Two BRICS member countries, India and South Africa, have recently experienced rather unedifying episodes related to the leadership of their central banks.
Raghuram Rajan, the governor of the Reserve Bank of India, was recently harassed out of the job by politicians belonging to the ruling Bharatiya Janata Party (BJP) party. The South African Reserve Bank, which has remained free of noticeable political interference, is having to manage signs of unhappiness about its position from senior governing party politicians aligned to President Jacob Zuma.
These incidents represent potentially grave threats to the independence of the countries’ central banks and by extension the proper functioning and credibility of key state institutions and economic performance.
There are still vigorous debates globally about central bank independence. I would argue that whatever the formal legal or constitutional prescriptions, it is imperative that the mandate and the decisions of a country’s central bank are understood and respected. The mandate of a central bank is materially linked to a country’s economic fortunes.
That’s not to say that the way central banks operate cannot be improved. A lot can be done to democratise an independent central bank without removing or threatening its independence. These relate, for example, to the way that monetary policy operates, its composition, its transparency and its accountability.
The Reserve Bank of India’s recent experiences make for a useful comparison with what is happening in South Africa, though the two cases are by no means identical in principle or detail. But both point to the fact that it’s possible for political parties to meddle in the affairs of central banks, even if there’s been a long history of independence.
The case of the Reserve Bank of India
Rajan, the governor of the Reserve Bank of India between 2013 and 2016, is a renowned economist. Reputed to be a free marketeer, he served as chief economist at the International Monetary Fund before taking the governor job. He is also credited with having the predicted the financial crash of 2008.
A year after he was appointed by the Congress Party’s Prime Minister Manmohan Singh the Bharatiya Jana Sangh (BJP) won national elections and came to power under the leadership of Narendra Modi.
From 2015 and intensifying into 2016 Rajan came under a blistering and persistent attack and hostility from elements in the right wing BJP government. In particular, his public calls for “social tolerance” (Hindu-Muslim cohesion) clashed with the Hindu-first agenda of the BJP.
The main attack dog was Subramanian Swamy, a BJP member of India’s Lok Sabha (lower house). Writing to Prime Minister Modi, Swamy accused Rajan of attempting to wreck the Indian economy. He contended that the central bank governor was “mentally not fully Indian” since he has a US green card.
Modi had initially publicly praised Rajan. But in the end both Modi and Finance Minister Arun Jaitley just stood back. Without government support Rajan felt his position untenable and decided against a second term for which he was fully eligible.
The notion of independence
The notion of promoting central bank independence was vigorously promoted in the 1970s and early 1980s. This was when academic economists and policymakers had fallen under the spell of the dominant “new neoclassical economics” school of thought. They became increasingly concerned about potential political interference with the operations of central banks.
This movement was followed by widespread insertion of central bank independence into law. At least 30 countries around the globe legislated central bank independence between 1990 and 1995.
The usual argument for central bank independence is that monetary policy is too important to be left to governments and the general public. It is thought that a government might use monetary instruments - such as raising or cutting interest rates - to further its own electoral ends.
On the other hand electorates might want a central bank to take a more benign approach to inflation. For example, South Africa’s Congress of Trade Unions has argued that the country’s inflation target (3% - 6%) should be scrapped because the central bank has to raise interest rates to keep inflation within the band. This in turn affects economic growth, particularly job creation.
Both of these pressures, it is argued, would lead to greater inflation. I agree that high levels of inflation can be damaging, particularly for the poor who can least afford to cope with rising prices. But I also don’t believe that fighting inflation single-mindedly through raising interest rates is the best route either. This is because higher rates are likely to damage investment, growth and employment.
The nuance here is that countries can live with moderate inflation as long as growth rates are robust enough. Some degree of inflation is good compared, for example, with deflation - when prices drop to the point that the “inflation” rate falls below zero. This can push a depressed economy into recession.
The counter argument
The counter argument to central bank independence is that monetary policy is too important not to be subject to democratic political processes. The monetary policies central banks formulate and implement, such as keeping rampant inflation in check, are a key determinant of a country’s macroeconomic performance and of the electorate’s economic well-being.
Democratically elected governments are held responsible for that performance. Why, then, should central banks not be held accountable in the same way?
In addition to this, decisions made by central banks are not just technical decisions to be left to a group of experts. They involve judgements about trade-offs. The most fundamental one is whether inflation or unemployment is a greater economic priority in any particular society. These trade-offs should therefore represent the values of people who make up society.
In the case of South Africa the central bank’s independence is enshrined in the country’s constitution. This means that it may be relatively safe from a full frontal attack by the Zuma faction in the ANC. But expect constant carping from the sidelines if this faction sees it standing in their way, especially on matters related to exchange controls and the outflow of capital. If indeed the Gupta family, which is closely associated with Zuma, pulls out of its investments in South Africa as it has announced it will do, this may become a reality sooner that we think.