Fiscal policy: A long view

Published : Sep 02, 2000 00:00 IST

Barring the 1950s when it adopted a restrictive monetary policy to fight off inflationary pressures, the RBI functioned as the handmaiden of the government ever since its establishment in 1935. It is only since the 1990s that it has attempted to reinvent itself to regain its hard-earned control of the monetary system.


CENTRAL banks are essentially 20th century institutions whose emergence affirmed the nation-state's evolution as an economic entity and was a dirge of lament at the demise of the open 19th century world economy. The 1920s saw the birth of many central ba nks under the tutelage of the Bank of England, which attempted to set itself up as a secular Vatican of monetary orthodoxy two decades before the Bretton Woods institution, the International Monetary Fund (IMF), came into existence in that role. The Bank of England intended these central banks as the first line of defence of an open international economy and the embattled financial oligarchy sponsoring it, against growing democratic and anti-colonial sentiment in their respective countries.

Ever since, central bankers and central banking have been in the thick of politics even when they profess to be guided by seemingly neutral and technical principles. In the 1920s Bank of England officials regarded themselves as practitioners of an esoter ic calling whose precepts were beyond the understanding of economists, let alone the lay persons who lost their livelihoods because of the bank's policies. But as Keynes's questioning of Montagu Norman, Governor of the Bank of England for a quarter of a century and the high priest of inter-war central banking, in the Macmillan Committee (1931) revealed, this self-conscious priest had little idea about how the economy or how its policy instruments worked.

The fortunes and stature of central banks declined the world over during the next half-century as most countries, including advanced industrial economies, imposed wide-ranging controls on external transactions and governments began to play a bigger role in managing the economy, often with a view to promoting employment. Though central banks began to re-emerge from the shadows two decades ago, the determined use of the Federal Reserve and the Bank of England by President Ronald Reagan and Prime Minister Margaret Thatcher to fight their respective political battles brought these institutions little credit.

The mid-1990s saw the re-invention of Alan Greenspan as a savant and of the Bank of England as a public institution following transparent policies made by a technical committee. But as Joseph Stiglitz's recent article in the New Republic on the IM F's handling of the 1997-98 crises shows, whether this institution (which is arguably the world's central bank) acted in the way it did from dogma or deceit, its reputation has not been enhanced by those events. Recent European Union (E.U.) wrangling ove r the powers of the European central bank have also brought the political aspect of monetary policy to the fore.

In India too politics and monetary policies have often gone hand in hand. In 1913, Keynes mooted a central bank as a means of deepening the Indian financial system. But the Reserve Bank of India was set up in 1935 to protect London's financial interests from damage at the hands of the representative government that was expected to take office under the Government of India Act, 1935. In the event, this Act made 'finance' a 'reserved' subject to be handled by a non-elected British official. Meanwhile, the RBI's plan went horribly wrong for the Government. Set up as a share-holders' bank in the hope of insulating it from nationalist politics, British officials in India were aghast to find businessmen with Congress sympathies being elected to the bank's ce ntral board.

In 1936, this central board wanted to ease the monetary policy to help weather a depression, which, because of the government's policies, had lasted longer in India than elsewhere. The board's views found an unexpected champion in Osborne Smith, the Aust ralian banker hand-picked and trained by Norman to head the new institution. But P.J. Grigg, an angular but orthodox treasury mandarin exiled to India as finance member, refused to heed this recommendation. Worse, suspecting Smith's loyalty, Grigg had hi s mail, and that of his alleged mistress, intercepted, and their telephones tapped. No evidence was found against Smith, but a violent slanging match between the two ended with Grigg threatening to put in his papers if Smith was not made to go. The first Governor of the RBI was compensated for his unceremonious exit with a generous pension and inclusion in the King's birthday honours list.

By comparison, the next two decades were years of relative peace for the RBI though it had, in the meantime, passed into public ownership and had, in 1951, energised itself under B. Rama Rau to adopt a restrictive monetary policy to fight off inflationar y pressures arising from the Korean boom. The bank's tranquility was interrupted in 1956 when T.T. Krishnamachari succeeded C.D. Deshmukh as Finance Minister.

