over to the U.S. Treasury.  The resulting consolidated Federal Reserve balance sheet has a trivial capital ratio of 0.9%.  Is that enough?  Who gets to say?

Prime Minister Modi’s idea of getting money to spend from the central bank’s reserves and profits is hardly a new idea.

Second, the Indian government wants the Reserve Bank to ease its regulatory constraints on banks which already have high ratios of bad loans, in order to promote more lending now, with as is often noted, an election coming up. That may be a bad idea, but who is the boss when it comes to financial regulation?  In the U.S., it is certainly the Congress, although the Fed and other regulators have significant discretion in interpretation.

After a marathon meeting of the Reserve Bank of India’s board on November 19, the bank agreed to reassess its policy on reserves and its rules for troubled banks. It does not seem too hard to guess what direction the “reassessment” will take.

While the immediate issues are about regulatory policy and helping out the government budget, the classic “independence” argument is that central banks should be independent in monetary policy, as their essential mandate. This aspect of independence has also been debated in India.  In contrast to its government’s preferences and to President Trump’s comments, recent Federal Reserve reform bills in the House of Representatives which would have subjected the Fed to significantly increased oversight, nevertheless always protected monetary policy independence.  Is that distinction a sacred principle or a sacred cow?  In U.S. history, the Truman administration, wanting the Fed to help finance the Korean War, certainly didn’t believe in it.  Will it be respected as the government of India continues to push the Reserve Bank?

It will be instructive to observe the continuing developments there, including the competing rationales and rhetoric.  As an example of the latter, “The independence of the central bank is still intact,” said one economist after the November board meeting—perhaps he proposes to redefine “independence.” “We don’t think that this issue has been fully solved yet,” said another.  For sure not–stay tuned.