By T T Ram Mohan
Central bank independence is an idea that came out of the stagflation in advanced economies of the 1970s. High inflation did not lead to reduced unemployment – the world discovered the truth that the Philipps curve trade-off exists only in the short-run. If you keep boosting money supply for too long, you get only inflation without the associated benefits of reduced unemployment.
So politicians decided they would leave it to central banks to decide monetary policy as a means of imposing overall macroeconomic discipline. Central banks would then no longer underwrite unlimited government borrowings and this was good for the economy.
Now central bank independence is under threat and it’s not on account of politicians, the Economist points out. The problem is the steady decline in interest rates in recent years, culminating in negative interest rates in many countries. Monetary policy no longer appears effective and this undermines the authority of central banks.
Moreover, the tool that some banks have resorted to, Quantitative Easing, which involves massive purchases of government bonds, amounts to the purchase of government debt using newly printed money – precisely what central bank independence was intended to avoid!
At the same time, there’s a general sense that fiscal stimulus has a key role to play in the present situation:
As monetary policy wanes in influence relative to fiscal policy, so will the importance of central banks.
Here in India, we have seen a movement away from the commitment to a 4 per cent inflation target on the part of the RBI. This has at least partly to do with the perception of the political authority that rigidity in respect of the inflation target of 4 per cent was coming in the way of higher economic growth.
Central bank independence is not ordained by the gods. It was a mechanism devised by politicians in response to a particular economic situation. You can count on politicians to reduce its importance in a different economic situation.
Prof. T T Ram Mohan is a professor of finance at the Indian Institute of Management, Ahmedabad.
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