Probably independent India's most imaginative Finance Minister, TTK had strong views on monetary policy. As an energetic back-bencher in Parliament he had crossed swords with Rama Rau over the future of the Imperial Bank of India. As Finance Minister he did not hesitate to make public pronouncements on policy matters that had earlier been handled by the RBI. Financing the Second Five-Year Plan was proving to be a heavy burden on the economy, and TTK's attitude towards institutions such as the RBI tended , against this background, to be instrumental, even ad hoc. Rama Rau, on the other hand, was protective of the RBI's autonomy, and it was not long before the two attitudes came into conflict.

TTK and Rama Rau differed over the monetary policy in the 1956-57 peak season. But differences broke out into open quarrel between the Finance Minister and the Governor in November 1956 when the former took powers to vary the stamp duty on bills, and thu s, indirectly, the effective RBI lending rate against bills under its bill market scheme. As if to add insult to injury, TTK told Parliament, while tabling his supplementary tax proposals, that the stamp duty was a "fiscal measure with monetary intent". According to B.K. Nehru's memoirs, TTK reportedly objected to Rama Rau lobbying against the stamp duty with Prime Minister Jawaharlal Nehru and his Cabinet, and when the two met afterwards, "let fly in no uncertain terms and in the loudest of voices". TT K followed it up by making public criticisms of the RBI and the State Bank. Both took their case to Nehru. Obviously loathe to let another Finance Minister go - it had only been a few months since Deshmukh had departed over the future of Bombay but two decades since a RBI Governor had been made to quit - Nehru sided with TTK and acquiesced in Rama Rau's resignation.

RAMA RAU'S successor, H.V.R. Iengar, and TTK worked closely, though not without their differences. It was TTK's responsibility to find resources for the ambitious Second Plan, but the RBI and Iengar were deeply worried about the inflationary impact of th e government's spending programme and its manner of financing it. These differences came out into the open towards the end of the Second Plan (by now Morarji Desai had replaced TTK who was forced out of office by the Mundhra affair) and in the early year s of the Third Plan period. If newspaper reports are to be believed the RBI pressed higher interest rates upon the government in 1960 and again two years later. The government was in no mood for anti-inflationary measures that pushed up its own costs of borrowing, forcing a rather frustrated Iengar to note on the eve of relinquishing office in 1962 that differences over monetary policy were likely to drive a deep wedge between the bank and the government.

No government can keep nominal interest rates down in a competitive market without affecting the market for its own loans. But this danger could be averted if quantity controls over credit were put in place and the capital market were segmented. Since 19 51, the RBI's major means of placing commercial banks in funds was by lending to them in the busy season (October to April) against government paper. With the government resisting increases in the Bank Rate, from 1960 the RBI began to restrict commercial banks' access to its accommodation through a variety of quota schemes. Shortly afterwards, the capital market was also effectively segmented by raising the 'liquidity' requirements of banks through the statutory liquidity ratio (SLR). In 1956, an innoce nt RBI agreed to lend virtually without limit to the Government of India against ad hoc Treasury Bills. This and the SLR requirements, which was to some extent the bank's own insurance against the government's excessive recourse to ad hocs, together help ed relax market-checks on the government's borrowing programme. Consequently, though interest rates hikes could not be avoided as the economy went deeper into crisis towards the mid-1960s, credit control increasingly came to mean controlling private sect or credit through an exceptional degree of micro-management of credit allocation between users, sectors and industries.

These initiatives inevitably marked the institutional weakening of the RBI vis-a-vis. the government. A good instance of the RBI's growing irrelevance to policy-making is offered by the 1966 devaluation of the rupee. Although its Governor, P.C. Bh attacharyya, was an active participant in the exercise, no one else at the bank, including its Deputy Governors, was involved in the decision. For the next two decades, the RBI functioned rather (as TTK intended), as a hand-maiden of the Finance Ministry . It is only since, and especially in the last decade that the institution has attempted to steer a more independent course. But as its mixed success in arresting the rupee's current slide shows, the RBI's hard-earned control over the monetary system cou ld already be under threat from the markets.

G. Balachandran teaches at the Delhi School of Economics.

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