| The notorious and still unfolding "sub-prime" mortgage crisis and its credit crunch aftermath last month in the US and other major OECD economies have blown a few holes in the new orthodoxy. It's useful to review the salient points and try to distil some lessons for India's monetary/financial policy in today's turbulent financial world. |
| The UK provides perhaps the best example of a wholesale shift to the new orthodoxy as well as some of the key weaknesses recent events have exposed. Within a few weeks of coming to power in 1997 the new Labour government's chancellor of the exchequer, Gordon Brown, implemented the three key pillars of the new orthodoxy in the UK. The Bank of England (BoE) was made independent. It was fully mandated to pursue the primary objective of inflation control, with explicit inflation targeting. The Bank's supervisory/regulatory functions were taken away and given to the newly established Financial Services Authority (FSA). For a decade the new system worked fine. Then, this September, as the ramifications of the US sub-prime crisis unfolded, it all came apart when the brave new ship of the new orthodoxy ran aground on Northern Rock, the UK's fifth biggest mortgage bank. |
| The events are well known and need no recounting. But the crisis did raise serious questions about the new orthodoxy. Can you really have an independent central bank when "the mother of central banks", the BoE, was seen to reverse its public stance within a matter of days, apparently under severe pressure from the government? In mid September, the governor, Mervyn King, was extolling tough central banking scriptures about not bailing out imprudent financiers. Within a few short days he was doing just that, while the UK Treasury was guaranteeing bank deposits (and to hell with the doctrine of discouraging "moral hazard"). Like it or not, financial stability and maintaining economic activity had become the primary concerns of the BoE, with inflation targeting put on the back burner. Nor did the FSA escape unscathed. Its supervision of Northern Rock had clearly been far from perfect. Questions were also raised about the separation of the supervision function (with the FSA) from the task of providing emergency accommodation (with the BoE). |
| Across the Atlantic, the Federal Reserve's actions also demonstrated pretty obviously that low inflation was only one of its major objectives. The reduction of the Fed's discount rate, the loosening of collateral provisions and the half per cent cut in the Fed Funds rate in September all clearly showed that Governor Bernanke and his colleagues accorded great importance to the other worthy objectives of preserving financial stability and maintaining the rate of US economic activity. Indeed, these three objectives of low inflation, financial stability and maintaining economic activity close to potential are really no different from the RBI's stated objectives. And it should not be surprising that, in fact, if not in rhetoric, serious central banks give major weight to all three. It's only the acolytes of the new orthodoxy who get carried away by the slogan of "inflation control as the sole objective". |
| If vindication of multiple objectives for sound central banking is one lesson of the recent crisis, what are some others? What about the doctrine of independence for central banks? Well, the September crisis in the UK suggests that whatever the legislation or the professed doctrines, in a crunch, the Leviathan (the government) tends to prevail. That does not mean good central banking should abandon the principle of autonomy and independence. It just means that in the real world such independence can never be absolute, and especially not in crunch situations. In India, with a relatively undeveloped culture and conventions for conferring true autonomy (from government) to public institutions, there may be still a case for legal amendments to enhance the RBI's independence. But such efforts should not feed the illusion of absolute independence. |
| How about the much hyped "single regulator" model? Have recent events discredited it? My sense is that the jury is still out on this one. In any particular country, what may matter more is not the form of the model prevailing (single vs. multiple regulators) but how well or badly it is worked and coordinated with the central bank and government by the incumbents and how much real acceptance the structure commands in the financial community and, more broadly, the larger society and polity. These are as much (or more) a product of institutional history and political/administrative culture as the organograms of particular models. In India, I think it would be premature, at present, to expect much success with the FSA type single regulator model. Besides, with our weak and unwieldy coalition governments, who has the stomach for the required legislative overhaul? |
| Finally, the sub-prime crisis and its credit-freezing aftermath have shown that even very mature and established central banks, financial supervision authorities and the respective governments of rich, industrialised nations resort to somewhat eclectic and ad hoc solutions and responses when confronted with unforeseen and serious, systemic financial problems. Against this background it should be easier to sympathise with the Indian authorities' recent and somewhat untidy efforts to grapple with the unprecedented surge in foreign capital inflows and their destabilising consequences. The shrill and simplistic critiques of over-zealous "market fundamentalists" are not very helpful. Nor, of course, is blind defence of any and all public regulatory interventions. |
| The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. The views here are personal |
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