RBI says monetary, fisc tension won’t go away easily

Reserve Bank of India governor D Subbarao said there is a possibility that the current high fiscal deficits across nations, that are being characterised as cyclical ones, may morph into being structural deficits and, consequently, undermine central banks’ independence.

The tensions between fiscal and monetary policies, which many believe are temporary, may not melt away with economic recovery as expected, Subbarao said.

“Many advanced country governments will not be able to wind down borrowing because of demographic factors and consequent growing social security payments,” Subbarao said at the International Research Conference organised here by the RBI.

Quoting a study by the IMF, Subbarao said government debt in the advanced economies could jump from the pre-crisis level of 78% of GDP in 2007 to 118% by 2014 even if one assumes some discretionary tightening starting this year.

“In such a scenario, what are now seen as cyclical fiscal deficits may, in fact, morph into structural fiscal deficits. We may then see the return of fiscal dominance and undermining of the independence of central banks,” he said.

According to Subbarao, most of the years since the Great Depression saw rivalry between fiscal and monetary policies for influence.

The latter usually suffered at the hands of the former, he said.
Support for central bank autonomy emerged from 1980s, as it was felt that expanding fiscal deficit and the consequent rise in inflation was detrimental to growth.

Fiscal dominance gradually yielded to independent central banks targeting largely, and in some cases exclusively, price stability, free of short-term political imperatives, Subbarao said.

However, notwithstanding their record on price stability, the crisis has dented the credibility of central banks, he said.

“The blame on central banks is wide ranging - loose monetary policies coupled with neglect of asset price developments, exclusive focus on inflation to the detriment of financial stability and lax and inept regulation that failed to keep pace with innovation.”

“There is resentment, if not outrage, against the famed independence of central banks; and there is an outcry for clipping their mandates and tightening the accountability mechanisms,” he said.

However, beyond the short-term, the threat to the independence
of central banks emanates from more critical factors - particularly from expansionary fiscal policies.

The case for central bank independence is coming under increasing assault as a result of crisis led developments, Subbarao said.

“The challenge for central banks is to make the case for independence not through weighty arguments but through more vigorous and voluntary efforts to be transparent, responsive and accountable.”

In his speech, Subbarao listed out the debate surrounding the position, a central bank must have, on asset bubbles.

He said the financial crisis has dealt a blow to the view that central banks must not address the issue of asset bubbles.

“The emerging view post-crisis is that preventing an asset price build-up should be within the remit of a central bank. Opinion is divided, however, on whether central banks should prevent asset bubbles through monetary policy action or through regulatory action,” he said.

There is a purist view that the case for monetary tightening to check speculative bubbles is questionable, he said.

“On the other hand, there is also a view that a necessary condition for speculative excesses is abundant liquidity, and that controlling liquidity should be the first line of defence against “irrational exuberance”, he said.

According to Subbarao, prior to the crisis, monetary policy had a
studied indifference to asset price inflation, which stemmed from the famous “Greenspan orthodoxy”.

The former Federal Reserve chairman Alan Greenspan had held a view that asset price bubbles are hard to identify on a real time basis, and the fundamental factors that drive asset prices are not directly observable. He had, therefore, felt a central bank should not second-guess the market.

Moreover, monetary policy is too blunt an instrument to counteract asset price booms, Greenspan had felt.

“In other words, it is not the job of central bankers to remove the punch bowl no matter that the party is getting wild,” Subbarao said, summarising Greenspan’s stand vis-a-vis asset bubbles.

“The crisis has dented the credibility of the Greenspan orthodoxy.”
Subbarao said a view that has emerged is that central banks have a role in preventing “bank centred” bubbles, but the instrument for this is not monetary policy but regulatory intervention.

“No matter how this debate settles, if it will at all, what is beyond debate is that central banks’ efforts to check asset price bubbles demands not just analytical capability but mature judgement of the nature of the risk,” Subbarao said.